Ukraine - Export Development Project

Report No. PIC3291 Project Name Ukraine-Export Development Project Region Europe and Central Asia Sector Non-Sectoral, Private Sector Development Project ID UAPA44851 Borrower State Export Import Bank of Ukraine Guarantor Ukraine Implementing Agency State Export Import Bank of Ukraine Mr. Alexander N. Sorokin, Chairman of the Board 8, Kreshchatik Str., Kiev-1, 2001, Ukraine 380 44 226 2745 (tel) 380 44 229 8082 (fax) Date Initial PID Prepared February 16, 1996 Date This PID Updated February 26, 1996 Projected Appraisal Date May/June 1996 Projected Board Date August/September 1996 Country Background I. Ukraine joined the World Bank on September 3, 1992. A first Country Economic Memorandum, dated June 1993, focused on macroeconomic developments and presented a framework for systemic change and structural reforms. The first Bank lending operation, an Institution Building Loan of US$27 million, was approved by the Board in June 1993. The following twelve months, however, were characterized by hyper- inflation, economic mismanagement, and irresolute structural reform. Hence, the Bank group's activities remained limited. II. After the mid-94 election, and the new Government's commitment to a strategy of stabilization and economic adjustment, the Bank expanded its activities. A Rehabilitation Loan of US$500 million in support of major economic reforms was approved in December 1994. In April and May 1995, investment loans for Hydropower Rehabilitation (US$114 million) and Agriculture Seeds (US$32 million) were approved. Ukraine has been a member of IFC since 1992 and of MIGA since 1993. IFC has an active technical assistance program in privatization and has made one equity investment. A draft Country Assistance Strategy has been prepared which provides detail on recent economic and structural developments. Project Description and Financing III. The proposed Export Development Project (EDP) will support the development of Ukraine's emerging private sector export potential by supporting production of goods and services for export in all sectors of  the economy. The project will provide: (i) credit finance to private exporters (US$50 million), (ii) technical assistance (TA) for the institutional development of the State Export Import (EXIM) Bank of Ukraine in the form of a twinning arrangement with an experienced foreign EXIM bank (US$5 million), and (iii) export development TA to private exporters (US$5 million). IV. Total project cost is estimated at US$60 million. EXIM will be the Borrower of the Loan as well as the implementing agency. The Government will provide a sovereign guarantee for the Loan. The beneficiaries of the credit finance will be private and privatized enterprises. Credit allocation decisions will be taken by EXIM using predetermined commercial sub-borrower and sub-project eligibility criteria. The credit risk for sub-loans to enterprises will be borne by EXIM. Project Rationale V. Macroeconomic Reasons for Export Promotion. Exports are a very important engine of growth in Ukraine. All CEE and other transition countries that have achieved positive growth rates have done so on the back of a strong and continuing surge of exports especially to Western markets. This should be no surprise: consumption will remain weak after the output drop and increasing fears of unemployment; private sector investment will remain low because of regulatory, tax and general policy uncertainty, and slow progress in privatization; and the Government itself will have to retrench under the impact of higher social expenditure and continuing difficulties in tax collection. This leaves exports as the primary engine of growth. VI. Experience in CEE and other transition economies confirms that, even though part of existing production capacity may be unusable (i.e., producing inferior products for which there are no markets), export growth has built predominantly on efforts to more effectively and efficiently use existing capacity. Thus, there is a clear case for policy intervention. Export promotion, through multiplier effects in the rest of the economy, is an obvious and legitimate intervention. However, if a recovery is to be sustainable, it will have to be private sector driven and based on profitable activities. The Government is in no position to subsidize the economy out of the crisis. VII. Microeconomic Reasons for Export Support. Private companies are mostly new in export markets. Even those with a past history as state enterprises do not have a strong Western orientation. This creates acute problems in financial markets, which are based on mutual trust and a recognition of mutual interest in continuing customer relationships. In Ukraine's uncertain legal environment credit relations are sustainable only if both parties know each other sufficiently to have faith in each other's interest in a continuing business relation and the associated intention to deliver on commitments. VIII. This characteristic of financial markets creates catch-22 problems for any company trying to enter a new market. To be trusted as a commercial partner it needs a presence in the market to maintain effective credit relations, but to establish such a presence it requires the very credit relations for which that market presence is a - 2 -  prerequisite. Given the crucial macroeconomic importance of a successful export drive, this microeconomic problem requires urgent attention. IX. Such credit market problems are especially urgent across international boundaries. First, legal recourse, as a practical matter, is essentially unavailable in the case of payment conflicts, which greatly increases the importance of mutual trust in establishing credit relations. But the information gap that needs to be bridged to establish such relations is especially large between potential partners from different countries. This problem is exacerbated when the firms involved are new. This is one of the reasons why export financing merits special attention and usually special institutions. X. The export sector is also the sector where the demand for financial services is most likely to pick up first. Consumer credit is virtually non-existent, and private investment is barely taking place: a situation which, if the recent history in CEE is of any guidance, will not change much for some time to come. Exports on the other hand will surge if proper policies are followed, creating an immediate demand for the associated financial services. Thus, working on credit market problems in other sectors may for some time look like pushing on a string, improving supply while demand is not yet there. Arguably financial sector support in the domestic markets should focus on restructuring, restoration of balance sheets, establishing proper ownership and incentive structures, establishing proper expertise and procedures, etc., and not yet on product development and support. The problem is clearly different in export markets, however, as demand for export finance is demonstrably there and there is a reasonably structured and working intermediary (EXIM - see paragraph 20 below) to act as counterpart. These considerations strongly argue for singling out export finance for a project early on in a wider ranging long term financial reform program. XI. Moreover, there is more to export support than the provision of modern financing facilities. In most countries export financing institutions do a great deal more than export financing. In particular small companies will have difficulty justifying the fixed costs of investing in information gathering, promotion of name brand recognition, acquisition of a reputation as reliable supplier, and so on. A substantial part of such costs can be more efficiently delivered by a central agency since organizing it for many firms is not much more expensive than organizing it for one firm. Examples are the setting up of a database with useful contacts in various regions of the world, provision of information on tax regimes, customs regulations and so on. Because of the non-exclusive nature of such services, substantial efficiency gains can be had by concentrating this type of activity in one place. EXIM would be a natural candidate because it already provides export oriented financial services, and because of its established name recognition. In fact, lessons learned within the Bank indicate that such activities are often the most successful in export development programs (see paragraphs 24- below). XII. In summary, jump-starting a private sector based recovery in Ukraine is key to the sustainability of the still fragile reform process. Experience elsewhere suggests that exports are the only likely -3 -  venue through which such a recovery can come about. This project will thus make a key contribution to consolidating the reform process and establishing the private sector as the dominant factor in Ukraine's economy. Bank Strategy XIII. The Bank is well advanced in preparing an Enterprise Development and Adjustment Loan (EDAL) which is expected to be appraised in the near future. The EDAL extends the work on enterprise development initiated in the 1994 Rehabilitation Loan and is designed to expedite the completion of the mass privatization of medium and larger enterprises, and to facilitate further small enterprise privatization. In addition, the EDAL will provide post-privatization support to enterprises, by strengthening the main capital market institutions and by facilitating the restructuring of privatized enterprises and improving governance. The EDAL will also address remaining issues in Ukraine's trade regime in order to encourage the external trade expansion upon which the success of Ukraine's overall reform program depends. XIV. Ukraine's exports total over $12 billion and imports are in excess of $14 billion. These totals are expected to grow significantly during the next few years as reform proceeds. At the same time, an increasingly large part of trade will involve new and newly privatized enterprises, will be to Western and other non-FSU markets and will be arranged strictly on commercial terms. This new trade will need a volume and range of financing products which does not exist at present but which the EDP is being designed to provide. Hence, the proposed project provides necessary support to the established reform program in the enterprise sector and specifically to the many newly privatized enterprises which will depend on export markets for their future survival and prosperity. XV. The EDP is also designed to contribute directly to the strategy for the financial sector as outlined in the Financial Sector Review (FSR) of June 1995. This strategy seeks to speed up the differentiation between strong, well capitalized and well managed banks which need to achieve expansion, and banks which are financially and managerially weak and may need to be closed or down-sized. This will be achieved both by bottom-up direct institutional strengthening of individual banks or groups of banks, and through top-down pressures towards improved bank performance through improved regulation and supervision, and a better legal and accounting environment. XVI. The bottom-up approach is already being pursued in the context of an EBRD line of credit for SMEs channelled through the better private banks. The Bank's own Financial Institutions Development Loan (FIDL) scheduled for Board presentation in FY1997 will complement this work both by extending the numbers of banks eligible for credit line participation, and by providing finance for larger potential sub-projects. As is the case with the EBRD operation, all banks seeking access to the Bank's credit line will need to implement substantial institutional strengthening both in terms of their capitalization and operational policies and procedures. As part of the preparation for the - 4 -  FIDL, grant funding has been mobilized to finance in-depth TA support to two of Ukraine's largest banks (formerly state-owned in both cases) through twinning arrangements with reputable Western banks. XVII. In line with the recommendations of the FSR, the top-down approach is being pursued through extensive TA especially in the areas of NBU supervision of banks, accounting reform and the reform of collateral and bankruptcy law. For the moment these programs are being delivered mainly by other donors with the Bank involved as a key player through the donor meetings which it initiated in May 1995, through training initiatives and through other networking activities. The Bank will take on a more direct role in these and other matters through the Financial Sector Adjustment Loan (FSAL), scheduled for FY1997, which will also attempt to take on residual questions about the structure and restructuring of the banking sector. XVIII. The EDP fits into this strategy as an important component of the bottom-up approach. EXIM is one of only two remaining state-owned banks (the other being the Savings Bank). EXIM is already specialized in trade finance, is reasonably well capitalized, has made significant strides in upgrading its accounting and other management systems and benefits from an existing management team which is committed to turn the bank into a serious and competent institution. By providing strategic direction and extensive TA for institution building in the bank through twinning with an experienced foreign EXIM bank, the EDP can ensure that this large and important bank becomes an important and positive element in the post-privatization reform agenda of Ukraine. The inclusion of the EDP in the lending program will ensure that three of the five large state and former state banks as well as the strongest private banks are all exposed to significant institutional strengthening via the bottom-up approach. Lessons Learned from Past Bank Projects XIX. Export development projects have been undertaken by the Bank in a number of countries, e.g. India, Mexico and Columbia, and a number of useful lessons have been learnt. These are: Provision of credit to the export sector was considered to have a positive economic impact during the transition from close state control of financial markets to a liberalized policy environment, especially when sectoral allocations in lending were left to the market. An EXIM bank or a foreign trade bank was usually the focus for onlending, (e.g. EXIM in India, Bancomext in Mexico, Bancoldex in Columbia). These banks were dedicated institutions for developing foreign trade, and did not carry out normal commercial retail operations. Usually they targeted export financing, and in some cases, they worked as wholesale banks and developed lending programs for the first tier banks, in addition to their own direct lending to exporters. Strengthening the capabilities of both enterprises and financial institutions in designing, implementing and appraising export development programs, and export oriented investments was considered vital for success. This was usually - 5 -  done by providing (a) export development TA to help exporters develop export plans and organize marketing, product development and technological know-how; and (b) institutional development TA for improving the financial institutions' capabilities to carry out credit assessment, risk assessment, and optimum pricing, and to promote and appraise export development programs and export oriented investments. Effective coordination of loan financing and TA was vital for the beneficiaries. Use of loan and grant funds in supporting the same enterprise when administered by different implementing institutions resulted in duplication of effort and weakening of an unified strategy. Trade promotion funding and activity through matching grant funds and joint participation by enterprises and financial entities in trade promotion organizations was considered very important. The matching grant facilities used in India, Indonesia, Singapore, Taiwan, and Columbia for these purposes had the objective of improving information flow between buyers and sellers, and providing advisory services to exporters. In India, Export Marketing Funds and Productivity funds were set up to provide TA as well as pilot marketing and business promotion assistance on a 50 W cost sharing basis. Funding for these TA efforts was provided by the Government on a grant basis. The experience showed that the grant funds helped enterprises' own efforts to begin or extend their markets through market surveys, travels to develop business contacts, and some testing and inspection; and were highly cost-effective when measured in terms of incremental exports. XX. The proposed EDP in Ukraine will incorporate these lessons by providing both export finance as well as targeted TA through a dedicated foreign trade bank by strengthening EXIM's supply capabilities, and targeted TA to enterprises to strengthen exporters' response capabilities. Environmental Aspects XXI. This project is a Category "B" Project involving intermediary lending. Program Objective Categories XXII. The project focuses on developing the export potential of Ukraine's emerging private enterprise sector. The project will be implemented by EXIM in close cooperation with the exporting community. Contact Point: Marie-Renee Bakker, EC4EF The World Bank 1818 H Street, NW Washington, D.C. 20433 (202) 473-9285 (tel) (202) 522-0005 (fax) - 6-  Note: This is information on an evolving project. Certain components may not necessarily be included in the final project. -7 -