By Natalia Zinets and Richard Balmforth
KIEV (Reuters) - The International Monetary Fund urged Ukraine on Thursday to raise gas prices for domestic consumers and introduce a flexible exchange rate for the hryvnia currency - both unpopular steps previously rejected by the Kiev government.
IMF mission leader Nikolay Gueorguiev laid out the Fund's view at the end of a 12-day visit to Ukraine, saying the ex-Soviet republic required a "set of comprehensive and credible reforms" to stabilize the economy and revive growth.
"Ukraine's significant external financing needs remain a key vulnerability," Gueorguiev said in a statement, referring to foreign debt repayments looming for gas deliveries from Russia and for servicing loans and credits, including to the Fund itself.
He zeroed in on the loss-making energy sector and called again for an end to the unprofitable practice of Soviet-era subsidies in which state-run oil and gas company Naftogaz sells gas to households and other domestic consumers at prices way below the level at which it buys from Russia.
"The large loss-making energy sector needs to be reformed," he said.
A priority measure was a "significant upfront increase" in the price of gas and heating for household consumers with a schedule adopted for further increases in future.
On the hryvnia, which the central bank keeps pegged at about 8 to the dollar as a symbol of national stability, Gueorguiev urged "increased flexibility" to boost export performance.
The IMF team was visiting Ukraine as part of a regular review of the country's economic situation. It froze a previous $15 billion stand-by program in early 2011 after Kiev refused to end subsidies and raise household gas and heating prices.
Kiev has not yet requested a new program but analysts expect its depleted finances mean it will eventually need one.
With a presidential election due in early 2015, President Viktor Yanukovich's government is reluctant to raise domestic gas prices and the issue has been seen in the past as a stumbling block in the way of any new loan deal with the IMF.
Ukraine's economy is dominated by steel and chemical exports, sectors which have been badly hit by weakening global demand.
But Kiev, which hopes to sign landmark agreements in November with the European Union to the dismay of its former Soviet master Russia, needs new credits to shore up depleted foreign currency reserves and cover a budget deficit.
Key indicators show the economic situation is significantly worse now than it was a year ago and analysts believe that Kiev may have to turn to the Washington-based lender soon.
Despite a hoped-for turn-round because of an all-time-record harvest this year, gross domestic product fell 1.5 per cent year-on-year in the third quarter - its fifth successive quarterly drop.
The IMF statement projected a budget deficit of 5.75 percent of gross domestic product this year- much higher than the government's target of 3.2 percent.
Though the IMF welcomed the authorities attempts to clear arrears in value-added tax owed to exporters, Gueorguiev implicitly criticized the government's policy of doing this by issuing promissory notes - a method which would only undermine future fiscal performance, he said.
The Ukrainian government last week gave the green light to a $1.5 billion promissory notes issuance to cover VAT repayments.
Efforts for fiscal consolidation should include wage and "employment restraint" in the public sector, subsidy cuts and "rationalizing" spending on goods and services, he said.
He supported the government's moves to put off cuts in VAT and corporate tax, which had been scheduled for 2014.
"Tax cuts should be postponed until the budget deficit is reduced to a sustainable level", he said.
The IMF also called for efforts to improve the business climate in Ukraine where potential foreign investors are often deterred by the threat of hostile takeovers, corrupt practice such as bribes, extortion and by red tape.
"We recommend a focus on structural reforms ... this includes revamping the judicial system, simplifying or repealing burdensome government regulations, stepping up anti-corruption measures and enforcing clear and consistent rules in tax administration," Gueorguiev said in the statement.
(Writing By Richard Balmforth; Editing by Susan Fenton)