Ukraine - Second Enterprise Development Adjustment Loan Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No: 19965 IMPLEMENTATION COMPLETION REPORT (Core ICR) ONA LOAN IN THE AMOUNT OF US$ 300 MILLION TO THE UKRAINE FOR A SECOND ENTERPRISE DEVELOPMENT ADJUSTMENT LOAN PROJECT ID: P049502 L/C NUMBER: 43900 January 14, 2000 Private and Financial Sector Development Department Europe and Central Asia This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (Exchange Rate Effective December 1999) Currency Unit = Hyrvnia (UAH) I UAH= US$ 0.1928 US$ I = 5.1860 UAH FISCAL YEAR July 1, 1999- June 30, 2000 ABBREVIATIONS AND ACRONYMS EU European Union IMF International Monetary Fund GDP Gross Domestic Product GOU Government of Ukraine MOE Ministry of Economy NASB National Accounting Standards Board NBA National Bankruptcy Agency SRO Self Regulatory Organization SCED State Commission on Entrepreneurship Development SPF State Property Fund of Ukraine SSMC State Securities and Stock Market Commission USAID United States Agency for International Development UAH Ukrainian Hyrvnia Vice President: Johannes Linn Acting Country Director: Lily Chu Sector Manager: Gerhard Pohl Task Team Leader: Vladimir Kreacic  FOR OFFICIAL USE ONLY UKRAINE SECOND ENTERPRISE DEVELOPMENT ADJUSTMENT LOAN CONTENTS Page No i . Project Data 1 2. Principal Performance Ratings I 3. Assessment of Development Objective and Design, and of Quality at Entry 2 4. Achievement of Objective and Outputs 3 5. Major Factors Affecting Implementation and Outcome 5 6. Sustainability 6 7. Bank and Borrower Performance 6 8. Lessons Learned 7 9. Partner Comments 8 10. Additional Information 8 Annex 1. Key Performance Indicators/Log Frame Matrix 9 Annex 2. Project Costs and Financing 10 Annex 3. Economic Costs and Benefits 11 Annex 4. Bank Inputs 12 Annex 5. Ratings for Achievement of Objectives/Outputs of Components 14 Annex 6. Ratings of Bank and Borrower Performance 15 Annex 7. List of Supporting Documents 16 Annex 8. Borrower Contribution 17 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   Project ID: P049502 Project Name: EDAL II Team Leader: Vladimir G. Kreacic |TL Unit. ECSPF ICR Type: Core ICR Report Date: January 14, 2000 1. Project Data Name: EDAL II LIC Number: 43900 Country/Department: UKRAINE Region: Europe and Central Asia Region Sector/subsector: II - Industrial Adjustment KEY DATES Original Revised/Actual PCD: 06/05/97 Effective: 09/18/98 Appraisal: 10/17/97 MATR: Approval: 09/15/98 Closing: 06/30/99 Borrower/lmplementing Agency: GOVERNMENT OF UKRAINE Other Partners: Ministry of Economy, State Securities and Stock Market Commission, National Bankruptcy Agency, State Commission on Entrepreneurship Development, State Property Fund, National Accounting Standards Board STAFF Current At Appraisal Vice President: Johannes Linn Johannes Linn Country Manager: Lily Chu Paul Siegelbaum Sector Manager: Gerhard Pohl Gerhard Pohl Team Leader at ICR: Vladimir Kreacic Bernard Drum ICR Primaty Author. Ragini Dalal 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unfikely, HUN=Highly Unlikely, HU=-Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development N Impact: Bank Performance: S Borrower Performance: S QAG (if available) ICR Quality at Entry: S Project at Risk at Any Time: Yes  3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: The original objectives of the Second Enterprise Development Adjustment Loan (EDAL II) included support to the Government of Ukraine's (GOU) privatization, capital markets development, accounting reform, bankruptcy reform, and deregulation programs through balance of payments assistance. Other objectives were to provide foreign exchange for the purchase of critical imports and to support the development of the foreign exchange markets. EDAL II is the second of two World Bank loans to Ukraine focusing primarily on the enterprise sector. The First Enterprise Development Adjustment Loan (EDAL 1) was prepared in 1994-5 and approved by the Board in June 1996. EDAL I was prepared at a time when Ukraine, a newly independent country, was still in the process of transforming its economy from a centrally planned system to a market-oriented one. In late 1994, a clear break was made from past policies as Ukraine began to lay the foundations for macroeconomic stabilization and structural reforms. An IMF-supported stabilization program which entailed tight fiscal and monetary policies was agreed. At that time, the Bank supported a wide range of programs aimed at reducing Government intervention in the economy, developing competitive markets, and introducing elements of a social safety net through a series of adjustment loans in the social, enterprise, agricultural, and energy sectors. EDAL I was the first of such Bank interventions in the enterprise sector and focused on privatization, trade and price liberalization, and capital markets development. The relative success of the EDAL I and the increasingly urgent need of the Government for balance of payments support led to the EDAL II which was approved by the Board in September 1998. Much was accomplished by the Government in 1995-7. Inflation was sharply reduced (to 40 percent annually in 1996 and 16 percent in 1997); the exchange rate was unified and a substantial degree of current account convertibility was established; domestic prices were largely decontrolled; tax reform was initiated; the state order system was abolished; a mass privatization program was in the process of being implemented successfully (largely due to the EDAL I program); and restructuring of the agricultural, electricity, and coal sectors had begun. However, a number of factors point to the fragility of the early successes. Tight monetary policy was not accompanied by sufficient structural measures to reduce expenditures. In effect, the fiscal situation appeared better than it was with the cash deficit being contained by running up arrears and postponing expenditures. Economic activity also remained weak. Officially recorded GDP continued to fall in 1998; albeit at a slower rate of 1.7 percent than in the previous years. Much of the new private sector activity stimulated by the privatization program and related reforms was channeled into the unofficial economy. This had implications for the tax and foreign exchange base, thus making macroeconomic stability that much harder to sustain. There were also setbacks in several areas of the reform program, particularly tax reform, energy sector reform, and agricultural sector reform. The Russian financial crisis of 1998 further negatively affected the Ukrainian economy: this is discussed in greater detail in Section 5. At this time, the Bank pursued a program that focused primarily on adjustment lending in all of the sectors mentioned above. The goal of the Bank's program had been to work with the GOU to put in place the necessary regulations and institutions in the key sectors while simultaneously providing needed balance of payments support. Though the EDAL II can generally be considered an exception, the GOU either failed to implement or reversed many of the serious reforms in the adjustment packages. This has led the Bank to adopt a more stringent stance towards Ukraine and severely curtail the lending program. Prior to resuming a full program of lending, the GOU will have to implement a set of reforms that will lead to significant, measurable outcomes such as successful and transparent cash privatization, administrative reform, and deregulation. The triggers for the resumption of a medium case lending scenario, as specified by the Bank - 2 -  in the May 1999 CAS Progress Report, are: (a) generation of US$ I billion in cash proceeds from privatization; (b) reform of the Aparat of the Cabinet of Ministers; and (c) significant reduction in the number of business inspections as confirmed by independent surveys. A limited work program now continues in key areas with the Bank's strategy shifting towards investment lending. In the private sector development area, the Bank is developing an investment loan that would pr9vide technical assistance for the restructuring and financing of private and privatized enterprises. 3.2 Revised Objective: Project Objective was not revised. 3.3 Original Components: The reform program supported by the loan included the: (a) completion of a mass privatization program of 9500 medium and large enterprises as well as the continuation of individual privatization of large attractive enterprises; (b) consolidation of the legislative framework and institutions to regulate the capital markets including the State Securities and Stock Market Commission, self-regulatory organizations for market intermediaries, and an effective trading, depository, and clearing and settlement infrastructure; (c) implementation of intemational accounting and auditing standards throughout the enterprise sector; (d) implementation of an effective modem bankruptcy process in Ukraine; (e) simplification and acceleration of the processes required for private business licensing, registration and inspections, and the institutionalization of the deregulation processes including public/private consultative mechanisms. 3.4 Revised Components: Project Components were not revised. 3.5 Quality at Entry: The project was not selected for a quality of entry assessment by the Bank's Quality Assurance Group. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: When the EDAL II was designed, the primary objective had been to complete the mass privatization program. This objective was clearly reached and the ambitious privatization targets of the loan were fully met by the Government. Similarly, great strides were taken in the development of capital markets and the areas of accounting reform, bankruptcy reform, and deregulation as described in Section 4.2 below. The Loan disbursed with full compliance of all conditionality in all three tranches within nine months of Board approval. The objectives of the EDAL II program can, therefore, be considered to have been broadly accomplished. The mass privatization program was the first step in creating a market economy following decades of Communism in Ukraine. Creating an enabling environment for business and private sector development were the larger objectives of the loan which proved more difficult to accomplish. While the GOU fulfilled all the conditions, the expected transformation of the private sector has been slower to occur. Both EDALs played a critical role in helping Ukraine begin to develop as a market economy by creating primary ownership changes and beginning to put in place the enabling legal and institutional environment for the next stage of development. Both programs organized and focused Govemment and donor commitment in this process. Political considerations and vested interests, however, prohibited moving the reform program beyond this point. Thus, while the objectives of the EDAL II were achieved, its sustainability can be questioned. The Bank's Private Sector Development team is addressing this issue by focusing current - 3 -  programs on enterprise level assistance in the regions of Ukraine in order to train Ukrainian enterprise managers and local consultants; create a demonstration effect from successfully restructured enterprises; and build a constituency for reform from the bottom up. 4.2 Outputs by components: (a) Privatization: At least 70% of the equity of over 9500 medium/large enterprises and 40% of the equity of 100 large enterprises have been transferred to private ownership. Progress was also made in the privatization of grain elevators and unfinished construction sites. Case by case privatization of thirteen large, attractive enterprises was initiated. However, the tender procedure selected for the case by case transactions was generally unfriendly to investors, including a number of unpopular conditions such as investment commitments, discharge of all enterprise liabilities, and retention of all staff for 4-5 years. To date only three enterprises have been sold to domestic investors. One enterprise for which there was considerable interest from reputable western investors was removed from the list. Even if this enterprise is "reinstated" and privatized as agreed, the overall demonstration effect -- as well as revenues to the budget -- will be very low. (b) Capital Markets: Enterprise shares were transferred to independent registrars, capital market activity at commercial banks has been separated from the regular operations of the banks, all brokers and registrars have become members of SROs, a new depository and clearance system for corporate securities was initialized, and disclosure of information on publicly traded companies became more transparent. (c) Accounting Reform: The Law on Accounting Reform was passed. This Law envisages a new national accounting system which will be in compliance with International Accounting Standards. Educational programs in accounting, consistent with IAS and ISA, were initiated at two graduate level institutions in Ukraine. (d) Bankruptcy Reform: A new law on Bankruptcy, which provides for adequate and transparent procedures for insolvent enterprises, was passed. An educational program and training for trustees and liquidators was initiated. (e) Deregulation: Registration procedures for businesses were significantly simplified. Initially, the number of business activities subject to licensing was significantly reduced as Board conditionality required that no more than 44 activities require licensing. Subsequently, this number increased because there were many activities that required govemmental permissions that were essentially like licenses and did not fall under the agreed list of 44 activities. Currently, the Government has proposed a list of 78 activities requiring licenses or other permits. This is a unified list that includes all permits and licenses. While the list of 78 activities is higher than the agreed 44 activities, the Bank and other donors support the creation and adoption of this list as it unites in one place all the activities requiring licensing/permits and streamlines the licensing procedures for businesses. While the GOU has formally complied with this condition, the number of "license-like" permits, warrants, and certificates required by enterprises continues to increase thereby diluting the positive effects of deregulation introduced through the EDAL II. 4.3 Net Present Value/Economic rate of return: Not Applicable. 4.4 Financial rate of return: Not Applicable. 4.5 Institutional development impact: The EDAL 1I was a balance of payments support operation with a reform agenda linked to the conditionalities of the loan. As such, it did not have institutional development objectives though it did enhance the implementation capacity of the agencies involved in fulfilling the conditions of the loan, such as the Ministry of Economy, the State Property Fund, the State Securities and Stock Market Commission, the -4 -  National Accounting Standards Board, the Bankruptcy Agency, and the State Committee on Entrepreneurship Development. It was also an example of good partnership between the GOU and all the donors involved. The Bank team worked closely with donor agencies to leverage the EDAL II policy conditionality with donor-financed technical assistance programs. 5. Major Factors Affecting Implementation and Outcome 5.1 Factors outside the control of government or implementing agency: Ukraine's experience during 1998 revealed the fundamental weakness of its economy. After the August financial crisis in Russia, Ukraine found it difficult to roll over its billions of hryvnias of T-bill debt, much of which had been sold to foreign investors. Those investors, having witnessed the problems in Asia and Russia, became wary of all emerging markets-particularly risky ones like Ukraine, where debt service obligations accounted for a major share of government expenditures. Once the T-bill debt could no longer be rolled over, Ukraine was forced to restructure virtually all the T-bill debt falling due in 1998, affecting nearly UAH 2 billion of T-bills and over $100 million of other debt. As a result of the Russian crisis, Ukraine also suffered a severe decline in output with GDP falling in nearly all sectors of the economy. However, by late spring 1999, the rate of decline in GDP began to slow down, industrial output began to register positive growth, and the Government was able to stabilize the currency. The fiscal situation, however, remained precarious making the GOU reluctant to undertake any reforms requiring budget outlays, particularly as the IMF austerity program severely squeezed the budget. Furthermore, parliamentary and presidential elections created the necessity to cater to nationalist/populist elements that opposed the reforms. 5.2 Factors generally subject to government control: The preparation of the EDAL II involved intensive coordination with key stakeholders (such as the SPF) as well as coordination with donor agencies and the private sector. In a time of political change and economic crisis, however, there were frequent changes in leadership at the higher levels of Government. Particularly, multiple changes in the top leadership of the SPF (there were at least three Chairmen during the nine month life of the EDAL II) impacted negatively on the EDAL 11. Though the GOU fulfilled the mass privatization targets of the loan, there was little political will to privatize the large, attractive enterprises. Potentially valuable enterprises were either taken off the list of thirteen demonstration cases or burdened by such pre-conditions as to make them unattractive for potential investors. For example, the SPF would require potential investors to fund 100% of the liabilities ofthe enterprise despite the fact that they were not buying the entire enterprise, or the SPF would stipulate that none of the workers could be laid off for 4-5 years. Thus, while legally in compliance with the EDAL II conditionality on this issue, the spirit of the reforms intended was only achieved to a limited extent. There was also a disagreement between the Bank/USAID and the Government with regard to the National Depository. Though the GOU wanted to maintain Government ownership, the Bank and USAID felt strongly that the central depository should be an independent, private organization. Currently, a compromise situation exists in which there is a clearing Depository with commercial functions that is private (and is supported by a USAID project), and a National Depository which has only regulatory functions that is state owned. However, this situation can change at any time if the State Securities and Stock Market Commission were to permit the state owned National Depository to have commercial functions. It is critical that this does not occur. -5-  5.3 Factors generally subject to implementing agency control: As an adjustment loan, there was no implementing agency such as a Project Implementation Unit, however, the Ministry of Economy oversaw the fullfillment of the conditions by the various agencies involved. 5.4 Costs andfinancing: Three tranches of US $100 million each were disbursed. Detailed cost figures can be found in Annex Four. 6. Sustainability 61 Rationale for sustainability rating: The specific conditions in Ukraine make sustainability hard to predict. If considered in isolation, the outcomes of the loan were delivered in a satisfactory and timely fashion. However, questions about the larger enabling environment for private sector development as well as lack of reforms in other sectors of the economy (i.e. administrative reform, pension reform, energy sector reform) will influence the long term sustainability of the loan. Nevertheless, sustainability has been rated as "Likely". The rationale for this rating is based on the fact that the project established a basis for the future development of the private sector by creating a large number of privatized enterprises, regulating the capital markets, advancing the development of bankruptcy mechanisms, establishing the basis for international accounting standards to enterprises, and making the entry of new businesses easier through the adoption of a simplified registration process. Follow on operations by the Bank and other donors have already shown that these mechanisms have assisted in the development of their projects. The European Union is now involved in assisting the GOU in selling four large attractive enterprises; the Bankruptcy Law has been passed, and the Bank's Private Sector Development (PSD) project has begun intensive work with privatized enterprises on the oblast/region level to train enterprise managers as well as restructure enterprises. The demonstration effect of the thirteen case-by-case privatizations supported by the EDAL II is yet to be proven. Recent reversals by the GOU on this condition and subsequent interventions by Bank staff have served to mobilize the Fund and other donors and elevated the discussion of the negative consequences of the GOUs current privatization policy to the highest levels of the Government. 6.2 Transition arrangement to regular operations: As mentioned above, this project has paved the way for the development of the Bank's PSD Loan which seeks to restructure enterprises and train Ukrainian managers and consultants throughout Ukraine as well as projects by other donors. 7. Bank and Borrower Performance Bank 7. 1 Lending: The Bank's performance in lending is assessed as satisfactory. The Bank's preparation of the project entailed intensive examination of the lessons learned from EDAL I as well as close coordination with multiple Government counterparts and donor agencies active in the enterprise sector in Ukraine. The loan was processed on a timely schedule in order to address the GOUs balance of payments needs as well as to advance the agenda for reform in the enterprise sector in Ukraine. The Loan was fully disbursed nine months after effectiveness. Bank missions visited Kyiv nearly every six weeks during the preparatory phases of the Loan. -6 -  7.2 Supervision: The Bank's performance in supervision is assessed as highly satisfactory. Supervision of the loan was intensive and significantly improved by the fact that the Program Team Leader (PTL) was based at the Resident Mission in Kyiv from one month after the effectiveness of the loan through till the disbursement of the final tranche. The presence of the PTL in Kyiv allowed daily contact with the counterpart agencies as well as immediate resolution of questions and problems. 7.3 Overall Bank performance: Overall Bank performance is assessed as satisfactory. Borrower 7.4 Preparation: The Borrower's performance in lending is assessed as satisfactory. There was close cooperation at the time of preparation between the Government and the Bank. Representatives from all the counterpart agencies were involved in the preparation of the loan. 7.5 Government implementation performance: The Government's implementation performance is assessed as satisfactory due to the reasons outlined in Sections 4 and 6. All the conditions of the loan were fulfilled. The most contentious issue, however, was the mechanism for the sale of thirteen large, attractive enterprises on a case-by-case basis. The Bank felt strongly that this should be done through transparent, open tenders where the winner is the one with the highest proposed price and that this process is outsourced to professional, reputable investment bankers. The Government chose instead to use non-price criteria and keep this process in-house as much as possible. The GOU agreed to use EU (TACIS) funded advisors for only four of the thirteen enterprises. Therefore, the condition regarding the sale of the three and then ten large enterprises can be said to have been fulfilled formally, and only following lengthy discussions with the Bank team. 7.6 Implementing Agency: Not Applicable. 7.7 Overall Borrower performance: The overall performance of the Government--until the final disbursement-is assessed as satisfactory. Clearly, this was driven by the urgent need for balance of payments support due to the economic crises discussed above. Once the leverage of the last disbursement was gone, however, signs of wavering appeared and it was necessary to continue working with the GOU to prevent backtracking. In the immediate future, further attempts to backtrack cannot be excluded and additional efforts may be required to sustain the impact of EDAL II. In the absence of a continuing lending program, however, this will be difficult to accomplish. 8. Lessons Learned Build ownership from the side of the counterpart Given the varied Govemmental agencies that were involved in the EDAL II, it would have been useful to have one agency, and a structure therein, as the main counterpart who felt ownership of the project and was answerable for results. The project would have been less affected by the changes in leadership at the higher levels of Govemment if a stronger team had existed at the working level. The example of the EDAL I suggests the SPF should have been that counterpart; however, the constant change in leadership of the senior management of the SPF made this impossible. -7 -  Create support from a variety of political spheres Given the difficult political climate in Ukraine and the often contentious relationship between the Government and Parliament, it would have been useful to involve participants from a variety of political spheres. If a broad base of political leaders had been involved, the EDAL II would have enjoyed wider support and the Bank would have taken into account the views of more stakeholders. Adjustment versus Investment In general, the usefulness of adjustment operations in a complex environment such as Ukraine, where executive power is divided between line ministries, the Cabinet of Ministers, and the Presidential Administration and where the majority of Parliamentary Deputies are opposed to economic reform, was brought into question. Wherever possible, the conditionalities were fulfilled by the issuance of decrees, with poor subsequent implementation. The current thinking of the team working on private sector development issues for Ukraine is that, at this stage, much more can be accomplished in the form of smaller investment projects with intensive technical assistance components. The mass privatization program has now been completed; basic laws and institutions have been put in place; and the Government now has a track record of dialogue with the Bank. The preparatory work being done on the PSD Loan has shown that strides can be made in institution building and training of locals through the form of intensive on-the-ground technical assistance. This is clearly a more labor intensive approach and requires much more input from the Bank team but the results seem to suggest that this would be one way the Bank can provide sustainable programs and assistance to Ukraine. Though the reforms supported by the loan were of critical importance, the Government's desperate need for balance of payments support was clearly the impetus for the fulfillment of EDAL II conditions. However, real long-term impact will be seen only when the framework set up by the adjustrnent loan is supported by follow-up technical assistance and investment operations leading to measurable on-the-ground results. 9. Partner Comments (a) Borrower/implementing agency: Detailed comments from the Borrower can be found in Annex 8. (b) Cofinanciers: Not Applicable. (c) Other partners (fGOs/private sector): Not Applicable. 10. Additional Information A detailed list of additional available documentation on the project can be found in Annex Seven. -8 -  Annex 1. Key Performance Indicators/Log Frame Matrix Not applicable -9-  Annex 2. Project Costs and Financing Not Applicable - 10-  Annex 3: Economic Costs and Benefits Not Applicable - 11 -  Annex 4. Bank Inputs (a) Missions: Stage of Projc Cycle No. of Prsons an Speialty PerfomneRtng :(e.g 2 Economt i MS. etc.) Implement 0atio Development Month/Year.L Count Seialty Progress Objetiv Identification/Pre paration 3 PSD Specialists, 1 Economist, I January 1997 Capital Markets Specialist, 1 Operations Officer March 1997 2 PSD Specialists, I Economist, 1 Accounting Specialist, 1 Bankruptcy Specialist May 1997 2 PSD Specialists, I Economist June 1997 2 PSD Specialists, 1 Economist July 1997 2 PSD Specialists, 1 Capital Markets Specialist, 1 Accounting Specialist, 1 Bankruptcy Specialist Appraisal/Negotiation November 1997 2 PSD Specialists I Capital Markets Specialist February 1998 Negotiations April 1998 1 PSD Specialist July 1998 1 PSD Specialist September 1998 I Economist I PSD Specialist Supervision October 2 PSD Specialists HS HS 1998-June 1999: resided in the field, constant supervision November 1998 I Operations Officer S S February 1999 1 Bankruptcy Specialist S S April 1999 1 Capital Markets Specialist HS HS May 1999 1 Bankruptcy Specialist S S May 1999 1 Accounting Specialist ICR July 2 PSD Specialists HS HS 1999-present, reside in field October 1999 1 Operations Officer S S -12 -  (Z) Staff: I Stage of Project Cycle Actual/Latest Estinate . - : No. Staff weeks US$ () Identification/Preparation 62.4 242.5 Appraisal/Negotiation 30.5 66.6 Supervision 33.4 93.0 ICR 3.76 13.2 Total 130.06 415.3 - 13 -  Annex 5. Ratings for Achievement of Objectives/Outputs of Components (H--High, SU=Substantial, M=Modest, N=Negligible, NA=Not Applicable) Rating