Ukraine - Financial Sector Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P7226UA REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ONA PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN IN THE AMOUNT OF US$ 300 MILLION TO UKRAINE FEBRUARY 24, 1998 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS/EXCHANGE RATES (as of February 18, 1998) Currency Unit = Hrivnya US$1 = 1.9541 UAH UAH = US$ 0.5117 WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 Vice President: Johannes F. Linn Country Director: Paul J. Siegelbaum Sector Director: Lajos Bokros Team Leaders: Alan Roe/Marie-Renee Bakker  FOR OFFICIAL USE ONLY ABBREVIATIONS AND ACRONYMS BRD - Bank Resolution Department BSD - Bank Supervision Department CAS - Country Assistance Strategy CPAR - Country Procurement Assessment Report EBRD - European Bank For Reconstruction and Development ECU - European Currency Unit EDAL - Enterprise Development Adjustment Loan EDP - Export Development Project EFF - Extended Fund Facility ESW - Economic And Sector Work EU/TACIS - European Union Program of Technical Assistance for the CIS EXIM - State Export-Import Bank of Ukraine FSAL - Financial Sector Adjustment Loan FSP - Financial Services Project FSR - Financial Sector Review FSU - Former Soviet Union GDP - Gross Domestic Project GNP - Gross National Product Gosbank - Former USSR State Bank IAS - International Accounting Standards IBRD - International Bank For Reconstruction and Development IFC - International Finance Corporation IMF - International Monetary Fund JEXIM - Japanese Export-Import Bank KBV - Karbovanets (Former Ukrainian Local Currency) MOE - Ministry Of Economy MOF - Ministry Of Finance MPP - Mass Privatization Program MU - Monitoring Unit NBU - National Bank Of Ukraine SBA - Standby Arrangement SMEs - Small And Medium Sized Enterprises SPF - State Property Fund SSCM - Securities and Stock Market Commission STF - Systemic Transformation Facility TA - Technical Assistance TOR - Terms of Reference UAH - Hrivnya (Ukrainian Local Currency) UBPR - Unified Bank Performance Report USAID - United States Agency for International Development This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  UKRAINE: FINANCLIL SECTOR ADJUSTMENT LOAN Loan Summary .............................................i INTRODUCTION ..............................................1 I. THE ECONOMY ............................................... IL THE COUNTRY'S ADJUSTMENT PROGRAM ............................................. 10 ]m. THE PROPOSED LOAN ............................................. 11 Rationale and Objectives ..............................................11 Benefits and Risks ............................................. 12 Coordination with the IMF and Project Sustainability ............................................. 13 Board Conditions, Tranche Triggers and Supervision ............................................. 14 Implementation ............................................. 21 Financial Arrangements ............................................. 22 Environmental Impact ............................................. 22 IV. RECOMMENDATION ............................................. 22 ANNEXES Annex 1 Key Economic Indicators Annex 2 Status of Bank Group Operations and Status of IFC Operations Annex 3 Timetable of Key Processing Events Annex 4 Memorandum on Financial Sector Development Policy Annex 5 Policy Reforms Program Matrix Annex 6 Country at a Glance Annex 7 Donor Assistance in Financial Sector Development in Ukraine Annex 8 External Financing TABLES Table 1 Overview of Banking Sector Structure, January 1, 1998 Table 2 Ukraine Monetary Survey, 1995-1997 FIGURES AND BOXES Box 1 Landmarks of Financial Sector Development in Ukraine Figure 1 Nominal Interest Rates, 1993-1997 Figure 2 Real Interest Rates, 1994-1997  UKRAINE: FINANCIAL SECTOR ADJUSTMENT LOAN LOAN SUMMARY Borrower: Ukraine Amount: US$300 Million Terms: Single Currency Loan, at the Bank's standard US$ LIBOR- based interest rate, with a proposed 5-year grace period and a 20-year maturity. Commitment Fee: 0.75% percent on undisbursed credit balances, beginning 60 days after signing, less any waiver. Objectives and Description: The main objective of the loan is to underpin Ukraine's macroeconomic reform program with a comprehensive set of policy measures intended to strengthen the financial sector, with a special emphasis on the banking system. The loan would reinforce the reform measures being undertaken under other Bank adjustment and investment operations by positioning the banking system to play a lead role in financing the investment needs of all sectors of the economy, particularly the newly emerging private sector. Benefits: The implementation of structural reforms in the banking system will reinforce Ukraine's stabilization and other structural reforms by helping to ensure that a growing part of total lending is made by better-capitalized banks. By taking explicit measures to reduce the risks which banks are allowed to accept, the loan will also help to make a possible crisis in the banking system less likely. Finally, the up-front strengthening of banks and the elimination of bad lending practices should reduce the size of the eventual claims on the Government budget if and when banks fail, and so will have a positive fiscal benefit in the longer term. The positive effect on Government saving may also be accompanied by improved private savings performance as confidence in banks increases. Risks: A general risk facing all adjustment operations in Ukraine is that the macroeconomic stabilization is still fragile and a resurgence of high inflation fueled by the inability to fund large budget deficits cannot be ruled out. Such a development could lead to further repressive pressures on the banks, which could undermine many of the positive changes, which the loan seeks to advance. A more specific risk relates to the complexity of many of the component issues and the relatively i  limited technical depth in the NBU and elsewhere to champion particular policy measures through to effective implementation. A third risk is that the institutional structures for implementing this loan are poorly developed especially where they involve active cooperation between different agencies of Government. This risk is particularly significant in those areas of the loan where some short-term fiscal cost is required to deliver improvements supported by the regulatory authority for banks. Finally, there is the possibility of the loss of policy commitment due to a lack of consensus between different constituencies of the Ukrainian administration. Schedule of Disbursement: Three tranche disbursement, the first immediately after loan effectiveness (expected in March 1998); the second and third-- provided the macroeconomic framework remains satisfactory- -when the policy actions specified in this document have been implemented (expected in December 1998 and June 1999, respectively). Rate of Return: Not Applicable Poverty Category: Not Applicable Project ID Number: UA-PE-40560 The World Bank Financial Sector Team (comprising Marie-Renee Bakker, Ragini Dalal, Angela Prigozhina, Lalit Raina, Alan Roe, and Martin Slough--ECSPF) wishes to thank the Ukrainian authorities, and in particular, their counterparts in the Presidential and Government Administrations, Ministry of Finance, the State Property Fund, and the National Bank of Ukraine, for their collaboration in preparing the proposed Financial Sector Adjustment Loan. The Team would also like to thank their colleagues in the International Monetary Fund's Ukraine Team for their collaboration and to express its gratitude to the Peer Reviewers of this operation, Messrs. David Scott, FSD and Gerhard Pohl, ECSPF; and to Paul Siegelbaum, ECC 11, and Marcelo Selowsky, ECAVP, for their overall guidance and support. ii  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED FINANCIAL SECTOR ADJUSTMENT LOAN TO UKJRAINE Introduction 1. I submit for your approval the following report and recommendation on a proposed Financial Sector Adjustment Loan to Ukraine for US$300 million to support the Government's financial sector reform program. The loan would be at the Bank's standard US$ LIBOR-based interest rate with a maturity of 20 years, including five years grace. I. THE ECONOMY Background 2. Although Ukraine has enjoyed considerable success in the monetary aspects of stabilization since the hyperinflation of 1993 and 1994, this stabilization rests on weak foundations. Reasonable price stability was achieved in 1996, with inflation settling at less than three percent per month in the last half of that year. Inflation in 1997 was only about 16 percent as compared to over 10,000 percent in 1993. This success on the inflation front enabled the authorities to introduce the new currency--the Hrivnya (UAH)--in September of 1996 and to stabilize the nominal exchange rate quite successfully thereafter. Unfortunately, stabilization in Ukraine has been based almost exclusively on monetary restraint and cash management, without sufficient structural reform to achieve a sustainable fiscal balance and restore growth. As a consequence, the economy's real productive performance has been very poor. Since Independence in 1991, Ukraine's economy has not seen even one year of positive growth. Official statistics show a decline in real GDP of 3.2 percent in 1997 -- the eighth year in a row that GDP has gone down. This trend spans all major sectors, and the overall cumulative decline in the formal sector now exceeds 60 percent since Independence. 3. The structural reform program in support of the macroeconomic stabilization effort has enjoyed moderate successes. Price structures are now largely liberal, as is foreign trade. The privatization of small- as well as medium- and large-scale enterprises has proceeded at a satisfactory pace since the end of 1994. 4. Today, the major challenge facing Ukraine is how to restore the confidence of its financiers, domestic and international, as well as multilateral. Plainly, a program of broad and deep structural reforms is needed to do this, complementing a dramatic fiscal austerity program to deal with the immediate fiscal pressures. The Government recognizes this need. The proposed loan, together with the simultaneously presented Second Enterprise Development Adjustment Loan (EDAL II), are intended to support the Government's efforts to achieve this goal. 1  The Situation In The Financial Sector Sector Structure 5. The financial sector in Ukraine consists of a complex mass of mainly small, unregulated, and inexperienced organizations operating as banks, trust funds, insurance companies, pension funds, commodity dealers, credit unions, and broker/dealers. However, the banks, which are the main subject of this present operation, still dominate the sector in terms of total assets and the volume of business transacted. They are also heavily involved, through subsidiary companies and in other ways, in many of the more significant investment trusts, brokerages, and other capital market institutions. 6. Before the liberalization brought by Perestroika in 1989, the Ukrainian "banking" sector was merely comprised of various Ukrainian departments of the USSR Gosbank, including the Ukrainian branches of the savings bank and the foreign trade bank. Although specialized by function, these "banks" were little more than channels either for the allocation of credit resources determined by central planners in Moscow or, in the case of the savings bank, for the collection of household savings deposits, also for centralized reallocation. At that time, they used few if any of the conventional skills of modem commercial banks and, in particular, had little need to make evaluations of credit proposals, manage assets and liability structures, or concern themselves with risk management. Box 1: Landmarks of Financial Sector Development in Ukraine Till 1998 Banking in Ukraine as departments of the USSR Monobank system. 1989-91 Liberalization allows creation of first commercial banks in FSU. 1990 Reorganization of USSR Gosbank into 5 specialized banks. March 1991 Law on Banks and Banking Activity creates two tier banking structure. December 1991 Independence of Ukraine creates independent state banks. October 1991 Establishment of first stock exchange. September 1992 Karbovanets established as temporary substitute currency. December 1992 Ukraine quits ruble zone and establishes separate monetary policy. February 1993 Ukrainian Interbank Currency Exchange created. January 1994 National Electronic Payments System created. 1995 First treasury bills issued. September 1996 Currency reform and introduction of the Hrivnya. 7. As of late-1997, there were about 230 organizations registered as banks by the National Bank of Ukraine (NBU). Twenty-one of these banks are in various rehabilitation programs organized by the NBU and a further 44 are earmarked for liquidation. Despite the rapid growth of the newly created private banks during the last few years, the five Former Soviet Union (FSU) specialized banks continue to dominate the Ukrainian banking system, although in all cases they have evolved new methods of operation, new products, and better qualified management in line with the needs of the market economy. They are the Prominvest Bank-the industrial bank; Bank Ukraina-the agricultural bank; Ukrsots Bank-the social sector bank; the State Export- Import Bank (EXIM}-the foreign trade bank; and Oschadny Bank-the savings bank. These banks are all seeking to develop as universal banks and have not been required to maintain the earlier limitations on their functions. The last two of these banks are still wholly Government- 2  owned, while Prominvest Bank, Bank Ukraina, and Ukrsots Bank are notionally private with a minority ownership stake held by the Government. 8. The data in Table 1 confirm the continued domination of the state-owned and fonner state-owned components of the banking system 3. However, a great deal has changed and is changing. In the period from 1990 onwards through 1993, permissive laws on bank entry encouraged the establishment of more than 250 new private banks, most of which were initially set up with very little capital, often to service the banking needs of narrow groupings of state- owned enterprises in the productive sectors. Table I indicates that by the beginning of 1998 the more successful top-layer of these new banks had significantly eroded the market share of the state and former state banks. Table 1: Overview of Banking Sector Structure: January 1,19984 Name of Bank Statutory Total Capital Capital Total Assets Total Lending Profit for Year Deposits (min UAH) (min UAH) (min UAH) (min UAH) (min UAH) (mln UAH) State/Former State- Owned Banks (except Exim): 295.62 1531.88 10746.76 3442.24 259.46 1591.76 Share of Total 20.9% 45.9% 47.6% 47.2% 28.2% 51.2% Private Banks w/ Share Capital greater than 20 min UAH: 276.53 573.81 5774.27 1681.97 260.12 668.27 Share of Total 19.6% 17.2% 25.6% 23.1% 28.2% 21.5% Private Banks w/ Share Capital greater than 6 min UAH/less than 20 min UAH: 430.70 739.05 3992.37 1411.81 278.48 526.14 Share of Total 30.5% 22.2% 17.7% 19.3% 30.2% 16.9% Private Banks w/ Share Capital less than 6 min UAH 323.36 395.14 1513.50 582.29 98.91 248.85 Banks w/ 100% Foreign capital 88.01 94.56 554.11 178.72 24.21 75.56 Share of Total 6.2% 2.8% 2.4% 2.4% 2.6% 2.4% Totals 1414.22 3334.44 22581.01 7297.03 921.18 3110.58 (in min UAH): Totals (in miln USD) 725.2 1709.9 11580 3742.1 472.4 1595.2 These three banks are corporatized, claim to be almost wholly private, but in fact are owned and controlled mainly by state- enterprises and their employees. All these banks are large, continue to be unified nationally and, while in most cases seeking to become more universal, continue to have dominance in their specialized markets. They all retain some monopoly power and until recently achieved wide margins, part of which were dissipated in lending to loss-making enterprises for "social" reasons. In varying ways, most of these large banks remain encumbered by explicit or implicit obligations to the state which undermines their commercial roles (Ukreximbank is an exception). 2 Initially in 1992, these banks were corporatized in a spontaneous fashion with large state enterprises acquiring the majority stakes in the banks which serviced their particular sectors. But in 1993, the Govemment ordered that all state-enterprise shares in these banks be transferred to the Ministry of Finance. This transfer was avoided by the banks through a variety of devices whereby the shares were transferred to the employees of the client enterprises and to the employees of the banks themselves. This has left the effective govemance fragmented and ineffective. 3 Fuller detail on the make-up of an earlier version of Table I is in the Ukraine Financial Sector Review, Report No. 14526 UA. "Ukraine: Financial Sector Risks," January 1, 1998. 3  9. Other important changes have occurred with the transition. First, increases in minimum capital requirements have slowed the creation of new banks by ending the virtually costless entry into the sector.5 Beginning in February 1996, the NBU acquired the full authority to license banks. Through 1996 and 1997, it carried out a re-licensing process for existing banks and thereby subjected many of these to more demanding conditions for continued operation. The more successful of the new entrants have no difficulty in meeting these conditions but the process is having the effect of shaking out the more marginal banks. This is clearly a very positive development for the general health and stability of the sector. 10. Second, the extreme inflation of the period through 1995 has sharply reduced the real magnitudes of bank liabilities, assets, and capital, which is evidenced by the relatively small USD amounts in the table. It is true that during the two years of relative stability to 1997, the USD magnitudes shown in Table 1 approximately doubled.6 However, Ukraine, like most countries in the FSU, still has a total banking sector the size of which is equivalent to about one medium-sized Western bank. Although many banks do carry a significant amount of non- performing loans on their balance sheets, the problem this creates is not large either in absolute terms or relative to the country's GDP (not greater than 2% of GDP). The additional capital sums needed to underpin the present level, or increased levels, of banking activity are relatively small and some of the longer established banks are demonstrating the ability to build new capital to compensate for their bad debt overhangs. 11. As the large debt erosion occurred, savers have had to accept large losses in the real values of their savings. Credibility in, and respect for, banks has been diminished as a consequence. This is of particular relevance for the savings bank in view of its continued dominance of the total, now much reduced, of household deposits. The bank's large branch network and staffing (60,000 persons) is not commensurate with its present business volume. Its aspirations to develop as a universal bank are also questionable. However, since the bank is well placed in terms of its broad national coverage, its restructuring as a lower cost organization capable of offering improved services and products to its traditional clients is one essential element of the strategy for achieving a recovery of household savings. Sector Performance 12. Banking system performance itself merely reflects performance in the real economy. In Ukraine, the large decline in real output in the formal economy, the rising importance of informal business, and very high inflation through 1995 were clearly damaging from this point of view. In particular, the near hyperinflation from 1992 and through the early months of 1995 (20 percent per month) resulted in highly negative real rates of interest which favored bdrrowers but discouraged lenders (see Figure 2). This, in turn, caused a substantial decline in the volumes of real credit in the system just when high inflation was also encouraging a significant shortening of credit maturities. Nonetheless, most of the banks established during the period of excessively liberal entry from 1991 to 1994 survived during the latter period on the strength of high margins on domestic currency business, profits earned from foreign exchange speculation, and from other opportunities created by inflationary distortions. However, the improved macroeconomic 5From January 1, 1997, all banks were required to have at least ECU 500,000 of capital; from July 1, 1997, ECU 750,000; and from January 1, 1998, ECU I million. These represent the latest of several increases in the minimnum capital since 1993. 6 Nomina UAH magnitudes have not kept pace with inflation but have nonetheless grown fast enough to outpace the limited nominal devaluation of the exchange rate. 4  stability achieved from end-1994 to late-1997 reduced lending margins and eliminated some of the easier routes to profitability.7 The fiscal stresses of end-1997 and the pressures on the banks associated with their, by then, large holdings of Treasury Bills served to intensify this squeeze on banks. These factors together have initiated and perpetuated the shake-out of the more marginal banks already mentioned and have placed a high premium on sound banking as the basis for long-term survival. 13. Interest rates in Ukraine are now mainly market determined although the NBU maintains some administrative influence through its control of its own refinancing rate, which has become the main reference rate in the system. Until recently, there was a strong statutory link between the NBU refinance rate and bank lending rates, but this has now been removed. Even where there is continued direction of credit by the Government, the information available suggests that this credit is now on-lent at rates at least equal to the refinance rate. This is given some support by the fact that the average lending rates of banks through much of 1995-97 were higher than the refinance rate (see Figure 1). Figure 1: Nominal Interest Rates (Quarterly, Ql 1993 - Q3 1997) 35 30 25 15. {s0 n a mt V ) m O xO q: % 1. r- r- 0%i 0% 0% 0%i 0% 0% 0% 0%i 0%i 0% 0% 0% 0i 0% c 0% 0% 0% 0% . Comm. Banks Nominal Interest on Credits (Weighted Average) Comm. Banks Nominal Interest on Deposits (Weighted Average) Nominal NBU Refmance Rate 7The banks' spread between the monthly weighted average lending and deposit rate of interest fell from 6.6 percent in the first quarter of 1995 to 2.7 percent in the second quarter of 1997. The banks offset this in part by allowing an increase in the loan to deposit ratio from 88 percent in the first quarter of 1995 to 107 percent in the second quarter of 1997. This increase in the loan to deposit ratio helped to reduce the immediate liquidity squeeze created by declining interest margins. 5  14. Although nominal interest rates were trending down for much of 1995, 1996, and through mid-1997, inflation declined somewhat faster. From October 1997, interest rates rose again to much higher levels (almost 50 percent in some Treasury Bill auctions) in response to the extreme difficulties of financing the fiscal deficit after the collapse of financial markets in parts of East Asia. Hence, real interest rates on bank loans, already positive in 1994, remained generally positive through most of 1995, 1996, and 1997 (see Figure 2). Deposit rates were also slightly positive in real terrns in most months of 1995 and 1996 but negative through the last months of 1995 and early 1996. These occasionally negative returns to depositors combined with the continued volatility of inflation, caused expected inflation to remain higher than measured inflation and, together with the exceptionally poor growth performance of the economy, helps to explain the banking system's poor record on deposit mobilization. A summary of some of the more general movements of the main indicators of financial sector activity can be found in Table 2. Figure 2: Real Interest Rates (Quarterly, Q3 1993 - Q3 1997) 30 % 20 - - 10 20