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UKRAINE Country Strategy

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  • 1. 2007-2010 Country Strategy: Ukraine BD2006-111 BLACK SEA TRADE AND DEVELOPMENT BANK UKRAINE Country Strategy 2007-2010 THESSALONIKI OCTOBER, 2006
  • 2. 2007-2010 Country Strategy: Ukaine BD2006-111 UKRAINE COUNTRY STRATEGY TABLE OF CONTENTS TABLES: Table 1: Basic Macroeconomic Indicators at a Glance TEXT: I. Recent Economic Developments and Outlook a. Real Sector b. Public Sector and Fiscal Policy c. Monetary and Financial Sector d. External Sector e. Forecast for 2007 II. Overview of Current BSTDB Portfolio III. Review of Country Strategy 2005 - 2006 IV. Priorities for 2007 - 2010 1
  • 3. 2007-2010 Country Strategy: Ukaine BD2006-111 Table 1: Basic Macroeconomic Indicators at a Glance Country Long Term Foreign Currency Sovereign Risk Rating at 10 October, 2006: Moody’s: B2 | S&P: BB- | Fitch: BB- 1998 1999 2000 2001 2002 2003 2004 2005 Proj. 2006 Proj. 2007 1 Population (Million) 49.9 49.4 48.9 48.5 48.0 47.6 47.3 46.9 46.5 46.2 2 Avg Exch. Rate (Hryvna/ US$) 2.45 4.13 5.44 5.37 5.33 5.33 5.32 5.12 5.05 5.08 3 Inflation (CPI Avg.) 10.6% 22.7% 28.2% 12.0% 0.8% 5.2% 9.1% 13.5% 10.0% 7.5% 4 Average monthly wages (US$) 62.7 43.0 42.3 57.9 70.7 86.7 110.9 157.3 5 GDP (Hryvna million) 102,593.0 130,442.0 170,070.0 204,190.0 225,810.0 267,344.0 345,113.0 424,741.0 464,876.0 492,751.0 6 GDP US$ million 41,874.7 31,584.0 31,262.9 38,009.3 42,392.9 50,133.0 64,880.6 82,880.7 92,054.7 96,998.2 7 GDP per capita (US$) 838.9 639.0 639.0 784.4 883.1 1,052.7 1,372.2 1,766.0 1,980.6 2,097.9 8 Real GDP growth, % -1.9% -0.2% 5.9% 9.2% 5.2% 9.6% 12.1% 2.6% 6.0% 6.5% 9 Official Unemployment (end of period) % 11.3% 11.9% 11.7% 11.1% 10.1% 9.1% 8.6% 7.2% 10 Industrial Production Growth, % -1.0% 4.0% 12.4% 14.2% 7.0% 15.8% 12.5% 3.1% 4.0% 14.4% 11 Agricultural Production Growth % -9.8% -6.9% 9.8% 10.2% 1.2% -11.0% 19.1% 0.0% 12 Domestic Credit Growth % 58.0% 30.5% 23.1% 21.9% 28.0% 38.4% 24.8% 34.3% 33.5% 29.3% 13 Domestic Credit/ GDP 24.6% 25.2% 23.8% 24.2% 28.0% 32.8% 31.7% 34.6% 42.2% 51.4% 14 Foreign Direct Investment - $US million 743.0 496.0 595.0 792.0 693.0 1,424.0 1,715.0 7,808.0 4,200.0 4,500.0 15 FDI/ GDP 1.8% 1.6% 1.9% 2.1% 1.6% 2.8% 2.6% 9.4% 4.6% 4.6% 16 Consolidated Budget Balance/ GDP, % -2.2% -1.5% 0.6% -0.3% 0.7% -0.2% -3.1% -1.8% -2.5% -2.2% 17 Public External Debt (US$ mn) 11,091.0 12,482.0 10,348.9 10,118.0 10,194.6 10,692.8 12,146.6 11,674.6 18 Public External Debt/GDP 26.5% 39.5% 33.1% 26.6% 24.0% 21.3% 18.7% 14.1% 19 Exports- $US million (Goods) 13,699.0 13,189.0 15,722.0 17,091.0 18,669.0 23,739.0 33,432.0 35,024.0 39,973.7 43,003.2 20 Imports- $US million (Goods) 16,283.0 12,945.0 14,943.0 16,893.0 17,959.0 23,221.0 29,691.0 36,159.0 45,801.5 52,353.2 21 Trade Balance $US mn (Goods) -2,584.0 244.0 779.0 198.0 710.0 518.0 3,741.0 -1,135.0 -5,827.8 -9,350.0 22 Trade Balance/ GDP -6.2% 0.8% 2.5% 0.5% 1.7% 1.0% 5.8% -1.4% -6.3% -9.6% 23 Current Account Balance $US mn -1,296.0 1,658.0 1,481.0 1,402.0 3,173.0 2,891.0 6,804.0 2,531.0 -927.3 -3,523.5 24 Current Acct. Bal./ GDP -3.1% 5.2% 4.7% 3.7% 7.5% 5.8% 10.5% 3.1% -1.0% -3.6% 25 Forex Reserves (end period- exc gold) US$m 761.3 1,046.4 1,352.7 2,955.3 4,241.4 6,730.7 9,302.4 19,114.5 20,120.0 22,460.0 Sources: Ministry of Economy and European Integration of Ukraine, National Bank of Ukraine, IFS –IMF September 2006, IMF Country Report No. 05/417 November 2005. 2
  • 4. 2007-2010 Country Strategy: Ukraine BD2006-111 I. Recent Economic Developments and Outlook a. Real Sector Ukraine’s real GDP growth has experienced some fluctuations over the last few years, although the overall picture since 2000 is positive. After two strong years of 9.6% growth in 2003 and 12.1% growth in 2005, real GDP grew by only 2.6% in 2005, as a slip in investment and a reversal in terms of trade- energy prices rose while steel prices slumped- hurt output growth. After several years of real double digit growth, the industry, which accounts for a greater share of GDP in Ukraine than in other countries, grew by 3.1%, while the agricultural sector continued its prolonged stagnation. Services fared slightly better, at close to 4% growth, but despite recent growth they remain relatively underdeveloped and thus have lower impact on the overall economy in Ukraine. Growth in the first half of 2006 has shown recovery, with the Ministry of Economy in August issuing forecasts of 6% GDP growth for the entire year1. This represents an increase on earlier estimates and is linked partly to a recovery in global steel prices, which should help exports, an end to political uncertainty, which should help investment to accelerate in the economy, and to continued strong private consumption, a result of an increase in earnings over the last couple of years. The sectoral breakdown of GDP growth corroborates these trends, as services are expected to grow more rapidly than industry, and agriculture is slated to recover but will remain a laggard. Ukraine’s economy grew by approximately 53% in real terms between from 1999-2005, while per capita incomes nearly tripled and average incomes nearly quadrupled. Originally, Ukraine was well placed to take advantage of the surge in demand in neighboring Russia, since much of its industry was working below capacity throughout the 1990s. while trade links with Russia remain significant, there is more to the growth than merely reactivation of idled capacity, as there has also been growth of the private sector in industries such as food-processing, and in construction and services generally, meaning that an increasing share of the growth is the result of new activities and investment in the economy. Strong domestic demand has been significant for these developments helping to diversify sources of growth and helping to mitigate the vulnerability of the economy to global commodity prices and changing patterns of international trade. b. Public Sector Beginning in late 1999, serious reform began with improved expenditure control and better tax collection. Wage and pension arrears were eliminated as tax collection improved, and the tax base broadened thanks to the curtailment of many tax exemptions and the increased monetization of the economy (reduction of non-transparent barter and in-kind payments). Combined with the economic growth, these measures created a cycle of growth and higher tax revenues underpinned by the fairer distribution of the tax burden and reduced evasion possibilities. More recently, the Government has brought revenue planning into line with IMF standards, established a predictable formula based method for the allocation of local government resources, introduced tax reforms such as a unified 13% income tax rate, undertaken an anti-smuggling program to improve customs revenues, and shifted energy related tax collections to the border. Although revenues are close to 40% of GDP2, 1 ISI Emerging Markets – Ukraine Today Press Review 17 August, 2006 2See Table 1, Ukraine: 2005 Article IV Consultation and Ex Post Assessment of Longer-Term Program Engagement- IMF Country Report 05/ 415, November 2005. 3
  • 5. 2007-2010 Country Strategy: Ukraine BD2006-111 the overall success has been mixed, as evidenced by a stalled effort to improve the value added tax system and reduce VAT rates. Spending has also risen sharply since 2004. After being virtually in balance between 2000- 20003, the cycle of presidential and then parliamentary elections resulted in considerable fiscal loosening, mainly pension and wage increases. This resulted in a jump in the deficit to -3.1% of GDP in 2004, before receding to -1.8% in 2005 as certain loopholes were tightened (abolition of special economic zones) tax administration was improved and capital spending was cut. For 2006, the Government is targeting an increase to -2.5% of GDP as a result of continued wage and benefit hikes. c. Monetary and Financial Sector After experiencing a sustained moderation of inflation, to almost zero in 2002, inflation in Ukraine has risen steadily since 2003, spiking at 13.5% in 2005. Rising global energy prices, a boom in bank credit, and unsterilized foreign exchange inflows have all played a role in fueling inflation. In 2006, additional inflationary pressure resulted came from the rise in gas prices. Despite this jolt, inflation in 2006 is expected to be lower thanks to a tighter monetary policy followed by the National Bank of Ukraine (NBU). The NBU developed a positive reputation and it has enhanced its standing over the years by remaining consistent to its key objectives of promoting low inflation, lower interest rates (when prudent) and improved currency stability, while at the same time achieving a significant rise in Ukraine's foreign-currency reserves. Since 2000, the hryvnia has officially been floating, even though in practice the NBU intervenes in order to prevent sustained appreciation against the dollar, mainly in the form of foreign-currency purchases. The hryvnia has thus remained stable against the US dollar, except for one phase in April 2005 where the NBU allowed 3% appreciation. Because of inflation levels, this means that the real exchange rate has appreciated versus the dollar and the euro over the last three years. Banking Sector & Capital Markets The Ukrainian banking sector is a two-tier system, with the NBU performing supervisory functions and commercial banks reporting to it. Since January 1, 1998, all Ukrainian banks have been required to convert to international accounting standards. A deposit insurance system is in place with individual accounts covered up to Hr 5000 as of April 2005. Total capitalization of the banking sector has grown rapidly between 2002-2004, doubling from 3% of GDP to nearly 6% of GDP, but even so the system remains undercapitalized. As of May 2006, there were 188 registered banks in Ukraine, of which 165 were licensed to conduct banking transactions. There were 28 banks with at least some foreign participation, of which 11 are wholly foreign owned3. Two banks are fully state owned. Approximately half of the capital is concentrated in the top twenty banks, with the ten largest banks accounting for nearly 55% of the sector’s net assets and profits. While the banking sector is still small, and intermediation lags relative to the levels observed in Central Europe, growth has been dynamic over the last few years. While domestic credit is only around 40% of GDP, lending has doubled in the last two years, and deposits have also grown 3 Bulletin of the National Bank of Ukraine, July 2006, Page 161. 4
  • 6. 2007-2010 Country Strategy: Ukraine BD2006-111 rapidly. Confidence in the system is growing, and NBU has shown a willingness to undertake needed measures, including increasing capital adequacy ratio for Banks from 8% to 12% at the end of 2004. Transparency and corporate governance issues also require addressing, since despite the rapid growth, the banking system is fragmented and there are many small undercapitalized banks that serve the needs of the related business groups. Among the priorities for the Government is to amend the prevailing Law on Banks and Banking to strengthen the NBU and the legal framework for banking regulation, in order to improve such areas as the corporate governance and risk management of banks, information disclosure about bank ownership, and enforcement of limitations for related party transactions. Ukraine established the legal framework for securities markets in 1991 with the Law on Securities and Stock Exchanges, which makes provision for the creation, utilization, and trade of the usual range of debt and equity instruments, for corporations and for Government bodies. Regulatory powers are vested in the Securities and Stock Market State Commission (SSMSC), which was established in 1996. The securities market remains underdeveloped compared with markets in east- central Europe. Despite periods of growth, trading levels are low, and have lagged because of perceptions of low transparency and liquidity, and weak corporate governance. Most stock issues come from the sale of newly privatized companies, while the majority of deals securities-related deals are made and settled outside of organized trading floors. The Government has passed a framework law on mutual funds, but has not succeeded in passing a law on joint stock companies. d. External Sector Debt Ukraine accepted the ‘zero option’ offered by Russia in December 1994, under which Russia assumed all Soviet Union era external debts and Ukraine relinquished all claims to former Soviet Union assets. Ukrainian external debt increased steadily through the 1990s, peaking at 39% of GDP in 1999 as a result of foreign borrowing to cover deficits, the assumption of inter-enterprise arrears as sovereign debt, and the sharp depreciation of the hryvnia in that year. Following a comprehensive debt restructuring between 2000 and 2002, public sector external debt has declined substantially and at the end of 2005 stood at approximately 14% of GDP. While public sector borrowing has declined as a share of GDP, aided by the economic expansion, the share of private sector borrowing has risen rapidly and now stands at nearly one half of total external debt stock, accounting for most of the recent growth. In March 2004, the IMF approved a Stand-By Arrangement in an amount equivalent to approximately US$605 million for a period of 12 months, but in August 2004 it concluded that key obligations had not been met and therefore the facility was suspended. It was allowed to expire in March 2005 and currently there is no lending arrangement of any sort with the IMF. Ukraine has enjoyed a steady stream of credit rating upgrades on its foreign and local currency sovereign debt, and it is at present. Trade and the Current Account Export led growth has been an important factor behind Ukraine’s strong economic performance. Although export growth slowed in 2005, it has picked up in 2006. The metallurgy sector has led the way, especially steel, sales of which have increased due to global prices and successful expansion into new export markets- especially in Asia. In addition, exports to Russia of electronic equipment and vehicles have continued to post growth. Ukraine is also an energy exporter, 5
  • 7. 2007-2010 Country Strategy: Ukraine BD2006-111 due to its significant refining capacity. Imports have also grown even more rapidly, in part due to growing consumer demand, but with a spur in 2006 caused by sharp increases in energy prices, particularly natural gas. The merchandise trade balance is expected to grow to over -6% of GDP after years of being positive. The current account balance is also expected to be negative in 2006 after years of being positive, but the deficit should only be around -1% of GDP. That is because Ukraine runs a large services surplus caused by the transit fees paid by Russian energy exporters (to central and western Europe). Russia is by far Ukraine’s most important trading partner. Among BSEC countries, Turkey is the only other BSEC Country with which there are significant levels of trade, and it was Ukraine’s third largest export destination in 2004. Foreign Direct Investment Over the years, Ukraine has lagged, relative to the 2004 EU entrant Central European ‘transition’ states, in attracting foreign direct investment (FDI). However, while it has not yet reached the levels of the 2004 EU entrants, there has been a marked improvement in recent years in attracting FDI, with 2005 in particular sticking out as an exceptional year, thanks to the re- privatization of the Kryvorizhstal steel plant for US$ 4.8 billion, the single biggest transaction undertaken in Ukraine. Whereas FDI ranged between 1-2% of GDP up to 2002, in 2003 and 2004 it jumped to over 2.5% and in 2005 reached 9.4%. Expectations for 2006 are that FDI will be in the range of 4-5% of GDP, a figure which is comparatively on a level with the levels attracted systematically by Central European states. The business environment has improved in recent years and foreigners have the same rights to invest in Ukraine as Ukrainian individuals and legal entities. The top five sources of foreign investment are the United States of America, Cyprus, the United Kingdom, Germany, and the Netherlands. Among BSEC Members, Russia is the largest investor, with Turkey ranking second. e. Forecast for 2007 The upturn witnessed in economic output witnessed during 2006 has resulted in more optimistic projections for GDP growth in 2007 as well. The 2007 estimates of the Ministry of Economy forecast GDP growth of 6.5%4, boosted in large part by industrial output growth expected to exceed 14%. The forecasts project a deceleration of inflation to an average annual rate of 7.5%, the government’s fiscal deficit reaching approximately -2% of GDP, and the hryvnia remaining stable versus the US dollar. The relatively tight monetary policy of the National Bank of Ukraine will likely be maintained, with an eye on inflationary pressures, and the money supply trends- growth in excess of 20% is expected, although this rate of growth will likely be lower than in previous years. Measures such as interest rate increases or increases in reserve requirements are unlikely unless external shocks threaten economic stability. During 2005 and 2006, Ukraine obtained market economy status from the European Union (EU) and the United States of America. In the course of the next year, Ukraine aims to become a member of the World Trade Organization. It has expressed interest in joining NATO and has participated in the Partnership for Peace program. Ukraine has also established the long term objective of become an EU member, and in the meantime acquiring a perspective of membership in the EU. However, Ukraine has not yet been recognized as a potential EU candidate by the current 4 ISI Emerging Markets – Ukraine Today Press Review 17 August, 2006 6
  • 8. 2007-2010 Country Strategy: Ukraine BD2006-111 members of the European Union. Instead, Ukraine’s relations with the EU are to take place on a bilateral level within the framework of the European Neighborhood Policy (ENP) for the period 2007-20135. II. Overview of Current BSTDB Portfolio As of 31 August, 2006, the active BSTDB portfolio in Ukraine amounted to twelve operations approved by the Board of Directors (BoD), involving an investment of US$ 154.1 million. Ten of these operations were signed (totaling US$ 132.7 million), and the outstanding disbursements amounted to US$ 108.7 million. Ukraine ranks second as a destination for operations by BSTDB, in terms of BoD approved operations, with 18.3% of the total portfolio. The Bank also has one operation in Ukraine amounting to US$ 5 million which was approved by the BoD but subsequently removed from the portfolio, and another operation which was approved for US$ 2.5 million which was signed and then cancelled. Among the signed and active operations: Transbalkan Gas Pipeline Project, Phase I The project, which represents the first phase of a program aimed at the expansion of the Transbalkan gas-pipeline system, involves the construction of a gas compressor station in Tarutino, Ukraine. The US$ 12 million loan approved for this project, which was a co-financing operation with the EBRD. Transbalkan Gas Pipeline Project, Phase II The second phase of the Transbalkan project involves expansion of the existing pipeline via construction of three looping sections. For this phase, the Bank approved a loan of US$ 6 million in September 2001. Port of Ilyichevsk – Grain Terminal The loan approved for this project amounts to US$ 9 million and its agreement was signed in October 2001. The loan is for the construction of a bulk commodity terminal with a deep-water berth needed for the expansion of the grain terminal in the port of Ilyichevsk, Ukraine. Procredit Bank Ukraine BSTDB signed in April 2003 a US$ 5 million Term Loan Facility for financing and developmental support of the micro and small business sector in the Ukraine, to the pre-eminent institution specializing in this sort of lending. As a follow-up an additional 2.5 million credit line was signed in June 2004, again for financing the micro and small business sector in Ukraine. In May 2006, BSTDB signed a second micro and SME loan facility for US$ 12.5 million, with a tenor of 3 years, intended to finance sub-loans offered by Procredit Bank. This facility comes in addition to the previous credit lines extended to Procredit Bank Ukraine (PBU). Chornomornaftogaz Under this facility, BSTDB has made available a corporate loan of up to US$ 20 million to Chornomornaftogaz, a leading company in the Ukrainian energy sector that carries out prospecting 5 For more on ENP generally, and Ukraine’s participation therein, see http://ec.europa.eu/world/enp/index_en.htm . 7
  • 9. 2007-2010 Country Strategy: Ukraine BD2006-111 and exploratory drilling on the shelf of the Black and Azov Seas, and is a major supplier of gas to the regions of Crimea and Southern Ukraine. The financing aims to support the core business activities of Chornomornaftogaz, including developing, commissioning and increasing output of s its gas fields. The loan was signed in August 2004 and carries a maturity of 7 years. JSC Stirol In October 2004, BSTDB signed an operation for the modernization of JSC STIROL, a leading producer of nitrogen fertilizers in Ukraine, providing a 5-year US$ 10 million loan. The operation includes the upgrading of STIROL's main production lines, as well as the establishment of new manufacturing facilities for chemical products, as part of an overall modernization program estimated at US$ 40 million. First Ukrainian International Bank Under this facility, signed in October 2004, BSTDB is providing the First Ukrainian International Bank with a credit line up to US$ 10 Million for the purpose of providing short-term trade finance products in Ukraine. The revolving credit line is being used by FUIB to provide pre-and post- shipment financing to Ukrainian exporters selling to customers in BSTDB member countries and beyond with a maximum tenor of one year. The facility provides Ukrainian companies with greater access to working capital required to perform under export contracts. Galnaftogaz Under this arrangement, BSTDB is making available a US$23 million corporate loan to Galnaftogaz, one of the top petroleum retail networks in Ukraine. The financing supports the company's investment program, which includes network expansion and modernization of existing gas filling stations (GFS), mainly in Western and Central Ukraine. The financing also facilitates modernization of the Company's network according to EU standards, reduction of harmful emissions and diversification of distribution sources in the local market. Astelit In August 2006, BSTDB signed a seven year loan with Astelit in an amount of US$ 23 million. The facility will finance further network roll-out of the Astelit’s GSM network in Ukraine, funding of initial working capital and refinancing of existing debts including local bank and vendors’ loans. The Operation aims to support Astelit’s position as a modern mobile telecommunications company with consumer orientated service packages and an advanced communications network infrastructure, which provides high quality services and communication portfolios to private and business users. III. Review of Country Strategy 2005-20066 a. Relevance: satisfactory strategies’ design and rationale Overall, the reviewed country strategies reflect well the Bank’s mandate and the priorities in Ukraine. They all focused on (i) trade finance (short term guarantees, pre-export credit lines, medium-term buyer/supplier credit, aiming export competitiveness, trade surplus, import diversity, employment, SMEs); and (ii) project finance (privatization-investments and technical cooperation, energy/efficiency/diversity, infrastructure, manufacturing, cross-border, SME, technical cooperation, regional investment inflow, agribusiness, telecommunications, municipal infrastructure, services). 6 Independent review carried out by Evaluation Office 8
  • 10. 2007-2010 Country Strategy: Ukraine BD2006-111 The strategies stress on the importance of ensuring additionality, funds/investment mobilization and development/cooperation impact, moving from relatively short term and narrowly focused to a longer/broader range of operations over the three periods, demonstrating consistency and continuity. The latest strategy reflects a new orientation towards EU membership and a respective modernization of the economy. While the strategies reflect well the country priorities, targeted operations could have been more directly referred to the capacity/competence of each sector-specific team, as some areas remained in- between allocated responsibilities, e.g. services. The Bank could have adopted a more elaborate/tailored genuine project finance approach, as opposed to the shift towards corporate finance. In conclusion, the strategies’ responsiveness to BSTDB’s mandate and the Ukrainian priorities was relevant, providing a rather unrestricted room for development interventions in many sectors. The overall rating on the strategies relevance is satisfactory. b. Effectiveness: satisfactory strategies’ implementation through operations b..1. Relatively large and sustained portfolio, with some decline in financial sector Ukraine’s portfolio is consistently among the largest, relative to the rest of countries, in terms of cumulative number of signed operations. It ranks 4th with 11 signed operations and 14.5% of the respective total amount. While the cumulative 1999-2006 figures indicate a good balance between project finance (9 signed operations) and financial sector (5 signed operations), the latter slowed its growth as only one financial sector operation was signed under country strategy 2005-06 (ProCredit Bank/SME - an extension of already existing operation). The effective share of financial sector has been further limited by the relatively smaller amounts and the rather high abandonment rate of 40% (vs. 35% Bank average; see C. further). Contrary to the revealed difficulties in reaching the claimed financial sector growth through “creative products”, the project finance has marked a very good performance. Here a particular reference is made to the good sector/product coverage; and the good number of cooperation/co-financing components in most operations. b.2. Good sector/product outreach and co-financing The portfolio in Ukraine is (consistently) one of the most diverse in terms of sector/product representation and has generally covered most of the intended outreach. This diversity was built already at the time of the first country strategy, with sufficient maintenance in 2005-2006. Most of the targeted sectors/products were adequately covered by relevant investments, with a particular reference to energy/infrastructure, trade finance, SMEs, manufacturing, telecommunications and transport, with a good number of operations having cross-border components and/or co-financing. Some sectors/products remained underrepresented, e.g. services, and municipal infrastructure, and further analysis and steps have to be taken in order to improve the situation. b..3. Strategies effectiveness summarized: satisfactory Further to the above overview, summarized in Table 1, and in reference to the strong performance on project finance the evaluation rated the effectiveness of each of the three strategies as satisfactory. 9
  • 11. 2007-2010 Country Strategy: Ukraine BD2006-111 UKRAINE: BSTDB STRATEGIES AND PERFORMANCE AT A GLANCE (1999-2006) CS 1999-2001 CS 2002-04 CS 2005/6 Performance Trade/SME Finance: Focus: As previous, with As previous, with Good overall, high shares exports; capital goods imports. longer-terms, broader further focus on (signed) in total portfolio. Diversify imports to decrease product range, more financial sector, 5 of all 14 approved dependency (energy) from Russia. co-financing, more innovation (e.g. operations are in financial SMEs: direct & by intermediaries. direct. leasing) and sector, recent focus on Short term, guarantees, pre-export “creative SMEs. Under CS 2005/6 lines, med-term buyer/supplier products”. there is only 1 fin. sector credit. Focus on export operation (PCB, $12.5M, IFI cooperation. competitiveness and extension). intermediaries. Project Finance: As previous. New: As previous. New: High shares (signed) in metallurgy, machine- EU membership total portfolio. Good Decrease dependence on energy building, chemicals, priority; flexibility coverage, except in imports. food, transport to private sector agriculture, tourism, SMEs: lines, direct, TC. infrastructure, FDI. demand; moderni- municipal infrastructure, Privatization: reg. investors. BSEC Energy: downstream- zation; services/ power/plants, energy FDI. Infrastructure with cross- refinery, environment, tourism; efficiency, services and border focus. Energy: power, gas, cross-border power, construction TC. 3 operations signed in oil, pipelines, terminals, etc. – power plants, infrastructure. 2005/6. reduce dependency from Russia. efficiency. Municipal Good in co-finance Telecom: regional FDI. infrastructure. /cross-border. Agriculture, with intermediaries. Co-financing/IFI. c. Overall performance rating: satisfactory The study assessed the overall performance of each country strategy 2005-2006 (hence the BSTDB’s performance in Ukraine) as satisfactory, based on the results under the four evaluation criteria, reviewed above (relevance, effectiveness, efficiency and sustainability – first two rated satisfactory, second two - excellent). Generally, the three country strategies were consistent with both the Ukrainian and the Bank’s priorities. Overall, the Bank developed a substantial and diverse portfolio that reflects the strategies, and demonstrated an outstanding efficiency in maintaining this portfolio, with very few (financial sector) operations being abandoned. d. Key conclusions and recommendations d.1. Enhance marketing and economy of scale, with a focus on financial sector In concert with overall business improvement efforts, the Bank should target an increased efficiency through improving returns from better economy of scale and scope, based on at least one operation per strategy-targeted sector. This implies work on two self-reinforcing fronts: (i) increased business generation through better marketing and higher average tenors/amounts; and (ii) improved generation rates in financial sector. The Bank should make/maintain substantial marketing efforts to compensate for the stronger presence of other lenders in Ukraine. As an alternative to having its own local office, it may opt for contracting an energetic representative, on a success-fee basis. Regardless of the decision on that matter, the Bank would need to foster its partnering with other funding institutions and take part in initiatives and events of high visibility. 10
  • 12. 2007-2010 Country Strategy: Ukraine BD2006-111 The current off-the-shelve, one-size-fits-all standard requirements could be tailored to better match specific degrees of clients’ sophistication. Given the diverse nature of potential borrowers, the Bank would benefit from a more flexible approach on security, information and pricing requirements, as well as internal approval procedures. For instance, the Bank may adjust its requirements, depending on the size of a client, type of operation, etc., thus seeking different information, security arrangements, and approval procedures. This will facilitate the eventual effort to target second-tier companies, as current BSTDB requirements and procedures were prepared to reflect the nature of first tier clients and turned to be unsuitable for less-sophisticated companies. d.2 Maintain sector diversity and improve strategy-plan linkage As some of the intended sector/product coverage was not realized, further strategies should better reflect lessons learned from the past, as well as use specific sector/product comparative advantage analysis of the Bank. Strategies should target sectors where BSTDB has or may build a comparative advantage. To achieve coverage and impact in strategic areas that remain underinvested, the Bank should explore more thoroughly the field of genuine project finance as opposed to its “blue-chip” corporate finance approach. To this end, the Bank has to proactively address the multiple dimensions of risk mitigations with a reference to the legal framework limitations on security enforcement, in order to successfully add value as a developmental institution of growing profile and competence. IV. BSTDB Operational Priorities for 2007 - 2010 Based on the 2007- 2010 BSTDB Business Plan, the Bank would expect to approve four operations per annum during this period, for approximately US$ 42 million per year on average. Over the four year period of the Business Plan, this implies 14 approved operations for approximately US$ 170 million. With the Bank committing to raising the level of commitments (signed operations) for 2007-2010, it is estimated that 12 operations for US$ 142 million will be signed (US$ 35 million per annum). The base case scenario presented above would involve an expansion of activities in Ukraine during the 2007-2010 period. Such an expansion is necessary for the Bank to be able to have an of impact in a country as large as Ukraine, and to generate value for the Bank’s shareholders. In line with the Bank’s Business Plan and operational philosophy, the operational objectives in Ukraine will remain to find ‘bankable’- in other words commercially promising and financially viable- operations, usually in cooperation with private firms. The notion of ‘bankability’ is consistent with the portion of the Bank’s mandate to promote economic development in its Member Countries since investments have positive economic impact on the host country, generate employment, frequently possess positive externalities (demonstration effects, multiplier effects, etc.), and promote private sector development. However, it has frequently been difficult to incorporate elements of regional cooperation- the other portion of the Bank’s dual mandate, since benefits accruing to two or more member countries from a private investment depend upon who is investing and what is the target market for the firm receiving the investment. In other words, financing for a private firm must meet bankability criteria and will almost always meet development criteria, but may or may not contain regional cooperation criteria. Therefore, while the strategy for Ukraine for the coming period will not entail dramatic changes in emphasis relative to previous strategies, the Bank will make a greater effort to incorporate greater degrees of regional cooperation benefits- defined as involvement of parties from two or more 11
  • 13. 2007-2010 Country Strategy: Ukraine BD2006-111 Member Countries with benefits accruing to two or more Member Countries. This will involve exploring opportunities to cooperate with firms and/or banks from other BSEC countries which are undertaking investment in Ukraine, so as to meet the Bank’s developmental and regional cooperation objectives. The Bank will also seek opportunities to work with Ukrainian firms (or banks) which seek to expand the range of their investment, trade, and financing activities to other BSEC Member Countries. Furthermore, it will involve searching more intensively for involvement in projects which tend to have greater cooperation benefits- such as infrastructure development- and finding more creative ways to achieve involvement, given the limitation of the Bank to provide financing on market terms. Ukraine is currently characterized by healthy economic growth, an improving business climate, increased interest from foreign investors, and evolving needs of local banks and companies which, as the economy grows and matures, require more sophisticated and longer term products from international financial institutions (IFIs). Moreover, the Bank will need to diversify its client base away from large, established low-credit risk firms which will need IFI assistance less and less, and instead expand its outreach to so-called ‘second tier’ companies- firms which are less well established and known, and with a smaller track record. Such firms may be promising and dynamic, operating effectively but without much recognition; however, they may require greater amounts of technical assistance, since they do not have experience working with IFIs, they may have no operating business plan, they may not have IFRS compliant audited financial statements, and they may lack the capacity to undertake studies or otherwise provide information normally required by IFIs. The Bank notes the interest of Ukrainian authorities for BSTDB to establish a field office in Ukraine in order to increase its local presence. Depending upon the decision of its shareholders as to the feasibility and cost-effectiveness of such an initiative, balanced against the expected benefits such as (i) expanded operational presence, (ii) more immediate access to authorities, and (iii) easier supervision of existing operations, the Bank will remain open to such a possibility insofar as it promotes fulfillment of the Bank’s mandate and generates greater value for shareholders. BSTDB’s project and corporate finance strategy Ukraine possesses strong potential, particularly in ‘heavy’ industrial sectors such as metallurgy, machine building, chemical industry, but also in ‘lighter’ sectors such as food processing and agribusiness. With respect to the ‘heavier’ sectors, the Bank will be more inclined to consider operations that involve modernization/ restructuring of facilities, particularly if they have strong energy efficiency and environmental components. This is the primary area of need for the development and evolution of the heavier sectors, which have been critical to the high growth observed in Ukraine over the last few years, but which tend to be energy intensive and low value added, benefiting significantly from cost competitiveness advantages conferred by the undervalued hryvnia. Firms which are interested in developing higher value outputs as part of their modernization and expansion will certainly be considered. This extends to heavy manufacturing such as shipbuilding, which is important to Ukraine’s economy and presence and with which BSTDB has operational experience7. Under appropriate circumstances, the Bank will seek to support the modernization and development of shipbuilding. Agriculture related industry, both food processing but also upstream agribusiness and agricultural supply businesses, represents an area with considerable potential for growth, employment 7 The Avin ship delivery project. 12
  • 14. 2007-2010 Country Strategy: Ukraine BD2006-111 generation, and creation of value. The economic growth observed in Ukraine and the growing interest of foreign firms make this an area of high growth potential, into which the Bank will be keen to cooperate with interested investors. Other industries such as textiles or small scale manufacturing will be targeted as well, insofar as the potential operation is financially viable and contains any or all of the following characteristics: it helps to introduce new technologies or possesses other positive demonstration effects; helps to generate or maintain employment; it involves foreign investment, particularly if from another BSEC member country; it helps to diversify or expand the export potential of Ukraine, it contains strong multiplier effects, etc. The service sector in Ukraine is underdeveloped relative to neighboring states. With continued economic growth and the growth of domestic demand, services related to retail development, real estate and construction, and tourism offer strong prospects for growth. These areas also offer some of the best prospects for creation of employment, thus rendering their economic development impact particularly favorable. The Bank will seek to work with reputable firms and large chains entering the Ukrainian market in areas such as retailing and hotel development, as well as opportunities related to development of winter and summer tourist facilities (either on the Black Sea or in mountain areas). Industries related to construction, such as building materials, will also be of interest. Infrastructure Since infrastructure projects contain important developmental elements as well as strong regional cooperation enhancement prospects, the Bank will be keen to participate in transport, energy, and other infrastructure operations seeking to upgrade existing, or build new, infrastructure in Ukraine. Ukraine’s improved financial position enhances the prospects for Bank involvement in such operations, although it will also be necessary to be creative and try to maximize private sector participation in certain activities, so as to minimize the costs and/or debt burden and improve the efficiency of participants and their incentives to maximize the value of the project. Ukraine is strategically positioned at the heart of the Black Sea Region, with a broad coastline on the Black Sea. It thus represents a natural transportation hub and transit point, and its transport infrastructure is vital for both regional and international trade. However, this infrastructure- roads, ports, airports- requires significant upgrading and expansion in order to be able to support the increased economic activity in Ukraine and the Region more generally. Put differently, transport infrastructure expansion is essential to avoid the current situation becoming a bottleneck and drag on the high rate of growth witnessed in other sectors of the economy. Port development represents one area in which the Bank has participated successfully in the past and port expansion, facility modernization, and surrounding infrastructure development all represent areas in which the Bank will seek operational opportunities. The Bank will also seek to participate in projects focusing on road construction and airport upgrading/ expansion as opportunities arise. In this respect, Ukraine’s participation in the proposed Black Sea Ring Highway (aka BSRH, or ‘Road of the Argonauts’), being promoted as a flagship initiative of the Black Sea Economic Cooperation (BSEC), will be crucial to the success of the BSRH enterprise overall and the Bank will be keen to provide financial (and other) support for the realization of this project. Municipal infrastructure represents another area in which the Bank hopes to establish an operational presence and assist Ukrainian municipalities in activities such as water supply and waste management. Above all, the Bank will seek projects aiming to improve energy efficiency or to increase energy saving in municipal, residential and industrial building stocks. Ukraine’s economy is 13
  • 15. 2007-2010 Country Strategy: Ukraine BD2006-111 highly most energy intensive but also wasteful in its use of energy resources, thus rendering a priority the undertaking of projects to improve the efficiency of local heating systems. Energy, more generally, is another significant area for seeking operational opportunities. Ukraine is an important energy transit conduit, and it contains significant refining capacity which has made it an exporter of finished energy goods even though it is a net importer of energy commodities. The Bank will therefore seek to continue its support to projects contributing to rehabilitation of the existing energy transport infrastructure that are designed to expand existing export capacities. It will also support projects designed to improve regional energy transport and handling infrastructure (like Transbalkan Phase I and II). Furthermore, the Bank will explore opportunities for projects in oil & gas downstream, such as upgrading of oil refinery facilities by improving their product quality or the environmental acceptability of refined products. In the electric power sub-sector, the Bank will seek opportunities for activities related to power generation as well as transmission. This includes greenfield start-ups and the renovation and upgrading of existing capacity of power plants in Ukraine, with the intention of facilitating the export of surplus electricity to neighboring Black Sea countries. A particular focus will be the upgrading and modernization of high voltage transmission lines, with an emphasis on cross-border rather than domestic electricity transmission projects due to the regional cooperation prospects offered. By way of contrast, the Bank is already present operationally in the telecommunications sector in a satisfactory manner. Therefore, the sector is not likely to constitute a core priority during the coming period, even though Ukraine’s great long term potential for growth remains, since both the number of fixed line telephones, and mobile telephone penetration lag behind other European averages. Nevertheless, if exceptional operational opportunities emerge, involving strong developmental and regional cooperation elements, then the Bank will consider further expansion of its presence in this sector. BSTDB Financial Sector Strategy BSTDB’s financial sector strategy has been to develop a network of financial intermediaries, through whom to deliver its trade finance and SME finance products and expand its trade finance products by introducing a combined trade finance facility. Since BSTDB began operations, the following products have been introduced through selected financial intermediaries in Ukraine for the purpose of Trade Finance and SME development: • Short-term Pre-export Finance product; • Short-term Single and Multiple Buyer products; • Medium – Term Micro and SME Finance products; By developing a network of financial intermediaries in Ukraine, BSTDB intends to support Ukraine’s emerging private financial sector. BSTDB considers support for this sector an important strategic priority and will devote efforts to upgrade further its presence in Ukraine. The sector has experienced sustained high growth in recent years, rendering prospects particularly favorable since it is a rapidly developing sector in an economy which is still ‘underbanked’ -as measured by the levels of activity in other European economies, an indication that there is still much room for further growth. Thus, a key part of the operational focus will remain to increase the number of financial intermediaries to deliver Bank products and to increase the exposure and tenor to existing financial intermediaries with whom the Bank has cooperated successfully, within their capacity. As the Ukrainian financial sector grows in sophistication, the Bank will need to adapt accordingly, within the scope of its Business Plan and its capacity, to expand its activities in strengthening specific types of financial institutions, taking into consideration the prevailing market, 14
  • 16. 2007-2010 Country Strategy: Ukraine BD2006-111 legal and institutional conditions. More specifically, the Bank will seek (i) to provide new products that may be required but not yet fully developed in the Ukrainian market, (ii) to support niches which have grown impressively but still require more resources, such as the provision of funding to financial intermediaries seeking to mortgage financing and retail banking, (iii) to extend longer term financing (e.g. greater than three years) where prevailing needs tend to be greatest, and (iv) to help local banks to improve their international networks and contacts through the business they conduct. The Bank will also consider option to take equity participations in select financial institutions and funds, and will also seek to develop quasi-equity products, such as subordinated loans. Other areas which will receive consideration include microfinance and municipal lending. Bank involvement will be determined by assessment of the potential of such involvement, and the extent to which involvement with such institutions will play a catalytic role and provide clear demonstration effects. A core priority for the Bank remains the provision of financial support to SMEs which undertake modernization programs of their production facilities, corporate development or investment programs. The focus of the Bank’s activity will be in particular on financing operations where such programs are expected to have high development impact and to produce sizeable positive effects on the economies of the BSEC region in terms of facilitating and expanding trade and contributing to an increase in commercial activities. The Bank hopes to find suitable partners to support the development of leasing, as well. However, the Bank intends the leasing product not only for SMEs but also for other companies as an effective financing tool for the promotion of regional trade. Medium-term credit lines opened to leasing companies will enable them to offer their customers finance for capital expenditures on imports from other countries in the region. Cooperation with other International Financial Institutions The Bank will also keep in regular contact with complementary international financial institutions (IFIs) such as EBRD and IFC to seek ways to coordinate activities and share experiences, given the opportunities which exist for joint involvement. The Bank has successfully cooperated with these- and other- IFIs in Ukraine as well as other BSEC Member Countries and intends to build further upon this and seek synergies where possible. Prospects for such activities have improved as a result of the creation of the Working Group (WG) for Co-Operation For Eastern Europe and Southern Caucasus, Russia, And Central Asia, in which the Bank is a participant, and which covers a number of BSTDB Member Countries including Ukraine. The Bank is a signatory to the Memorandum of Understanding guiding the activities of this WG together with a number of IFIs and the European Commission; within the context of this WG, the objective of the Bank is to cooperate, coordinate, share information, and seek co-financing opportunities with other WG participants, including with the EC under its new European Neighborhood Policy Instrument. Moreover, the Bank will be open to technical assistance requests which promote regional cooperation, knowledge generation, introduction of new products or activities involving state of the art methodologies, and/or enhance the prospects for resource mobilization in the economy. 15

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