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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY PROJECT PAPER ON A PROPOSED ADDITIONAL LOAN IN THE AMOUNT OF US$ 150 MILLION TO THE JOINT STOCK COMPANY THE STATE EPORT-IMPORT BANK OF UKRAINE WITH THE GUARANTEE OF UKRAINE FOR A SECOND EPORT DEVELOPMENT PROJECT (EDP2) July 27, 2011 Report No: UA 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.

2 CURRENCY EQUIVALENTS (Exchange Rate Effective July 14, 2011) Currency Unit = Ukrainian Hryvnia (UAH) 7.97 UAH = US$ US$ = UAH 1 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS CAR CEO CPS CY EBRD ECA EDP F FY GOU IFC IFRS ICB IFR IMF ISR IT ISA NBU NPL OM PB PFRL PIU QAG UEB Vice President: Country Director: Sector Director: Sector Manager: Task Team Leader: Capital Adequacy Ratio Chief Executive Officer Country Partnership Strategy Calendar Year European Bank for Reconstruction and Development Export Credit Agency or Europe & Central Asia (Region) Export Development Project Foreign Exchange Fiscal Year Government of Ukraine International Finance Corporation International Financial Reporting Standards International Competitive Bidding Interim Financial Report International Monetary Fund Implementation Status and Results Report Information Technology International Standards on Auditing National Bank of Ukraine Non-Performing Loan Operations Manual Participating Bank (bank or leasing company) Programmatic Financial Sector Rehabilitation Loan Project Implementation Unit Quality Assurance Group Joint Stock Company The State Export-Import Bank of Ukraine Philippe H. Le Houerou Martin Raiser Gerardo Corrochano Lalit Raina Marius Vismantas

3 UKRAINE Project Paper Data Sheet Project Paper ADDITIONAL FINANCING FOR SECOND EPORT DEVELOPMENT PROJECT (EDP2) CONTENTS I. Introduction... 1 II. Background and Rationale for Additional Financing in the amount of $150 million... 1 III. Proposed Changes IV. Appraisal Summary ANNE 1: Results Framework and Monitoring ANNE 2: Operational Risk Assessment Framework (ORAF) ANNE 3: Revised Implementation Arrangements and Support... 21

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5 UKRAINE SECOND EPORT DEVELOPMENT PROJECT ADDITIONAL FINANCING ADDITIONAL FINANCING DATA SHEET Country Director: Martin Raiser Sector Manager/Director: Lalit Raina/Gerardo Corrochano Team Leader: Marius Vismantas Project ID: P Expected Effectiveness Date: January 31, 2012 Lending Instrument: Financial Intermediary Loan (FIL) Additional Financing Type: Scale-up Basic Information - Additional Financing (AF) Sectors: FPD Themes: Export Development and Improved Access to Finance Environmental category: FI Expected Closing Date: December 31, 2014 Joint IFC: No Joint Level: No Basic Information - Original Project Project ID: P Environmental category: FI Project Name: Second Export Expected Closing Date: December 31, Development Project (EDP2) 2011 Lending Instrument: Financial Joint IFC: No Intermediary Loan (FIL) Joint Level: No AF Project Financing Data [ ] Loan [ ] Credit [ ] Grant [ ] Guarantee [ ] Other: Proposed terms: variable spread US Dollar loan of 30 years of maturity, including a 6- year grace period. AF Financing Plan (US$m) Source tal Project Cost: Cofinancing: Borrower: tal Bank Financing: IBRD IDA New Recommitted tal Amount (US $m) Client Information Recipient: Joint Stock Company The State Export-Import bank of Ukraine (Ukreximbank) Responsible Agency: Joint Stock Company The State Export-Import bank of Ukraine (Ukreximbank) Contact Person: Mr. Nikolay Udovichenko, Chairman of the Management Board of Ukreximbank Telephone No.: Fax No.: SKhudiyash@hq.eximb.com

6 AF Estimated Disbursements (Bank FY/US$m) FY FY11 FY12 FY13 FY14 FY15 Annual Cumulative Project Development Objective and Description The objectives of the Project are to: (a) provide medium and long term working capital and investment finance to private exporting enterprises to assist the Guarantor s private exporting sector; and (b) further improve the ability of the banking sector to provide financial resources to the enterprise sector through development of intermediation by expanding private financial institutions lending products. Revised project development objective: N/A Project description: EDP2 Additional Finance (AF) is a top-up of the existing credit line under the EDP2 project. EDP2 is a follow-up project to the previously successful EDP 1. The project provides a new credit line, backed by the Bank's variable spread flexible US Dollar loan of 30 years of maturity, including a 6-year grace period, and guaranteed by the Ukrainian government on behalf of the Ukraine, to the Joint Stock Company The Export-Import bank of Ukraine (Ukreximbank or UEB), a state-owned foreign trade development bank, for further on-lending to eligible financial intermediaries. The financial intermediaries further on-lend the credit line funds to eligible exporters. The main project emphasis is on UEB operating as a wholesale export finance provider. During the project implementation, due to the effects of financial crisis in Ukraine and weakening of the participating banks, the EDP2 project was restructured to allow UEB to lend directly to final beneficiaries eligible exporters. Following provision of EDP2 AF, UEB is expected to provide both wholesale (through selected participating banks) and direct financing to Ukrainian exporters. Safeguard and Exception to Policies Safeguard policies triggered: Environmental Assessment (OP/BP 4.01) Natural Habitats (OP/BP 4.04) Forests (OP/BP 4.36) Pest Management (OP 4.09) Physical Cultural Resources (OP/BP 4.11) Indigenous Peoples (OP/BP 4.10) Involuntary Resettlement (OP/BP 4.12) Safety of Dams (OP/BP 4.37) Projects on International Waters (OP/BP 7.50) Projects in Disputed Areas (OP/BP 7.60) []Yes [ ] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No [ ]Yes [] No

7 Does the project require any exceptions from Bank policies? Have these been approved by Bank management? [ ]Yes [] No [ ]Yes [] No Financing Agreement Reference Conditions and Legal Covenants: Description of Date Due Condition/Covenant Satisfactory legal opinions on Before effectiveness the Loan and Guarantee agreements have been received US$130M actually disbursed under the original EDP2 credit line UEB to maintain satisfactory financial management systems, including records and accounts, and prepare financial statements satisfactory to the World Bank. Annual project accounts and an IFRS audit of UEB's financial statements to be provided within six month: of each year-end during the implementation period. Audits to be carried out by independent external auditors in accordance with International Standards of Auditing (ISA) and International Financial Reporting Standards (IFRS), under terms of reference satisfactory to the World Bank. UEB to maintain a PIU with satisfactory staffing and other resources as required for effective project implementation Before Board Continuous throughout the project implementation period Continuous throughout the project implementation period

8 UEB to monitor project performance in accordance with the agreed performance monitoring Indicators Continuous throughout the project implementation period UEB to use Operational Manual for implementation, not to be altered without Bank consent. UEB to on-lend for export development sub-projects and to on-lend to PBs for onlending for export development sub-projects in accordance with defined criteria main terms and conditions of which are reflected in the annex and attachment in the Loan Agreement and all of which are contained in OM UEB to comply with the capital adequacy requirement and with other NBU requirements and banking regulations, including in particular insider and large lending exposures, liquidity, and fx exposures

9 I. Introduction 1. This Project Paper seeks the approval of the Executive Directors to provide an additional loan in an amount of US$150 million to Joint Stock Company The Export-Import bank of Ukraine (Ukreximbank or UEB) with the guarantee of Ukraine as Additional Finance to Second Export Development Project (EDP2) P [IBRD-48360]. 2. The proposed additional loan would help finance scaled-up activities of EDP2 to enhance the impact of a well-performing credit line to Ukrainian exporters. The resumption of growth of the Ukrainian economy is particularly dependant on the pick-up in exports in the post-crisis environment. UEB has been particularly effective in extending sub-loans directly to exporters throughout the crisis period ( ), after participation of the intermediating local banks was temporarily suspended due to the worsening of their financial condition and violation of eligibility criteria in late 2008-early Going forward, EDP2 AF credit line would be extended both by UEB directly, and through resuming or new participating banks, thus enhancing the reach of the project. No changes to the current project design are being proposed. Expected outcomes from the activities to be supported with additional financing would relate to increased exports of the Ukrainian corporate sector in the short term, its enhanced capacity to sustain and grow exports in the medium- to long-term, and improvements in its average cost (reduction) and maturity (extension) of funding. 3. As in the original EDP2, there will be no partnership arrangements. II. Background and Rationale for Additional Financing in the amount of $150 million Original project performance 4. The proposed EDP2 AF is fully consistent with the current CPS objectives for Ukraine and is specifically noted as one of the planned IBRD projects. The project, by providing medium- and long-term financing to eligible exporting enterprises, enabled some to nearly double their export revenues in the last two years, thus helping mitigate the effect of the economic crisis. Recovering export capabilities serve as a key engine for restoring Ukraine s GDP growth in the post-crisis environment, recovery in demand from exporters for stable long-term funding is evident, and the EDP2 AF will come in timely, as the original EDP2 credit line is approaching full disbursement. UEB has indicated a growing demand for long-term lending resources; it restarted wholesale lending activities in 2010 by removing suspension of participation of 3 original PBs. A few more banks are targeted as potential new PBs. EDP2 AF will strongly contribute to restoration of longterm credit flow to the economy, and will also add to restoration of stability in the banking system, by PBs meeting and maintaining the project s eligibility criteria and reducing maturity mismatches by receiving long-term funding from the credit line. 5. The original loan amount for the EDP2 project was US$154 million. The loan was approved by the Board on July 27, 2006 and became effective on March 20, The 1

10 project s key development objectives were (i) to serve as a catalyst to support export and real sector growth in Ukraine during the EDP 2 implementation period and beyond, by providing medium and long-term working capital and investment finance to Ukrainian private exporting enterprises, and (ii) to further improve the ability of the Ukrainian banking sector to provide financial resources to the enterprise sector, through further development of intermediation, by expanding its depth and breadth through more and better lending products. 6. The project s design included two components. Component A is a credit line of US$150 million to eligible Ukrainian exporters, channeled by UEB as wholesale finance through participating banks. Component B is an institutional development component of US$3 million which UEB intends to use to purchasing IT hardware equipment and software for its new branch/data processing center. 7. During the implementation of the project, Ukraine was hit by an economic and financial crisis, which significantly negatively affected the banking system. As a result, two participating banks became insolvent, while the other banks failed to comply with the eligibility criteria. UEB temporarily suspended participation of all the participating banks in In order to ensure a flow of credit to exporters in the environment of decreased capitalization of the system, including project PBs, and an ensuing credit crunch in Ukraine, the project was restructured in May 2009 to allow UEB to lend to exporters directly. This resulted in a significant amount (around US$59.5 million, of which US$39.8 million UEB direct lending) of the EDP2 credit line approved from the time of the restructuring. The other US$20 million were approved in 2010 by the PBs whose participation in the project was resumed after they restored their capital in line with the NBU prudential requirements. 8. EDP2 has maintained compliance with all legal covenants, and did not face safeguard, environmental, or fiduciary problems. ISR ratings have been satisfactory for the duration of the Project (latest ISR was filed in June 2011). EDP2 has consistently been rated as one of the best-performing projects in World Bank s current Ukraine portfolio during the Joint Country Portfolio Reviews with the Government. EDP2 implementation arrangements and UEB s commitment to the Project have also received positive assessment in QAG s recent disbursement review for ECA region. 9. As a result of the global financial crisis, which accentuated the inherent vulnerabilities in the Ukrainian banking sector, the ability of private enterprises to access term finance at reasonable cost has been severely undermined. Faced with the dramatic decline in foreign capital inflows, the need to deal with accumulated asset quality problems, and the uncertain macro-economic environment, most Ukrainian banks have been, and still are to certain extent reluctant to extend new loans to enterprise sector (after almost doubling in 2008, the loan volume to corporate clients remained flat in 2009 but started increasing again in 2010 and 2011). Additionally, deposit outflow and shift to sight deposits in 2009 and 2010 worsened maturity mismatch between assets and liabilities, thus further restricting the ability of banks to provide longer term credit. 2

11 EDP2 Participating Bank, Subsidiary Loan, and Sub-loan performance 10. Of the 5 original PBs, two Nadra bank and Ukrgasbank failed and were placed under NBU s temporary administration. While Ukrgasbank later became one of the three banks recapitalized by the GOU, Nadra bank remains under temporary administration, however as of July 2011 it has received substantial equity investment from a private investor and is expected to exit temporary administration in the short term. The four PBs Megabank, Kreditprombank, Ukrgasbank and Kredit Dnepr bank have had their PB status restored after temporary suspension, after they increased their regulatory capital to and beyond the minimum capital adequacy levels required by the NBU. Kreditprombank, Ukrgasbank, Megabank and Kredit Dnepr banks had exhausted their Subsidiary Loan allocations, although the allocation to Megabank was augmented in July EDP2 disbursed credit line quality has slightly decreased during the crisis, albeit insignificantly as compared to the overall loan portfolio of the banking system. Of all the sub-loans extended under the EDP2 project, only one sub-loan extended by Nadra bank 1, was individually non-performing at the time of this report. All other subsidiary and subloans continued their timely repayments. Rationale for Additional Financing 12. The resumption of the flow of credit to enterprise sector is one of the critical preconditions for ensuring the speedy and sustainable recovery of the Ukrainian economy. Exporters in particular need ready access to external finance in order to take advantage of the recent improvements in competitiveness following the real exchange rate depreciation and resumption of growth in the main trading partners. The market analysis conducted by UEB, and the rising demand for EDP2 financing, suggest that there are a growing number of firms which are capable not just to maintain, but increase exports and enter new markets in the present conditions, provided they have timely access to working capital finance. As the economy rebounds, it is expected that the exporters will show renewed interest in longer term investment finance, given the substantial potential to enhance competiveness through improvements in physical capital stock. Companies in food processing sector are particularly well represented in the current sub-project pipeline as they were relatively less affected by the recession and hence are more capable to take on new debt obligations. 13. Additional Financing for EDP2 is proposed as the fastest and lowest cost instrument to improve access to finance for export-oriented enterprises as the economy recovers from the crisis. It allows for a faster and cheaper delivery of improved access to finance than would a new Project by using a streamlined approval procedure in the Bank and by leveraging the experience and institutional capacity that have been built within UEB to execute the Project. The proposed Additional Financing is consistent with the World 1 Of the total of three sub-loans extended by Nadra bank, two remain performing and continue their repayments to Nadra bank. 3

12 Bank guidelines for additional Financing (OP/BP ) under which the Bank may provide an additional loan to finance the implementation of additional or expanded activities that scale up a project s impact and development effectiveness. The project has already proven effective in generating longer term credits to exporters by providing funding through UEB and eligible PBs. 14. The proposed amount of US$150 million is based on a forecasted demand for such longterm loan funds by UEB and the Bank. The forecast is based on a number of factors, including the pace of disbursement of the original EDP2 credit line component, demand from PBs and exporters for longer-maturity funding in the post-crisis environment following a systemic credit crunch, especially, and a number of potential PBs and evolving risk management practices of UEB. The proposed AF credit line will be divided into two sub-components (UEB direct lending and wholesale lending through PBs) as discussed in para. 32 below. 15. The only viable alternative to additional financing was a new export development project. However, AF was preferred as there are no proposed changes in the design of the original EDP2 project, nor there are changes in key project participants. AF will ensure a fast and efficient provision by the Bank of additional long-term funding to the exporting segment of the Ukrainian economy. 2 Operational Policy and Bank Procedure of the World Bank 4

13 Country context 16. Until mid-2008, Ukraine recorded strong economic growth, but signs of overheating became increasingly apparent. Growth over averaged 7.5 percent, which is among the highest in Europe. Greater amounts of investment, both foreign direct investment and bank lending, flowed into the country, which together with strong improvements in the external terms of trade due to high steel prices sustained double digit growth in domestic demand. However, with a pre-crisis fixed exchange rate and procyclical fiscal policy, buoyant international liquidity translated into increasing domestic overheating and high inflation (well over 30 percent by mid-2008), with the current account widening by 20 percentage points of GDP between 2003 and The global economic and financial crisis hit Ukraine particularly hard given pre-existing macroeconomic imbalances, structural weaknesses, and policy shortcomings 3. By the fourth quarter of 2008, capital inflows came to an abrupt stop, the terms of trade reversed as steel prices tanked and export markets shut down. The crisis also accentuated the vulnerabilities of the banking sector, leading to a systemic liquidity and solvency crisis, including the leakage of deposits. GDP contracted by 15 percent in 2009, with private consumption and fixed investments falling by 16 and 54 percent, respectively. Since October 2008, the national currency has lost about 40 percent of its value against the US dollar. 18. Against this background, the Ukrainian authorities requested IMF support in late October Incomes policies, the introduction of exchange rate flexibility, a commitment to prudent fiscal policy and measures to stabilize the banking system were at the core of the government s macroeconomic response supported by a two-year Stand By Arrangement (SBA) amounting to SDR 11 billion (USD 16.6 billion) approved by the IMF Board on November 5, The IMF Board approved the first and second reviews under the SBA in May and June However, in the pre-election period, the political consensus supporting the program unraveled, and the authorities failed to take measures to stabilize the fiscal situation in line with commitments under the program. tal USD billion has been disbursed under this program during At the request of the new Government which has been appointed soon after the Presidential elections in Ukraine in February 2010, IMF Board on July 29, 2010 has approved the new 29-month SBA for Ukraine in the amount of SDR 10 billion (about 11.7 billion, or US$15.3 billion) in support of the authorities economic adjustment and reform program. Ukraine has received the first allocation of funds under this program and in case of successful first review of the program by the IMF Board on December 22, 2010 Ukraine s disbursements under this program will reach USD 3.4 billion at the end of In 2010, the Ukrainian economy has started to rebalance and stabilize, and industrial production has started to gradually pick-up. With exchange rate realignment, the current account deficit shrank from over 7 percent GDP in 2008 to 1.7 percent in 2009 with a 3 See, for instance, World Bank, 2007, Program Document for the Second Development Policy Loan, Report No UA, and World Bank, 2008, Program Document for the Third Development Policy Loan. 4 The policy actions supported by the IMF SBA are detailed in the Memorandum of Economic and Financial Policies (MEFP) 5

14 slight increase up to 1.9 percent of GDP in Inflation came down to 12.3 percent by end 2009 and leveled out at 9.8 percent by the end The financial sector has stabilized and banking system deposits have fully achieved the pre-crisis level by September 2010, as the exchange rate has settled around a new parity of roughly UAH8/USD. With the global recovery well under way by the second half of 2009, industrial production has started to increase again in 2010 (11 % growth) after a sharp over 20% decline in Sector context and policy 20. Ukraine has been hard hit by the global financial crisis and its severe effect on Ukraine s economy and the financial sector. Inaccessibility of deposits in one of the largest banks in early October 2008 and a 40% depreciation of the national currency triggered a 25% contraction of local currency deposits during October 2008 March Tightening liquidity and increasing credit risks resulted in ceasing of bank lending to the economy and households. Economic recession, growing unemployment, and UAH depreciation brought about a 9-fold increase in nonperforming loans (NPLs). This led to historically high losses of the banking sector in 2009 of UAH35 billion (around US$4.4 billion) and further UAH13 billion (around US$1.6 billion) in 2010, significant capital erosion, and insolvency of a number of banks. Overall, 27 banks were taken into temporary administration by the National Bank of Ukraine (NBU), of which 16 went into liquidation. Table 1. Performance of the Banking Sector, Indicators Number of operating banks, incl: with foreign capital with 100% foreign ownership Share of foreign banks in capital, % Assets, UAH bln Assets as % of GDP* Assets growth, % Loans, UAH bln Loans as % of GDP* Deposits, UAH bln Deposits growth, % Financial depth (Deposits to GDP) * Loans to deposits ratio, % Equity, UAH bln Capital adequacy ratio, % Profit/Loss, UAH bln Return on assets Return on equity Net interest margin Source: NBU 6

15 21. The authorities tried to restore trust in the system and preserve its core, primarily through public and private recapitalization at over USD 6 billion (close to 5 percent of GDP). While there are still some banks with deficient capital, they are not systemically threatening. The NPLs at the level of around 40 percent are very high but fairly well provisioned, although a more systemic approach of their resolution is needed. Ukraine, with around 175 banks, is still largely overbanked and medium and small banks are likely to face significant capital and growth constraints and consolidation pressure. 22. address the root causes of the crisis, the GOU has committed to a two phase program crisis response and medium term. The first phase aimed at preserving the core banking sector through the period of crisis. The second aims at supporting consolidation and increasing the sector s resilience to future crisis by strengthening supervision and governance. The GOU s banking sector rehabilitation program focused on five areas: (i) enhancing market confidence, (ii) establishing an effective liquidity management framework, (iii) performing a diagnostic test to determine the banks financial condition and capital deficiency, (iv) enforcing a private and public bank recapitalization scheme, and a resolution program based on least cost principles, and (v) strengthening the legal/regulatory and enforcement frameworks. 23. support the program, the World Bank launched preparation of a serious of two programmatic development policy loans designed to support a multi-year program of assistance to Ukraine to address the effects of the financial sector crisis. The first PFRL (US$ 400 million) was disbursed in September 2009 aimed at preserving the core Ukrainian banking sector in the context of the crisis, while the second aims at restructuring the sector and enhancing the legal and regulatory framework to make it more resilient and position the sector for post crisis recovery. The second PFRL (US$ 350 million) is under preparation and is aimed at further stabilization and capitalization of the system, and the enhancement of quality and resilience of the banking sector by implementing a number of structural reforms (such as reform of banking supervision, reform of deposit guarantee system and transfer of bank resolution powers from BSD to DGF, increasing market transparency, quality of reporting and disclosure of information on ultimate controllers, introduction of consolidated supervision and enhanced consumer protection). 24. The banking sector contributed to the overheating of the economy, was at the center of the macroeconomic pressures as the crisis unfolded, and is essential to the recovery. Mounting vulnerabilities in the banking sector, generated by lax credit analysis in the context of fast credit growth fueled by external borrowing, were accentuated by the crisis. During the years leading to the downturn, regulation and supervision were unable to catch up with the growth of the sector, and thus currency and maturity risks increased coupled with a severe under-provisioning for potential problem loans. The economy cannot afford further drastic deleveraging and thus rehabilitating the sector is essential to secure a stability and recovery. This requires a renewed effort to tackle the legacies of the past and strengthen regulation and transparency to regain trust. Foreseen risk factors 7

16 25. At the time the original EDP2 was prepared in H1 2006, there were few signs of the potential impact of the upcoming global economic and financial crisis on the Ukrainian economy and banking sector. Nevertheless, the EDP2 PAD recognized potential political, macroeconomic policy, and banking sector risks. Indeed, while there was full support across the political spectrum to attracting long-term funding to the exporting sector through EDP2 and similar foreign lines of credit, the EDP2 implementation period was marked by serious political uncertainties and disagreements within the country, affecting policies and speed and quality of the response to eventual crisis. Banking sector vulnerabilities grew from 2006 to 2008 (see Table 1, for instance growth of system s Loan/Deposit ratio and decrease of Capital Adequacy Ratio), and were revealed to a full extent by the crisis. Despite tight prudential eligibility criteria for participating banks, 2 of the 5 PBs became insolvent and were taken over by the authorities. Participation of the three others was temporarily suspended by UEB at the time of major uncertainties in H of the overall health of the entire system and its individual banks, but has been resumed in Significant risks remain within the Ukrainian economy. Those include, but are not limited to, reversal of recent growth due to a weak global growth recovery and future prospects, inherent weaknesses in the monetary, foreign exchange, fiscal, and regulatory policies of the authorities, balance sheet vulnerabilities of the Ukrainian banking system, and a slow progress with structural reforms which are needed to sustain growth going forward. Key risk factors for the EDP2 AF project include the following: a. Generally weak macroeconomic environment, potentially influenced by the second wave of macro and trade shocks globally, b. Continuing weaknesses in the Ukrainian banking system, potentially rendering the risks of intermediating local banks too high for UEB to accept, and narrowing the reach of the AF credit line to the sub-loans extended by UEB to its exporting clients directly. Unforeseen events 27. The global economic and financial crisis was a key unforeseen event which hit Ukraine especially hard, first through a major shock of depressed world steel prices to its steel exports, and then by global financial disturbances revealing the vulnerabilities of the Ukrainian banking system. GDP growth tanked 15% in 2009, among the sharpest recessions in the world, and a full-blown banking crisis ensued. Up until fall of 2008, the banking system and its risks built up very fast, first and foremost by the banks bringing significant foreign financing and extending it, without due regard to prudent risk assessment, as F lending to unhedged retail and corporate borrowers. Insider lending, loan concentration, and insufficient regulatory and supervisory standards and efforts further contributed to the major risk build-up going unchecked and causing a confidence crisis. 8

17 28. Given the still uncertain global economic and trade environment (where commodity gas, oil, steel, grain - prices in particular affect Ukraine), and weaknesses of the domestic economy, there are potential unforeseen exogenous events which can lead to renewed deterioration of growth. At the same time, political economy developments could reduce UEB s ability to manage its operations with the required degree of prudence and independence. Institutional or capacity issues 29. UEB has been very successful in the role of an implementing agency for EDP1 and EDP2. Backed by a solid risk management process, a relatively healthy balance sheet (with minor retail lending exposure), and above all infusions of new capital by the GOU, it has successfully maintained its image of one of the most trusted banks in the Ukrainian banking system throughout the crisis, in the eyes of depositors, international lenders, and borrowers. As a testament to that, it has booked during the past 12 months a stronger than market average growth of retail deposits, and attracted new foreign funding from IFC and EBRD. The World Bank also approved in April 2011 another credit line operation with UEB for energy efficiency. Annex 3 provides more detailed description of the financial, institutional, and management capacity of UEB. Demand/absorptive capacity of eligible project beneficiaries 30. Ukraine is emerging from a deep economic recession and financial crisis of EDP2 was very successful in contributing to the provision of long-term funding to exporters during the crisis and an ensued credit crunch (Annex 4 provides details of the original project performance). However, the financial situation of participating banks and their capacity to channel the EDP2 credit line funds weakened considerably in late 2008 and 2009, and their participation was suspended by UEB due to heightened risk of UEB exposure to the banks. As foreign trade of Ukraine shrank during a global trade crisis, demand from the real sector for new loans, especially investment loans, has decreased dramatically. In response to these developments, project was restructured to allow UEB to lend to exporters directly. The restructuring assured an uninterrupted, albeit slower than originally anticipated, flow of credit to exporters. 31. The new funding under the proposed EDP2 AF is being requested by UEB in anticipation of a sustained rebound in export-led economic activity in Ukraine, following an economic and financial downturn of , and a wide-scale credit crunch. So far, 2010 has signaled a return of growth, with further prospects of GDP increase in 2011 and beyond. Project design 32. Project design will not change under the proposed EDP2 AF from the existing EDP2 arrangement. Provisions of the Operations Manual of EDP2 will apply to EDP2 AF, both to PBs and UEB, subject to relevant adjustments as needed (terminology changes, revised procurement guidelines and similar minor updates). Following a restructuring of the 9

18 original project in 2009, UEB will continue to channel the remaining original EDP2 and the new AF credit line to final beneficiaries either by providing wholesale funding to participating banks (PB), for further onlending by the PBs to exporters, or directly to exporters. Accordingly, the AF credit line will be divided into two sub-components: (i) Direct Lending by UEB, and (ii) Wholesale Lending to PBs. The proposed split between the sub-components is 30:70, i.e., US$45 million of the total AF credit line of US$150 million would be lent by UEB directly while the remaining US$105 would be allocated to PBs on the basis of Subsidiary Loan Agreements, following the practice of the original EDP2. It is expected that in the initial stage of the project the UEB Direct Lending subcomponent may disburse relatively faster than the Wholesale Lending sub-component, reflecting the slow resumption of lending among the private banks in Ukraine. The Wholesale Lending sub-component is predicted to go into a faster pace of disbursement starting in CY2012. The amount of the credit line could be rearranged between the components during project implementation if the pace of disbursement or other unforeseen circumstances render such rearrangement expedient for the achievement of project s development objectives. Disbursement breakdown Category Sub-loans and Lease Financing Of which Wholesale lending through PBs Direct lending by UEB Front end fee Unallocated Amount of the Loan Allocated (expressed in USD) 150,000, ,000,000 45,000,000 TBD TBD Percentage of Expenditures to be financed 100% 100% 100% TOTAL AMOUNT 150,000, During the original EDP2 project preparation it was agreed that UEB would gradually move to separate its export finance and guarantee business (and, potentially, other wholesale and development banking services) from retail banking portfolio. The establishment of a dedicated Export Credit and Guarantee Agency under UEB s auspices would improve the range, volume and quality of products available to other financial intermediaries and the Ukrainian exporting community. It is also necessary in order to avoid the perceptions of conflict of interest and unfair competition that may arise from UEB s current universal banking model. 10

19 34. UEB prepared the concept document for institutional restructuring and submitted it to the Government for review in early The document envisions the separation of retail commercial banking into a subsidiary under UEB holding company, with the latter focusing solely on export credit and guarantee operations, wholesale finance, and development banking. This vertical split model is generally consistent with one of the possible restructuring options discussed during EDP2 preparation and recorded in the Project Appraisal Document. Although this agenda had been delayed due to the banking crisis, the Bank team has recently resumed the dialogue on the subject with the new GOU and new UEB management, both in the context of EDP2 and the Financial Sector Rehabilitation Loan (PFRL). In April 2010 UEB has re-submitted to the new Government for comments the draft concept document. While deliberations in the GOU are ongoing, including preparation of a draft law on export support, such discussions, as much as they affect UEB institutional restructuring, are likely to continue beyond the forecasted timetable of the EDP2 AF processing and Board consideration. The Bank considers it to be highly important to prepare UEB restructuring with all due consideration of costs, benefits, and other implications. Therefore, it is proposed to continue the dialog on UEB restructuring in parallel with the preparation of EDP2 AF and PFRL2, and implementation of the Bank s financial sector technical assistance program, without making it a condition of the EDP2 AF. III. Proposed Changes 35. There are no development objective or design changes proposed under EDP2 AF. UEB will continue to act both (i) as a wholesale funding provider to participating banks for further onlending of the credit line by the banks to eligible exporters, and (ii) as direct lender to its exporting clients. Institutional, financial management, disbursement and procurement arrangements will largely remain the same, as described in the EDP2 Operations Manual, subject to updated procurement guidelines as noted in Annex 5 of this Project Paper (commercial practice threshold raised from US$4 million to US$5 million, and ICB procurement method replaced with Open Competitive Bidding method). The proposed closing date for the AF is advanced 3 years from the original closing date of EDP2 (December 31, 2011), to December 31, This should allow sufficient time for the absorption of the AF by exporters. The original closing date of EDP2 shall also be extended, to match the proposed AF closing date. An updated disbursement schedule foresees US$30-40 million disbursement from the AF credit line per full fiscal year. 36. A few changes in the eligibility criteria of UEB, originally described in the EDP2 PAD Appendix 6.2, are proposed, as detailed in the table below. There are no changes in the CAR as reported under the Ukrainian and International standards. Proposed changes in F and Liquidity ratios would match the UEB eligibility criteria under EDP2 with the applicable NBU regulations. The same set of eligibility criteria, including those noted below and all others applicable to the UEB under the EDP2 would also apply to the UEB under the proposed new Bank loan to UEB for energy efficiency. 11

20 Risk-Weighted Capital Adequacy Ratio (CAR) should be not less than 10% calculated according to the IFRS (as defined by the Basle Committee on Banking Regulation and Supervisory Practices) and NBU Regulatory Requirements CAR as calculated according to the NBU regulatory requirements is not less than 10% or higher Foreign Exchange Exposure. Bank is fully compliant with NBU foreign exchange regulatory requirements; bank s total foreign currency position should not exceed 35% where long open currency position should not exceed 30% and short open currency position not exceed 5 %; Liquidity Ratio. A ratio of liquid assets t o total assets of at least 25%, where liquid assets are the sum of cash and cash equivalents, correspondent account balances, precious metals, trading securities and bank s interbank placements with maturity of not more than 30 days, less any of the aforementioned assets pledged to the third parties; Original criteria value Proposed new criteria value 10% 10% 10% 10% Max 35%, with 30% long and 5% short Fully compliant with the applicable NBU requirements (total long open F position max 20%, total short open F position max 10%, no limit on total F position, subject to future changes in the regulations) Min 25% Fully compliant with the applicable NBU requirements (Quick Ratio min 20%, Current Ratio min 40%, and Short-term Ratio min 60%, subject to future changes in the regulations) IV. Appraisal Summary 37. The proposed EDP2 AF is a scale-up activity, responding to the Borrower s and Ukraine s request to continue provision of a successful credit line to exporters. There is no cost overrun under the project. The AF will top up the original credit line component of EDP2. The project remains economically justified, as UEB and participating banks provide financing to eligible exporters by adding their own risk-based margins to the Bank s cost of funds. There are no subsidies of any type involved in the design of the project. 12

21 38. There are no changes proposed in the original fiduciary or implementation arrangements, except updated procurement guidelines reflected in Annex 5 of this document. No further safeguard policies other than OP/BP 4.01 on Environmental Assessment, also present in the original EDP2 project, will be triggered. The environmental category will remain FI. There will be no exceptions to Bank policies. 39. The Financial Management (FM) arrangements for EDP2 AF operation will remain the same as under EDP2 loan. Existing formats of IFRs and audit TORs will be used during the implementation of EDP2 AF loan. The FM arrangements of EDP2 have been reviewed periodically as part of regular project monitoring process. According to the last FM review carried out in November 2010, the existing financial management systems were continued to be fully satisfactory. Quarterly reports (IFRs) were submitted on time, and there are no overdue audits. 40. EDP2 AF loan proceeds will be disbursed using the same procedures as the original project, either as direct payments, or through advances to a designated account (DA), which will be replenished under the transactional disbursement procedures. Details on the ceiling of the Designated Account and Minimum Application size will be provided in the Disbursement Letter. 13

22 ANNE 1: Results Framework and Monitoring UKRAINE: EDP2 ADDITIONAL FINANCING PDO Current (PAD) Revisions to the Results Framework Proposed Comments/ Rationale for Change Serve as a catalyst to support export and real sector growth in Ukraine during the EDP 2 implementation period ( ) and beyond, by providing medium and long-term working capital and investment finance to Ukrainian private exporting enterprises Further improve the ability of the Ukrainian banking sector to provide financial resources to the enterprise sector, through further development of intermediation, by expanding its depth and breadth through more and better lending products. PDO indicators Same Same Current (PAD) provide medium and long term working capital and investment finance to private exporting enterprises ensure the depth and breadth of financial intermediation as measured by the PBs' ability to reach a diverse set o f borrowers Proposed change* Continued/No change Continued/No change improve credit management practices in financial intermediation based on sub-borrower creditworthiness criteria Intermediate Results indicators Current (PAD) Export Multiplier: Incremental average aggregate annual exports generated (measured over 3 years for all subborrowers) / total credit line disbursed Range of Financial Intermediaries participation: Number of PBs participating in EDP 2 and their individual and combined market shares Sub-loan Performance Indicators: Decreasing amount of non-performing subloans and leases; Interest and/or principal defaults / total amount of subloans and leases disbursed Continued/No change Proposed change* Continued/No change Revised Continued/No change 14 Increasing share of number of subprojects and amounts disbursed through PBs participating in EDP2 / total number of subprojects and total credit line disbursed * Indicate if the indicator is Dropped, Continued, New, Revised, or if there is a change in the end of project target value

23 Core REVISED PROJECT RESULTS FRAMEWORK Project Development Objective (PDO): Serve as a catalyst to support export and real sector growth in Ukraine during the EDP 2 implementation period ( ) and beyond, by providing medium and long-term working capital and investment finance to Ukrainian private exporting enterprises PDO Level Results Indicators 5 UOM 6 Baseline Original Project Start (2007) Progre ss Date (2010) 7 Cumulative Target Values Frequenc y Data Source/ Methodolog y Responsibilit y for Data Collection Comments 1. Volume of Bank lending cumulative disbursed US$ million Annual Borrower Borrower 2. Outstanding Loan Portfolio US$ million Annual Borrower Borrower 3. Portfolio at Risk of the Borrower (PAR) % tbc tbc tbc tbc tbc tbc Annual Borrower, audit reports Borrower 4. Financial Sustainability of the Borrower (ROA) Beneficiaries 9 Project beneficiaries, Of which female (beneficiaries) % tbc tbc tbc tbc tbc tbc Annual Numbe r of SMEs N/A Borrower, audit reports Borrower Annual Borrower Borrower 5 Please indicate whether the indicator is a Core Sector Indicator (for additional guidance please see 6 UOM = Unit of Measurement. 7 For new indicators introduced as part of the additional financing, the progress to date column is used to reflect the baseline value. 8 Target values should be entered for the years data will be available, not necessarily annually. Target values should normally be cumulative. If targets refer to annual values, please indicate this in the indicator name and in the Comments column. 9 All projects are encouraged to identify and measure the number of project beneficiaries. The adoption and reporting on this indicator is required for investment projects which have an approval date of July 1, 2009 or later (for additional guidance please see 15

24 ANNE 2: Operational Risk Assessment Framework (ORAF) UKRAINE: EDP2 ADDITIONAL FINANCING (P109649) Project Development Objective(s) (i) (ii) Serve as a catalyst to support export and real sector growth in Ukraine during the EDP2 implementation period and beyond, by providing medium and long-term working capital and investment finance to Ukrainian private exporting enterprises; and, Further improve the ability of the Ukrainian banking sector to provide financial resources to the enterprise sector, through further development of intermediation, by expanding its depth and breadth through more and better lending products. PDO Level Results Indicators: 1.Incremental average aggregate annual exports generated (measured over 3 years for all sub-borrowers)/total credit line disbursed 2. Number of PBs participating in EDP2 and their individual and combined market shares 3. Decreasing amount of non-performing sub-loans; Interest and/or principal defaults/total amount of sub-loans and leases disbursed Risk Category 1. Project Stakeholder Risks 1.1 Stakeholder Risk Rating High Impact/ Low Likelihood Risk Rating 10 Explanation This AF builds upon almost 15 years of WB s cooperation with the Borrower (UEB), during which the latter has proven to be a reliable and dedicated partner. However, there is always a risk that a government change may lead to limiting the operational independence of UEB, and an increase in directed lending. Risk Description The Borrower (UEB) may propose major changes to the project design or may lose interest in the project Proposed Mitigation Measures Maintain permanent dialogue with the Borrower (new TTL based in the field), both on the implementation of EDP2 and on the organizational restructuring of UEB in the direction of development bank Timing for Mitigation: Prep/Impl This section is part of the deliberative process and will be available in the system but not in the final documentation. The document will reflect all other aspects which will be disclosed. 11 Please see para. 14 of the guidance note for details on filing in timing for mitigation measures. 16

25 2. Operating Environment Risks 2.1 Country Institutional (sector & multi-sector Level) Low Impact/ High Likelihood High Impact/ Low Likelihood 3. Implementing Agency Risks (including FM & PR Risks) The abatement of political infighting following the recent Presidential elections led to a more stable political environment. The IMF has reached staff level agreement on new SBA which should help to anchor adequate macroeconomic policies. However, there are significant risks to the implementation of the program, particularly as regards to fiscal policies (as it did happen in 2009 when the former IMF SBA was derailed). There is also a risk to medium term macro sustainability macro and growth if deep fiscal, structural and banking sector reforms needed to secure a sustained recovery are not implemented. Severe banking crisis can cause major disruption in project implementation, as shown by events of UEB has so far maintained sound financial condition in the crisis environment. It is distinguished favorably from most other Ukrainian banks by the absence of a significant retail portfolio in foreign currency, and the strong commitment and ability of shareholder (Government of Ukraine) to maintain adequate level of capital. Over the past several years, the bank has made significant investments into risk management, internal control and reporting functions. The remaining active Participating Banks (PBs) are adequately capitalized (following NBU stress testing and subsequent recapitalization by the owners) and have relatively strong corporate governance Ukraine s macroeconomic risks remain high. The high financing needs and large structural fiscal deficits may have a negative impact on longer term economic performance. Financial condition of the Borrower (UEB) and other PBs may deteriorate due to external pressures (e.g., slippages in the monetary and financial sector policies) and/or imprudent internal decisions. The IMF and the Bank (through its policy lending subject to agreement on specific reforms) would be assisting the authorities in maintaining sound macroeconomic policies and implementing needed structural reforms to resume growth. As the Borrower, UEB has been obliged by the Loan Agreement for EDP2 to maintain compliance with a wide range of qualitative and quantitative eligibility criteria, and provide regular reporting to the World Bank. The same criteria need to be followed by other PFIs. 3.1 Capacity High Impact/ Low Likelihood Thanks to its strong market position and business reputation, UEB is capable of attracting and retaining the qualified personnel UEB may experience shortage of competent staff with adequate Under Loan Agreement UEB is obliged to maintain the fully staffed implementation unit for EDP2. Capacity of this unit has recently been enhanced as 12 Please see para. 8 and 27 of the guidance note for details on completing this section. 17