Ukraine - Institution Building Project

D_csmmt of The World Bank FOR OFFIIAL USE Otl qut N. P4072-Uk n~ORAM AND RI O'F TME PRESIDENT OF TE ITERNATIONAL BANK FOR RECNSTRUCTIOn AND DE TO TE ECUTIVE DIRECTORS ON A PROPOSED LOW IN AN AMDuNT EQIVALT TO US$27.0 MLION TO UKRAIN INSTITUTILON BUILDING PROJECT MAY 18, 1993 HJicRO)PICNE COPY Pep.rt o .:P- 60!7-,o'-U(A tnl,N ! Title TNfTTTUTJC)N Pl. LDTNG P!F;.fiEC T Author: A1TT,KE2., T Fxt. 384313 Becm: -47 ->4t . :E. 42 This doement has a resticted distbudion d may be nsed b recients only in the performauc of tbir official duties. Its eotents may not otherwise be discosed without World gBak uth0orization.  CtURRNCY EQISVALEM Cum Uni - Karbovanets (Krb) EXCHANGE RATES: IRB PER USS (End of Period) December 1992 750 March 1993 2000 April 1993 3000 WlGH1S AND MEAStRES metric System ABBRVITIONS AND ACRONYMS AMC And-Mionopoly Commitee BAFS Broadly Adopted Fmancial Staments ICB Itrnatona Competitve Bidding MOE Ministry of the Economy MOP Ministry of Fnan NBU Naional Bank of Ukrae NPC Nadoxal PaymenCouni s11 State Tax oemu jKaMAN FISCAL YEAR Janury i to December 31  FOR OFFICIAL USE ONLY UKRAIEq INSITUTION BUDING PROJECT Lem and Proje Summary Borrowmr Govenmient of Ukraine Lan Amount: US$27.0 million Team: Seventeen years, including a five year grace period, at the BDRD standard variable interest rate. Project Duration: Implemsntation will stat in July 1993 and continue until July 1996 Perject Objecdves: Assist tho Ulrainian govemment to implement economic reforms and to strengthen instions essenti to the transition to a matet economy through the provision of consultant services, trainig and equipmen three are: (a) enteprise reform, (b) flnanci sector reform, and (c) public fincial management. Fmdng Pl : Lod EQda rdi (JJS$ miioU) Government 2.0 - 2.0 IBRD _ 27.0 27.0 TOTAL PROJECT 2.0 27.0 29.0 Economic Rate of Return: not applicable Staff Appraisal Report: not applicable Map: IBRD No. 24253 This document has a restricted distribution and may be used by recipients only in the performance of thdir nfficial duties Its cnntants mnw nnt nthArut he hals.eeA uwithoust WnQlA Rlank authiriqatn  MEMORANDUM OF RECOMMENDATION OF THE PREIN OF THE BIRD TO TE EXECUTIV DIECTORS ON A PROPOSED LOAN TO UKRAN E!OR A N BUIIDING PltO 1. I submit for your approval the following meandum and recommendation on a proposed loan to Ukraine for the equivalen of US$27.0 million to help fance istiion building activities. The loan woud be at the Bak's sandd varibe interest rate, with a matuity of 17 years, including 5 years of grace. Paraldel fimancing of appiroximately US$16.9 million is being provided by the EC, EBRD, Nethelands, UK, and WMF. Badcground 2. Fornma contacts between Ukraine and the World Bank were Initiated during a mission in Jamnry 1992. Ukraine joined the IBRD in September 1992. An economic report, entided Ukraine: Couty Fxonomic Memorandwn (Report No. 11029-UA), will be distributed prior to consideration of the proposed project The proposed project would be the Bans fis operation in Ukraine. 3. Ukraine faces the immese challenge of creatig the instiuons of a sovereign state while sngft the transition from a cetally planned to a marketbased economy. Seventy years of Soviet ontol have left the counry with a sttre of production and trade tha reflects the polidcal economy objectives of central planners rather than the most efficient use of resoure, and thus, with a poore populatdon. At its most basic level, the shift to a maketorleted econowmy will require a radical change In relative prices, and correspondingly, a major reallocation of resources. This trmation constitutes the very basis for future growth and Improved living condidons for the people of Ukrne. 4. The Govenament has expressed its commiment to the transition to a maket economy, but is still in the process of developing a concrete program and the polical consensus required to achieve this transition. The role of government in the economy is gradually evolving from a focus on direct control over prducton activities to m nomic and structural policies supportive u. ficiency and growth. At this stag, the Govement must deal simulously with th overriding issues. First, it must provide a stable macroeconomic e me to control inflation so tgat prices give meigbl signals for resource allocation and to mitigate the shortt-tm decline in rea savings and production. Second, it needs to cary out systemic reforms to promote competition including the ransfer of ownership from the state to the private sector, for without these refors there will be no supply response and only fiWl stabilizatin. Third, it wi have to protect the poorest groups of society during the transition. S. Reent Economic Developments. Economic perfimance has deterirated sharply in recent yeas. Output continues to contact as GDP fell by about 15 percent in 1992 following a decline of 11 percent in 1991. Industry, which accounts for about 42 percet of GDP, has been particulady hard hit by shortages of imported inpu, pardtculay energy. and the loss of traditional export markets in the fome Soviet Union (FSU). Reflecting these developments, value-added in tie industrial secto iS edmated to have fallen by 9 percen in 1991 and a further 10 percent in 1992. Value-added in agriture, which account for roughly 30 percen of GDP, fell by 13 percent in 1991 owing to the dual effet of input shortages and drought. Agricultue output declined further In 1992 despite improved weather conditions. Per capita GNP is emated at $2,340 for 1991, according to the World Bank Adas methodology.  -2 - 6. nenatona trade, wbich reprened WproxmWy 29 pefcen of GDP In 1990 (including FSU trade), is estimated to have fallen by about 50 percent over the last two years. The collapse of trade with the staes of the FSU, which accounted for 82 percent of Ukraine's total trade in 199, has had an especay disruptive effect, leading to domic shorages of essentW inputs and consumption goods. The movement to world prices in such trade, particularly for oil and gas, will moreover constitute a major adverse terms-of-trade shock for the Ukrainian economy. 7. While output and trade have fallen precipitously, inflation has accelerated. Inflation exceeded 2,000 percent fom sd-1991 to end-1992, and is estimated to bave reached 30 percent per month in early 1993. Price dses have been fuelled by a large visible fiscal deficit and a large quasi-fiseal deficit which has been monetzed causin rapid monetary expansion. Total govement expenditure in 1992 is estimated to have exceeded 70 percen of GDP, including social sector spending of about 40 percent of GDP and extrabudgetary trnsfers through the bankig system to enterprises and farms of approximately 19 percent of GDP. The 1992 deficit was on the order of 35 percent of GDP and financed largely by central bank credi. There has also been a massive incease in credit to the enterprise sector, including a 14-fold increase in the fist nine months of 1992. All in all, the monetary system has broadly accommodated the rise in prices. In addition, incomes poli,y, which until recendy encompassed mandatory wage indexation, led to an increase in real wages between 1991 and 1992. 8. The present Government was named at the end of 1992 in large measure because of dissatisfacton wthb the economic poLcies of its predecessor. Despite strong vested interests opposed to reform, it is beginng to address the fundamental ecomic problems. First, it has publicly ackwledged that there is a crsis, and that difficult and unpopular measures will be necesary. Second, it has tae nita steps to Implement reforms in a number of areas, including small enterpis prvatzaton, privatizaton of household land plots, sueamlng business registration procedures, some targWtng of social expendures, ending wage indexation and introducing a temporary wage f*eeze, and reducing the fiscal defick in the fir quaer of 1993. These actions do not amount to a comprehensive reform progm, but they are encouraging steps. Tie Bank will continue to work closely with the Government on the elaboration and implemeltatin of an economic reform program. 9. onal Cosals. The Govemment of Ukrine has begum to take actions to achieve the transition to a market-based economy. Tbe instional cacity to design and implement reforms, as well as to maage an economy with decentralized decision-makig, is, however, limited. Both the basic institutions of a market economy and the public sects capacity to manage the ansition are weal. The Govemment recognizes the prol lems posed by weak istitutonal capaq to design and implement refoms, and has requested assistance from the Bank to develop and help finance a project for nsional developmet. T7U Goverment has identified thtee pority areas in which prompt and extensive institutional development assistance is required: (a) privatization and private sector development, (b) financial sector reform, including improvements to the payments system, bank accountig, and the management of commercial banks; and (c) public financial management. The following paragraphs review briefly the situation in dtese dtree areas. 10. Pidvatlon ard Pvaw Sector De mlopme. le Goverment has already created the basic instiuions and legal famework for privatizon. In the fall of 1991, Parliament created the State Property Fund and adopted a mmber of fundamental laws, notably (a) the Law on Ownerh 0 whiolh defies ownership rights for enterprises Et the municipal, oblast, and republican levels; (b) the Law on Prhu tladonofkSt-Ow Cpas which contains a detailed description of privatizaon procedures; (c) the Law on SmallScle Priataon which defines the types of enterprs open to small-scale  .3- prazton, the methods of small-scale privatization and the procedures to be followed, and eligible buyeas and sellers; and (d) the Law on Privaztion Certflces which describes in general terms the type of vouchers or certificates that cold be used in privatization. A Privtizaton Program was also approved by Parliament in July 1992, envisioning the rapid privatization of most small and medium enterprses. Weak implementaion capacity is, however, a major problem for privatization in Ukraiae. In paticular, the State Property Fund (SPF lacks the technical resources required to carry out Its mandate. 11. As in the rest of the FSU, private enterprises are a relatively new phenomenon in Ukraine. They are, howewr, emeging at a tapid pace, and by early 1992 nearly 43,000 had been registered. These are widey disprsed throughout the country and are esumated to employ approximately one million persons. Although the basic legal framework for private enterpis activity is essenally sound, inpi_ n measures and administratve practice still present unnecessary obstacles for private busines activity. Business registration procedures, restricted access to commercial real estate, and local regulatory abuses have been identified as particulrly important among a wide range of regulatory problems. More generaly, fair and expedient mechnism for dispute resolution, contatual enforcement and administrcve appeal are still lacking. 12. Fsncw i Sector. In addition to the problers posed by the macroeconomic imbalances and high inflation desced above, the financia sector suffrs from an extremely weak fdtrucre, including an underdeveloped legal framework and supervisy and regulatory capacity, a poorly fimctionag payments system, inade e accuts, and weak commercial bank manage_en The IMF has been adving the NBU with regard to the iegal frmework and bank sprvis, including the provision of assistance and training by the Central Bank of the Nethrands to bank supevisrs. The cumat payment sytem is charcteized by long delays in maidag payments, high levels of foat, the allocation of significant filancial resources toward clearig balances, and potential bank and systemic risk. Many of these problems are the result of massive changes to the banking system of the FSU. The existng payments system was developed to meet the needs of a monobaking, centrally planned economy within a snle politcal entity. The move to a multi-bank, multi-county system based on maket principles has rendered the old system obsolete. Surveys of private busin in Ukraine, undertake as part of the Bank's economic and sector work, have indicated that difficulties in effectng paymenAs are one of the most serious obstales to the expansion of business activit. The National Bank of Ukaine (NBU) and the mmercl banks have made and continue to make modificao to the old payment systemz in order to adapt it to the new environment. They lack, however, the experience with payment systems in market economies required to create a safe, seure, reliable, and cost effective system for meeti the most basic of baking sevices, namely the payment transfer needs of bun and household customers. 13. Ukrine is in the process of adopting inteational accountg standards in conjunction with revision of the banks' Chart of Accounts." The whole accounting framework for private and public entpris, and financlal instdutions warnt drastic overhaul. At present, the commercial banks coinue to rwort their financial situadon using the forms developed by Gosbank, the Central Bank of the FSU, to serve the Inormational requirements of a cetrlly planoed economy. The orentation of Gosbaks reportig requirements, which aimed at controlling the direction and use of financial resources acrdig to the instrcions of the national plan, are Inadate for a more decentralized and market- oriented economy, where financial infbnnation is an important tool in decision-making. Equally mpotnt, the lack of an adequate loan classification system, and the viou accounting conventions of the Gosbank system, lead to ficancial statments which are highly misleading and inadequate for  -4- providng meaningN financial inom on, including to the NBU for supvisy and egatory purposes. 14. Ukrinian state-owned specialized banks were re-chartered as joint-stock companies during 1990- 92. The banks hawe been involved in an almost consta process of reorganization since 1987 when the mono-bank system ws abolished. This process has implied a large urover of staff and a very fluid organizaional structure in an increasingly unstable economy. 'he principal new component in the emerging fnacial system i a group of some 150 new "commercial banks.' Many of these instiuions resemble finance companies or money brokers more th traditional bas. Some were formed for the express pupose of rAisig funds for specific aetprises; othe concenate on the intermediation of funds in the ntebank makeL While die banks have strted implemenig their own limited instutional development programs, thev do not have the full range of inernal resources and, more impornly, the know-how to undertake the required moderion progm to meet the banking needs of a market economy. 15. Pubc Economic d inanial Mnagemn. Under cental planning, the Ministry of Finance played a subordina role, redbstributing the surpluses of the public enterprise sector in the form of subsidies and transrs. Prices were largely accounting entries and bore little resemblance to what would be derived by market forces. Decisions on resource allocation were taken by the central planning apparatus, based in Moscow, for implemeation by republic bodies. The strumre and staffing of the Ministry of Fnace in Ukraine reflects this inherited sysm It has resulted in a body that is ill-prepred to perfm the role of a finance minstry in a market economy, including fostering m c stability, supervig the finances of the government, and ensuring dta resources are spent efficiently and effecy on public progrms. To adapt the Ministry of Finance to the new envioronent requires a combination oIfrganiz change, the shedding of some functions and the. acquiition of others, the development of new systems of financial management, coupled with substl staff trainig and re- equipment. Progress is being made in such a direction. In Ocber 1992, a new Depament for BWget Execution was established, which is well placed to evolve into a full-fledged Treasury Depament. In addition, adapting the Mistry of Finace to its new role in a market economy will require stregthedning budget preparation and creating the capacity to scruinse expet more thoroughly, review invesmet spending proposals, and reshape the composition of the state budget. On the reenue side, it wil requir changing the tax structure and stengthening the capacity of the State Tax Inspecoa to collec taxes, while at the same ie ensuring that taxes are applied with the fewest exceptions and at rates that are modest and do not dicouage compliance. 16. The role of tie Ministry of Economy is also in the pocess of evolving from a largely central plaML function to that of defining economic policies in a market-based economy. At present the Ministry is poorly equipped to fulfill the lead role that it has been assigned in the development of a comprehensive reformn progm. Such an evolution will require short-tem advisory assistance and a major training effbot in the Ministry to strengthen its capacity for economic analysis, particularly in the areas of macro analysis, policy fonmulation, and public investment programming. It will also depend on major anges in the type, quality and methods of data wilection employed by the Ministry of Statistics. 17. Bank's Role and Sttegy. Ihe overriding economic objectives for Ukraine are to stabilize prices, to quickly reorient production to viable activities, and to initiate far-reaching systemic reforms. Detailed policy poposas have been put forward in the key areas for realization of the above objectives: price and trade policies, financial sector reforms, privatizon and private sector development, agriculte, energy, and the socia safety net. Implementation of a program to achieve the above  -5- objwctves could be supported by a Rehabilitation Loan and subseqenly by a series of sector loam, As noted above, Ukaine is in the process of creating many of th Institutions of a market economy. Insiutionail development lending will be essental to stngthen the instional nfrastructure needed for such an eonomy and to improve the cacity of the govement to design and Implement reform, as well as to absorb additional extra support. The proposed operaion would be the frst Bank loan to Ukraie. It would strngthen the government's cpa to achie the above objectves by supportg pvtzaton and privme sector deveiopment, strengthening the basic infrastucure of the financid sector, and providing the Ministry of Finance and the Ministry of Economy with the means to manage economic and financial policy formulation and implementation. In addition to providing specific insiudonal suppo, It would stren the cosituency for reform and faciitate policy dialogue both wi Ukraine ad with international financial institutions. In paricular, it would enlarge the dialogue between Ukraine and the Bank to coret assistance in specific areas of reform. Project Desciption 18. ObjetIves. The objecdtves of the proposed ntiudon Building Project are to support implementaticn of economic reforms and to strengthen institudons essentia to the efficient operation of a market economy. In order to achieve these objectives the project will provide consultant services, training and equipment in three broad areas: enterpise reform, fiancial sector reform, and public economic and financial management. The project will complement activities already underway or planned by other donors in these areas. The loan would also include an unallocated amount to respond to addidonal r _ identified during implemetation; such actvities would be mutuly agreed upon by the Governmen and the World Bank and consistent with the project's objectives. 19. Enterpris Reform (US$43 nilon). Private sectctdevelopmen, including privatizion, wlln be the key to future growth in incomes and employment in Ukraine. It is key to achieving the transition to a market economy, since, in addition to leading to a more efficient management of firms, private sector development and privatzation are the very means of creaing markets in mo goods and serices. The enterprise component will provide assistance in four specific activities: (a) implemenation of privatization and business regulatory reform in selected oblasts and cides; (b) pilot privatzations program, (c) demonopolization; and (d) a public information campaign regarding privazation. 20. Au ace to Oblks and Cdes. The project will prove pnvaiatio and private sector development assistance to selected oblasts and cities aimed at acceleratig piva ion of state and muicipal property and promoting the rapid expansion of private sector actvit. This importa element of the project has been prepared following an explicit bottom-up appach. It is designed to provide assistance to localities that are prepared to move on the acual implementation of privatizaton and other reforms. Initially such assistance will focus on the organization of auctions for small enterprise privatization and simplification of the regulatory framework for private business. With regard to small enterprise privatization, the project would finance an expansion of aucions, based on the IFC-supported pilot auctions conducted in Lviv and elsewhere, and integrate them with regulatory reforms and other privazation assistance. It would subsequentdy assist the same localities develop and implement programs for the privatization of medium-size enterprises, land, and housing. Assistance has already been Iniated in Kharldv and is proposed for at least four other cities, including possibly Donetsk, Kiev. Mykolaiv, and Yalta. The project will finance a coordinator for small enterprise privatization at the State Property Fund in Kiev (18 person-months), and full-time city coordinators (24 person-months), two local assistants (48 person-months), and short-term consultants (12 person-months) for each city sub-project. It will also  -6- finace basic office equipment for each city sub-project and training for local officials and enterprise 21. PoW Pdv4dzadon. Tle project will provide assistance for the pilot privatzation of approximaely five enterpes in order to test and fine tune the methodologies to be employed under the privatzation program to be carried out by the SPF. To the ext-et possible, the enteprises will be selected in those cities which are receiving support under the small enterprise privatiaion and private sector developmet subcomponent described above. The project will finance approximately 30 person-months of consulting services to be provided to the SPF for the privatization of the selected enterprises. The composition and durtion of consulting services required will vary from enteprise to entepise, but include legal, fIancial, and engineering assistance. 22. Demnoapolkadin. The demonopolization subcomponent will support the newly created Anti- Monopoly Committee (AMC) in the preparation and initin on of a program to break up selected monopoly enterpris and to prevent practices aimed at restrictng competition. The UK Know-How Fund will finance a long-term advisor for the AMC (approximaey 18 person-months). The project will finance additional short term consultants for a total of 20 person-months. TIhis will include assisance for (a) the break up of selected monopoly enterprises and (b) the finalization of legal tem, work program, operating guidelines and organ'zational structure of the AMC. The project will finance training for AMC staff in the form of a two-week seminar to be held in Kiev and work visits to anti-monopoly agencies in other countries. The project will also finance office equipment for the AMC headquarters and regional offices. 23. Public lqmaton Campaign. The project will finance a public information campaign on the privatization program aimed at imprving the public's understanding of the privadzadlon process and generatng support for implementation of Ukraine's privatmation program. The public infomaton empaign, to be maaged by the SPF, will cover all aspects of the privatization process, including its context in the general reform process, and will give specific coverage to small etrprise pivaization and the use of prvatization certificates. It will make use of all available media, including TV, radio, press releases, seminars, speeches and public meetings. It will include presentaions by key political figures and regional spoMespersons such as enterprise managers, investment fid managers, and private entrepreneurs. The project will fimd a public relations advisor for six months to design and implement the program and the preparation of the neceary publicity materials, including electronic media preentations. 24. Asstacefrom Other Donors. ITe above assistance is designed to complement and be closely coordinated with ongoing and planned assistance from ECtrACIS, EBRD, the Nethrands, the UK Know-How Fund, and USAID. The EC/EBRD have placed a f-am of advisors in the SPF to asist in the definition of an overall privatization strategy and the promotion of privatzation procedures (totl cost ECU 1.8 million). The ECtTACIS program will also provide assistance (a) to enterprises in their negotiations with foreign investors (ECU 0.7 million) and (b) for the preparation of 6-9 pilot enterprises for their privatization (ECU 4.3 million). The EBRD is also providing assistance in pilot privatization tasactions with funding from Japan (ECU 0.9 million). The Netherlands wiU provide parallel financing (US$0.5 million) for smah-enterprise privatization in Kharkiv. Tne UK Know-How Fund will finance advisors to the Anti-Monopoly Committee (US$0.25 million). USAID is considering additional assistance to the State Property Fund.  -7- 25. Pinandal Soctor Rform (JS48 milUon). Efficiet financial Iemediation will be crical to facil the mmssive relocaon of resources ImpVIe by the move to a market economy and major chages in reladve prices. The project would begin to address ficial sectr Issues thrmugh strengtheingthe setor's istoa ra c , Including the mo basic of baking sevices, namely efecting payments betwen economic agent. Specifically, the financial sector compone will provide asis e In de areas: (a) modeizaton of the paymens system, (b acounting refom for fnacW insdtutions, and (c) Instiional gtn of commercial banks. 26. Payments Systm The projec will assist the National Bank of Ukraine (NBI" and the banldng industry in developing a safe, secure, reliable and eost effective payment system meets the needs of businesses, consume, and banks to asfer Mm and eft payments. Ihe upport provided under thie project builds upon the assistance provided by the IMP and the Austrian National Bank to the NBU. Asstnce wll be provided in the following areas: system architure and development str, payment instrument design, clearn and setement systems, standards, legal and regulatory structue, safet and security, ownship and control, cost recovery, and i'abank systems. Toe project will finance approximately 30 person-months of consutant services for Iimedie short-term Improvemens and for the design and initial implementation of a modern payments system; training for NBU and commercial bank sta and inidal hardware and software needs for implemenation at the NBU, commercial banks, and cearinghouse. Technical specification of hardware and software requirements would be prepared during the design phase and agreed with the Bank prior to initiating procurement. 27. Accowgfor handcal InsUalons. The project will provide assistance for the rapid adoption of refors in bank accounting, Intoducto of a new 'chart of accounts", and training a core group of senior bank accounts and supervisors. The project will finance a taining seminar in Kiev to introduce a new bank accounting system (BAFS-Broadly Adapted Financial Statements), expert assistance (3 personmonths) to undertake two pilot projes applying the new accounting medtodology and formats, consulting services (6 person-months) to prepare for adoption of the svstem, consulting services (3 person-months) to the NBU's Computw Center in software development, and a one month intensive training program for senior bank acountats. 28. Insttional Strengdzenlng of Banks. he project will prvide assistance to two Ukrainian bank, the Savings Bank and a Commercial bank, aimed at acceleratng their development into modern, market- oriented bang Istitutions. The first phase of assistamce (6 person-months per bank) will focus on a diagnostic of the istdtonn needs of the bank and development of a moderization program. A second phase of assistance (64 person-months per bank) will focus on implemention of such a program Assistance wfll focus on business strategy, credit policy and procedures, risk management, preparation for financial restructuring, treasury management, accounting and interal audit systems, auomation strtegy, and training requirements. The assistance wIll be provided by foreign savings and commercial banks or a specialized consulting firm, with a view to laying the groundwork for commercial cooperation and the possibility of eventual foreign investment. 29. Assistance friom Other Donors. Additional assistance in the areas of trainig and general accounig standards will be financed by other donors. The EC/TACIS program will support the creation of a bankers training center (ECU 2.7 million) and provide assistance for revamping gener accountng standards (ECU 0.3 million). The UK Know-How Fund is providing assistance for accounting taining (approximately