Ukraine - Country assistance strategy : progress report

Report No.: 19225 UKRAINE: COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT 1. This Report provides an update on progress in implementing the Country Assistance Strategy (CAS) for Ukraine, as described in the June 3, 1996 CAS document.' This is the second such update, the first having been discussed by the Executive Directors of the Bank on May 21st 1998. Regrettably the continuing economic and political uncertainties in Ukraine, and the resulting difficulties of finalizing a three-year perspective on strategy have required a further delay in presenting a wholly new CAS document to supercede the one presented in 1996. Uncertainty on the political front is caused mainly by the forthcoming Presidential elections and the resulting lack of clarity about the complexion of the next administration and its degree of commitment to reform. Uncertainty on the economic front is largely a result of the ongoing consequences of the 1998 regional financial crisis and the continuing difficulties of containing its macroeconomic consequences. A new country assistance strategy will be prepared and presented to the Executive Directors in FYOO, after the October Presidential elections. I. RECENT POLITICAL AND ECONOMIC DEVELOPMENTS 2. The Political Situation. Parliamentary elections in March 1998 resulted in anti-reform parties winning 171 out of the 450 seats, while pro-reform parties won 152 seats; the balance of power is held by a shifting group of other parties and independent Deputies. This configuration resulted in a continuing deadlock between the President and the Govenmment on one hand and the Verkhovna Rada (the Ukrainian Parliament) on the other. Moreover, the economic drama in the country is now being played out against the backdrop of the preparations for the October 1999 Presidential Elections. These preparations are increasingly characterized by populist pressures on the Government to resist politically painful reform measures, as well as an explicit lack of cooperation from anti-reform and some other factions within the Verkhovna Rada. As a result, actions needed to deliver sound reforms and an adequate flow of external resources from the Bank and the IMF - the only significant sources of external financing currently available to the country - have become gradually more difficult to implement. Occasionally, the Government has been able to achieve important progress in spite of this political stalemate. A significant recent example was its success in obtaining approval of a relatively tough 1999 budget. But at other times the reform program has sustained major set-backs - recent examples being the Verkhovna Rada's extended delays in ratifying several World Bank and EBRD projects, its decision to grant broad tax exemptions to the agriculture sector and its unwillingness to sanction increases in tariffs for public utilities. The outcome of the Presidential elections themselves is far from certain. In any case, until the Fall of 1999, at the earliest, the political scenario will remain unfavorable for implementing the demanding measures needed to address both the immediate and the longer-term economic challenges facing the country. Report No. 15674-UA of June 3, 1996. 2 In March 1999, after much political maneuvering and delay, the Verkhovna Rada voted to ratify a GEF grant for reducing Ozone Depleting Substances, the restructuring of the second tranche of the Coal Sector Adjustment Loan and the Kyiv District Heating Loan. However, two other Bank projects continue to be delayed, the Pre-export Guarantee Facility and the Treasury Systems Project. In addition, the Constitutional Court has invalidated the 1998 law prohibiting increases in utility tariffs, but the Verkhovna Rada has voted unanimously to propose to the Constitutional Court that it cancel its ruling. These developments only illustrate the difficulties the Government faces, and the uncertainties in policy making and implementation in the present political environment.  3. Economic Developments. Since late 1994 when Ukraine, supported by the Bank and the Fund, launched its program of stabilization and economic reform, there have been some notable successes as well as some significant failures. Inflation, which reached hyperinflationary levels in 1993, was reduced to less than 2 percent per month by the second half of 1996. In spite of the severe external shocks from the financial crises in Asia and Russia in the subsequent two years, the annual inflation rate remained consistently below 20 percent per annum and it is expected to remain in this region throughout 1999. The success in controlling inflation also enabled the authorities to introduce the new currency - the Hryvnia (Uah) - in September 1996 and to enjoy almost two years of exchange rate stability until the Russian financial crisis in August 1998. 4. Notwithstanding this success in controlling inflation, macroeconomic stability viewed more broadly has remained fragile. Stabilization has been largely based on tight monetary policy, and structural measures to reduce the budget deficit on a sustainable basis have lagged behind. This has led to the emergence of significant arrears of budgetary payments and, in the period 1996 to end-1998, to increasing dependence on expensive sources for financing the fiscal deficit.3 This fragility was dramatically illustrated in the aftermath of the financial crisis in Russia, when the cost of domestic borrowing to the government rose to over 80 percent per annum for a time, and external private sources of financing dried up. Despite a well-managed restructuring of domestic and foreign debt in September 1998, foreign exchange reserves dwindled to only $685 million by end December 1998, equivalent to two weeks of imports. The exchange rate came under severe pressure in spite of the release of initial tranches from the IMF's Extended Financing Facility (approved on September 4th), and the Hryvnia depreciated rapidly from Uah 2.1 per dollar in mid-August 1998 to Uah 3.4 per dollar by end-September 1998. Although the debt restructuring in 1998, together with the release of IMF and Bank adjustment funds, staved off an immediate payments crisis, the fiscal imbalance and the external payments situation remain critical. Large debt repayments are once again due in 1999-2000, access to private capital remains closed, and by March 1999, international reserves had fallen to less than two weeks of imports. The exchange rate remains under severe pressure and the exchange rate band has recently been widened to Uah 3.4 to 4.6 per US dollar. 5. The most obvious and regrettable economic failure since Independence in 1991 has been the relentless decline in overall economic activity. Official statistics indicate that, between 1991 and 1998, the cumulative decline in real, measured GDP was almost 60 percent. A welcome recovery was starting to become evident with low but positive growth during the first half of 1998, but this faltered in the second half. Consequently, real GDP fell by a further 1.7 percent in the year as a whole. The adverse impact of the Russian crisis - the main cause of this mid-year reversal - will be felt in 1999 as well, and real GDP is projected to decline yet again: this time by about 3 percent. This contraction in economic activity is mitigated to some extent by the reported growth of the parallel economy, whose size is estimated to range between 40-60 percent of total GDP. However, the failure to embrace this parallel activity in the formal economy limits its beneficial consequences and casts doubts on its robustness, since participants in the informal sector consume public services without contributing to the economy's tax base. Certainly, programs of broad and deep structural reforms, including reforms in the structure of Government, tax administration, deregulation, agriculture, energy, and the financial sector are needed to restore economic growth. These programs need to build upon the reforms already implemented, many under the guidance of the Bank, including the liberalization of domestic prices and 3Total budgetary arrears (at all governmental levels) on wages, pensions and social benefits increased by Uah 1.1 billion in 1998 and amounted to nearly Uah 4.3 billion at the end of 1998, equivalent to 4.1 percent of 1998 GDP (Source: IMF). 2  foreign trade, the privatization of small, medium and large enterprises, the rationalization of the regulatory regime affecting small businesses, and tax reform. 6. In summary, both the political and the economic environments in Ukraine are substantially more fragile than at the time of the last Progress Report. Although agreement on an IMF Extended Financing Facility (EFF) and the restructuring of domestic and foreign debt, both in September 1998, gave the authorities some breathing space, the country is once again likely to face serious financial stress in 1999-2000 as large debt service payments come due. With access to private sources of finance likely to remain limited at best,4 a strong fiscal adjustment from the Government, continued financial support from the IMF and the Bank, the realization of substantial cash privatization proceeds and, in all likelihood, some measure of debt rescheduling will be needed to prevent a debt default and sustain even the present modest level of economic stability. Since disbursements under the Bank's adjustment loans and the IMF's EFF are conditioned on implementing serious reforms which may prove difficult in the present political environment, the risks of macroeconomic instability and debt default further delaying the resumption of economic growth are very real. II. MACROECONOMIC PROSPECTS 7. The economic outlook will remain grim in the next twelve to eighteen months. The external environment is likely to remain unfavorable. Ukrainian exports to Russia, which is its largest export market, will be depressed because of the projected slowdown of the Russian economy during this period (GDP in Russia is projected to decline by more than five percent in 1999-2000). Exports to the rest of the world will be hit by the depressed market conditions for metals and food products which are the main exports of Ukraine. And foreign capital flows to Ukraine will remain scarce due to contagion from the financial crises in Asia and Russia, as well as continued investor discomfort with the slow pace of market reforms. During this period, three broad scenarios are conceivable. In the "Reform" Scenario, the Government and the Verkhovna Rada recognize the gravity of the present crisis and begin to accelerate a core program of structural reforms, including reforms to overhaul public administration, promote land reforms in agriculture and payment discipline in energy, strengthen the independence of the National Bank of Ukraine (NBU), further deregulate private sector activities, and make the pension system financially sustainable. The "Muddle-Through" Scenario is the one currently prevailing, in which the Government is unable to implement a comprehensive program of reforms, and merely implements partial reforms in fits and starts, largely to retain access to financial support from the Bank and the Fund. The "Collapse" Scenario represents a decisive rejection of market friendly, private sector-oriented economic policies and a return to price and trade controls and other Government interventions. In the present political environment, the second scenario seems most likely and the first least likely. But this could all change quickly if policy-makers come to realize that the second option is one of unacceptably slow recovery. 8. In the Reform Scenario, real GDP is projected to decline by almost 3 percent in 1999 as tight fiscal and monetary policies, combined with the unfavorable external conditions continue to dampen economic activity. As the effects of the Russian crisis become less severe and the economy begins to register productivity gains from structural reforms, the slowdown in economic activity is halted and 4Ukraine's access to the international capital markets is presently closed and is unlikely to reopen to any sicnificant degree for the remainder of 1999, while its access to foreign direct investment has been severely limited by the perception, on the part of potential investors, of the hostility of the local environment for private business. During the period 1991-97, for example, cumulative per capita FDI was only $36 in Ukraine, far less than the comparable figures for reforming economies in the region, such as Hungary ($1,483) or Estonia ($693).  GDP is projected to grow 0.5% in 2000, 2% in 2001 and 3-4 percent per year thereafter. Despite the progressive increase in public utility tariffs to increase cost recovery and reduce subsidies, tight monetary and fiscal policies prevent the rate of inflation from rising beyond 20 percent during 1999- 2000. The rate of inflation is projected to fall to 8-10 percent per year by 2005. Even in this favorable scenario, external capital inflows during 1999-2001 are largely confined to disbursements from the IMF and the Bank and the share of private creditors in total debt begins to rise only later. After jumping up sharply in 1999, external debt increases to around 44-48% of GDP between 2000-2005. 9. The Muddle-Through Scenario differs from the Reform scenario in the following ways: (i) The less restrictive financial policies provide a temporary boost for the economy and the decline in GDP 1999-2000 is less severe; however, the inflation rate is substantially higher. (ii) The stop-and-go implementation of stabilization measures and structural reforms elicits more modest disbursements from the IMF and the Bank, while foreign direct investment is also more limited. (iii) To remain current in its debt service payments, imports are cut back and reserves are maintained at bare minimum levels (less than two weeks of imports); but, even so, debt default remains a strong possibility. (iv) The slow pace of structural reforms, limited external capital inflows, and the cuts in imports constrains economic recovery beyond 2000, and GDP growth remains weak (0-2 percent per year) throughout 2001-2005. The combination of low growvth, high inflation and increased fragility over a prolonged period is unlikely to be sustainable economically, leading to pressures to move either to the Reform Scenario or the Collapse Scenario. The timing of such a move is highly uncertain, however, in the light of the Government's demonstrated ability, over the past 18 months, to avert an outright crisis with adroit, last minute maneuvering. 10. In the Collapse Scenario the government relies more and more on administrative controls to check price rises and on credit expansion and directed lending to boost economic activity. Disbursements from the IMF are stopped, and disbursements from the Bank are limited to ongoing investment projects. The country is unable to meet all its external debt service obligations in 1999- 2000 and default becomes unavoidable. The expansion of output in 1999-2000 proves illusory as controls drive more and more of the economy underground, capital flight becomes rampant, prices surge and shortages are increasingly evident. The economy goes into deep recession and looming hyperinflation, reminiscent of 1993-94, ultimately forces the abandonment of this strategy. III. PROGRESS UNDER THE 1996 CAS AND REMAINING CHALLENGES 11. In addition to achieving sustained macroeconomic stability, the main 1996 CAS objective was to help Ukraine to achieve growth through implementing a structural reform agenda with four key elements: (i) promoting private sector activity; (ii) restructuring the public sector and recasting it in a supportive role; (iii) ensuring the social sustainability of the transition; and (iv) ensuring environmental sustainability. 12. These four areas of focus were reported on in detail in the CAS Progress Report discussed by the Board on May 21st 1998. In brief, the 1998 Progress Report noted good progress in achieving CAS objectives in relation to the fostering of private sector activity; especially trade liberalization and privatization, and some initial progress with work on environmental sustainability. In contrast, little progress was reported on objectives relating to the restructuring of the public sector, and in achieving the consensus necessary for effective work on social sector reformns. The 1998 Progress Report recommended continued work in all four priority areas, with greater emphasis on the areas of public sector reform and social sector work. 4  13. The 1998 Progress Report also outlined a short-term strategy that included: (i) linking the approval of new adjustment loans and disbursement of adjustment loan funds to macroeconomic sustainability as evidenced by continued compliance with the IMF EFF program; (ii) preparation of only those investment loans capable of providing substantial benefits in an environment of economic uncertainty; and (iii) increased ESW and other non-lending services in areas where lending is not currently possible. 14. Progress in the four priority areas, and in the implementation of the short-term strategy has been as follows: A. Promoting Private Sector Activity 15. Private Sector Development and Deregulation. The privatization program has been one of the successes of economic reform in Ukraine. Small-scale privatization, supported by an IFC-led program, was virtually completed by end-1997. Under the first Enterprise Development Adjustment Loan (EDAL I; FY96), more than 8,500 medium and large scale enterprises transferred at least 70 percent of their shares to private owners by end-1997. The second Enterprise Development Adjustment Loan (EDAL II; FY99) consolidated this success by increasing the number of medium and large enterprises that have been privatized to more than 9,500 by end-1998, largely completing the voucher-based, mass privatization program. However, the rate of progress of the case-by-case privatization of strategically important companies in areas such as telecommunications and energy is still unsatisfactory; improvement in this area could have large benefits for both economic efficiency and the budget. Moreover, there is a need to restructure and improve management in newly privatized enterprises and to improve the environment for the private sector generally. In support of private sector development, the Bank has started the preparation of an innovative and ambitious loan (the Private Sector Development Loan). This has been structured as an Adaptable Program Loan and will support post- privatization restructuring through management training and education. The effects of EDAL II on improving the business climate through deregulation will be complemented by reforms aimed at improved administrative efficiency in various branches of Government as detailed below in para. 18. In addition, a Facility is in preparation to support Foreign Direct Investment in high value-added sectors of the economv'. Guarantees under this facility would not provide commercial or production risk protection, but would simply guarantee that foreign investors would be faced with a consistent set of business environment policies (no targeted changes in licensing taxes, etc.). The benefits of this project would be to (i) demonstrate the ability of Ukraine to provide profitable foreign investment opportunities as a stable policy environment is developed, (ii) provide support for companies interested in converting from military to commercial production, and (iii) generate employment in high value- added industries. 16. Financial Sector Reform. Pressures on the financial sector have deepened. Declining bank capital, weak loan portfolios, direct losses from Russian debt holdings, foreign currency trading losses and an impairment of the value of Governnent securities held by banks have all further weakened already weak banks. The Bank has been working, to improve the overall financial sector framework, 5The precise structure and operation of such a facility remain to be determined, but the principle is that individual guarantee commitments by the Facility would only come into existence over time., after the facility itself is effective. Work remains to be done on the legal and credit exposure implications of such a unique structure under the Bank's guarantee and credit exposure policies. 5  and the implementation of the Financial Sector Adjustment Loan (FSAL; FY99), will strengthen the NBU; initiate the restructuring of Oschadny Bank (the holder of the majority of household deposits); reduce the banks' exposure to non-performing government guaranteed loans, improve bank supervision, tighten licensing and performance standards for commercial banks, and improve and implement procedures for dealing with distressed banks. In addition to these systemic and regulatory reforms, the Bank has recently begun work with the Fund and several interested donors to develop a banking resolution program directed at the seven largest banks. The IMF has recently led a comprehensive review of these banks (representing over 60% of banking sector assets) and, based on the preliminary results, discussions are already underway to develop bank-specific reforms. Once agreement on reform recommendations is reached, the Bank will work with a large group of interested donors to develop appropriate programs of institutional strengthening and technical assistance for these banks to complement the work of the FSAL. Box 1. The Banks' Current Program The implementation of the current program in Ukraine has had mixed results. The non-lending program has been going well, often with high levels of participation from the Ukrainian side. The overall performance of the lending portfolio has also been satisfactory, particularly in light of the challenging working environment in Ukraine. This was confirrned during the Portfolio Review meeting with the Government in early December 1998. However, recently approved projects have run into problems due to the difficulty in bringing several recent Bank loans and grants to effectiveness (see para. 2 above). The Lending Portfolio. The number of satisfactory projects is 13 (81 %) out of the total portfolio of 16 projects (including GEF): a sound performance given the difficult overall environment. The Government's capacity to implement Bank projects has been steadily improving, and the Bank's counterpart agencies have achieved improved capacity and understanding of Bank policies and procurement procedures. This has had a positive impact on the implementation performance of the portfolio. However, the capacity of the Government to efficiently process Bank projects through its bureaucracy and the Verkhovna Rada is still limited. If the effectiveness problem is not resolved soon, some deterioration in the portfolio performance is to be expected. A frank and open discussion about the Bank's program in Ukraine took place during the portfolio review meeting in December 1998. The Government and the Bank discussed the portfolio under implementation, the project pipeline, ESW for the future and the overall business plan for the next 18 months. As a result of this discussion, the Government and the Bank jointly defined actions needed for improving the performance of the current portfolio and identified priorities for our future collaboration. These priorities are centrally reflected in this Progress Report although the volumes of lending are below those proposed by the Government. Economic and Sector Worl The Government has expressed its satisfaction with the preparation of the Country Economic Memorandum (CEM) which is being done in an innovative way with very broad participation of local experts on the Ukrainian side. The title of the CEM is "Restoring Growth with Equity". Seven thematic groups of Ukrainian civil servants, researchers, NGOs and foreign experts have worked on producing CEM inputs. This approach has several advantages: in addition to producing a document which is fully owned by the Government, this work has made a strong contribution to local capacity building. The work on strengrthening the Government has also been successful and highly appreciated by our counterparts. Substantive ESW is also being done in the areas of Health, Education, and Intergovernmental Finance. The final reports are expected in April/May 1999. The Government expressed its willingness for even closer involvement in defining the priorities and development of the economic sector work, and this is reflected in the program of ESW shown in Attachment 1. 17. Agriculture. Agriculture has always been recognized as one of the priority sectors in Ukraine and one which has tremendous potential as a source of income generation and export earnings. Consequently, in 1997 the Bank selected Ukraine as the primary rural focus country in the ECA region and allocated specific additional resources from the Strategic Compact for this purpose. Regrettably, the progress of reforms in the Agriculture Sector has been disappointing. Although sufficient progress was made, in areas such as trade and price liberalization and the privatization of agricultural distribution and processing, to support the disbursement of the second (and last) tranche of the 6  Agriculture Sector Adjustment Loan in September 1998, there are concerns that these reforms may not be sustainable. There are constant efforts to reverse the spirit if not the letter of previous reforms. A very important follow-up operation - the Pre-Export Guarantee Facility - whose aim was to insure a conducive investment environment in agriculture, has yet to become effective. And Govenmment intervention in the sector - particularly through the allocation of scarce inputs and the control of outputs - remains unacceptably high. In view of these misgivings, the program in this sector will be limited to a low case until the Government can demonstrate its commitment to more effective and consistent reform. B. Restructuring the Public Sector 18. Public Administration. The current fiscal problems, coupled with the Government's difficulties in managing and implementing budget priorities, have confirmed that fiscal and public sector reform must remain a priority. The Bank is working intensively with the Government to develop and implement major reforms to streamline the Government and improve public sector efficiency and fiscal management. Progress, however, has been extremely slow, impeded by an array of special interests which strongly resist the inevitable shifts in the allocation of political power and position that accompany fundamental restructuring of government. If reforms in these areas are forthcoming, the World Bank would provide support through adjustment lending, such as the proposed Public Administration Reform Loan (PARL, FY01). The Bank has also completed ESW on fiscal and debt management, intergovernmental finance and health and education expenditures6. In addition, because systemic corruption is a widely recognized and deeply entrenched problem in Ukraine, the Bank has been working on a number of initiatives focused on anti-corruption and improved corporate governance. This is a central reason for the Bank's strong push for enterprise privatization and then de- regulation and other administrative reform in both the EDAL2 and the PARL, and for its push to replace discretionary by formula-based systems in its advisory work on sub-national finances. More directly and in close cooperation with other donors, most notably Canada, the Bank has also developed a pilot program aimed at building integrity at the municipal level through strengthening the voice of citizen's groups in demanding better governance and services. 19. Energy Sector. The Bank's program in the energy sector is an important part of the initiative taken by the Ukrainian Government and the G-7 countries. Progress to date has been mixed. Although some reforms under the Electricity Market Development Project (EMDP) have been implemented, there have been setbacks in key areas such as cost recovery and political interference with the setting of tariffs, which led to the suspension of the loan in FY98. Removal of the suspension was delayed by the application of VAT to barter transactions, which discouraged these non-cash payments altogether, as well as by a law prohibiting service shut-offs to non-paving customers and the increase of tariffs for electricity and other communal services while public sector wage arrears remain unpaid. Higher tariffs and improved collections are part of the conditions of a financial recovery plan, jointly developed between the Bank and the Government, needed to lift the suspension of the loan. In response to the invalidation of the law limiting rate increases and service disconnections by the Constitutional Court, a substantial tariff increase became effective on April 1, 1999, and the Government has rescinded the application of VAT to barter payments. If the early indications of increased collections performance prove stable over the next month, this suspension will be lifted. Progress in certain localities has been achieved in district heat and energy efficiency programs. Bank projects in this area in Kyiv and other major municipalities have enjoyed excellent cooperation from the local beneficiaries and will remain 6 These studies are in addition to the participatory Country Economic Memorandum (CEM) which will be discussed with the authorities in June. (See Box 1, above). 7  an important part of the program, with the goal of extending the concepts of cost recovery and system efficiency nationwide. Work in the gas sector has been less promising and the Bank program is presently confined to advice about specific reforms such as the introduction of cash auctions of gas received from Russia as a fee for transit services, and the improved management of the country's huge pipeline facilities. Recent positive results from new gas auctions give some reason for optimism in this area, if these results can be sustained. 20. Bank work to help restructure the country's large coal sector has had a modest positive impact so far, with the completed or pending closure of 44 of Ukraine's estimated 250 coal mines. The Bank's projects have demonstrated that nonviable and unsafe mines can be closed with adequate social and environmental safeguards and the challenge for the future will be to extend these lessons to the sector as a whole. The undisbursed second tranche of the Coal Sector Adjustment Loan ($150 million) was restructured into four smaller tranches and approved by the Executive Directors in September 1998. After six months delay, the Verkhovna Rada ratified the amended Loan Agreement on March 22, 1999. If the restructured Coal SECAL can be implemented smoothly, then a program of further operations designed to raise the efficiency and improve.the very poor working conditions in the sector will be activated. 21. It was noted in the 1998 Progress Report that the Bank has drawn back from participation in several energy-related projects which the Government agrees would be more appropriately handled by the private sector. This development and the uncertainties about the Bank's role in several of the sub- areas of the sector will require a fundamental reconsideration of the Bank's energy sector strategy for Ukraine in the very near future, in preparation for next year's full CAS. 22. Infrastructure. Progress has been limited in infrastructure reform and development. A housing project was cancelled in FY98 due to the Verkhovna Rada's refusal to ratify the loan. However, progress has been made on a municipal water project in Lviv and other municipal infrastructure projects are being developed in the context of the Community Development Project (FY01). This project builds on the Intergovernmental Finance Note (FY99) referred to in the earlier 1998 Progress Report. The objectives of the program include strengthening of the financial planning and project management capacities of a few key municipalities. The proposed project will finance basic municipal works such as improved water and heating, school facilities, and local roads. The Bank's comprehensive Transport Sector Review (FY99) has also been completed and has been well received. The Report demonstrated the huge potential for efficiency gains in various branches of the sector and provides a useful basis for the design of specific lending and TA operations for the future. C. The Social Sector 23. The Ukrainian population has suffered greatly as GDP has continued to decline for the eighth year since Independence. The Bank completed a Poverty Assessment in 1996, which concluded that poverty then touched as much as 28% of the population. New household surveys involving Bank technical assistance will provide up-dated information by June of this year. Other evidence shows that the critical economic situation of the recent past has worsened many social indicators. For example, the arrears of local government social protection outlays rose from 5% of committed amounts in 1995 to 33% in 1998. Wage arrears by September 1998 had climbed to 6.5% of GDP one of the highest levels among transition countries. Tensions in labor markets have increased markedly with some 1.2 million officially registered as unemployed in 1998 - a 52% increase over the 1997 level. The health system is in crisis and the incidence of communicable diseases such as tuberculosis is rising rapidly. Cuts in government run social programs, and the recent rapid devaluation of the hryvnia, have also contributed 8  to a further fall in living standards of the population. Despite a large share of Government resources (an estimated 12-15 percent of GDP) being allocated to social sectors, as much as 70 percent of the population has been affected by "transient" poverty (slipping below the poverty line at least once during the year). While there is greater recognition that existing policies and programs have failed to protect the poor, and that fiscal pressures are intensifying, a strong consensus in favor of comprehensive reform of the social sectors has been slow to emerge. 24. As a result, the Bank has a mixed record in developing an active lending program in the social sector although policy discussions are improving.7 A project providing institution building for social safety nets (Social Protection Support; FY97) has been successfully implemented. Active work is being carried out on a review of Health and Education expenditures to identify potential efficiency gains and cost savings, and technical assistance on conducting household surveys is being provided. Initial discussions about a Social Investment Fund to provide direct assistance to the most vulnerable groups have been positive. Discussions on pension reform, which could lead to a major reform-based loan, are also underway. A major piece of sector work, updating past work on identifying the main poverty groups and restructuring the main instruments of social protection, is planned for FY00. The Bank hopes that after the Presidential elections in October 1999, this active program of non-lending services currently underway will lead to a more positive social sector dialogue and, subsequently, to an active lending program in these sectors. 25. The Bank has been successful in incorporating social aspects into other projects. The Coal Pilot Project and Coal SECAL, for example, have severance payments and micro credit programs as key components which will support coal miners in their transition to other types of productive work. Social assessments are being carried out in infrastructure projects such as district heating and municipal water, to develop ways of mitigating the effects of tariff increases on the most needy. D. Ensuring Environmental Sustainability 26. Progress in this area continues to be good, although the challenges in the environmental area remain substantial. A number of environmental programs are proceeding well. Two IDF projects on Environmental Policy and Environmental Management are being implemented smoothly, as well as GEF funded projects to promote biodiversity and protect wetlands. A project for Ozone Depleting Substances (ODS, approved June 1998) was ratified by the Verkhovna Rada in February 1999, after much delay. Preparation of the GEF-funded projects for Black Sea Wetlands Preservation and Coal Bed Methane are also proceeding well. In addition, preparation is underway for projects supporting pollution abatement, waste manag,ement, and water resource management. IV. THE BANK'S ASSISTANCE PROGRAI 27. The proposed strategy for the remainder of FY99 and FY00, pending the preparation of a full CAS, is a cautious one, responding to the very difficult and uncertain macroeconomic and political situation described above. It applies stringent conditions to any substantial increase in the Bank's exposure through the disbursement of adjustment lending. At the same time, it takes into account the fact that many of these difficulties are driven, in large measure, by a specific event -- the Presidential elections -- and may be resolved after the elections, or even before, if external financial pressures drive 7Previous project requests from the Government have focused on new investments in health and education and on sector- related industries, such as pharmaceutical, medical equipment, or textbook production. In those areas, however, the Bank assessment is that efficiency improvements in existing assets would be more productive then investing in new assets. 9  the Government to a more pro-reform posture. Accordingly, it seeks to maintain progress on investment operations which respond to problems which will remain after a possible financial crisis is over while maintaining the Bank's capacity to resume an aggressive lending program without delay, if conditions improve and the Government becomes more responsive to reform. 28. The proposed strategy also takes account of the lessons from previous operations. Two main cases for new lending are envisioned: (i) "Medium Case," in which the macroeconomic environment corresponds to the "Reform" scenario described in Section II, and in which the Government's capacity and commitment to deliver reforms is judged to be satisfactory.8 In this case, the Bank would continue with the active preparation of critical new adjustment operations, such as the Public Administration Reform Loan, the Public Resource Management Loan, and a new operation supporting policy reform in the area of intergovernmental transfers. The first of these loans to be presented to the Executive Directors would be accompanied by the new, fuill CAS. In addition, and subject to the specific conditions discussed in detail in para. 35, the Bank would continue disbursements under the already approved adjustment loans. (ii) A "Low Case," which would respond to the "Muddle-Through" scenario described in Section II above. This Low Case would incorporate five projects (including one GEF project) to be presented to the Executive Directors in FYOO, and four projects (including one GEF project ) in FYO. It could apply even if the IMF program went temporarily off track. In addition, and subject to the specific conditions discussed in detail in para. 35, the Bank would continue disbursements under the already approved adjustment loans. 29. It should be noted that there is also a possible "Zero Case" in which the macroeconomic situation conforms to the "Collapse" scenario described in Section II above, and is associated with debt default, the restoration of broad based administrative controls, much higher inflation, and the complete collapse of the IMF program. In this case, disbursements of already-approved adjustment loans would be curtailed, as would approvals of new lending. 30. The present macroeconomic situation places Ukraine in the Low Case for new lending. However, the effectiveness issues discussed further in para. 33 below currently preclude the presentation of new loans to the Executive Directors so the Zero Case is the de facto situation for new lending until the effectiveness problem is resolved, although, disbursements under already approved adjustment loans would continue if the detailed conditions described in para. 35 are met. The triggers to move to the Medium Case will be, first, satisfaction, on the part of the Bank, with both the substance and the sustainability of the macroeconomic framework. Continued success with implementation of the Fund's EFF program will contribute to this conclusion, but the Bank will also monitor this situation closely, with particular emphasis on the issue of sustainability and whether the structural problems lying behind fiscal issues are being addressed successfully. Second, as noted above, Ukraine's ability to avert a financial crises and sustain the current fragile macroeconomic stability will largely be a function of the depth of the Government's reform commitment and its impact on Ukraine's ability to 8 it is noted that this Progress Report does not incorporate a "High" case lending strategy. Such a strategy was associated in the original 1996 CAS with a situation of fast, deep, and broad reforms and an annual lending program of around $1 billion. The circumstances prevailing during the 12-18 month time frame of this Progress Report are unlikely to conform to this situation and hence the high cane possibility is excluded for the time being,. 10  meet its external debt obligations for the remainder of 1999 and into 2000. In the light of these critical needs, the Bank has identified three key indicators which it will track, in addition to the general macroeconomic framework, to determine whether it is appropriate to increase lending support for a Medium Case scenario. Substantial, implemented progress on all three will be required to trigger the Medium Case. * Implementation of an effective program of reform of the Apparat of the Cabinet of Ministers,9 a critical step in for creating a more efficient government structure; * Implementation of a program of enterprise deregulation which results in a material reduction in the average number of official inspections and audits endured by private enterprises;