Ukraine strategy overview

Full strategy  (0.4Mb) Approved 18  Sep 2007

Стратегія діяльності в Україні  (1.1Mb)

Summary of public comments  (0.1Mb)

Ukraine is committed to and applying the principles of multiparty democracy, pluralism and market economics in accordance with the conditions specified in Article 1 of the Agreement Establishing the Bank.

Political transition: achievements and challenges

During the past two years Ukraine’s democratic political transition has progressed on many fronts. Some important political institutions have been strengthened and have placed the country on a course toward a European-style representative democracy. The parliamentary election of March 2006 was deemed free and fair by international monitors and was characterised by a lively campaign and genuine political competition. Another positive development is the improvement in media freedom and civil society development. These are notable achievements; however, they must be balanced against the still sizeable challenges Ukraine faces in building a unified, law-governed democratic state. First among them is the need to strengthen the judiciary and courts system and reduce corruption. Democratic consolidation will take time. Achieving it will entail converting the broad consensus in pro-European values, which is evident in society as well as in the agendas of the major political parties, into a workable programme of political and economic reform. At the top of the agenda is the need to clarify the respective powers of the President, the Cabinet and the Parliament, as contained in the amendments to the Constitution which went into effect in 2006. Ongoing disputes over the meaning and intent of these changes have resulted in political stalemate and have placed limits on policy effectiveness.

Nevertheless, Ukraine’s overall progress in transition to democracy has had a positive impact on investor sentiment and some aspects of the business environment. Over the last two years Ukraine has experienced a strong increase in foreign direct investment, including market entry by several foreign financial institutions. Significant progress was made in the negotiations to join the WTO. The economy has rebounded from the temporary slump that followed the Orange revolution. Real GDP growth was an estimated 7.1 per cent in 2006, compared with 2.6 per cent in 2005. Contrary to the past, when growth was export-led, domestic investment and private consumption, fuelled by credit growth and generous increases in wages and pensions, became the key drivers of growth in 2006. The economy showed a high degree of resilience to higher energy prices, absorbing a near-doubling in the price of gas imported from Russia since 2005.

Risks, challenges remain

However, many long-term challenges and short-term economic risks remain. The rapid growth in foreign currency lending and rising private external debt, albeit from a low base, pose strains on the still under-developed financial system. At the same time, access to capital, both equity and debt, remains a constraint to many enterprises. If protracted, the current turbulence in Western financial markets, with lower global liquidity and decreased appetite for risk, may have a negative impact on Ukraine growth in the medium term, as bank lending may slow down and companies may face difficulties in financing their ambitious modernisation programmes, with negative repercussions on domestic consumption and investment. The economy is also vulnerable to a sharp terms-of-trade shock, which may be triggered by either swings in metals prices, Ukraine’s main export commodity, or further increases in energy import prices. In the long-term, the gradual convergence of domestic energy prices to international levels may act as a catalyst for industrial sector restructuring and energy efficiency improvements, as Ukraine is one of the most energy intensive and inefficient economies in the region.

Key transition challenges

The Ukraine economy is thus facing important structural and economic challenges in the years ahead, which the Bank stands ready to support with its operations over the next strategy cycle. The key transition challenges will be how to:

• Diversify the production base and improve the country’s competitiveness, in response to increased pressures coming from external suppliers, as the country is expected to join WTO in the near future and start negotiations on an extended free trade agreement with the EU shortly thereafter. Achieving these goals will require further economic diversification (metallurgy and metal processing account for more than a quarter of total industrial production and about 40 per cent of total exports) and market liberalisation, limiting the use of administrative controls in the economy. To fully reap the benefits of greater trade and economic integration with the world economy, significant investment will also be needed to overcome infrastructure and transport bottlenecks.
  
  
• Improve access to capital by developing local capital markets, to meet the increasing financing needs of the corporate sector. Ukraine’s financial sector experienced profound changes over the past two years. While financial intermediation is deepening, helped by the entry of major foreign players into the banking system, information disclosure, transparency over ownership and opaque lending practices in smaller banks remain a concern. The development of a domestic capital market is still at an early stage and is hampered by the poor protection of minority shareholders rights and lack of appropriate legislation to regulate issuance and trading of derivatives. The existence of burdensome currency regulations on investment by foreigners, weak regulatory frameworks for mortgage, leasing and factoring services and delays in the implementation of pension and health care reforms are further obstacles to the development of non-banking financial institutions.
  
  
• Press ahead with energy sector reform, by reducing cross-subsidisation among different categories of consumers and ensuring cost-recovery tariffs to stimulate investment and promote energy efficiency measures, promoting private ownership or operation of energy assets and strengthening the independence of the National Electricity Regulatory Commission.
  
  
• Strengthen corporate governance and transparency, by improving company law, advancing judicial reform, reforming the public administration and creating a playing level field for all private investors. The resale of Kryvorizhstal, Ukraine’s largest steel mill, to Mittal Steel in October 2005 raised the standards for future large-scale privatisations in the country. However, there is still some way to go before a stable and transparent tax and business regulatory framework is in place in Ukraine.

Main operational priorities

In the face of these challenges, the main operational priorities of the Bank for the next Strategy period will lie in:

• promoting higher efficiency, competitiveness and corporate governance standards in the local private sector and assisting foreign direct investment;
• promoting the development of the domestic capital markets and providing continued support to micro, small and medium-sized private enterprises through dedicated long-term credit lines with partner banks.
• promoting energy efficiency and security, environmental protection and sustainable use of natural resources throughout all sectors of the economy;
• improving efficiency and reliability of key infrastructure, power generation, transmission and distribution and of the oil and gas transport systems of Ukraine.

In the corporate sector, the main focus will be to support local companies in their drive to improve overall competitiveness, energy efficiency, productivity, corporate transparency and environmental performance. The Bank will also support the increasing flow of foreign direct investment which has a high demonstration effect in terms of good corporate governance, introduction of modern know-how and higher environmental standards.

In the light of increased energy prices and low energy efficiency in Ukraine, the Bank will reinforce its energy efficiency initiatives in all sectors of the economy: both through direct lending in the corporate, power and infrastructure sectors and through an expansion of intermediated lending within the framework of the industrial energy efficiency credit lines and the structuring of new residential energy efficiency credit lines.

In the financial sector, the Bank will encourage foreign investment as a means of strengthening the capital base of the sector as well as increasing competition. In order to help improve the stability of the banking sector and its ability to fund the real economy, the Bank will continue to provide long term funding to local banks. The Bank will seek to develop local currency financing instruments based on the approach used already in Russia and other countries as a means to encourage local currency borrowing by corporates and consumers. Through its local currency program the Bank will also aim to give an impetus to the development of the local capital markets and the use of money-markets derivatives.

In the power and energy sector of Ukraine, the Bank will help support the implementation of the MoU on EU-Ukraine cooperation in the field of energy (of 1 December 2005) which is the cornerstone of EU-Ukraine cooperation on energy. In particular the Bank will assist the modernization and rehabilitation of the main trans-European energy networks of Ukraine. It will invest in modern and energy efficient generation, transport and distribution of energy. The Bank will also support the diversification of supply sources and promote alternative fuels. These aims will be complemented by support to reforms in the energy sector to develop further its liberalization and promote private sector involvement.

In the area of nuclear safety, a major challenge for the Bank will be to improve the standards of nuclear safety at existing NPPs, the safe decommissioning of Chernobyl NPP and the creation of a safe confinement for its Unit 4. The government will need to continue to ensure a supportive institutional environment.

The Bank will support the improvement of Ukraine’s transport and communications infrastructure which is key to the country’s competitiveness and its integration into European transport networks and the world economy. The focus will be on the development of the TRACECA corridor and the other main transport corridors in Ukraine and their interconnections to the Trans-European Transport Networks aiming to facilitate the transportation of goods and passengers, as recommended by the High-Level Group on the extension of the main trans-European transport axes to neighbouring countries as well as by the Long-Term TRACECA Strategy up to 2015.

In the municipal sector the Bank will focus on financing energy efficiency in district heating, water/wastewater, solid waste and public transport investments in large and medium-sized cities. In the preparation of municipal projects, the Bank will promote institutional reforms and corporatisation of municipal utilities, financial and operational performance improvements and full cost recovery through tariffs, taking into account affordability constraints.

Cooperation with other institutions

Given Ukraine’s enhanced role as one of the key neighbours of the enlarged EU, the Bank will support the implementation of the external mandate of the EIB in Ukraine and the European Neighborhood Policy noting in particular the Memorandum of Understanding between the European Commission, in liaison with the European Investment Bank and the EBRD signed in December 2006. In particular, the Bank will actively co-finance projects with the EIB in accordance with agreed principles and in accordance with the EIB external mandate.

What the Bank can achieve under the proposed Strategy is contingent on the progress in reforms in the coming years. It is hoped that the Government of Ukraine, in addition to its ambitious public infrastructure investment program, will show a strong commitment to further reforms in the corporate, capital markets, tax and justice areas.