Ukraine Economic Growth and Financial Infrastructure. Michael Bleyzer March 2005 v10

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Ukraine Economic Growth and Financial Infrastructure Michael Bleyzer March 2005 v10 1

UKRAINE: Economic Highlights Few non-oil producing countries in the world can show the following combination of economic achievements over the last three to five years: High average rate of economic growth of about 9% pa Low average annual inflation rate of less that 7% pa Low average fiscal deficit of about 1% of GDP High current account surplus of more that 8% of GDP Fairly stable foreign exchange rate High international reserves (currently $9.5 billion) in excess of three months of imports Very low ratio of external debt to GDP of 23% 2

Economic Performance 2000 2001 2002 2003 2004 Real GDP Growth 6.0% 9.2% 4.8% 9.4% 12.1% Fiscal Balance (% GDP) 0.6% -0.3% 0.7% -0.5% -3.3% Inflation 25.8% 6.1% -0.6% 8.2% 12.3% Exchange Rate (Hr/$) 5.4 5.4 5.3 5.3 5.3 Current Account ($bn) (as % of GDP) International Reserves ($bn) 1.2 3.7% 1.4 3.7% 3.2 7.7% 6.3% 2.9 11.0% 7.0 1.6 1.7 4.4 6.9 9.5 Foreign Debt/GDP 32% 27% 24% 22% 23% Source: National Bank of Ukraine, State Statistics Committee 3

Real GDP Growth (%) in Ukraine Compares well with other Transition Economies 16 2000 2001 2002 2003 2004(e) 14 12 10 8 6 4 2 0 Kazakhstan Ukraine Russia Romania Hungary Bulgaria Czech Republic Poland Source: WIIW, State Statistics Committee 4

Ukraine's Economic Success is not an accident Since 1999, when Mr. Yushchenko was Prime Minister, a number of crucial reforms were implemented, including: Tightening of financial budget discipline, including elimination of arrears Restricting barter or non-monetary transactions in the energy sector Accelerating privatization Liberalizing monetary and exchange rate policy Progressing with land privatization by allowing transfer of agricultural land to individual farmers Initiating administrative reform Improving the banking system External factors also favorable Ukraine's exports were helped by the hryvnia devaluation of 1998 Increased demand and prices for Ukrainian goods, particularly metal products 5

Possible Risks to Future Economic Growth Inflationary pressures are emerging in 2005 as a result of: Substantial fiscal loosening approved in 2004 (as a result of the increase in pensions approved in September 2004) Spending of privatization receipts for current, noninvestment purposes Lack of exchange rate flexibility Rapid credit expansion and low quality of credit portfolio External shocks (Ukrainian growth is, to a great extent, exportled ) If tight fiscal and monetary policies are not implemented by the new government, inflation may reach double digit levels in 2005, discouraging investments and growth 6

Policy Actions for Ukraine President Yushchenko is aware that to ensure sustainable economic growth over the medium term, sound monetary and fiscal policies must be maintained and must be complemented by policies facilitating sustainable investment activity or investment drivers (1) Macroeconomic stability (2) Business liberalization and de-regulation policies (3) Stable and predictable legal environment (4) Corporate and public governance (5) Foreign trade liberalization and international capital movements (6) Healthy financial sector (7) Eliminating Corruption (8) Reducing Political uncertainties (9) Country promotion and image 7

Mr. Yushchenko's Presidency The following reforms and changes are being taken by Mr. Yushchenko: On March 25, 2005, an amended Fiscal Budget for 2005 was approved by Rada, eliminating most tax privileges and exemptions, introducing moratorium on the creation of new free economic zones, and increasing excise taxes. De-regulation and virtual elimination of the use of government institutions to intimidate the private sector Friendlier approach by Government to small and medium size businesses Reducing the size of the shadow economy Fairer government and legal systems Stronger working relationship between Ukraine and the West Increased interest and support from international institutions Yushchenko s track record as both Chairman of the National Bank and Prime Minister set the basis for Ukraine s recent economic performance, and bode well for Ukraine s future 8

Financial Sector Overview Ukraine's excellent economic performance was supported by significant progress made in improving its financial infrastructure Significant growth in financial assets took place, expanding by about 44% per year during the last five years 35000 30000 25000 20000 15000 10000 5000 Ukraine's Financial Sector Assets Total assets, $ million % of GDP 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0 1999 2000 2001 2002 2003 2004 0% Source: National Bank of Ukraine, State Statistics Committee 9

Financial Sector Overview Financial sector growth in Ukraine on average has exceeded growth in other comparable countries. Banking asset growth in Ukraine decelerated in 2004 due to political uncertainties during the Presidential elections. 70% 50% 30% 10% Banking Assets Growth in Ukraine, Bulgaria and Romania, 2000-2004 -10% Banking - BG Banking - Ro Banking - UA Source: IMF 2000 2001 2002 2003 2004 10

Financial Sector Overview Despite this growth, Ukraine's financial sector is still small relative to the size of its economy, with financial assets at 46% of GDP, below Central Europe and developed countries But Ukraine's financial sector should continue to grow due to strong GDP growth, increased demand for financing, and better regulations Financial Sector Assets as Percent of GDP 400% 300% 200% 100% 0% Source: IMF 11

Financial Sector Overview The banking sector dominates with a share of 89% in total financial assets. It is followed by Insurance with 10%, and Credit Unions with 0.7%. Ukraine's Financial Sector Structure in 2004, % of total assets Insurance 10.08% Credit Unions 0.7% Banking 88.8% Leasing Companies 0.1% Other 1.0% Pension Funds 0.0% Investment Funds 0.3% Source: National Bank of Ukraine, State Securities and Stock Market Commission 12

Financial Sector Overview As is the case in other countries, as Ukraine further develops, the share of non-banking activities should increase significantly Composition of Financial Sector by Institution Type 100% 75% 50% 25% 0% Source: IMF Banking Institutions Insurance Other 13

Improvements in Banking Infrastructure The following improvements in banking infrastructure have helped to increase confidence in the sector: A new Banking Law gave the NBU better governance and banking regulations The implementation of a modern electronic payments system reduced settlement times The liberalization in the opening of bank accounts permitted firms to have more than one account The elimination of old regulations terminated the past practice of confiscation of deposits by tax authorities The strengthening of the supervisory capacity of the NBU helped to identify problem banks early 14

The Banking Sector -- Overview A better banking sector infrastructure facilitated the expansion of bank assets, which increased four-fold from $6 billion in 2000 to $26 billion in 2004 But the size of the banking sector is still small (at 40% of GDP 25% including informal GDP), below the world average of 60% and the below the developed counties (Germany, 220%; Japan, 150%, and the US, 60%- which has a large non-banking sector) Banks ability to fund lending was boosted by strong increases in banking liabilities, particularly bank deposits Bank deposits and money supply in general expanded as a result of the purchases of dollars by the NBU in the inter-bank market, as it had to issue more hryvnias to buy dollars Increased confidence in the hryvnia and in banks contributed to rapid bank deposit growth 15

The Banking Sector Credit and Deposit Growth 70% Credit and Deposit Growth in Ukraine, 1997-2004 60% 50% 40% Credit growth, % yoy Deposit growth, % yoy 43% 54.8% 30% 20% 30,6% 35,2% 10% 0% 1997 1998 1999 2000 2001 2002 2003 2004* Source: National Bank of Ukraine Up to October 2004, Credit and Deposit growth was similar to previous years (as marked by black lines). However, the political uncertainties in November/December led to a sharp decline of deposits and credits. The situation was stabilized by February 2005 thanks to temporary measures taken by the NBU (credit ceilings, band for foreign exchange rates, and limitation on early withdrawals) 16

The Banking Sector Credit to GDP Ratio Bank credit to GDP in Ukraine reached 25% in 2003 and 26% in 2004. It compares well with other Central/Eastern European transition economies, whose ratios for 2003 were: Bulgaria 25.8%, Romania 9.5%, Poland 17.8%, Czech Republic 17.9%, Hungary 42.3%, Slovakia 25.0%. 35 Ukraine - Credit to GDP ratio, % 30 25 20 15 10 5 0 2000 2001 2002 2003 2004 Credit to GDP ratio, % Source: National Bank of Ukraine, State Statistics Committee 17

The Banking Sector -- Ownership The banking system is mostly privately-owned Of a total of 160 licensed banks, only 2 are state-owned banks (the government also owns minority stakes in few other banks) Seven banks are 100% foreign-owned, and 12 banks have foreign participation in equity Foreign banks account for about 10% of total paid-in capital The banking sector is led by strong national banks (PrivatBank, Prominvestbank, Aval, UkrSibbank, First Ukrainian Int.) as well as subsidiaries of well-known international banks (Calyon, Raiffeisen, ING, HVB, Citibank, Alfa) The sector is concentrated, with 15% of the banks (25 banks) accounting for 75% of bank assets, as noted below 18

The Banking Sector Sector Concentration Ukraine's Banking Sector Concentration 80 70 60 50 40 2000 2001 2002 2003 1H2004 Share of assets of largest 10 banks Share of assets of largest 25 banks Source: IMF 19

The Banking Sector -- Lending Lending to the real sector amounts to 62% of total banking sector assets Bank lending is concentrated on a few very large industrial clients, with few resources going to medium and small firms Consumer loans represents only 10% of banking assets and 4% of GDP Banking System Assets Structure in 2004 25.5% 51.5% 5.8% 10.3% Commercial loans Consumer loans Securities Other assets Source: National Bank of Ukraine 20

The Banking Sector - Lending Structure Consumer loans are also under-represented in other regional countries, at less than 10% In some Western countries consumer loans to GDP exceed 100% 80% Selected Bank Assets as % of GDP % of GDP 60% 40% 20% 0% Bulgaria Romania Ukraine Total Assets Total Loans Consumer Loans Source: EBRD Transition Report 21

The Banking Sector - Issues The IMF estimates the share of non-performing assets in total assets at 28%, much higher than the 3.4% reported by the NBU The NBU uses loan classifications different from internationally recognized ones: the NBU includes only past-due loans as nonperforming debts, whereas the international practice is to include also sub-standard loans as non-performing (which amount to 21% of assets in Ukraine) The NBU also give undue weight to collateral valuations. Furthermore, the bad practice of just extending the maturity of pastdue loans, to avoid charges to Provisions, is used extensively Mandatory Provisioning against these non-performing assets is also inadequate at 6% of total assets The rapid and indiscriminate growth of lending was probably the main reason for the poor "quality" of banks' portfolios Ukraine's level of non-performing assets, compares unfavorably with other countries 22

Non-Performing Loans and Provisioning Non-Performing Loans and Provisions, 2003 Bank Provisions to Total Assets Non-Performing Loans to Total Assets US Slovakia Estonia Bulgaria Ukraine Czech Republic Hungary Russia 0 5 10 15 20 25 30 Percent of Total Assets Source: IMF Global Financial Stability Report 23

The Banking Sector - Issues Capital Adequacy is another problem area, despite the increase in the minimum Capital Adequacy ratio to 10% since March 2004 This is because, contrary to international Basel standards, banks include as "real" capital such "non-tier I capital" items as loan loss reserves, fixed assets revaluation reserves, and current earnings Furthermore, given rapid credit growth, capitalization is not sufficient and market risk is relatively high In addition, minimum equity size is small: depending on specialization and location, the capital requirements for a bank vary from EUR 1.3 million to EUR 6 million Compared to other countries, the profitability of Ukrainian banks is low, as note below 24

The Banking Sector - Profitability 40 35 30 25 20 15 10 5 0 Banking System Profitability in 2003, % Return on Equity - left scale Return on Assets - right scale Poland Ukraine Croatia Bulgaria Russia Czech Republic Source: IMF 3,0 2,5 2,0 1,5 1,0 0,5 0,0 25

Areas for Improvement: Banking Sector Rules for Loan Classification and Provisioning must be made consistent with international standards Capital adequacy requirements must be increased and better enforced Ownership of banks must be disclosed Rules on related-party lending must be tighten NBU s Resolution 482 must be repealed as it requires special bank accounts for capital inflows that lead to multiple foreign exchange conversions at additional cost and delays Bank consolidation must be encouraged Greater participation of foreign banks should be encouraged Related legal framework should be improved by enacting the Joint Stock Companies Law, removing inconsistencies between Civil and commercial codes, and improving the judiciary and its enforcement 26

Non-Banking Financial Institutions: Exchanges Non-banking financial institutions are even less developed than banks, accounting for about 10% of all financial assets Ukraine's stock market capitalization at 8.7% of GDP compared poorly with Central Europe (about 25%) and developed countries (US- 110%, Canada- 80%, Japan-65%, Western Europe- 60%) Market Capitalization in Selected Transition Economies in 2003, % of GDP Ukraine Czech Republic Poland Hungary Russia 0 10 20 30 40 50 Source: PFTS, EBRD 27

Non-Banking Financial Institutions: Exchanges Stock exchanges are underdeveloped in part because many stock market transactions take place outside formal markets In last two years, corporate bond issues have increase rapidly with a threefold increase in 2003 and a twofold increase in 2004 Corporate bonds now represent 5% of bank assets and account for 60% of the transactions in the official securities exchange Bonds are issued by few large companies, some of them not fully creditworthy 28

Non-Banking Financial Institutions: Exchanges The stock exchange index increased substantially last year, given good macroeconomic performance and positive expectations about the future PFTS Stock Exchange Index and Trading Volume 3000 2500 Total trading volume UAH mn (left scale) PFTS index (right scale) 350 300 2000 1500 1000 250 200 150 100 500 50 0 0 Nov'97 May'98 Nov'98 May'99 Nov'99 May'00 Nov'00 May'01 Nov'01 May'02 Nov'02 May'03 Nov'03 Jun'04 Feb'05 Source: PFTS 29

PFTS and SB50 Indices 300% 250% 200% 150% 100% 50% 0% -50% -100% PFTS SB50 Ukraine -150% Jul-97 Jan-98 Jul-98 Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 PFTS includes 10 stocks. Uses an odd methodology (doesn t include trades outside bid-ask spread, uses average spread on days when no trades, etc.) SB50 more representative broader index including 50 stocks. More transparent (rules modeled on S&P/FTSE) 30

...Non-Banking Financial Institutions: Exchanges To sustain further growth, the following improvements in security exchanges are needed: Upgrading the capacity of regulatory agencies Improve the operations of depositaries Improve clearance and settlement systems Further develop credit rating agencies Improve stock market regulations to encourage greater transparency and accountability 31

Non-Banking Financial Institutions: Insurance Insurance is the most rapidly growing non-banking financial sector, with premiums reaching $3.5 billion in 2004 4000 3500 3000 2500 2000 1500 1000 500 0 Ukraine's Insurance Sector Development Premium Revenues, $ million % of GDP 1999 2000 2001 2002 2003 2004* 6% 5% 4% 3% 2% 1% 0% * 9 months of 2004 Source: Ukrainian Insurance Association, State Securities and Stock Market Commission 32

Non-Banking Financial Institutions: Insurance New insurance products have been introduced, including agriculture risk insurance, life insurance, mandatory car insurance Ukraine's ratio of premium-to-gdp in 2003 was 3.5%, comparable to the ratio for emerging countries (3.8%) but below the Western European average(8.3%) In 2004, this ratio in Ukraine increased to 5.7% of GDP Premiums -2003 Country (US$ million) % of GDP Romania 795 1.45 Bulgaria 387 1.90 Ukraine 1,712 3.54 Hungary 2,454 3.01 Czech Rep. 3,714 4.48 Poland 6,258 3.02 Turkey 3,242 1.35 Greece 3,668 2.10 Portugal 10,810 7.31 Spain 47,014 5.58 EU25 947,509 8.35 Source: Swiss RE, CEA 33

Non-Banking Financial Institutions: Insurance On a premium-per-capita basis, however, Ukraine has one of the lowest ratios of premiums per-capita to GDP, at US$35 in 2003 and $57 in 2004 Premiums per capita 2003 (in US$) EU25 Spain Portugal Greece Turkey Poland Czech Rep. Hungary Ukraine Bulgaria Romania 48 35 49 36 162 248 343 363 1080 1146 0 200 400 600 800 1000 1200 Source: Swiss RE, CEA 34

Non-Banking Financial Institutions: Insurance The number of insurance companies have also increased in the last years, reaching 378 companies in 2004 The government holds stakes (one controlling and two blocking) in three insurance companies only Approximately 50% of the Total Insurance Premiums have been paid to re-insurers, including US$345 million to non-resident In 2003, 65% of insurers in Ukraine were profitable, and 2/3rd of these reported profitability levels exceeding 60% 2003 9M 2004 Total Insurance Companies 327 378 Including Life Insurers 30 41 Total Insurance Brokers n/a 72 Source: Ukrainian Insurance Association, Institute for Economic Research and Policy Consulting, 35

Non-Banking Financial Institutions: Insurance However, market penetration rates (total premiums/ GDP) and insurance density rates (total premiums/ capita) are over-estimated in Ukraine due to the large pseudo-insurance activity in Ukraine A large portion of insurance transactions do not reflect real insurance activities: Commercial banks that own insurance companies find it attractive (for tax purposes) to transfer some operations to their insurance subsidiaries. Insurance premiums are also inflated to export capital overseas through reinsurance Nevertheless, in Ukraine there is room for growth in the insurance sector as coverage of estimated insurable risk is only 5% (compared to 90% in developed countries) Future growth of the sector will require changes in the Insurance Law to better regulate the sector, improve governance, improve capitalization, improve creditworthiness, and eliminate discrimination against foreign insurance companies 36

Non-Banking Financial Institutions: Leasing The amendment to the Leasing Law in late 2003 was expected to stimulate leasing operations: It reduced the number of required provisions in leasing contracts from 14 to 3, making them more transparent It also eliminated inconsistencies between Civil and Commercial codes on leasing But leasing operations are still limited: the Ukrainian Leasing Association reports that 50 leasing companies have so far generated limited leasing services so far Following recently approved related leasing legislation (tax and depreciation treatments), leasing has become more viable But improvements are needed in the law on state registration of property rights and in mechanisms for enforcements of contracts 37

Non-Banking Financial Institutions: Pensions A three-pillar pension system was introduced in Ukraine in January 2004: the new legislation foresees the rationalization of the existing government s pay-as-you-go system (pillar I), and the introduction of a compulsory (pillar II) and voluntary (pillar III) accumulation capitalized systems The major rationalization of the pay-as-you-go system (pillar I) relates to the benefit formula pensions are now calculated based on covered service period (number of years during which an individual paid pension contributions) and the wage on which pension contributions were paid. Earlier a person could choose either any of 60 months in a row or last 24 months of service to calculate pension benefits The second pillar will be introduced after establishing a State Pension Accumulation (Capitalization) Fund, which is expected to start operating in 2007 38

Non-Banking Financial Institutions: Pensions The non-government pension component (pillar III) is managed by Non-State Pension Funds (NPFs), insurance companies and banks Participation in the third pillar is voluntary but encouraged by a number of tax privileges for both employers and employees Currently the sub-sector infrastructure is being built up; there are 26 Non-state Pension Funds registered in the country and 33 Asset Management Companies have been licensed or applied for a license to manage the pension funds assets The sub-sector activity is in its initial phase: NPFs assets are estimated to be only 0.01%-0.02% of GDP Future growth will also require the resolution of a number of legal and regulatory issues for Pillar III, including more satisfactory standards for capital adequacy, liquidity, asset allocation, portfolio diversification, and currency matching for assets and liabilities. 39

Conclusions Ukraine's excellent economic performance in recent years was supported by a rapidly growing financial sector So far, the financial sector has avoided major crises despite the relatively high level of nonperforming assets But its future stability and support to further economic growth will depend on substantial improvements in Ukraine's financial infrastructure, as discussed in this presentation 40