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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 IMPLEMENTATION COMPLETION REPORT (SCL-46390; TF-28396) ON A LOAN IN THE AMOUNT OF US$250 MILLION TO UKRAINE FOR A PROGRAMMATIC ADJUSTMENT LOAN (PAL I) 03/12/2003 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Report No: 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 December 31, 2002) Currency Unit = Hryvnia UAH1.00 = US$ US$ 1.00 = UAH5.339 FISCAL YEAR January 1 December 31 ABBREVIATIONS AND ACRONYMS CAS - Country Assistance Strategy CFAA Comprehensive Financial Accountability Assessment CoM - Cabinet of Ministries CPAR Country Procurement Assessment Report EBRD - European Bank for Reconstruction and Development EFF - Extended Fund Facility EU - European Union FDI - Foreign Direct Investment GDP - Gross Domestic Product IEA Inter-enterprise arrears IFC - International Financial Corporation IFI - International Financial Institutions IMF - International Monetary Fund MO Mutual Offsets NBU National Bank of Ukraine NGOs - Non-governmental organizations PAL - Programmatic Adjustment Loan PAG Privatization Advisory Group PFU Pension Fund of Ukraine PHRD Policy and Human Resource Development PREM Poverty Reduction and Economic Management SI Strategic Investor SME - Small and medium enterprises SOE - State owned enterprises TA - Technical Assistance UAH - Ukrainian Hryvnia USAID - US Agency for International Development WTO - World Trade Organization Vice President: Country Director: Sector Director: Sector Manager: Task Team Leader: Johannes F. Linn Luca Barbone Cheryl Gray Deborah L. Wetzel Mark Davis

3 UKRAINE PROGRAMMATIC ADJUSTMENT LOAN (PAL-I) CONTENTS 1. Project Data 2. Principal Performance Ratings 3. Assessment of Development Objective and Design, and of Quality at Entry 4. Achievement of Objective and Outputs 5. Major Factors Affecting Implementation and Outcome 6. Sustainability 7. Bank and Borrower Performance 8. Lessons Learned 9. Partner Comments 10. Additional Information Annex 1. Key Performance Indicators/Log Frame Matrix Annex 2. Project Costs and Financing Annex 3. Economic Costs and Benefits Annex 4. Bank Inputs Annex 5. Ratings for Achievement of Objectives/Outputs of Components Annex 6. Ratings of Bank and Borrower Performance Annex 7. List of Supporting Documents Page No.

4 Project ID: P Team Leader: Mark S. Davis Project Name: Ukraine: Programmatic Adjustment Loan TL Unit: ECSPE ICR Type: Core ICR Report Date: June 27, Project Data Name: Ukraine: Programmatic Adjustment Loan L/C/TF Number: SCL-46390; TF Country/Department: UKRAINE Region: Europe and Central Asia Region Sector/subsector: Central government administration (35%); Compulsory pension and unemployment insurance (25%); General industry and trade sector (20%); General agriculture, fishing and forestry sector (10%); General energy sector (10%) Theme: Public expenditure, financial management and procurement (P); State enterprise/bank restructuring and privatization (P); Other public sector governance (S); Other economic management (S); Regulation and competition policy (S) KEY DATES Original Revised/Actual PCD: 10/31/2000 Effective: 09/21/2001 Appraisal: 01/31/2001 MTR: Approval: 09/20/2001 Closing: 12/31/ /31/2002 Borrower/Implementing Agency: Other Partners: GOVERNMENT OF UKRAINE USAID, Dutch Goverment, DFID STAFF Current At Appraisal Vice President: Johannes F. Linn Johannes F. Linn Country Director: Luca Barbone Luca Barbone Sector Manager: Deborah L. Wetzel Samuel K.E. Otoo Team Leader at ICR: Mark Davis Dusan Vujovic ICR Primary Author: Sati Achath 2. Principal Performance Ratings (HS=Highly Satisfactory, S=Satisfactory, U=Unsatisfactory, HL=Highly Likely, L=Likely, UN=Unlikely, HUN=Highly Unlikely, HU=Highly Unsatisfactory, H=High, SU=Substantial, M=Modest, N=Negligible) Outcome: S Sustainability: L Institutional Development Impact: SU Bank Performance: HS Borrower Performance: S Quality at Entry: Project at Risk at Any Time: QAG (if available) ICR HS No

5 3. Assessment of Development Objective and Design, and of Quality at Entry 3.1 Original Objective: In 2000, for the first time in since Ukraine s independence, its government prepared a medium-term program that signaled a clear departure from the past and secured endorsement of its parliament. Against the negative backdrop of the 1990s, and combined with an acceleration of the reform program, the economic situation turned around in the year Led by robust double digit industrial growth, particularly in food-processing, light industry, and metallurgy, Gross Domestic Product (GDP) grew by six percent in 2000 and recorded nine percent growth for the year In this context, the Programmatic Adjustment Loan program (PAL) forms the backbone of the Bank s financial assistance under the Base Case scenario envisaged in the Country Assistance Strategy (CAS) discussed by the Board on September 12, PAL is designed as a three-year program of approximately US$750 million in three operations (PAL I, PAL II and PAL III) in support of concrete achievements in the implementation of the Government of Ukraine s Medium-Term Economic Development and Reform Program. The program is articulated around five thematic areas which cut across sectors and aim at an improved institutional framework. These include: (i) financial discipline, (ii) regulatory framework, (iii) property rights, (iv) public sector accountability, and (v) management of social and environmental risks. The program provides the foundation for sustainable growth, with attendant job creation and higher incomes, which over time lead to greater opportunities for the poor. By addressing the institutional and governance bottlenecks that prevent private investment from taking a strong hold, it capitalizes on the existing favorable economic juncture and creates the conditions for sustainable, job-creating growth, especially in small and medium enterprises. Second, the program strongly emphasizes the need to increase public sector accountability through increased participation in decision-making of citizens and NGOs at all levels of government. Third, the program aims to help protect the poor by undertaking a pro-poor restructuring of the existing social programs. PAL I was presented to the Board of Directors on September 15, It was originally intended as a one-tranche operation. However, a change of government in May 2001, while the operation was still under preparation, raised the question within the Bank as to whether the new administration would be committed to reforms. Consequently, the operation was split into two tranches. The first tranche of $150 million was based on achievements already obtained on the ground and the second tranche of $100 million on a track-record of the new government, confirming and validating ownership of strategic institutional reforms supported under PAL. The two tranches were disbursed within the calendar year The overall objective of PAL I was to support the government in addressing systemic institutional and structural issues which are viewed as key limiting factors to the magnitude and sustainability of inclusive growth in Ukraine: (i) poor fiscal and financial discipline leading to serious non-payments problems and soft budget constraints in the public and private sectors; (ii) a highly complex and non-transparent regulatory environment; (iii) weakly-defined and poorly-protected - 2 -

6 property rights; (iv) capture of public institutions by private interests, (v) non-transparent and poor management of public monies; and (vi) increasing exclusion of the poor and weak cooperation with civil society. PAL I s objectives were clear and appropriate. The benchmarks themselves supported selected activities of the government program already approved by the parliament. The operation was important because it was the basis for transforming the country from a low case scenario to a base case scenario. Inter alia, PAL makes investment projects more feasible by supporting the policy framework necessary to make them successful. Some examples include reforms in tax administration, land titling, mortgage and finance, business environment, fiduciary manage, and improvement in the operation and control over social funds. The operation was responsive to the needs of the borrower. It catered to the borrower s circumstances and priorities on a long-term perspective. The operation took into account lessons learned from previous Bank assistance to Ukraine in light of the benefits and risks involved. Since many of the activities proposed under the operation were already executed before the Board presentation, the risk element was reduced to the degree possible. Implementation of PAL I was complex and extremely demanding for the borrower because it involved a multi-sectoral program and an untested mechanism of disbursing the loan only after implementation of the outcomes on the ground. It was demanding politically; the reforms ran counter to the interest of some strong power groups. However, the operation was feasible since the borrower viewed these challenges as fundamental to the success of its medium to long-term program, and proved capable of implementing it with commitment. 3.2 Revised Objective: Not applicable 3.3 Original Components: Overall Design: PAL I consisted of five thematic components which supported achievement of outcome oriented benchmarks: (i) financial discipline, (ii) regulatory framework, (iii) property rights, (iv) public sector accountability, and (v) management of social and environmental risks. The first tranche benchmarked substantial accomplishments toward improved institutions and better public and private sector governance. The second tranche continued this process, but also sought to establish a track record of the new government which was appointed just prior to the Board presentation of the program. PAL I s components were determined by the medium-term framework of structural reforms set out by the entire PAL program. The program outcomes are summarized in the table below (see Table 1). At the time of this writing, PAL II is in advanced stages of preparation. Table 1. PAL Program at a Glance 1999 PAL I PAL II PAL III - 3 -

7 Thematic Focus A. Fiscal and Financial Discipline Mutual Offsets (MO) account for a quarter of budget revenues. MO disallowed & Tax collections in cash at 66% of tax revenues. Revenues collected only in cash. Q4 CY 04 Inter-enterprise arrears (IEA) at 91% of GDP. IEA at 68%. IEA at 55%. IEA continue to decline toward international norms. Barter at 33% of gross sales. Barter at 17% of gross sales. Barter at 4% of gross sales. Barter is not an issue. Budget arrears at about 4% of GDP Pension arrears eliminated. Wage and other budget arrears eliminated; social protection arrears reduced by 75%. Budget arrears are not an issue. B. Regulatory Framework Cash collection of electricity bills at 7.7% of billings and 15% of billings in gas. Registration costs - $67, business inspections - 16; licenses per firm Cash collections of energy bills at 50%. Registration cost $22, business inspections 12 ; licenses per firm 1.5. Cash collections for gas and electricity at over 90% of total invoices. Cost of Doing Business Survey confirms business environment continues to improve. Cash collection of energy bills approach international norms. Cost of Doing Business Survey confirms business environment continues to improve. Weak framework for corporate governance. Auditor certification procedures in compliance with IAS. Traded companies and all financial institutions comply with ISA and IAS. New legal framework enacted to protect shareholder rights. Weak regulation of financial sector. NBU enforcing key BIS-compliant regulations on banks. All commercial banks compliant with IAS and ISA. Management of Saving Bank (with 40% of household deposits) a systemic source of concern. Restructuring plan for Savings Bank goes into effect. Rules governing management of all state-owned banks reformed & Savings Bank capitalsufficient. Weak regulation of Energy Regulator brings Regulator of Non-bank Regulator in telecom - 4 -

8 natural monopolies & non-bank financial institutions. electricity tariffs to full cost recovery level. financial institutions established sector established and working efficiently. C. Property Rights WTO accession process stalled. Land reform is stalled. WTO accession restarted. 6.5 million land certificates issued. Bi-lateral WTO protocols signed with 11 countries. Adoption of the Land Code & issuance of 2.7 million land titles. Ukraine WTO ready. Unified system of registration for legal rights to land and real estate in place. Non-transparent privatization process a major source of concern. Privatization Advisory Group (PAG) formed. Privatization slows, but PAG confirms high quality implementation of privatization program. Privatization accelerated under new privatization law. Quality confirmed by PAG based on random sample reviews. Energy sector reform off track. 6 Oblenergos privatized to strategic investors through high quality process. Debt Restructuring Law enacted which facilitates completion of power privatization. Oblenergo privatization process restarted. Oblenergo privatization near completion; genco privatization under preparation. D. Public Sector Efficiency and Accountability Bank Ukraina insolvent, threatening financial stability of the Banking Sector. Lack of accountability of budget funds and extra-budgetary funds. Banking license of Bank Ukraina withdrawn. Singe Treasury Account established; all non-social extra-budgetary funds brought into the Treasury. Financial advisor hired, plan prepared and market tested for telecom privatization. Good progress on Bank Ukraina liquidation. Most social funds brought into the Treasury System. Telecom privatization under way or completed. Bank Ukraina liquidation nearly complete. All social funds brought into the Treasury System. Non-transparent discretionary allocation of transfers to local budgets. Formula-based system for allocation of transfers to oblasts implemented. Refinement of transfer formula, including provision of transfers from the State budget directly to the rayons and cities. Lack of legal and Public procurement law Non-competitive Non-competitive - 5 -

9 institutional framework for public procurement. approved. procurement methods reduced to 25% by number of contracts. procurement methods further reduced to 15%. Inefficient and cumbersome system of public administration, comprises more than 100 of central bodies of executive power. Number of ministries and other central executive power bodies reduced from 89 to 50, including 16 ministries. Decision-making delegated downward and the role of State Secretariats clarified. Civil Service candidates selected based on specific procedures including standard exams. E. Management of Social and Environmental Risks Tax exemptions given by COM on discretionary basis to selected enterprises/sectors. General plan agreed for 3 pillar pension system, but pension reform stalled. 256 CoM Resolutions, granting tax privileges, cancelled. Tax exemptions and privileges reduced by 60%. New tax code under implementation. Legislative framework for first and third pillar of pension system in place and fiscally sustainable. Personified system introduced and unified social insurance database initiated. Pensions calculated on basis of personified records. 11 social assistance programs with as many different administrations. Social assistance programs reduced to 5 and administration combined. Targeted housing and communal services subsidies provided in cash to recipients. Unpaid entitlements of social and occupational privileges amount to 13% of GDP. Occupational privilege entitlements frozen by Parliament. Social and occupational privileges income tested for all public employees. Social and occupational privileges eliminated and/or fully income targeted. TB/AIDS epidemics growing without national programs in place to address them. Comprehensive health and education reform strategies adopted by the Cabinet. TB/AIDS national strategies under implementation. Comprehensive health and education strategies refined and under implementation. No clear environmental policy program. Government/Bank dialogue on environmental policy initiated. First steps taken toward comprehensive environmental policy fees adjusted, audits Integrated pollution prevention permits issued and operational for 8 pilot enterprises

10 undertaken and permit system piloted. In order to design and implement a program to reach the objectives, five working groups were created, consisting of about 100 staff drawn from various ministries, corresponding to the five thematic areas. These made implementation of the project effective, focused, and well coordinated. Creation of the working groups was viewed as a way to help build capacity of counterparts in the government. It also proved to create ownership by counterparts at the expert level, since in most cases they were the authors of the innovations supported by the operation. Specific Components: A: Fiscal and Financial Discipline Lack of fiscal and financial discipline during the past decade led to a large accumulation of fiscal and inter-enterprise arrears with negative consequences on contract compliance and the overall business environment. It thus affected the level of economic activity and employment, real incomes, and timely payment of wages and pensions. This component focused on concrete improvements in financial discipline, both in terms of addressing arrears to and from the budget, and focusing on energy payments in cash as the nexus of inter-enterprise arrears. The benchmarks under this theme included the following: (a) elimination of budgetary offsets, (b) elimination of pension arrears and reduction of wage and other budget arrears, (c) increasing the payment record, in cash, of gas and electricity customers, and (d) starting the comprehensive process of energy sector debt restructuring by focusing on a restructuring plan of the debts of Naftogaz

11 B. Regulatory Framework This component sought to remove obstacles to doing business while providing clear rules of the game through better, more independent and more accountable regulatory systems. In order to achieve this, efforts focused on (a) facilitating entry, operation and exit of businesses, (b) accession to WTO and supporting reforms, (c) strengthening corporate governance, and (d) improving regulatory systems in key sectors (including finance, telecom and energy). The PAL I benchmarks included achievements to streamline and simplify business registration and licensing while reducing the number of inspections. Work was also initiated in the other areas listed and they were thus included as indicative benchmarks for PAL s II and III. Technical assistance support was identified where needed to move the process forward. C. Property Rights Weaknesses in property rights inhibit opportunities for income-earning activities and investments, they reduce the power to enforce contracts, and hamper the ability of citizens and legal entities to retain the benefits of own effort. PAL I targeted the following strategic areas for improved ownership rights: (a) strengthening property rights in agriculture; (b) supporting a transparent privatization processes; and (c) utilizing bankruptcy as a mechanism for facilitating the restructuring (or closure) of ailing enterprises. In agriculture, the benchmark focused on issuance of land certificates and land titles to agricultural workers while reducing the involvement of the state in agricultural input and output markets. Efforts were made to improve the transparency and overall quality of the privatization process, while deepening it to key strategic utilities in the communications and energy sector. The focus in the area of bankruptcy was Bank Ukraina, a 100 percent state owned bank that had become insolvent and represented systemic financial risks, and which also had raised questions about the state s governance. D. Public Sector Efficiency and Accountability Ukraine s fiscal management and public administration system was designed to encompass almost every aspect of social and economic life. Making the state more focused and efficient in the framework of a market economy is an ongoing process supported by the PAL program. Within this framework, PAL I sought to (a) reform of the system of intergovernmental finance, including supporting conversion to a formula based system of inter-governmental transfers, (b) implement a single treasury account system, (c) initiate tax reform through the elimination of tax exemptions earlier created through Cabinet of Ministers (CoM) decree, (d) support a streamlining of the ministries and agencies of the state while improving the functioning of the Secretariat of a reduced CoM, and (e) establish the analytical and planning basis for a comprehensive reform of Ukraine s fiduciary management and procurement system, which would be supported by future PALs

12 E. Social and Environmental Risk Management Ukraine inherited an inefficient and overextended system of social services which has limited its ability to address the emerging social risks that it faces. Similarly, the system of environmental protection has not responded effectively to lower revenue levels, nor the fundamental changes that are taking place in the economy and in the sources of pollution. In order to be effective in the provision of these global public services, the government committed to prioritizing, streamlining and making efficiency improvements to mitigate downside risks and set the stage for long term restructuring and improvement of the system. In particular, the program sought to (a) develop an institutional and technical framework for pension system reform, (b) improve administration and income targeting of social assistance, (c) improve efficiency of the systems of health and education and (d) free up public resources and improve targeting of social assistance through a rationalization of the social and occupational privileges system. 3.4 Revised Components: Not applicable (N.A.) 3.5 Quality at Entry: Highly Satisfactory. Despite the concerns, the overall rating is considered highly satisfactory given the innovative nature of the project s design and the resultant improvement - both in terms of the quality of reform in Ukraine, and in terms of the improved Bank-client relationship. Operational Design: As mentioned earlier, the objective was consistent with the CAS and the government s priorities and met the critical needs of the country. The innovativeness and quality of design was high, and fit the needs of the client, contributing to a marked change for the better in the Bank-client relationship in Ukraine. Innovative features of the operation include, (a) the switch to outcome-oriented benchmarks, as opposed to conditions which in the past were action oriented and often poorly owned by the client, (b) multi-sectoral cross-cutting thematic issues, which allows for progress to be made in a stepwise, yet comprehensive fashion, (c) emphasis on institutional building as the key to sustainability and implementation of the government program, (d) design and implementation work executed through inter-agency working groups in each of the thematic areas, and (e) the risk-minimizing mechanism of disbursing the loan amount only after implementation of the agreed outcomes. The design of the program was focused and well structured. The team also secured sufficient and critical technical assistance grant funds for implementation through PHRD grants and through the Dutch Grant which was allocated for implementation of the CFAA and CPAR action plan and to assist the government in its WTO accession activities (more detail on the grants is provided below). The operation also ensured that all prerequisites were transparently presented and in place on matters such as budget, inter-governmental financial operations, and financial accounting practices, before it was presented to the Board. Of some concern is the fact that the operation was highly optimistic about the timing and ownership for follow up reforms to be carried out with the support of the PAL II and PAL III operations. Indicative benchmarks for PAL II and PAL III were sometimes vague and at times understated the great leaps forward that would be necessary to achieve them. To give a couple of examples, the PAL II indicative benchmarks include statements such as, protection of minority - 9 -

13 shareholders secured, equal treatment of foreign and domestic investors secured (WTO), independence [of the energy regulator] secured. Also, the time frame envisaged within the Government s Action Plan to Implement the Comprehensive Financial and Accountability Assessment was far too optimistic and should have been toned down. Another concern was the lack of focus on the quality of the health and education reform strategies prepared by the government. These strategies were not costed out, represented a wish list, and were not sufficiently reviewed (and potentially revised) by and with the help of the Bank staff in the social sectors before the operation was submitted to the Board. In sum, PAL I did an excellent job of designing both the overall program and in setting up the working relationship with the government to deliver the critical policy and institutional reforms to the success of the government s program. However, the magnitude of the envisaged reform program is extremely large, a great deal of work was left for future PALs, and the time frame envisaged by PAL I for subsequent PALs was overly optimistic. While there was significant commitment and ownership on the part of the Borrower, the depth and breath of the called for reforms, which naturally will span more than one government, will require continued and intensive efforts to deepen understanding and ownership for the proposed package of reforms. That said, the PAL team envisaged that these reforms would take serious time and effort, and thus proposed a programmatic approach. Coordination with the IMF. Intense discussion and information sharing took place at the preparation and implementation stage of PAL I between the Bank and the Fund. Especially in the areas of improved financial discipline and fiscal reform, the IMF and the Bank cooperated on a continuous basis. In monitoring the progress of structural reforms, the Bank took the lead and the IMF relied on Bank support. Especially, these related to the following: strategic privatizations of large industrial enterprises and companies in infrastructure sectors (especially energy and telecom), restructuring of the banking sector, improved cash collections in energy, reforms in agriculture, progress in deregulation and public administration reform. Coordination with other Donors. PAL provided a framework for integrating and prioritizing donor technical assistance and making it more effective. This allowed the government to reduce the dispersion of efforts that sometimes took place in the past. Moreover, PAL, by focusing assistance on priority areas, helped deal with the decreasing total volume of external donor support. The three-year framework of the government program supported by PAL offered a more appropriate time horizon to permit donors to align their assistance with the emerging priorities. A Policy and Human Resource Development (PHRD) Grants from the Japanese Government of US$ 490,658 were provided for preparation of PAL I. Funds within the PHRD grant were used in each of the five thematic areas. Following Board approval of the PAL I operation, the Bank presented donors with a program of priority TA, and set up a mechanism of donor coordination to enable the government to deliver on the expected outcomes and reliably measure achievements during the latter part of the three-year program. A Dutch Grant in the amount of $2,640,000 was extended to focus on three specific areas: (a) implementation of the CFAA Action Plan, (b)

14 implementation of the Country Procurement Assessment Report (CPAR) Action Plan, and (c) preparation assistance for the WTO accession process. Other technical assistance was coordinated with PAL I primarily through the periodic budgeting process of Ukraine s active donors. 4. Achievement of Objective and Outputs 4.1 Outcome/achievement of objective: Satisfactory. Through various reform measures and improved governance implemented through PAL I, the government succeeded in achieving economic growth and macroeconomic stability for the first time since independence in Equally importantly, PAL I made significant progress in the establishment of a program of institutional and structural reform which can sustain the positive economic dynamics over the medium to long term. Macroeconomic stabilization and growth (satisfactory): Key achievements on the macroeconomic front include cumulative growth since 1999 at 22%, single-digit inflation, a sustained current account surplus, and a quadrupling of reserves (to 8 weeks of imports despite sizeable IMF repayments). The government was also able to maintain a low fiscal deficit (a small surplus in 2002), reduce the ratio of debt to GDP, and considerably reduce stock of budgetary arrears. While it is difficult to attribute causality, there is a strong correlation between the implementation of reforms under PAL I and Ukraine s improved economic situation (See table 2). On the cautious side, the dramatic increase in money demand and deposits by the population and domestic enterprises into the banking sector (banking assets are growing at a rate of over 50 percent per year), while good news, creates risks of financial instability. Real interest rates remain relatively high, bank supervision, while a part of the PAL II program needs continual improvement, and the fledgling banking sector too often lacks the expertise to properly evaluate and track its lend portfolios. Efforts moving forward need to be continued to watch this evolving situation very closely, while improvements in the legal and institutional framework (a focus of PAL II and PAL III) need to be made to facilitate financial intermediation in Ukraine. Table 2. Macroeconomic Indicators, Real GDP Growth (% p.a.) Export Growth (% of current $) Fiscal Balance (% of GDP) Current Account Balance (% of GDP) External PPG Debt (% of GDP) Inflation (% p.a.)

15 Fiscal and Financial Discipline (satisfactory): Non-transparent budget offsets based on non-registered veksels Veksel roughly translates to tradable I.O.U s 1 were disallowed in mid-2000 and completely eliminated in the budget This was sustained under the PAL I second tranche. Figure 1 Non-payments in Ukrainian Economy Years Overdue payables/gdp, % (left scale) Barter/gross sales, % (left scale) Budgetary arrears/gdp, % (right scale) By mid-september 2000, the government had completely eliminated pension arrears which had stood at UAH 1.3 billion at the beginning of the year. It has remained current ever since. During 2000, wage arrears payable from the budget were reduced by about 60 percent to less than UAH 470 million, and by November 2001 they had been reduced by 97 percent. Social protection arrears were reduced by 26 percent and stood at about UAH 700 million at the end of the first quarter Progress was also made reducing arrears of the budget to the energy sector. During 2000 and the first two months of 2001, the outstanding amount of energy arrears from the budget was reduced by UAH 4.2 billion or almost 75 percent (Figures 1 and 2). Figure 2 Cash Collections Electricity Gas Percent In the energy sector, large electricity debtors were identified and the debt of six oblenergos was restructured. These six oblenergos were subsequently privatized by selling them to strategic

16 investors. Fostering financial discipline in the sector, oblenergos exercised their legal right to disconnect 23,000 delinquent customers out of 33,000 debtors. Significant progress was made in terms of cash collections for gas and electricity. Cash payments from the oblenergos to the Energomarket increased dramatically, from 10.7% of electricity bills in January 2000 to 75.5% as of October 1, 2001 (with an average of 71.1% for the first 10 months of 2001). Similarly, the level of cash settlements for consumed natural gas as of November 1, 2001 was 90.2%. Progress was made identifying the internal debt of Naftogaz and preparing a restructuring plan. As envisaged, these developments had a significant impact on the energy sector in particular and on the economy in general. By the middle of 2002, for example, barter transactions in the economy had fallen by more than 50 percent from their peak and represented less than 4 percent of GDP. Despite these dramatic improvements in financial discipline, significant problems remain. Among the biggest is the continued problem of the accumulation of tax arrears to the budget, and the accumulation of VAT refund arrears from the budget to exporters. Naftogaz in particular, while collecting more revenues in cash, continued to accumulate large tax arrears during the PAL I period. The tax amnesty that was extended to the enterprise sector during 2001 was a negative influence on financial discipline, and is now a major issue for the ongoing PAL II program. Regulatory Framework (satisfactory): Concrete progress was made toward improvement of Ukraine s business environment, especially for small and medium enterprises. Toward this end, the program focused on business registration, licensing and inspections. One-stop registration has been put in place. In accordance with CoM Regulation On Procedure for State Registration of Subjects of Entrepreneurial Activity the term of state registration makes up not more than five office days. Additionally, a mechanism for accelerated registration (during one day) has been introduced. The licensing procedure was also simplified. In June 2000, the parliament approved a new licensing law, which streamlined licensing procedures by allowing a single license to cover multiple economic activities. Implementing regulations of the law were adopted by October 2000 and they have been under implementation since that time. Progress in improving the business environment was demonstrated through the ongoing process of annual surveys of newly-registered businesses conducted by the USAID and IFC. Surveys indicated: (i) the official cost of registration has gone down from US$192 in 1997 to US$22 in 2001, while the time needed to register a new business (i.e., obtain a new registration certificate) has decreased from 34.7 days in 1997 to 12.1 days in 2001; (ii) the number of licenses needed per enterprise has gone down from 3 in 1997 to 1.5 in 2001, while reasonable time limits (a maximum of 16 days) are set to help avoid delays and opportunities for graft seeking by officials empowered to issue licenses 2 ; and (iii) the number of inspections has been brought down from an average of 30 per enterprise during 1998 to 12 in (Figures 3 and 4). Figure 3 Figure

17 Number of Small enterprises Small enterprises, thousands Small enterprises in industry, thousands Time to Register an Enterprise Days While real improvements were made to improve the business environment for small and medium enterprises, perhaps more should have been done toward the establishment of regulatory bodies. The regulatory of the energy sector does not have de facto independence, and too often remains under the wing of the CoM in terms of major policy decisions in the energy sector. Also, the telecom privatization process was out in front of the establishment of clear rules of the game in the sector. While a law was passed clearing the way for sale of management control of Ukrtelecom, within the PAL I framework, no policy statement on telecom regulation and tariffs objectives was issued by the government, no progress was made to establish an independent regulator, and no changes were made or envisaged to rebalance tariffs prior to privatization. Experience has shown that all of these steps are important for the quality of the privatization process toward good development outcomes for the sector through devolution by the state of telecom utilities. Property Rights (satisfactory): Progress was achieved in the process of transformation of the ownership/organizational structure in agriculture. Kolkhozes in Ukraine were discontinued,

18 which formerly were the dominant organization form for agricultural production. Land certificates were distributed to more than 6.5 million former Kolkhoz members. Ownership rights to land plots averaged 4.2 hectares of arable land. Following the issuance of land certificates, close to 1.3 million land title deeds to specific plots of land were assigned and registered by the time of the first tranche. This figure had been increased to 1.81 million titles by November 1, Also, state monopoly in the procurement of agricultural inputs and the purchase of agricultural output was further reduced and now stands at less than one-tenth of pre-reform levels. During the year 2000, progress was made in initiating privatizations of large-scale enterprises, launching and completing privatization of six additional oblenergos, and in identifying a pool of large state-owned enterprises to be privatized in the next three years. In parallel, progress was made to improve the transparency and effectiveness of the privatization process of industrial and energy enterprises. A Privatization Advisory Group (PAG) was formed, made up of a group of local and foreign experts, to review privatizations done during the first three quarters of This included the review of privatization of eight large industrial enterprises ex poste, according to a pre-set list of transparency criteria. PAG confirmed that the privatization process was acceptable and that the majority of privatization tenders reviewed in January-September, 2001 met the transparency criteria. In the area of telecommunications, the telecom privatization law was passed allowing a strategic investor to: (a) acquire a minimum of 25 percent+1 shares through a competitive process; and (b) gain operating control of the telecom (i.e. 50 percent plus one share) by receiving for management an additional block of shares owned by the state. A competitive tender to hire an advisor for the privatization of Ukrtelecom was also issued and an advisor was selected. The government also made significant progress in resolving the insolvent Bank Ukraina through bankruptcy. A government decision was taken to implement the Resolution Plan for Bank Ukraina, and it was implemented as agreed. The Banking license was removed and formal foreclosure procedures were started through the appointment of a liquidator. While good progress was made in the area of property rights, problems remain which need to be addressed. The quality of land titles actually issued to certificate holders is reportedly not high, due to lack of a cadastre and other factors. Efforts are ongoing to address this problem through PAL II and through a bank project on land titling and cadastre. While the PAG did confirm that the privatization process was acceptable according to the transparency criterion, the criterion themselves do not capture competitiveness of tenders, and the list of privatizations reviewed by PAG was selected by the government. This latter issue was addressed through PAL II preparation work, and the issue of competitiveness was raised during that process to be addressed in PAL III. While extremely important for the country, the quality of the power privatization process could have been better. There was not sufficient background work done to clarify the assets that are associated with the privatization tenders, and not enough was done to clear the debts of the sector overall, so that the privatization program moving forward has been stymied by the need to deal with the large debt overhand among the remaining majority state owned power companies. The mismatch between the Ukrtelecom privatization process and establishment of a good regulatory environment in the telecom sector was raised above

19 Public Sector Efficiency and Accountability (satisfactory): Budget transparency was improved. The formula-based calculation of transfers was included in the Law on 2001 Budget (Article 50) specifying both the transfers from the state budget to oblasts, and the methodology for calculating further transfers to lower levels of government. This methodology, developed by the CoM, was adopted by oblast and Republic of Crimea legislatures and implementation was monitored by the Ministry of Finance and the Bank during the first nine months of It was confirmed that the use of formula for distributing transfers had a positive impact on the fulfillment of local budgets as to revenues and ensured funding of functions placed on local bodies of power. Local budgets were fulfilled as to revenues by 100% in the first 10 months of The distribution of equalization subsidies belonging to local budgets from the state budget for this period were financed in full measure. As of November 1, 2001, local budgets received equalization subsidies amounting to UAH million or 90% of the annual volume. This process was continued for the 2002 Budget formulation. Distribution of volumes of inter-budgetary transfers (equalization subsidies and funds, which are transferred from the state budget) between the state budget and local budgets for 2002 was carried out in conformity with CoM Regulation No 1195, dated September 5, The 2002 Budget extended the formula-based system to both the oblast and rayon level. Progress toward implementing the single Treasury account also proceeded well. By the end of PAL I, all departments of the State Treasury had been included into the electronic payment system of the National Bank of Ukraine. Introduction of a State Treasury account was completed in all oblasts of Ukraine by December 1, In the follow up to the Comprehensive Financial and Accountability Assessment (CFAA) prepared by the Bank in 2001, tangible progress was made during the last quarter of 2001 toward implementing its recommendations. In particular, an action plan of the CoM was approved by the CoM Commission for improving the system of financial control of Ukraine. This plan was prepared by the Ministry of Finance with the participation of representatives of ministries and departments and coordinated with World Bank experts. In parallel, an action plan of the Country Procurement Assessment Report (CPAR) was also adopted by the CoM. The key development on that front was the passage of a new procurement law which has wide applicability, allows a decentralized procurement system, and advocates sound public procurement principles. Efforts were also made to improve the decision making process of the CoM. In particular were the following: (a) creation of a smaller and more efficient Cabinet with less than 20 members representing a reduced number of central government bodies (from over 80 to 50 including 16 ministries); (b) establishment of specialized CoM Committees; and (c) improved functioning of the CoM Secretariat and adaptation of its structure to meet Cabinet needs. Finally, the process of reforming tax policy was begun through the elimination of tax exemptions which had earlier been granted by the CoM. This included a CoM decision to cancel 256 earlier CoM resolutions resulting in less distortion from the tax system and a substantial increase in Ukraine s tax base

20 Social and Environmental Risk Management (satisfactory): An institutional and technical framework for a reformed pension system was established. A unified system of personal pension accounts was introduced enabling a detailed recording of lifetime contributions as a basis for future pension/benefits determination and an anchor of two mandatory pension pillars. This was complemented by a transfer of the pension determination function from the Social Protection units to the Pension Fund, and the creation of a unified social insurance database enabling an efficient reform of the social insurance system. 3 Social assistance was improved by consolidating social benefits and the social assistance administration. A new unified targeting methodology was approved and was being used in all means-tested programs. In order to make progress in creating a unified social insurance database, a tender was held which resulted in the state publishing company Poligraphkombinat Ukraina becoming a winner. The contract was signed with it for production of 100 thousand social insurance IDs by the end of Also, the network of territorial centers was extended to all rayons in the country and outreach services were expanded to include an additional 10,000 old and disabled persons. A framework was developed for improvements in health and education, and concrete steps along the way were taken. A medium-term strategy of reforms in health protection sphere was approved. 4 Included in the health strategy was a program to reduce the threat of HIV/AIDS. 5 The government also approved an education sector reform strategy. A draft of the National Doctrine for Developing Education in Ukraine in the 21st Century was developed and approved at the Second All-Ukrainian Congress of Educationalists. Laws of Ukraine On Out-of-School Education, and On Preschool Education were adopted. The CoM Regulation On Transition of General Educational Establishments to New Contents, Structure and 12-Year Term of Study was adopted on November 16, Also, the CoM Regulation, dated May 6, 2001, On Approval of Program for the Informatization of General Educational Establishments, Computerization of Village Schools for was adopted. While a significant step forward in terms of outlining a strategy to move forward toward fundamental structural reform of the social sectors, the medium term strategies need significant additional work. Both strategies are large on wishes and small on realistic estimates of what can be done within the fiscal/financial envelop available to Ukraine s public sector. The strategies were not accompanied by realistic financial projections, nor a clear program of needed investment. Also, they did not consider the potential benefits and positive incentives that could be provided through the ongoing fiscal decentralization effort. The linkages on that front have yet to be fully drawn. Part of the problem here was perhaps too little input by the Bank human development and economic management team in the formulation of the strategies. Efforts in the future need to be focused squarely on this issue, in particular if they are to be supported by future Bank investment projects. Nevertheless, while working on the design of a medium-term institutional strategy to improve health and education systems in Ukraine, the government achieved a number of tangible outcomes such as: (a) improved control of public health risks achieved through pilots started in Donetsk Oblast and Kiev to test the TB DOTS method adapted to national conditions; (b) primary health care improved through new family medicine centers and introduction of new university

21 specialization in family medicine; (c) a health resource allocation pilot was started in Lviv; (d) improved methods of education management and finance were piloted in Lviv; and (e) a national program of 12-year compulsory education was adopted. In addition, the Ministry of Education and Science jointly with the International Renaissance Fund, Institute of Educational Policy (Budapest), and UNDP introduced a large-scale technical aid project for Support Program for Developing an Education Reform Strategy. The goal of the project is to assist the government of Ukraine in the formation of a national education policy by means of analyzing policy, attracting and paying due account to public opinion and supporting national discussions of education reform. The program ensures support to the Ministry of Education and Science in developing the draft of the National Education Development Doctrine. Progress was also made to rationalize Ukraine s system of social and occupational privileges, which are not justified on poverty or equity grounds, are for the most part not paid by the budget, and yet represent a significant financial burden on communal service and transportation companies which cannot charge for services that they are obliged to render. During 1999, 2000 and 2001 the government froze the entitlements of many categories of privileges recipients through inclusion of an article to that effect in the annual budget laws. This resulted in a 40 percent reduction of the number of privileged persons. However, in the lead-up to the parliamentary elections this article was omitted from the 2002 Budget law. In 2003, the Government of Ukraine restarted to take measures aimed at revisiting the system of social and occupational privileges. Article 59 of the Budget law 2003 has introduced means-testing in order to limit the number of occupational privileges recipients to those public workers whose income is less than subsistence minimum. The government has also started creating the single registry of social privilege recipients in order to eliminate double counting of entitled persons and control the amounts requested by utility enterprises from local governments for privileges. Article 59 of Budget 2003 also limits housing and communal service entitlements to immediate family members of privileged persons. Efforts are now ongoing to re-register all remaining privilege recipients. 1 Veksel roughly translates to tradable I.O.U s. 2 These time limits are as follows: 10 days for acceptance of an application and decision-making by the authorities, 3 days to for the authorities to notify an applicant of the decision, and 3 days for paperwork. 3 The setting up of an institutional and technical framework for pension reform was started when the pension determination function was transferred to the Pension Fund in 11 of Ukraine s 26 oblasts. Pursuant to the Resolution of the CoM On Approving Priority Tasks of the Cabinet of Ministers of Ukraine for 2001 preparatory work has started to transfer pension-determination function to the Pension Fund of Ukraine (PFU) bodies in remaining oblasts. 4 This included the following: (a) Enactment of the President of Ukraine On Concept on Development of Public Health Protection in Ukraine which was signed on December 7, 2000; and (b) CoM Regulation On Approving Measures for implementation of the Concept on Development of Public Health Protection in Ukraine adopted on August 9, Toward this end a number of legislative documents have been adopted: (a) the Law of Ukraine On the Ratification of the Agreement on Co-operation in Addressing the HIV-infection Problem ; (b) enactment of the President of Ukraine # 1182 of November 1, 2000, On the Urgent Measures to Prevent the Spread of HIV-infection/AIDS ; (c) Cabinet of Ministers Regulation # 116 of February 7, 2001, On Setting up a