KIEV Ukraine will start negotiating a $15 billion (9.5 billion pounds) loan with the International Monetary Fund this week with its position significantly weakened after a shock gas bill from Russia.
The talks, starting on Tuesday, were planned before Ukraine's gas company Naftogaz was presented with the $7 billion bill from Russian gas giant Gazprom (GAZP.MM) last week.
But the huge bill adds to the $9 billion of foreign debt which Ukraine needs to repay this year and may force the country to be more open to the IMF's austerity prescriptions.
However, accepting the Fund's tough lending conditions could have longer-term political implications for the Ukrainian leadership and negotiations on the deal could take months.
"The IMF will likely demand tough fiscal austerity, gas price hikes and foreign exchange market liberalisation as the minimum price for any deal - any programme will also be long on prior actions and short of front loaded cash disbursements," Standard Bank analyst Timothy Ash said in a note on Monday.
"Ukraine's room for negotiation has suddenly shrunk quite considerably."
Gazprom says the bill is for imports of gas which the former Soviet republic, Russia's biggest importer of natural gas, never took last year but which it is still obliged to pay for under a "take or pay" clause in a 2009 10-year contract.
Domestic gas and heating prices are the main stumbling block in the talks, due to end on February 12, and disagreement over the issue prompted the IMF to suspend Ukraine's previous programme in early 2011.
Ukraine buys natural gas from Russia and then resells it to households and heating companies at a discount, with the state budget absorbing billions of dollars in losses every year.
Abolishing the subsidies, as suggested by the IMF, would be a politically risky move for the Kiev government and personally for President Viktor Yanukovich who plans to run for a second five-year term in 2015.
For the last two years, his government has been trying to negotiate a discount on Russian gas supplies instead while cutting gas imports.
But these talks have produced no results.
The surprise $7 billion bill - which took the gloss off a Ukraine $10 billion shale production deal with Royal Dutch Shell (RDSa.L) aimed at reducing Kiev dependence on Russian gas imports - is likely to weigh heavily on relations with Moscow.
It will also rob Ukraine of the argument - used in previous discussions with the IMF - that a new, favourable gas pricing agreement with Moscow is just around the corner and thus there is no need to raise domestic gas prices.
Prime Minister Mykola Azarov - who promised voters last year he would not raise utility prices - hinted at a possible shift in position this month, saying the government was ready to hike gas and heating fees for high-income households.
"The government proposes passing some of the (gas price) burden... onto the rich," he told a government meeting.
Azarov and other officials have not explained how exactly utility providers would tell rich consumers from the poor ones.
"The prime minister's latest statements indicate that Ukraine is ready to move towards a compromise with the IMF on (gas and heating) prices," Dragon Capital economist Olena Belan said.
Even so the government may find it hard to get money from the Fund quickly and without committing to a larger reform plan.
"We are sceptical that a timely program will be agreed upon unless market pressure increases," Goldman Sachs analyst Andrew Matheny said in a note last week.
"Our base case is that this will happen in the second quarter of 2013 and that an IMF program will be accompanied by a currency devaluation of around 30 percent."
Ukraine's central bank has kept the hryvnia pegged at about 8 to the dollar since early 2010, selling dollars from its reserves in order to support the currency.
The bank says that allowing depreciation would lead to panic and hurt the banking system while its critics argue that the peg is eroding the competitiveness of the already troubled steel industry, Ukraine's main exporter.
Ukraine, in the meantime, can take advantage of low interest rates on the bond market where spreads on its debt have fallen to a 15-month low.
(Additional reporting by Natalia Zinets; Editing by Richard Balmforth and Anna Willard)