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By Chris Vellacott
LONDON, March 12 (Reuters) - Efforts to restore financial stability in Ukraine face "exceptionally high" risks from further conflict and disgruntled creditors, the International Monetary Fund said on Thursday.
In a report by IMF staff released after the fund announced a $17.5 billion loan package, the IMF said the programme it was backing and Ukraine's journey back to economic health are most vulnerable to being derailed by renewed conflict in eastern Ukraine.
The fund's report also highlighted the risk that creditors holding Ukrainian bonds may balk at the terms being offered in a restructuring.
The overall package amounts to more than $40 billion. That includes the $17.5 billion of IMF loans, a further $7.5 billion in lending from other international organisations and $15.3 billion in debt relief that Ukrainian officials hope to gain from bondholders.
Debt-restructuring talks with holders of its sovereign debt, who include top fund managers Franklin Templeton, Blackrock and PIMCO, are due to begin on Friday, according to Finance Minister Natalia Yaresko.
"Creditors may balk at the terms being offered in the debt operation and holdouts may try to free ride," the IMF report said. "The negotiations may be protracted, particularly as some creditors have large positions in specific bond issues."
The financing package assumes $5.3 billion debt relief from the restructuring this year, $3.4 billion next year, $4.4 billion in 2017 and $2.3 billlion in 2018.
Questions remain over whether Russia, which holds $3 billion of Ukraine bonds, will participate in the restructuring.
The IMF also noted that reforms -- which hinge on strengthening public finances, repairing bank balance sheets, shaking up the energy sector and running a tight monetary policy to stabilise its currency -- could be blocked by "vested interests".
"Ukraine's track record on program implementation is weak and punctuated by repeated false starts," the fund said in its assessment of the reform package.
"In fact, in key policy areas such as the exchange rate regime, energy sector, anti-corruption, and agricultural VAT, progress was stalled in the past under pressure from vested interests."
The IMF conceded, however, that Ukrainian authorities made progress in addressing these issues in connection with an earlier loan agreement approved last year. That loan is now deemed insufficient in light of Ukraine's ongoing conflict with pro-Russia separatists in the east.
The fund noted that the reform package, if successful, could leave Ukraine with a more robust long-term outlook because the current crisis presents the country with a unique opportunity to push through tough policies.
Ukrainian authorities proposed to the IMF a structural turnaround that will involve some belt tightening for their citizens, such as spending cuts and an energy-sector shake-up that will involve increases to household gas prices.
Monetary tightening aimed at stabilising the currency and replenishing foreign currency reserves would be helped by the IMF's intention to front-load its rescue package, pumping $10 billion into the economy in the first half year, the fund said.
Governance of the central bank will be bolstered in consultation with IMF staff. Banking sector supervision will also be tightened alongside anti-corruption measures and deregulation to lure back investors.
Reporting by Chris Vellacott; Editing by Larry King