Ukraine - Community Development Program Project

Report No. PID7906 Project Name Ukraine-Community Development Program Region Europe and Central Asia Region Sector ME - Economic Management Project UKPE56806 Borrower(s) Government of Ukraine Implementing Agency Ministry of Finance Environment Category C Date PID Prepared June 17, 1999 Projected Appraisal Date March 6, 2000 Projected Board Date November 7, 2000 1. Country and Sector Background The ability of municipalities to provide effective and efficient services and to invest in either new or rehabilitated capital stock has deteriorated rapidly since the beginning of the 1990s. Lack of investment in urgently needed infrastructure and municipal services limits economic growth and leads to worsening standards of living and social conditions. It is essential to help support communities in restoring their infrastructure and services. There are currently several factors that constrain the municipalities. First, municipalities are affected by the overall financial and macroeconomic crisis that Ukraine has faced in recent months. The tight fiscal squeeze has created a liquidity crunch, which in turn has generated extremely high real interest rates. This combined with general instability and uncertainty has postponed the development of long-term financial markets in Ukraine at present. Second, the current system of intergovernmental finance creates an unstable and unpredictable fiscal environment for municipalities. Such an environment would make acquiring access to long-term credit difficult even if such a market did exist. Lack of clarity on expenditure responsibilities for different levels of government leads to poor incentives for investing in provision of services. The current system discourages localities from increasing revenue collection and the system of transfers is highly unpredictable. Cost recovery in service provision is also relatively weak. Finally, the intergovernmental finance system as a whole does not promote a hard budget constraint, but rather, encourages non-repayment of loans, especially among levels of government. Third, many localities are only beginning the transition to the new budget classification required by the Ministry of Finance (MoF) and have a relatively limited capacity in strategic planning, multi-year capital budgeting and in the accounting and financial management practices that are required in order to be able to attract financing for investment projects. The Government of Ukraine is working to implement the measures necessary to restore macroeconomic stability, to bring interest rates down and to further the development of the financial market. By implementing the measures  necessary for approval of the Fund's EFF, they have increased the possibility of addressing these issues. The Bank's recent Country Economic Memorandum highlighted a range of structural issues and the Government continues to work to stabilize the economy. In recent months there has been an active dialogue on issues related to intergovernmental finance in Ukraine. The Bank's Intergovernmental Finance Study provides a framework for reforms in five key areas for improvement of the intergovernmental system: 1) strengthening the institutional and legal framework for intergovernmental finance, 2) clarifying expenditure assignments, 3) building sound sources of local revenue, while improving local resource mobilization and strengthening cost recovery, 4) creating a stable and transparent system of transfers, and 5) supporting prudent subnational borrowing. This framework sets the agenda for the progress required as part of the program. There is consensus on the need to improve the predictability and transparency of the system in order to improve fiscal management at all levels of government and a number of Government agencies have been working toward this end. The Government and other donors such as USAID are also supporting a wide range of efforts to improve the capacity of local governments in budget management, fiscal planning and project preparation. 2. Objectives The project presented here is the first phase of the overall program. Development objectives of the project are focused on: (a) strengthening two particular aspects of the system of inter-governmental finance - the intergovernmental system of transfers and the legal and regulatory framework for subnational borrowingi/, (b) creating and launching operations of the MDLF, and (c) building LG capacity for fiscal and financial management. At the outset, the MDLF will provide modest loans to LGs for well-designed capital investments in infrastructure and communal services to initiate safe lending to qualified municipal borrowers. These objectives will be pursued with the aid of Technical Assistance (TA). 1/The CDP plan for improving the intergovernmental finance system will be based on the World Bank. 1999. "Inter-Governmental Finance in Ukraine: An Agenda for Reform" and in consultation with the central and local governments. 3. Rationale for Bank's Involvement In addition to supporting the improvement in service delivery in a number of municipalities, the CDP will significantly improve the fiscal and financial management capacity of all LGs participating at each level of the project process. The link with specific policy actions will help to improve the system of intergovernmental finance as a whole. Finally, the project will help to foster a new financial "hard-credit" culture in Ukraine, the value- added of which can not be over-estimated. 4. Description Central Government Policy Development Local Government Capacity Building Creation and Initial Operation of Municipal Development Loan Fund 5. Financing -2-  Total ( US$m) Government 0 IBRD 0 IDA 0 Total Project Cost 0 6. Implementation The core implementing institution of the project is the MDLF, which will have semi-autonomous status under the Ministry of Finance. Although all initial funding for the MDLF will come from a World Bank loan passed on to the MDLF, it is envisaged that the decision-making structure and staffing will accord the MDLF significant independence in order to carry out its mandate. The MDLF financing mechanism is structured to create incentives for lenders and borrowers that are compatible with commercial, well-functioning credit markets and penalties to discourage default and with possible use of an intercept function. The basic structure of the project is as follows: The Loan Agreement with the Government of Ukraine will be standard for such documents and will contain all terms and conditions pertaining to the use of the proceeds of the loan. It oblidges the Government to repay the World Bank in the currency loaned on an agreed schedule. The agreement between the Government of Ukraine (Ministry of Finance) and the MDLF will specify the possible project finance purposes for which the MDLF can lend, as well as the decision-making procedures to be applied by MDLF. The MDLF's obligation to repay the MoF is in no way affected by its collection rate from borrowers. The agreement will denominate the loan to MDLF in local currency and will charge an interest rate which covers the cost of funds, expected foreign exchange risk to the Government of Ukraine and reasonable administrative costs. The Credit Agreement with the municipalities will be a standard financing agreement between the MDLF and borrowers. The borrower will be required to agree in a legally binding manner to the intercept of transfers in favor of MDLF in the event of default. Disbursement from MDLF will be against physical progress on implementing the agreed project. The guiding policies for MDLF activities will be set and monitored by a supervisory board (MDLF-SB) whose membership shall consist of stakeholders and will be similar to that of the current CDP working group. The full-time staff of MDLF will comprise an Executive Director and appropriate staff in the areas of finance, legal, project evaluation, loan supervision and portfolio management. The principal of out-sourcing many needed technical services will keep MDLF fairly small and efficient. Such a strategy will also facilitate subsequent transformation of the system to the private sector. Examples of services which may be contracted out by MDLF are reviewing of engineering proposals, and the processing of payments and holding of local accounts by using qualified Ukrainian commercial banks. The MDLF-SB will also determine the type of investments eligible for MDLF financing most likely by issuing a "positive list" of investments that can be considered. An example of such a positive list is provided here: Energy efficiency projects, such as better housing heat isolation and boiler rehabilitation or replacement; Water supply efficiency improvement (including meters installation); Electricity distribution improvement (including meters installation); - 3-  Public transport investment; Garbage collection and solid waste management; Parking lots; Public markets; Other, activities that are financial and economically viable and that do not undermine or compete with private sector development. Cities applying to the MDLF will be required to go through a standardized application process. First, the municipality will complete a "fiscal snapshot" designed to quickly assess whether a full scale creditworthiness analysis is warranted. The "snapshot" will focus inter alia on overall revenues, expenditures, arrears, barter status and debt standing of each applicant. If an applicant's fiscal snapshot is not sufficiently strong to go to second stage participation, TA will be offered to help LGs build their fiscal capacity to meet "snapshot" thresholds. The second stage is for applicants to present a detailed Municipal Finance Plan that will allow assessment of the creditworthiness of the municipality and measure debt servicing capacity. This is a much more extensive process than the snapshot. If rejected at this stage, applicants will be directed to technical assistance based on the specific problems found in the Municipal Finance Plan. Once a borrowing limit is established, a potential customer of MDLF will present a project proposal. The third step is an evaluation of the project in the usual fashion. If acceptable, a loan will be granted and implementation can proceed. Full information including an operations manual for MDLF procedures and selection criteria will be widely disseminated and applicants will be able to submit materials for more than one step at the same time if they wish. However, a satisfactory assessment at each step will be mandatory before proceeding to the next TA will feature in most aspects of the project. The bulk of TA is expected to come from donors who are already active in the area or who have indicated their intertest in supporting such activities. However, the loan has been designed to fund essential TA in the event that donor support is not forthcoming. The government will be free to use donor supported TA rather than loan-funded TA when it is available. As a minimum the project will finance a TA coordination office, likely in a local institute. 7. Sustainability Sustainability: The sustainability of MDLF depends primarily on its loan collection performance. Several measures have been taken to minimize this risk. First, the emphasis on qualifying the borrower gives primacy to the "ability" to repay. Second, the semi-autonomous status of MDLF removes these loans from the budget process, which may increase the "willingness" to repay. Starting with small loans and basing future access to loans on repayment records should alsoencourage prompt payment. Finally, the imposition of an intercept that penalizes the borrower and makes whole the lender ultimately assures the sustainability of the MDLF. Critical Risks: (reflecting assumptions in the fourth column of Annex 1) There are unavoidable technical/organizational risks associated with the MDLF's implementation capacity and the capacity and willingness of the local governments to implement agreed projects according to the project conditions. Capacity risks exist in particular with respect to ensuring timely payback of the MDLF loans, which depend heavily upon good LG fiscal and financial -4 -  management. In order to mitigate these risks the project design adopts rigorous prior conditions on the LG's financial health. Additionally, the project integrates previous Bank experience in MDP projects in Philippines, Brazil, and Jordan by incorporating both intensive monitoring of the client local government's financial health and project performance to mitigate the above risks. The specific risk that the MDLF is unable to collect its loans is addressed in the first instance by the emphasis on qualifying borrowers as the first step in processing applications. However, the proposed intercept of central government transfers to LGs in the event of default ultimately protects the financial integrity of MDLF. Another risk is the limited capacity of many local governments. The screening criteria at each stage will be designed to funnel the most progressive and financially sound local governments towards project financing and funnel unprepared LGs to technical assistance. Given the critical role that TA plays in the project its delivery in an effective and timely fashion is critical for project success. Coordination and management of TA will be directly supported by the project and sufficient funding to provide some of the necessary assistance is included in the loan as a contingency in the event that donor response is inadequate. Long term strategic risks: such risks are associated with the political commitment of the government towards strengthening LG fiscal and financial independence. Although the Government has demonstrated a strong ownership of a sub-national intergovernmental reform program with its positive reactions to initial IGF findings, review on a regular basis will assess progress made and appropriate corrective measures will be proposed, if necessary. 8. Lessons learned from past operations in the country/sector International experience with MDLF type institutions has been mixed. (See Peterson and Hamman (1998) and recent work by OED evaluating the experience of the Philippines and Brazil.) Often such funds have not met their primary objectives, either in terms of achieving good repayment records or in terms of stimulating private sector financing for local government investment. The design of this project has taken these lessons into account in three ways. First, the risk of high default rates is addressed by screening borrowers for creditworthiness before project details are considered. An intercept on the intergovernmental transfer system is incorporated as insurance that the MDLF will be compensated in the event of non-payment. Finally, a plan to start with relatively small loans and offer borrowers, in good standing, opportunities to receive additional loans should minimize the risk to MDLF of large defaults and maximize the incentives for borrowers to repay their loans in order to access additional credit. Second, the project is designed mimic a commercial transaction to reduce the barriers to the transition to private lending to municipalities. MDLF will not politically pre-select its projects but rather will respond to the demand of municipalities who are willing to subject themselves to a screening test of fiscal management and creditworthiness. TA will help municipalities as they go through this process and is already under way in some cities. MDLF pricing will reflect the cost of funds and will cover foreseen risks and administrative costs. Additionally the structure of MDLF can be used without modification in a system where and when banks choose to take credit risk of this type of lending. Outsourcing of services by MDLF from the outset is - 5 -  designed for efficiency and to provide the incentives for MDLF to shrink its role at the appropriate time. Third, a concerted effort to put key policy reforms in place will provide a supportive context for MDLF. Foremost among these are the up-front changes to the intergovernmental transfer system and the regulation of subnational borrowing. 9. Program of Targeted Intervention (PTI) No 10. Environment Aspects (including any public consultation) Issues: 11. Contact Point: Team Leader Deborah L. Wetzel The World Bank 1818 H Street, NW Washington D.C. 20433 Telephone: 202-458-4026 Fax: 202-522-2754 The InfoShop The World Bank 1818 H Street, N.W. Washington D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Processed by the InfoShop week ending June 25, 1999. Note: This is information on an evolving project. Certain components may not be necessarily included in the final project. - 6 -