By Paul Starobin in Odessa, with Roman Olearchyk in Kiev
Business Week Online: International--European Business
November 25, 2002

When it was privatized in 2000, the Odessa Oil & Fat Plant was a rusted hulk in the grimy Moldavanko section of Odessa, a Ukrainian city on the Black Sea. But Konstantin Grigorishyn, 36, a politically connected former physicist who built a fortune trading computers and currency in the 1990s, thought it had potential. After buying a controlling stake in the plant, he spent $12 million on top-of-the-line equipment. Sales have climbed from $20 million to $80 million since privatization, and the factory has captured 28% of the Ukrainian margarine market. Thanks to investments such as Grigoryshin's, Ukraine's $38 billion economy is on track to grow 4% this year.

So is it finally time to cheer for this former Soviet Republic as entrepreneurs rebuild an economy devastated by a decade of industrial banditry? No--it may be time to weep. A country with a history of political tragedy, Ukraine can't seem to avoid more heartache. A government scandal is threatening the country's budding but still-fragile economy and may thwart its long-range goals of membership in the European Union and NATO.

At the center of the tempest is President Leonid Kuchma, a 64-year-old former Soviet factory director. According to audio tapes secretly made by Kuchma's former bodyguard and recently authenticated by the Bush Administration, Kuchma, back in 2000, approved the sale of a Ukrainian-made Kolchuga aircraft-detection system to Iraq. The sophisticated device is capable of helping Saddam Hussein shoot down U.S. and British warplanes patrolling Iraq's airspace. It's not clear whether the system was actually delivered, but such a transaction would violate U.N. sanctions against Iraq.

The Bush Administration, which has suspended $55 million in U.S. aid while it ponders further action, is not accepting Kuchma's denial that he approved the sale. "Ukraine is at a crossroads," says a U.S. diplomat. "To be a part of the West, Ukraine has to act like the West."

With its vast swathe of fertile black earth and well-educated population of 49 million, Ukraine is an emerging market worth playing for. Big Russian conglomerates are snapping up refineries, metals factories, telcos, and milk plants. Western multinationals such as McDonald's Corp., with 51 outlets in Ukraine, Philip Morris Cos., with a $60 million tobacco plant, and Nestlй, with a $20 million candy factory, are establishing footholds. "They're all making money," says Jacques Mounier, head of the Crédit Lyonnais branch in Kiev. He estimates their returns at 20% to 30%.

But the Kuchma scandal is rattling markets. Mobile-telcom Kyivstar GSM recently halved a scheduled $200 million Eurobond placement, a first for a Ukrainian company. The Kuchma regime itself could have trouble placing the $500 million to $600 million Eurobond offering it needs to roll over debts coming due next year. "There is a chance of default," says economist Tetiana Sytnyk at the International Center for Policy Studies in Kiev. On Nov. 12, Standard & Poor's voiced concern over the "fragile integrity" of Kuchma's government and changed the outlook on Ukraine's B rating to negative.

The Iraq scandal is merely the latest embarrassment for Kuchma. The ex-bodyguard's audio tapes also implicate him in the gruesome beheading last year of a Ukrainian investigative journalist, Giorgi Gongadze, and a Kiev appellate court recently opened a corruption probe against him. Kuchma has denied any involvement in the murder.

As Kuchma fights to save his presidency, a pro-presidential majority in Parliament has collapsed. Proposed reforms, such as cutting the top rate of personal income taxes from 40% to 20%, are on hold as a result. That's especially painful since recent gains in economic growth are only just beginning to trickle down to workers, who earn an average monthly wage of $80.

Polls show that some 70% of citizens distrust Kuchma. Some are taking to the streets to demand his resignation--two years before presidential elections. At a Nov. 7 demonstration in Kiev, a throng of some 5,000 protesters chanted "Kuchma, het!"--Ukrainian for "Kuchma, out!" "Unemployment is flourishing, salaries are not paid on time, and prostitution is spreading," complained Mykola, 51, a worker who declined to give his last name for fear of being identified. "We don't need this regime."

Business barons as well as workers fear the regime. Grigorishyn's Energy Standard Group, which owns the margarine plant, has also invested $200 million in eight power plants. This money, the company says, came from Grigorishyn's activities in currency arbitrage, electricity and metals trading, and the financing of uranium-enrichment supplies for power plants. "We want to become the leading Ukrainian blue chip with fully transparent accounting," Grigorishyn says.

But Grigorishyn is scrambling. He claims a business clan connected to Kuchma wants to take control of his electricity holdings. The group, says Grigorishyn, is led by Viktor Medvedchuk, Kuchma's chief of staff, and has ties to a Russian gang. Grigorishyn recently fled to Moscow after being detained by police on suspicion of possession of cocaine and a pistol. Parliament Deputy Volodymyr Sivkovych, who chairs a committee on economic security, calls the detention a blatant setup. "The best business in Ukraine is politics," Grigorishyn grumbles. Medvedchuk, whom Kiev political insiders say could be handed the presidential post if Kuchma resigns, declined to comment on these allegations, as did Kuchma.

Kuchma is clearly no saint, but some policymakers wonder if there's any alternative. "The situation in Ukraine is not ideal," concedes National Security Advisor Evgeny Marchuk, "but it's predictable and stable." Kuchma's opponents dispute that contention, but they can't figure out how to oust him. Former Deputy Prime Minister Yulia Tymoshenko says the opposition must isolate the regime through street protests. "Ukraine is becoming an incubator and exporter of criminality," she says.

But former Prime Minister Viktor Yushchenko, the most popular opposition figure, believes radical tactics could unnerve citizens. Yushchenko has good ties with Western leaders, who like his emphasis on liberal economic reforms. But if the U.S. overplays its hand by coming down too hard on Kuchma, it risks being portrayed as a bully. That's why the best outcome would be the emergence of a nonviolent protest movement that forces Kuchma to step down in favor of early elections--akin to what removed Serbian President Slobodan Milosevic from power. Yet much as Kuchma is despised, most Ukrainians, following a tradition of passivity, haven't joined in the protests. "If the political regime is changed, it will happen because of the Americans, not because of the people," says Crédit Lyonnais' Mounier. So the question, it seems, is what the Bush Administration wants to do about another nation in its ever-more-crowded gallery of rogues.