Ukraine - Pilot Rural Finance Project

Report No. PID7006 Project Name Ukraine-Pilot Rural Finance Project (+) Region Europe and Central Asia Sector Socially Sustainable Development Project ID UAPE56847 Borrower Ministry of Finance, Government of Ukraine Implementing Agency National Bank of Ukraine Date This PID Prepared August 17, 1998 Projected Appraisal Date March 1999 Projected Board Date June 1999 1. Country and Sector Background. With a population of 52 million people, Ukraine is the second largest country in Europe. Although Ukraine has enjoyed considerable success in stabilizing the currency and reducing inflation, the stabilization program remains on weak foundations. In particular, the present fiscal crisis facing the country shows that the macro-economic reforms have not been accompanied by sufficient structural reforms to achieve a sustainable fiscal balance and restore growth. Since independence, real GDP has continued to decline and per-capita income (estimated at US$ 1,630 in 1995) has dropped by 50%. 2. The Agriculture Sector. Agriculture continues to be a key sector for the economy, contributing about 21% to the economy and employing about 24% of the population in 1996. However, economic development in the rural areas is hampered by a number of factors, perhaps most important of which is the high marginal cost of lending, described as follows. a) Average nominal interest rates are high (around 709), creating a liquidity squeeze for banks and resulting in short average maturities for loans (generally up to 6 months) and for deposits (generally up to 3 months). b) Many farmers lack personal resources to use as collateral for loans. This difficulty is compounded by the fact that they generally cannot sell or use the land certificates received during restructuring as collateral. c) A weak court system and unclear legislation makes enforcing loan repayment difficult, and has made banks cautious in lending to small farmers. d) Commercial banks have primarily targeted their activities to urban areas, leaving much of the rural areas without effective financial intermediation. Though the former state banks - Bank Ukraine (for agriculture, minority state owned) and the Savings Bank (majority state owned) - have the largest branch network in the rural areas, they face financial weaknesses which limit their ability to provide financial services to the rural areas. In addition, there is a predominance of unproductive collective farms in the rural economy; private farms and small rural enterprises are just emerging and are still small in number. The commercial banks lack experience making the smaller loans demanded by this clientele. e) Credit Unions had a traditionally strong role in the financial sector in Ukraine before becoming a part of the Former Soviet Union, but their reemergence has been hampered by the recent period of hyperinflation, limited awareness of them by the population, and the lack of a comprehensive legal and regulatory framework for them. Although credit unions are licensed and have  statutes approved by NBU, they do not fall under the banking law, and are not subject to banking, or any other form of external, supervision. 3. All of these factors contribute to the current lack of capital and access to financial resources by small farmers, and have resulted in a general reduction in lending to individuals and enterprises. 4. In addition, there remains a lack of structural reforms in the sector. By 1996, most of the country's agriculture was still effectively collectivized. Private agriculture consists of about 37,000 private farms with an average area of 23 ha and of about 11.3 million private households farm household plots of generally less than 1 ha . Private farms and household plots use about 15t of the total agricultural area, but produce about half of total agricultural output. Against the general decline of Ukrainian agriculture, the output from the private agricultural sector has increased annually, which is mainly due to increased production on the household plots. The number of private farms and their output has remained stable since 1996. 5. The Financial Sector. The financial sector is of key importance for the transformation of the entire Ukrainian economy, including the rural economy. The sector is still extremely vulnerable if the macro-economic situation continues to deteriorate and the Ukrainian currency depreciates suddenly. The banking sector is dominated by the former state banks, but the new private banks are growing and have gained a significant share of the banking market. The National Bank of Ukraine (NBU) has started to tighten the prudential rules for banks, which should lead to a consolidation of the banking sector, and to the emergence of full-service banks which are larger, and more robust. All of the former state banks and a number of the bigger private banks are participating in a donor assisted Institution Building Program. Some of the difficulty in providing services to the rural areas might be compensated by some private banks which have developed a branch network in the regional centers, and in small and medium-sized towns, and are interested in expanding their services in the rural areas. 6. Credit Unions. In 1992, credit unions started re-appearing in Ukraine after they had disappeared for nearly 50 years during the Soviet Union. At the beginning of the 20th century, about 3,000 cooperative savings and credit associations with about 2 million members existed in Ukraine. At present, there are about 130 active credit unions of which 68 are organized in a National Association of Credit Unions (UNASCU). These credit unions have about 30,000 members, from low and middle income groups, and assets of about UHA 5.4 million. Credit unions are managed and controlled by their members and all commercial transactions are exclusively between members, to ensure the necessary trust for savings deposits. The strength of the Ukrainian credit unions is their strong local basis so that their entire loan portfolio has been financed through deposits or share capital from members. To build on this foundation, UNASCU has developed a strategy to assist the establishment of an appropriate legal framework, increase the marketing and the trust of potential members in credit unions by developing and adopting prudential standards for their operation, and improve the institutional framework at the local and the national level. 7. Despite the problems identified above, banks and credit unions report that with additional funds and improved financial technologies, the size of -2 -  their rural lending portfolio could be increased substantially, due to the new types of clients emerging in the rural areas. There are already some private agroprocessing enterprises that are actively exporting processed goods to neighboring countries. About 50 food and wood processing enterprises obtained loans (average loan size US $900,000) from an EBRD credit line. Household plots and private farms play an important role in providing the domestic markets with food products. Also, a small service industry is developing in the rural areas. The Project 8. Introduction. One of the major constraints facing the development of private farms, private farm enterprises that have been restructured, and small rural enterprises is the difficulty in accessing primarily loans and other financial services such as leasing or deposits from financial institutions. This is less a constraint for larger and financially viable private agribusiness and wood processing enterprises who have obtained loans to finance capital investments in plants and equipment through the EBRD credit line (ECU 100 million). The collective farm sector continues to receive state support to finance farm inputs and machinery but due to the increasing budget deficit the Government most likely can not continue these subsidies. 9. Objectives. In the above context, the pilot project wants to demonstrate to Government that primary agriculture and small rural enterprises can be financed through existing financial intermediaries on a commercial basis, and that the existing state-subsidization programs for collective farms are costly and ineffective. Specifically, the Pilot Rural Finance Project aims to increase lending to primary private agriculture, small rural enterprises and agribusinesses by expanding the financial services of commercial banks and credit unions. To achieve this objective, the Project would work with and through existing financial institutions, e.g. commercial banks and credit unions, which would receive a credit line to relieve the liquidity constraints they are facing, and technical assistance to build up their capacity to make small loans more cost-effectively. In addition, technical assistance would be provided to improve external regulation of credit unions and to expand their number in rural areas. Description A. Strengthening Commercial Banks (US $22.0 million) 10. A credit line will be provided to allow participating banks (PBs) to diversify their portfolio risk by using the Bank loan to make small loans to farms and small rural enterprises and larger loans to agribusinesses. Each PB should ensure that at least 50t of all loans from the credit line are directed to primary agriculture and small rural enterprises. Financing will be for working capital or investment capital. In addition, Technical Assistance will be provided to develop the retail lending capacity of PBs in the rural areas, strengthen the registration of moveable collateral, and explore the possibility of expanding leasing companies. B. Development of Credit Unions (US $3.0 million) 11. A credit line will be provided to participating Credit Unions (CUs) operating in urban and rural areas. Each credit union must meet certain eligibility criteria, and must have been in operation for at least 1 year and employ at least 2 staff. In addition, technical assistance for CUs will be -3 -  provided to expand their numbers in the rural areas (potentially financed by US, Canada, or UK), and to develop an external supervision and regulation system (likely provided through the German Bundesbank and Raiffeisenverband). Financing 12. The total project cost is US $34 million. The project financing consists of a Bank loan of US $25 million, which will be complemented by US $1.0 million from the Government of Ukraine, US $5.0 million from project beneficiaries (participating commercial banks and credit unions), and US $3.0 million from international banks and development agencies for technical assistance. Implementation 13. The Ministry of Finance will be the Borrower on behalf of the Government of Ukraine. MOF will sign Subsidiary Loan Agreements with commercial banks certified to participate in the project. However, MOF does not have experience in managing credit lines and monitoring the compliance of commercial banks with eligibility criteria and has therefore asked NBU to execute the Project. For this purpose, NBU has established a new Project Management Unit to manage this project and future World Bank credit lines. NBU has appointed a head designate for the PMU and a junior staff member to exclusively work on this project. These staff will be responsible for: (i) administering disbursements of the credit line to the PBs and participating CUs; (ii) overseeing the collection of funds advanced to the PBs and CUs; (iii) constantly monitoring the eligibility of the PBs and CUs; (iv) coordinating project activities; (v) managing monitoring & evaluation, procurement and reporting to IBRD, and (vi) maintaining records and accounts for the Special Account and ensuring proper audits by independent auditors acceptable to the Bank. NBU has already gained considerable experience in administering an EBRD and KFW credit line. The Ukrainian project preparation team includes a representative of the National Agency for Reconstruction and European Integration (NAREI); the Ministry of Agroindustrial Complex (MAIC); and the National Bank of Ukraine (NBU). 14. Eligibility Criteria for Participating Banks. ECSPF will carry out the initial and ongoing financial intermediary pre-qualification for all financial intermediation operations in Ukraine, and assist the PMU staff in this respect. 15. On-lending Terms and Conditions for Commercial Banks. The commercial banks would assume the full commercial risk. PBs will evaluate all sub-loan applications and submit them to the PMU, which will review them to ensure conformity with the project's eligibility criteria. Dollar denominated loans (interest and possibility for local currency denominated loans will be explored during pre-appraisal) will be made available to the PBs at LIBOR plus a margin for PMU's expenses and MOF's credit risk. The margin will be finalized at appraisal. The PBs would need to maintain a balanced portfolio from the credit line between: (i) loans to primary agriculture and small rural businesses; and (ii) loans to agribusinesses. This ratio would be subject to annual review by the Government and the Bank. 16. On-lending Terms and Conditions for Credit Unions. The credit unions would assume the full commercial risk. Each eligible credit union could - 4 -  borrow for a term of up to 12 months, and after successful repayment of the first loan, receive a second loan for longer periods of up to 24 or 36 months (to be determined at appraisal). The credit unions would be free to choose the on-lending interest rate to their members. 17. Financial Management and M&E. The Bank will review the existing financial management systems that are used for the EBRD and KFW credit line to determine their suitability for Bank purposes. M&E will be the responsibility of the PIU using monitoring indicators. The monitoring and evaluation results will be used to determine and design the follow-on project or, to the extent applicable, influence the design of the Agribusiness Project. Sustainability 18. Increased delivery of financial services by commercial banks engaging in new retail operations should create solid long-term clientele, which should keep the banks profitable. The traditional strength of credit unions in the country will be enhanced by the provision of technical assistance to improve the regulatory framework, and create trust in the private sector of the use of the credit unions' services. In addition, there is a built-in incentive for credit unions to continue savings mobilization because: (i) only CUs with considerable minimum assets and operational experience can participate; and (ii) CUs can only borrow up to a certain amount of their assets. Sustainability of the project will also depend largely on World Bank prequalification to determine those banks and credit unions which meet eligibility criteria, and consistent ongoing monitoring of compliance with the criteria. Lessons learned from past operations in the country/sector 19. The pilot rural finance project will be one of the first follow-on projects aimed at deepening the sector reforms supported under the EDAL, FSAL and the AGSecal programs. 20. The proposed loan presents the second credit line operation and the second investment operation in the agricultural sector. Past experience shows that project implementation in Ukraine is often delayed due to cumbersome bureaucratic procedures. Therefore, the PMU in the NBU was selected as the main counterpart for implementing the project, because of its experience gained in implementing the EBRD and KFW credit line, and its autonomous status vis-a-vis the Government of Ukraine. As the banking sector is still at risk, the performance of the participating banks has to be monitored continuously and carefully by the PIU and the Bank. 21. Some lessons learned from other rural finance operations in the region include: (a) strong project ownership and advanced preparation of project components is necessary for timely implementation; (b) simple procedures and documentation requirements for PFIs facilitate disbursements; (c) technical assistance is necessary to support the banks and the PMU in loan appraisal and monitoring of PFI eligibility. 22. Microfinance institutions that have a successful track record of operation and have managed to mobilize substantial savings from their members have the highest chance in achieving and preserving financial self- sustainability. The Ukrainian credit unions have mobilized about US$ 2.5 - 5 -  million in savings, and are a promising partner if coherent external supervision and regulation of member credit unions is ensured. Poverty Category 23. N/A Environmental Aspects 24. The proposed Project is rated as a financial intermediary (FI) operation. For FI operations, the Bank requires that each FI screens proposed subprojects and ensures that sub-borrowers carry out appropriate EA for each subproject. Sub-projects that would be financed by participating banks would include agroprocessing enterprises, primary agriculture and other small rural enterprises. Based on the existing information, all sub-projects are expected to fall into category B (small agribusinesses), or category C. Sub-projects to be financed by Credit Unions would be small in size (average loan US$ 1,000) and no major negative environmental impacts are expected. Banks participating in the credit line will have already participated in the EBRD Credit Line and follow the "EBRD environmental procedures for local banks". EBRD's due diligence process involves environmental screening by the staff of the participating bank, identification and evaluation of environmental impacts and risks, risk control and risk monitoring. The participating banks will therefore follow the same due diligence process for loans under this credit line. A simplified manual for screening sub-loans will be developed for the staff of credit unions. An environmental consultant would be hired to review the experience with the local banks in applying the EBRD environmental procedures for local banks and adapt them to the Banks needs The Project will draw on the experience of the banks with the EBRD environmental procedures for local banks. Program Objective Categories 25. The Board approved the most recent CAS for Ukraine on June 3, 1996. The CAS identifies three main priorities for the Bank's rural development strategy for Ukraine: : (i) improve and accelerate policy reforms; (ii) support to the private sector in both rural (farm and off-farm) development and post- privatization restructuring of agroindustry; and (iii) institutional changes in public institutions to strengthen support programs for private agricultural sector entrepreneurs. These priorities provide the framework for the proposed Pilot Rural Finance Project. The project will support these priorities, particularly numbers (ii) and (iii), by facilitating the development of local financial intermediaries, e.g. commercial bank branches as a first attempt to provide credits and other financial services to private agriculture and small rural entrepreneurs. In addition, the Bank's support to the establishment of a supervisory and regulatory system for credit unions will help these institutions to attract more savings from the public and to ensure a better protection of the savings. 26. Beneficiary Consultations. During project preparation, a survey will be carried out by local social scientists to identify the needs, interests, and constraints of private farmers and small rural entrepreneurs. The social assessment will cover the credit demand, credit use, constraints in accessing credits, transaction costs, collateral, and possible institutional structures. In addition, the about 30,000 members of the credit unions participated - 6 -  through direct presentations at the annual meeting of credit unions, through the preparation of questionnaires and through National Association of Credit Unions considerably in the design of the credit unions component. Further, consultations were held with the Private Farmers Union and local governments in the pilot regions. 27. Contact Point: The InfoShop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Telephone No. (202)458 5454 Fax No. (202) 522 1500 Mr. Florian Grohs, ECSSD The World Bank 1818 H Street N.W. Washington, DC 20433 Telephone No.: (202) 458-4319 Fax No.: (202) 477-3291 Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending October 30, 1998. - 7 -  Annex Because this is a Category B project, it may be required that the borrower prepare a separate EA report. If a separate EA report is required, once it is prepared and submitted to the Bank, in accordance with OP 4.01, Environmental Assessment, it will be filed as an annex to the Public Information Document (PID) . If no separate EA report is required, the PID will not contain an EA annex; the findings and recommendations of the EA will be reflected in the body of the PID. -8-