Document of The World Bank Public Disclosure Authorized Report No: 22470 UA

PROJECT APPRAISAL DOCUMENT

ONA Public Disclosure Authorized PROPOSED ADAPTABLE PROGRAM LOAN

IN THE AMOUNT OF US$ 30 MILLION

TO

UKRAINE

FOR A

PRIVATE SECTOR DEVELOPMENT

PROJECT Public Disclosure Authorized In support of the First Phase of a US$60 Million Private Sector Development Program March 6, 2002

Private and Financial Sector Deveikopment Department Europe and Central Asia Region Ukraine/Belarus Country Unit Public Disclosure Authorized * CURRENCY EQUIVALENTS (Exchange Rate Effective February 2002) Currency Unit = UAH (Hryvnya) UAH 1 (Hryvnya) = US$0.1879 US$1 = UAH 5.3206

FISCAL YEAR January 1 -- December 31

ABBREVIATIONS AND ACRONYMS APL Adaptable Program Lending ARIA Moldovian Agency for Restructuring and Enterprise Assistance CAS Country Assistance Strategy C/B Cost Benefit CERMA Georgian Center for Enterprise Restructuring and Management Assistance CQ Consultant Qualifications CPAR Country Procurement Assessment Report DFID Department for Intemational Development EDAL Enterprise Development Adjustment Loan EDAL II Second Enterprise Restructuring Adjustment Loan FBS Fixed Budget Selection FDI Foreign Direct Investments FMR Financial Monitoring Report FSL Fixed Spread Loan FSU Former Soviet Union GDP Gross Domestic Product GoU Government of Ukraine GPN General Procurement Notice IC Individual Consultants ICB International Competitive Bidding IFC International Finance Corporation IFIs International Financial Institutions IMF International Monetary Fund IR Industrial Restructuring IS International Shopping LCS Least Cost Selection MOF Ministry of Finance of Ukraine N/A Not-Applicable N.B.F. Non-Bank Financed NCB National Competitive Bidding

Vice President: Johannes F. Linn Country Director: Luca Barbone Sector Manager: Khaled Sherif Task Team Leader Vladimir G. Kreacic NGO Non-Governmental Organization NPV Net Present Value NS National Shopping PHRD Policy and Human Resources Development PIU Project Implementation Unit PPF Project Preparation Facility PSD Private Sector Development PV Present Value QBS Quality Based Selection QCBS Quality and Cost Based Selection RFP Request for Proposal SA Special Account SCRPE State Committee on Regulatory Policy and Entrepreneurship of Ukraine SFB Selection under a Fixed Budget SL Short List SMEs Small and Medium Enterprises SOE Statement of Expenditure SOEs State Owned Enterprises SPF State Property Fund of Ukraine SRO Self-Regulatory Organization SS Single Source TA Technical Assistance TACIS Technical Assistance for the Commonwealth of Independent States TORs Terms of Reference UCER Ukrainian Center for Enterprise Restructuring and Private Sector Development USAID United States Agency for Intemational Development

UKRAINE PRIVATE SECTOR DEVELOPMENT

CONTENTS

A. Program Purpose and Project Development Objective Page

1. Program purpose and program phasing 3 2. Project development objective 3 3. Key performance indicators 4

B. Strategic Context

1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 4 2. Main sector issues and Government strategy 4 3. Sector issues to be addressed by the project and strategic choices 6 4. Program description and performance triggers for subsequent loans 7

C. Program and Project Description Summary

1. Project components 8 2. Key policy and institutional reforms supported by the project 8 3. Benefits and target population 8 4. Institutional and implementation arrangements 9

D. Project Rationale

1. Project altematives considered and reasons for rejection 10 2. Major related projects financed by the Bank and other development agencies 11 3. Lessons leamed and reflected in the project design 11 4. Indications of borrower commitment and ownership 12 5. Value added of Bank support in this project 12

E. Summary Project Analysis

1. Economic 13 2. Financial 15 3. Technical 15 4. Institutional 16 5. Environmental 17 6. Social 17 7. Safeguard Policies 18

F. Sustainability and Risks 1. Sustainability 19 2. Critical risks 19 3. Possible controversial aspects 20

G. Main Loan Conditions

1. Effectiveness Condition 21 2. Other 21

H. Readiness for Implementation 23

I. Compliance with Bank Policies 23

Annexes

Annex 1: Project Design Summary 24 Annex 2: Detailed Project Description 26 Annex 3: Estimated Project Costs 35 Annex 4: Cost Benefit Analysis Summary 36 Annex 5: Financial Summary 41 Annex 6: Procurement and Disbursement Arrangements 42 Annex 7: Project Processing Schedule 52 Annex 8: Documents in the Project File 53 Annex 9: Statement of Loans and Credits 54 Annex 10: Country at a Glance 55

MAP(S) UKRAINE Private Sector Development Project Appraisal Document Europe and Central Asia Region ECSPF Date: March 1, 2002 Team Leader: Vladimir G. Kreacic Country Director: Luca Barbone Sector Manager: Khaled Sherif Project ID: P054966 Sector(s): IR - Industrial Restructuring Lending Instrument: Adaptable Prograrn Loan (APL) Theme(s): Private Sector Poverty Targeted Intervention: Y Program Financing Data Estimated APL Indicative Financing Plan Implementation Period Borrower ______~~~~~~~~~~~(BankFY) IBRD Others Total Commitment Closing US$ m % US$ m US$ m Date Date APL 1 30.00 78.9 8.00 38.00 09/01/2002 06/30/2007 Ukraine Loan/ Credit__ __ APL 2 30.00 75 0 10.00 40.00 07/01/2007 06/30/2011 Ukraine Loan/ Credit______Total 60.00 18.00 78.00 [X] Loan [ ] Credit [ ] Grant [ ] Guarantee [ Other: For LoanslCredits/Others: Loan Currency: United States Dollar Amount (US$m): 30 Borrower Rationale for Choice of Loan Terms Available on File: 1 Yes Proposed Terms (IBRD): Fixed-Spread Loan (FSL) Grace period (years): 8 Years to maturity: 20 Commitment fee: 0.85percent on the undisbursed loan Front end fee (FEF) on Bank loan: 1.00% amount for the first four years of the Payment for FEF: Capitalize from Loan Proceeds loan's life, and 0.75percent thereafter, until maturity Initial choice of Interest-rate basis: Auto. Rate Fixing by period 6 months Type of repayment schedule: [X] Fixed at Commitment, with the following repayment method (choose one): annuity [ ], Linked to Disbursement Conversion options: [X]Currency [X]Interest Rate [X]Caps/Collars: Capitalize from Loan Proceeds Financing Plan (US$m): Source Local Foreign Total BORROWER 4.00 0.00 4.00 IBRD 4.46 25.54 30.00 UK: BRITISH DEPARTMENT FOR INTERNATIONAL 0.00 2.00 2.00 DEVELOPMENT (DFID) NETHERLANDS: MIN. OF FOREIGN AFFAIRS / MIN. OF 0.00 2.00 2.00 DEV. COOP. Total: 8.46 29.54 38.00 Borrower: UKRAINE Responsible agency: UKRAINIAN CENTER FOR ENTERPRISE RESTRUCTURING AND PSD State Committee of Ukraine for Regulatory Policy and Entrepreneurship Address: 27 Komintema St., Kyiv 01032, Ukraine Contact Person: Oleksandra Kuzhel Tel: (380 44) 246 8647 Fax: (380 44) 216 2435 Email: kuzhel(dkrp.gov.ua Other Agency(ies): PIU - Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER) Address: 14b Dymytrova St., Kyiv 03150, Ukraine Contact Person: Viktor Bekh Tel: (380 44) 227 5152 Fax: (380 44) 227 1097 Email: [email protected] Estimated disbursements (Bank FY/US$m): FY 2003 2004 2005 2006 2007 2007 2008 2009 Annual 1.80 5.70 14.90 5.60 10.00 Cumulative 1.80 7.50 22.40 28.00 38.00 Project implementation period: September 2002-December 2006 Expected effectiveness date: 09/01/2002 Expected closing date: 06/30/2007 OCSPAOAPtF- RM.~ Ah-D2

-2 - A. Program Purpose and Project Development Objective 1. Program purpose and program phasing: The purpose of the Program supported by the Bank Adaptable Program Loan (APL) is to foster private sector development in Ukraine using a bottom-up approach, which focuses on enterprise adjustment and the creation of a market friendly regulatory environment. The APL is planned as an 8 year Program consisting of 2 loan phases. The first phase of this Loan (USD 30 rnillion), which is the subject of this PAD, will focus on creating the baseline conditions for private sector development by working in collaboration with the Government of Ukraine (GoU) to improve the regulatory environment for private business, and provides intensive training of Ukrainian business managers and consultants to support enterprise restructuring. The first phase of the project will be initiated in 4 pilot oblasts. The second phase (USD 30 million) will extend the institutional and restructuring experiences acquired to a larger number of oblasts and enterprises. The four pilot oblasts were selected on the basis of their demonstrated commitment to reforns, which support a market friendly regulatory environment for the private sector. Incentives have been built into the project to ensure that such comrmitment continues, so that any oblast, which fails to continue to support the necessary regulatory reformns will be dropped from the project, and another oblast, which has demonstrated its commitment to support positive private sector reforms will be substituted. The Loan will support intensive training programs to upgrade technical business management skills of Ukrainian managers and management consultants, as well as facilitate the process of enterprise restructuring. Individuals who go through the training process will become the local experts and leaders in enterprise restructuring, which will take place through various conventional modes like spinning off SMEs from existing obsolete industrial complexes, or selling off certain assets or proprietary rights to create new start-up enterprises. Enterprises that achieve financial viability will likely become strong competitors in domestic and foreign markets. In this way, transforming inefficient and obsolete industrial enterprises into profitable companies will accelerate the rate of growth in the industrial sector, demonstrate to the public at large (as well as to foreign investors) that enterprises can actually thrive in an imperfect business environment, and expand institutional capacity for further private sector development. The first steps of this project, which set the groundwork for policy reform, have already been achieved. These have included establishment of the necessary institutions to support private sector development and implement the PSD Loan, as well as adoption of certain deregulatory measures by oblast administrations in pilot oblasts. The State Committee of Ukraine for Regulatory Policy and Entrepreneurship (SCRPE) and the Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER) have been created to implement programs under the Loan. This Loan will build upon prior IFC-fumded TA projects in the areas of SME privatization, divestiture of unproductive assets, corporate governance, and creation of a market for high quality business advisory services.

2. Project development objective: (see Annex 1) The development objective of the PSD project is to increase competitiveness of the Ukraine enterprise sector. In line with this objective, the project is aimed at laying the groundwork for the development and expansion of the private sector in Ukraine by: a. Creating demand for restructuring and constituencies for reform at the enterprise and oblast levels, and responding to this demand by creating sustainable institutional capabilities, creating a market for managerial expertise and developing local capabilities to utilize and supply this market;

- 3 - b. Demonstrating the economic pay-offs resulting from positive restructuring by assuring the sufficient supply response to reforms (including increased sales, exports, investments, FDI of pilot enterprises); and c. Providing incentives to oblast administrations to improve the local business environment and reduce administrative costs of doing business by measurable results in these areas a precondition for receiving assistance. This approach is intended to demonstrate the benefits that can be expected from successful enterprise restructuring, training of managers and consultants, and improvements in the legal and regulatory environment for business activities.

3. Key performance indicators: (see Annex 1) Key performance indicators to monitor and evaluate the program and the project consist of two types indicators. The quantitative indicators will include the following: * the number of restructured enterprises; * the number of created SMEs; * the number of trained managers, and * the number of trained consultants. The qualitative indicators that link the project's development objectives to outcomes and impacts will include: * rate of growth of SMEs in pilot oblasts; * rate of growth of output of private sector in pilot oblasts; and * value/added per employee in restructured enterprises.

B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: R2000-167 [IFC/R2000-179] Date of latest CAS discussion: 09/12/2000 This project is consistent with the Bank's present CAS for Ukraine, which designates promotion of private sector development as a top priority. The proposed APL will provide funding for improvement of the performance of private enterprises in the selected oblasts of Ukraine. Furthermore, targeted assistance at the enterprise level will be complemented by strengthening institutional capacity at the policy and regulatory level. This will ensure the growth and success in individual enterprises as well as in the business environment initially in the selected oblasts. This experience will be spread throughout Ukraine and will create a positive demonstrative effect as the project reaches new oblasts. The strengthening of the private sector will also create a stronger taxable base for the central and local budgets and thereby improve fiscal revenues.

2. Main sector issues and Government strategy: Following successful stabilization between 1996 and 1997, Ukraine has maintained a relatively stable macroeconomic environment. However, lack of structural reforms and the Russian financial crisis in 1998

- 4 - prevented a full economic recovery. Highlights of recent macroeconomic performance as for the end of 2001 are: * Inflation reduced to 6.1 percent. * Real GDP growth: a 3% decline recorded in 1997 was followed by a 1.7% decline in 1998, a smaller 0.4% decline in 1999, and 6% growth in 2000, for the first time since Ukraine independency, followed by 9% growth in 2001. An increase of 5% in GDP is currently projected for the year 2002, based on continued revival of industrial production (initially metals and metallurgy and more recently light and food industry) and agricultural production. * The trade and current account balance have improved. The NBU estimated the former current account deficit (which remained virtually unchanged at $1.3 billion in 1997 and 1998), has turned into a $500 million surplus for 1999. * The cash deficit of the general government has been reduced from 5.6% of GDP in 1997, to 2.8% in 1998, 2.4% in 1999 and less than 2% in 2000. This reduction resulted from improved budget discipline, tighter expenditure controls, elimination of budget offsets, and cuts in tax privileges and social subsidies, while lowering tax burdens on the business sector. The development of the private sector, particularly of new SMEs, has been much slower in Ukraine than in neighboring Central European countries. There are only four active SMEs per 1,000 people compared to around 6 in Russia, 25 in Estonia and 35 in Poland. Although more than 650,000 private firms have been registered, only some 217,930 are small (less than 50 employees). SME activities differ geographically and still have very low impact on the economy - on average, in 2000, small enterprises delivered 6,9% of total industrial output and employed 15,1% of the Ukrainian labor force. In the most advanced regions, SMEs contribute no more than 15 percent of the GDP and employment. FDI per capita as of late 2001 was US $85, which is significantly less than in neighboring Poland and has had a negligible impact on restructuring of the Ukrainian economy. Relatively cheap labor could be a comparative advantage for the Ukrainian economy. This advantage is, however, eroded by the low quality of products and the high risk of an unstable regulatory environment. As a result, Ukraine is "specializing" in "dirty" and energy consuming industries (such as steel products and raw chemicals) where quality requirements are lower, unaccounted environmental extemalities higher, and where a short-term comparative advantage is possible due to the depletion of assets installed in Soviet times. The decline in manufacturing has been even more severe than the average decrease of GDP, and has led to a change in the GDP composition. The service sector has increased from 50% in 1997 to 53% in 2000 at the expense of industry, agriculture and construction. Base industries (coal, energy, ferrous and non-ferrous metallurgy) have survived in relatively better shape than machine-building and light industries. The emerging sub-sectors pattern is that some enterprises within a given sector are struggling to survive while others have stopped their activities altogether. Structural reformns have generally been driven by negative forces (contraction and rent-seeking behavior) rather than expansion of sub-sectors through green-field investments or serious restructuring at the enterprise level. However, serious steps to improve the business environment have already been taken by the Governnent of Ukraine. These included simplification of a registration procedure for new entrants, reduction in the number of state inspections for companies, decreasing the number of licenses needed to do business, and acceleration of cash privatization of large Ukrainian enterprises. The Government has canceled almost all the tax privileges to industrial enterprises (that in previous years reached USD 4 billion and seriously distorted the competitive environment). Privatization is the main visible long-term base for the emerging private sector, both in terms of going concems and assets. Privatization of SMEs was practically completed by the end of 1998. On average, new private companies emerging from state owned enterprises (SOEs) have a better ownership structure than,

- 5 - for example, their Russian counterparts. In privatizing larger enterprises, Ukraine has recently succeeded in offering shares of privatized companies through open auctions to outsiders. Independent shareholder registrars and public disclosure requirements introduced early in the reform program also make management more accountable to shareholders. In addition, managers in enterprises privatized through "buyout-through-leasing," are more accountable to employees than in other FSU republics. Despite these factors, the incentives and skills necessary to undertake the challenge of the market economy are poor and the number of cases of real enterprise restructuring are still too small. The most common scenario is one in which an insider-led reorganization is usually oriented towards survival and the preservation of jobs, and is achieved by rebuilding old networks of cooperation. Spinning-off most profitable technological units and creation of small private trade companies continues, although at the reduced level. Searching for foreign investors is a part of the agenda but the fear of losing control of assets is a serious limitation (although this is decreasing due to the rapidly deteriorating conditions of enterprises). Government's Economic Reform Priorities The Government's overriding medium term priorities include achieving fiscal sustainability by improved tax collection and better management of public spending, and economic growth. The development of a dynamic private sector plays a key role in the achievement of both priorities. However, the Government presently operates within an ultra-short time horizon with its decisions determined by the repayment of foreign and domestic sovereign debt, constant pressure of overdue budgetary obligations to the social sphere, and often successful lobbying by industrialists, for bail-outs and subsidies. Despite these unfavorable conditions, systemic reformns are expected to continue, due in part to ongoing Bank Programmatic Adjustment operation and the IMF's Extended Fund Facility. These reforms include increased volumes of the budget revenues through cash privatization of large infrastructure and other enterprises, and the effective introduction of international accounting and auditing standards. New business start-ups will be encouraged by streamlining regulatory processes (deregulation); creating a simpler, more transparent taxation system; and improving exit mechanisms by the creation of an appropriate framework and process for bankruptcy. The capital markets will be developed to improve corporate governance by increasing transparency, accountability and facilitating ownership transfer in the secondary markets. It is hoped that the success of the PSD project in training managers, local consultants, and turning around enterprises will create a strong demonstration effect and a lobby for PSD at the local level, thereby improving the climate for PSD in Ukraine from the ground.

3. Sector issues to be addressed by the project and strategic choices: To accelerate the development of the private sector and to increase the attractiveness of Ukraine to foreign investors, the project will address the following areas: * Lowering business transaction costs (which presently include numerous fees, bribes, bureaucratic red tape, non-commercial risks) in order to encourage domestic and foreign entrepreneurs to start businesses in Ukraine (see Box 1); * Improving the skills, knowledge, and incentives of managers and employees which is a necessary precursor to functioning as a modem enterprise in a competitive market environment; * Strengthening Ukraine's comparative advantage of a relatively inexpensive and well-educated labor force and a favorable geographical location; and * Developing good corporate governance by clarifyfing and strengthening the rights of external owners and creditors to make the financing of enterprises an attractive investment.

- 6 - Box 1 Cost of Doing Business Surveys The project will use the methodology for assessing costs of doing business in Ukraine developed by the USAID-funded project Regulatory Reform Program in Ukraine. The main goal of the survey was to get reliable data for assessing the cost to businesses of compliance with state regulations and to provide benchmarks that enable comparisons of the business climate between the regions and over period of time. Since 1997, when the first survey was initiated, average costs for an industrial enterprise per year decreased from USD 22,000 to USD 12.5 thousand in 1998, and to about USD 6,000 in 1999, which confirms that measures undertaken by the new government had a positive impact on regulatory environment. This survey covered 10 oblasts and illustrated that the average cost of doing business for industrial enterprises in some regions can be 4 times higher than in other regions. We found that the most costly items for entrepreneurs are registration of a new business (USD 180) and various official inspections (USD 1,500). Additionally, companies involved in foreign trade are subject to huge imnport and export transaction costs. The study found that administrative expenses per transaction can cost up to USD 6,000.

4. Program description and performance triggers for subsequent loans: The first phase project of the proposed APL Program would be appraised as successful and, therefore, lead to its expansion to other regions only when the following triggers are met: * Reduction of time needed to obtain all the necessary pemnits to start non-licensed business activities to 2 weeks; * Implemented regulatory changes that streamline licensing regime as demonstrated in that all licensing conditions are mainly based on public safety concems; * Legislative changes implemented which: 1) limit the number of agencies authorized to conduct inspections, impose penalties or stop business activities to 10 (total); 2) limit the number of inspections per authorized agency to not more than one inspection per enterprise per year; and 3) strictly limit the authority of other agencies to monitor compliance of enterprises with regulations through issuance of recommendations and enforcement of laws/regulations only through court proceedings. * A majority of participating enterprises are operating successfully in financially sustainable manner (positive cash flow, adequate intemal financing for restructuring needs, and loans rescheduled to avoid bankruptcy proceedings); and * Improvement in the regulatory environment for business activities is demonstrated by a higher growth rate in number of SMEs in participating oblasts than the average growth rate in Ukraine.

-7 - C. Program and Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown):

Indicative Bank- % of Component Sector Costs % of financing. Bank- (US$M) Total (US$M) financing Enterprise Restructuring (market IR 24.00 63.2 19.00 63.3 adjustment) Managerial and Consulting IR 11.50 30.3 9.00 30.0 Secondments Monitoring and Project Administration Institutional 1.38 3.6 0.88 2.9 Development Improvement of Regulatory Business 0.82 2.2 0.82 2.7 Environment Environment Total Project Costs 37.70 99.2 29.70 99.0 Front-end fee 0.30 0.8 0.30 1.0 Total Financing Required 38.00 100.0 30.00 100.0

2. Key policy and institutional reforms supported by the project: Ukraine is often criticized for a highly bureaucratic and unfriendly business environment, poor policies toward entrepreneurs (both domestic and foreign), and weak institutional support of private business. These negative conditions of doing business are amplified by the disruptive practices of the regulatory agencies, such as the tax authorities, fire department, and health inspectors. The Loan will seek changes in these areas by a combination of improved policy dialogue and additional funding tied to the satisfactory completion of specific conditions (triggers for the lending sequence under the APL). A three-pronged approach will be used with close collaboration of the PSD Loan team and the teams processing the Programmatic Adjustment Loan, especially in taxation and public administration reform areas. In this regard, concrete examples from the pilot oblasts will be shared and used to inform and forward policy discussions with the government at the oblast and national levels. Loan processing will also be heavily dependent on strengthening governmental counterparts and non-governmental agencies involved in the implementation of the project. There are important synergies between government policies oriented toward private sector development and the proposed project. Pilot oblasts will be required to rein in often oppressive behavior of tax and other inspections, while at the samne time, the project will help highlight problems faced by entrepreneurs in order to help the government become more responsive to the needs of business and find workable solutions.

3. Benefits and target population: Benefits: * Improved competitiveness of Ukrainian enterprises both domestically and abroad. * Introduction and dissemination of best practices on the continuous improvement and adjustment of enterprises to market challenges.

-8 - * Strengthened rights of external owners and creditors, and better accountability of managers. * Job creation in new enterprise clusters, and averting massive job elimination, which would inevitably result to the liquidation of unrestructured enterprises. Target Population: The first phase of the Project will be implemented in up to eight competitively selected oblasts (see Annex 2 Component 2). * Owners of enterprises will enjoy the benefits stemming from the enhanced earnings and growth potential as well as increased shareholders' protection and improved capital markets. * Employees of privatized enterprises will have improved employment opportunities, as enterprises will be growth oriented and financially sound. Additionally, the environment to establish start up enterprises will be significantly improved. * Local consultants will benefit directly from involvement in the project and from the opportunity to collaborate with foreign consulting firms. * Local communities will have better access to better quality and less expensive products and services as a result of the spinning-off of a large number of SMEs. * Local knowledge and expertise in management will improve, and this will enhance the opportunity for exponential dissemination of this expertise to all interested sectors of the local business communities (including entrepreneurs, bankers, academics, consultants, universities, etc.)

4. Institutional and implementation arrangements: The project minimizes the dependence on the central administration. A Working Group established by the Government for the proposed PSD Loan, and chaired by the Head of SCRPE, is to be used for policy dialogue and intervention only when necessary. UCER, a specially created non-profit agency will serve as the project implementation unit and will manage implementation of the project on a day-to-day basis. UCER will delegate many of the implementation functions to its regional branches to minimnize the potential impact of national political turbulence on project implementation. The project is to be started in the four pilot oblasts with the highest "reform potential" demonstrated by: (1) commitment of local authorities (reduction of bureaucratic obstacles to PSD, in-kind and financial support to implementing agencies); (2) commitment of visited enterprises to participate in the project; and (3) existence of a robust business community. The project will also work with and support a variety of non-govemmental organizations, self-regulating organizations (SROs) of managers and consultants, training organizations, and independent research groups. The oblast administration achievements will be monitored regularly through the surveys that assess the cost of doing business. Financial Management FinancialManagement Assessment: During pre-appraisal, the implementing agency and the Bank jointly agreed upon a series of measures to strengthen intemal financial controls and to improve financial reporting. The implementing agency carried out the agreed upon measures on a timely basis and subsequently the project satisfies the Bank's minimum financial management requirements. Disbursements: Project funds will be disbursed under the Bank's established procedures, including Statements of Expenditure (SOEs) and Summary Sheets. The Borrower has selected Fixed-Spead Loan (FSL) that carries a commitment charge of 0.85% on the undisbursed loan arnount for the first.four years of the loan's life, and 0.75% thereafter, until maturity. The

-9- FSL commitment charge for the first four years includes a risk premium of 0.10%. An authorization to sign withdrawal applications must be submitted to the World Bank immediately upon effectiveness of the Loan Agreement. Pursuant to Section 11.03 of the General Conditions, the Minister of Finance may authorize the Head of SCRPE and any other officer to have signature authority for purposes of disbursements under the Loan. FinancialMonitoring Reports (FMRs): Management-oriented FMRs will be used for project monitoring and supervision. The formats of the FMRs, which have been agreed with UCER, are included within the Operational Manual and have been confirmed. The UCER will produce a full set of FMRs semi-annually throughout the life of the project beginning not later than the period ending 6 months after project effectiveness date. Audit Arrangements: Extemal audits by independent private auditors acceptable to the Bank, and on terms of reference acceptable to the Bank will be procured by the UCER. Annual audited financial statements of the UCER and of the Project will be provided to the Bank within 6 months after the end of each fiscal year and also at the closing of the project. Terms of reference for the audit of UCER and of the project financial statements have been agreed with UCER. Procurement Arrangements Project procurement arrangements shall include the procurement of goods and consultants' services and shall follow the latest editions of the Bank guidelines "Procurement under EBRD Loans and IDA Credits" and "Selection and Employment of Consultants by World Bank Borrowers" accordingly. Procurement under the project shall be managed by UCER using relevant Bank standard procurement documentation and Operations Manual, developed by the UCER and approved by the Bank. UCER has an adequate number of regular employees combined into 4 sections; procurement section is one of them. It includes a procurement specialist who will manage procurement under the project with the permanent assistance of the lawyer and the financial manager. The unit reports to the Deputy Executive Director of the UCER The Procurement Plan will be updated within one month after the Board approval of the Project.

D. Project Rationale 1. Project alternatives considered and reasons for rejection: * Introduction of strict top-down hard budget constraints upon enterprises trying to restructure in post-communist economies has back-fired. Leaving such enterprises purely to the mercy of free market forces in an environment where the institutional, regulatory and enforcement capacity of executive branch institutions, courts and police authorities is low, often perpetuates illegal and unethical business practices like asset stripping, fraud, and embezzlement. In post-communist countries, appropriate skills that would enable owners and managers to take the necessary steps to restructure companies in a legal .and ethical manner are often lacking. Where such skills are missing, those who own or control business assets tend to engage in unethical business practices when they believe it is the most profitable and efficient solution. Narrowing this knowledge and skill gap would enable business leaders to tum failing businesses into profitable ones in an ethical and responsible manner. Successfully restructured businesses would demonstrate to the business community at large that unethical and irresponsible business practices are neither the only option, nor the best solution. * Court-led bankruptcy (liquidation and Chapter XI style reorganization) - rejected due to the weak institutional capacity of the courts and limited success in much more advanced transition economies

- 10- (i.e. Hungary). However, during project preparation a creditor-led approach compatible with the Bankruptcy Law has been developed and tested successfully. * "Enterprise jail" model (Isolation Programs, for example in Bulgaria and Romania) - rejected due to the significant risk of the reinstitution of governmental subsidies and bureaucratic control, and the strong likelihood of numerous turf battles among branch ministries.

2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned). Latest Supervision Sector Issue Project (PSR) Ratings (Bank-financed projects only) Implementation Development Bank-financed Progress (IP) Objective (DO) Privatization/Macro PSD reform Ukraine EDAL (completed) S S (UA-PE-35814) Post-privatization restructuring Moldova PSDII (ongoing) S S (MD-PE-3581 1) Post-privatization restructuring, Uzbekistan EIBL (ongoing) S HS case-by-case Privatization (UZ-PE-55159) Post-Privatization Restructuring Georgia ERP (ongoing) S S (GE-PE-08416) Other development agencies Privatization (USAID) Unfinished Construction Site Privatization Project (completed) (IFC-00502545-TF021908) Business consulting (USAID) Business Development Project (completed) (IFC-00502944-TF020391) IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U(Unsatisfactory), HU (Highly. Unsatisfactory) 3. Lessons learned and reflected in the project design: * Extensive work with the Government, local officials and politicians to explain the merits of spending public resources on TA to privatized enterprises and building the skills of managers. * Study tours for senior Government officials to other transition economies that have implemented similar programs in order to use success stories to provide a demonstration effect. * Training of consultants from transitional economies that have implemented similar programs, and extensive training of Ukrainian consultants in these countries. * A strong team of WB staff on the ground for extensive periods of time. * The establishment of a highly qualified locally staffed agency implemnenting the project on a daily basis, with strong local leadership. * The up-front commitment of participating regions, with 3-4 restructured enterprises during the project preparation. * The downplaying of unrealistic expectations of quick and easy results.

4. Indications of borrower commitment and ownership: The Government has established a Working Group in the form of the Inter-Agency Coordinating Council for preparation and implementation of the project. This Group is already working in close coordination with the World Bank team and is headed by the Head of SCRPE and includes high level representatives from all major governmental ministries and agencies. A project implementation agency (UCER) has been created and offices have been provided by the Government. The Bank has also agreed to the Govemment's request to reallocate USD 500,000 from the Enterprise Development Adjustment Loan's (EDAL) TA component for the institutional strengthening of the UCER. UCER has been operational at the central and oblast level since fall of 1999. There is also strong interest in the project at the local administration level, as confirmed during multiple visits to the regions and a number of separate meetings requested by the oblast governors. Proposed selection criteria for participating oblasts include a number of deregulatory and tangible measures to be undertaken in advance by the winning oblasts. As an indication of the seriousness of their interest in the project, many oblasts have financed visits to successful neighboring countries and training centers in order to increase their competitiveness to participate in the project. The four oblasts that have been selected jointly with the Govemment as pilot projects are Volyn (Northwestem Ukraine); Chernovtsy and Khmelnitsky (neighboring oblasts in Southwestem Ukraine); and Zhitomir (Central Ukraine).

5. Value added of Bank support in this project: The Bank's experience with successful post-privatization restructuring of enterprises and development of managers' skills (Moldova, Georgia) and the experience of other countries in the region (Poland, Slovenia, Hungary, and Slovakia) can provide a powerful demonstration effect for the Ukrainians. Furthermore, synergy will be created with the Bank's adjustment operations, and provide strong policy and financial support to the reformistic element of the Govemment in undertaking difficult measures. The project will consolidate and strengthen a variety of donor activities already in place by using donor supported business centers (e.g. created by the IFC TA projects. See Box 2), and intensify the work on accounting reform and capital market development already begun under other Bank and donor funded programs. The project can leverage the training and business advisory work that has been done by the business centers in the regions by following up with on-site assistance to enterprises. The Govemment of the Netherlands intends to support the Project. The British Department for Intemational development has commnitted to provide GBP 1.2 million (approx. USD 2 million) as co-financing the Loan. The discussions on possible cooperation with other donors - like EU (TACIS) and USAID are proceeding. The project strengthens and expands, in a hands-on way, the reforms supported by the Bank's adjustment lending for private sector development and deregulation through the First and Second EDAL, and the Programmatic Adjustment Loan. Lastly, the Bank will use consultants from Moldova and Georgia that were involved in the implementation of similar programs in their own countries, and are experts in the areas of enterprise restructuring and management training. Box 2 PSD Development in Ukraine: Synergy between IFC and World Bank Complimenting its core investment activity, IFC has provided major technical assistance and consultation to the Government of Ukraine since 1993. The focus of this assistance is in privatization and corporate sector development. IFC has been working on three technical assistance projects in Ukraine:

- 12- * Unfinished Construction Site Divestiture - aimed at the creation of a new class of private owners, the development of small and medium-sized businesses, the formation of a competitive environment in this field on the basis of unfinished construction objects. It also helps to divest unproductive assets as a pre-restructuring activity at 6 enterprises involved in the PSD Loan preparation; * Corporate Governance - targeted at improvement of the investment climate in Ukraine by laying a solid foundation for incorporation of effective corporate govemance practices at newly privatized Ukrainian enterprises that will complement the successful enterprise restructuring provided under the PSD Loan. * Business Development - focused on providing assistance in overcoming obstacles to the development of small-scale and medium-scale businesses through creation of the business-centers throughout Ukraine. In addition, the project advised central government officials on policy issues. This project will assure synergies with IFC TA projects in the following way: * Developing local consultant's market TORs for intemational consulting firms will contain a provision specifying that the foreign company should sub-contract local consulting companies or individuals for particular tasks in which they have comparative advantage. For example, such tasks might include local market research, business-planning, legal analysis and other areas. In this way, local consulting firms and individuals will have opportunities for professional development under competitive circumstances. * Focusing on low end beneficiaries -- weak firms with low capacity to pay full costs of services delivery and developing new clients for IFC business development services. The project focuses on enterprises in difficult financial situation but with promising assets. This is to develop competitive and viable spin-offs of the enterprises being restructured. These spin-offs will be natural and solvent clients for emerging local consulting markets.

E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic (see Annex 4): * Cost benefit NPV=US$0.035 million; ERR = 9.73 % (see Annex 4) O Cost effectiveness O Other (specify) All cost-benefit calculations (including Tables of Annex 4) capture the benefit of the Enterprise Restructuring component. Benefits of other components are very difficult to quantify. Discount rate is assumed 10%. Prices, and therefore financial results, are often distorted by two factors: (a) the role of multidimensional barter transactions, i.e. making and accepting payments to suppliers, employees, and buyers in goods; and (b) the fact that some enterprises still use resources and assets artificially depreciated during hyper-inflation. Economic evaluation methodology: Project Cost-Benefit analysis The Cost Benefit (C/B) Analysis attached in Annex 4 discounts the incremental cash flows to the Government's budget (from VAT) from the enterprises, which participated in the project as opposed to the enterprises that did not. The discount rate used is the Bank recommended rate of 10 percent. The C/B analysis shows that for the

- 13 - project to increase its cost efficiency, it has to target medium to large enterprises rather than small ones. To achieve the same increase in the VAT payments that cover project costs, small enterprises need a bigger increase in sales in the first year of the project. On the one hand, the flexibility of small enterprises allows for a bigger percentage of increase in sales in the first year, however, small enterprises also have more difficulty in sustaining the increase beyond the first year. A cost/benefit analysis is possible at the level of individual participating enterprise. Large (and positive) externalities of "soft" investments in managerial skills, and the peculiarity of transition in FSU countries when compared with other developing economies, make a C/B analysis less feasible for the development impact of this project. There is, however, enough experience from other transition economies to demonstrate that similar types of TA projects have, on average, produced results that outweigh costs (see Box 3). Box 3 The Moldovian Agency for Restructuring and Enterprise Assistance The Moldovian Agency for Restructuring and Enterprise Assistance (ARIA) was created in 1995 with the principal objective of accelerating adjustment of newly privatized enterprises to market conditions. It was supported by two Private Sector Development Loans of the World Bank. The data taken from a firm-level database provided by the Moldovian Department of Statistics indicate the following restructuring impact: In 1995 the firms that would eventually find their way to ARIA's doorstep, were on average worse off than firms that would never be assisted by ARIA, both in terms of productivity and profitability. By the end of 2001, despite worsening economic conditions in Moldova, ARIA-assisted firns were more productive than their unassisted counterparts, exported more in relative terms, and paid more in taxes per worker. In 1995, the firms that ARIA would assist were underpaying their share of taxes, and under-exporting. In 1999, these trends were reversed, and now ARIA firms are paying a greater share of taxes and exporting a greater share of their output relative to their size. ARIA assistance is positively, significantly, and consistently correlated with the real productivity growth, with the growth in exports per employee, and with the sales growth. Extemal restructuring assistance by other agencies (USAID, TACIS) has no effect, nor do agreements between firms and the Moldovian Council of Creditors in boosting performance. Among the firms ARIA assisted, the "ARIA effect" is strongest among the companies that were the least profitable in 1995, with the benefits of ARIA's assistance diminishing as the 1995 level of profit/employee increased. ARIA was successful because it has found an efficient solution to politically charged issues of liquidation and restructuring by working with existing capital and human resources to develop enterprises. The key to ARIA's success leis in its ability to co-opt mangers or, if they are not cooperating, to replace them. ARIA does not have formnal authority to do so. However, its "reputation authority" is such that it is often, but not always, able to get results. The "reputation authority" is a result of ARIA's track record as well as of its unique position as an autonomous government agency with a strong and committed leadership and dedicated and skilled staff. Industrial parks created by ARIA perform three functions: * Recombination of assets: a technique (fornalized in operation manual) to carve out viable assets (office space and some equipment) and lease them to spin-off SMEs;

- 14 - * Creation of 'forced entrepreneurship' by convincing and cajoling most capable managers of the existing plant to become managers/owners of spin-off SMEs; and * Provision of better business environment (security protection, some protection from inspections) and business development services to spin-offs, which are the part of the industrial park.

2. Financial (see Annex 4 and Annex 5): NPV=US$ 0.03 5 million; FRR = 9.73 % (see Annex 4) Participating oblasts and enterprises should cover part of the cost of the assistance, primarily through in-kind contributions (such as office space, telephone lines, support staff). The Loan will be provided to the Ministry of Finance on standard maturity terms--20-year repayment with a 8-year grace period. Loan proceeds will be transferred to the implementation agency as a grant under the control of the Government. The implementation agency (the UCER) will be expected to cover a growing part of its operational costs, with full self-financing of operational costs approximately five years after the Loan effectiveness (excluding the costs of foreign consultants). The use of Loan proceeds for project implementation will be audited in accordance with the rules of the Bank. This project is designed to demonstrate the benefits of restructuring to enterprise managers, Government officials, and foreign and local investors. A few successful cases of restructuring advisory services will help in convincing officials, and enterprise managers, about the benefits of consulting services and the feasibility of restructuring. Building the capacity of the local consulting industry will ensure that the successful cases are replicable in many other enterprises and regions. Also, the know-how and management skills acquired by the Ukrainian consultants from foreign experts and offered at the local prices will contribute to project sustainability.

Fiscal Impact: The Fiscal impact analysis coincides with financial impact, i.e. financial impact calculates the fiscal impact of the enterprise restructuring component of the project.

3. Technical: N/A

4. Institutional: The success of the project depends on the removal of numerous administrative obstacles to the development of the private sector. However, it is expected that many administrative obstacles will be identified only during the process of project implementation. The Bank's previous experience in Ukraine has shown that it is vital to have the backing of a strong and stable leader at the governmental level as well as a strong manager for the implementation agency. The changing political environment in Ukraine has made it difficult to secure both of these simultaneously, however, a promising candidate who enjoys high level support in the Government has been identified and has been leading UCER since 1999. The successful completion of the EDAL TA Component has been treated as an important trigger for the further implementation of this Loan to strengthen institutional capacity on the Ukrainian side.

4.1 Executing agencies: The Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER) is the designated the executing agency for the PSD Loan.

- 15- 4.2 Project management: The Project Implementation Unit (UCER) was set up as a separate legal entity in November 1998. It will be responsible for day-to-day project implementation and management, and will delegate, as necessary, some implementation functions to its regional branches to further minimize the impact of potential turbulence in the national political scene on project implementation. The project minimizes the dependence on the central administration. An Inter-Agency Coordinating Council established by the Government for the proposed PSD Loan, and chaired by a Head of SCRPE, is used for policy dialogue and intervention only when necessary.

4.3 Procurement issues: The Country Procurement Assessment Report (CPAR) has been finalized and submitted to the Government for comments. The procurement capacity assessment of UCER demonstrated that UCER could adequately carry out project procurement responsibilities as it had built up experience and capacity through procurement training and through implementation of EDAL TA project financed by the World Bank, and preparation of PSD project while hiring consultants from the PHRD and PPF proceeds. The capacity of UCER is further being strengthened through regular seminars and procurement sessions.

4.4 Financial management issues: Financial Management Capacity: The financial management capacity within Ukraine has not been the subject of a detailed review by the Bank. Any weaknesses that may exist in the country's financial management capacity have been mitigated by the use of a specialized project implementing agency - the Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER), for project preparation and implementation, and drawing upon experience of projects of this nature. The main risks related to the project's financial management system are as follows: (i) Capacity of staff in the UCER. UCER currently employs one full-time accountant whose responsibilities include maintaining accounts for the project preparation grant, project accounting, internal controls and financial reporting. An additional accountant can be recruited if required during project implementation, and this would be funded from the proceeds of the loan. UCER accounting staff will be further trained, as needed, and this training will be provided as a part of the technical assistance for the project. (ii) Capacity of accounting system to generate the agreed Financial Monitoring Reports (FMiRs). UCER is using an accounting software package, which is capable of generating information needed to produce FMRs. UCER has hired consultants to configure the system to maintain IAS compliant general accounting data and to provide the information necessary to complete FMRs. Basic configuration has been completed and full-scale FMRs will be produced by no later than 45 (forty five) days after the end of the first semester after the effective date. (iii) Banking Arrangements / Special Account (SA). Although UCER has previous experience in operating SA for the Japanese PHRD Grant proceeds, the Borrower will open a separate new Special Account in US Dollars in a foreign commercial bank acceptable to the World Bank to receive the loan funds. For payments in hard currencies the Special Account may be used directly. To facilitate local payments in national currency, a separate transit account will be opened in a local commercial bank acceptable to the World Bank. To minimize potential losses arising from currency fluctuations, balances in the transit account will be maintained at a level not greater than that required to meet requirements in national currency for one month. The Special Account will be audited annually and the results will be available to the Bank.

- 16 - 5. Environmental: Environmental Category: C (Not Required) 5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (including consultation and disclosure) and the significant issues and their treatment emerging from this analysis. The project will have no direct impact on the environment. The Project does not deal with enterprises with severe problems (including environmental ones), which cannot be solved without large investments. For the purposes of Operational Directive 4.01, the project has, therefore, been placed in Category C and does not require an environmental assessment.

5.2 What are the main features of the EMP and are they adequate? N/A 5.3 For Category A and B projects, timeline and status of EA: Date of receipt of final draft: N/A 5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EA report on the environmental impacts and proposed environment management plan? Describe mechanisms of consultation that were used and which groups were consulted? N/A 5.5 What mechanisms have been established to monitor and evaluate the impact of the project on the environment? Do the indicators reflect the objectives and results of the EMP? N/A 6. Social: 6.1 Summarize key social issues relevant to the project objectives, and specify the project's social development outcomes. Enterprise restructuring may accelerate ongoing layoffs, which in turn may further deepen current social problems, particularly in cities whose economies depend on one factory. Structural reduction in employment has occurred to a lesser extent in Ukraine than in other FSU republics, thus increasing the social and political sensitivity to creating unemployment. The Program, at least in the first phase, will avoid these extreme situations. Participating enterprises will also be required to divest their social assets, removing another source of potential social conflict. Furthermore, as the experience of Moldova shows (see Box 3), after initial contraction, enterprises under restructuring start to grow and employ additional labor.

6.2 Participatory Approach: How are key stakeholders participating in the project? Project preparation missions worked closely with Government officials on shaping the Loan in the broader context of the proposed PSD strategy. Representatives of the GoU traveled to the oblasts with the project team, and were an integral part of decision making. The team also consulted with and discussed the project with some 50 privatized and private enterprises in 12 oblasts, numerous business organizations, and SROs.

The Team met with many Ukrainian consulting organizations, and held discussions with providers of management training. The Project Team held an extensive consultation with the IFC TA projects operating in Ukraine. Its Business Development, Corporate Governance and Unfinished Construction Sites projects laid a good foundation for the effective preparation of the PSD Loan. The PSD Program -- its objectives and components -- were presented to the media and the Program was discussed with present and potential foreign investors in Ukraine.

- 17- 6.3 How does the project involve consultations or collaboration with NGOs or other civil society organizations? The project aims to support already existing NGOs or create at least one NGO per oblast that will facilitate public-private dialogue. For example, during project preparation, the PSD team has been working closely with Podilya Pershi, an NGO that has been organizing meetings of entrepreneurs and local university representatives with the oblast administration to seek ways of improving the business environment.

6.4 What institutional arrangements have been provided to ensure the project achieves its social development outcomes? The Project would foster long-term social development in Ukraine by helping the Government and local oblast governments understand their role in supporting private sector development. In addition, the business management training programs will train a vast multitude of professionals and business leaders in the process of company restructuring, which will lead to financial sustainability and profitability for existing obsolete and loss-making enterprises.

6.5 How will the project monitor performance in terms of social development outcomes? The targets established for increased numbers of newly created and restructured enterprises that achieve financial sustainability, and the requirement that beneficiaries of the training programs publicly dissemninate their knowledge, will indicate the degree to which the social development objectives, including improved job opportunities for the general population, are achieved.

7. Safeguard Policies: 7.1 Do any of the following safeguard policies apply to the project? Policy Applicability Environmental Assessment (OP 4.01, BP 4.01, GP 4.01) 0 Yes * No Natural Habitats (OP 4.04, BP 4.04, GP 4.04) 0 Yes 0 No Forestry (OP 4.36, GP 4.36) 0 Yes 0 No Pest Management (OP 4.09) 0 Yes 0 No Cultural Property (OPN 11.03) 0 Yes 0 No Indigenous Peoples (OD 4.20) 0 Yes 0 No Involuntary Resettlement (OP/BP 4.12) 0 Yes 0 No Safety of Dams (OP 4.37, BP 4.37) 0 Yes 0 No Projects in International Waters (OP 7.50, BP 7.50, GP 7.50) 0 Yes 0 No Projects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60)* 0 Yes 0 No

7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies. N/A

- 18- F. Sustainability and Risks 1. Sustainability: The implementation agency should be sustainable after five years of operation (operational costs exclude the costs of foreign consultants). Restructured enterprises are expected to cover follow-up costs that may occur relating to continuous adjustment, finding investors and external financing, and training of staff. Even if progress on the project is deemed unsatisfactory to move to the second phase of the APL, the program will be successful because the training and assistance provided in the Phase One TA portion of the loan will leave behind a critical mass of trained Ukrainian managers, turnaround specialists, and restructured enterprises.

2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1): Risk Risk Rating Risk Mitigation Measure From Outputs to Objective Shortage of reasonably efficient M Up-front agreed list of candidates from selected enterprises as candidates for restructuring. oblasts. Shortage of good managers ready and able M Start with a group of managers already trained to participate in secondments abroad. locally by donor supported programs; intensive preparatory training locally; intensive marketing of the Program.

Worsening of overall business M Competition between participating oblasts; close environment cooperation with the state agencies responsible for regulations of business activities; deregulation and business friendly administrative practices used as triggers for the next loans within the APL structure. From Components to Outputs Lack of visible improvement in S Combination of qualified international participating companies in spite of consultants and local specialists. intensive TA. Lack of visible improvement in selected M Incentives for managers to gain best practice companies in spite of the buildup of new from the western enterprises to establish managerial and consulting skills. advantageous business linkages. Low impact of restructuring in terms of S Only oblasts with reasonably good environment spin-offs and start-ups because of high for SMEs are selected. costs of entry. Overall Risk Rating M Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk)

3. Possible Controversial Aspects: The main controversial aspects are related to the project design in the following areas: * possible govemment interference in the enterprise selection process;

- 19- * subsidies to enterprise restructuring undermiining the consultant market (based on full cost recovery of service provision); and * incentives of foreign consultants to transfer knowledge to local consultants. The project design incorporates these issues in the following way: Incentives for the Government to minimize its involvement in the enterprise selection process The risk of political interference in the process of selecting of enterprises is minimal as the Project is working only with 'best of the worst' enterprises. These are enterprises in which bureaucrats have little interest as the potential to extract further rents from them is low, yet enterprise management remains eager to restructure the firm and achieve profitability. An additional safeguard is a two-stage selection procedure. Out of initial candidates for restructuring, consultants select short list of potential enterprises. Short-listed enterprises are visited and assessed by two groups of consultants. Such 'second opinion' for short-listed enterprises assures impartial objectivity of selection, minimizes possible selection bias of consultants and raises credibility of selection process in the eyes of the govermment. Incentives for stakeholders to maximize cost recovery of consultant services Since firms selected for restructuring are firms operating at a loss, it is unrealistic to charge pre-set fees for consulting services. Instead, a graduated fee schedule will be used to create incentives for stakeholders (consultants, managers and the govemrnent to maximize cost recovery) to maximize cost recovery. Incentives for consultants Consultants are reimbursed 100% of the costs of services. A fixed percentage of fees they raise from the enterprise is their to keep as a strong power incentive to maximize cost recovery. Incentives for managers Managers would have more flexibility in selection of the scope, terms and areas of consulting services provided. Incentives for the government The Govermment contribution to the project comes from the cost recovery. This means that the govemment will have every incentive to maximize cost recovery and reduces the risk of the govemment insisting on restructuring of unviable enterprises, from which the cost recovery would be unlikely. Using and developing the local consulting market TORs for intemational consulting firm will contain a provision specifying that foreign companies should sub-contract local consulting companies or individuals for particular tasks in which they have comparative advantage. For example, such tasks might include local market research, business-planning, legal analysis, and other areas. In this way, local consulting firms and individuals will have opportunities for pressional development under competitive circumstances. The use of foreign consultants The main use of expensive foreign consultants will be for on-the-job training of local consultants, and, as needed, in the application of special skills, not available locally, to individual, specialized enterprise problems. To assure efficacy and efficiency of the on-the-job training (by foreign consultants as coaches to local consultant teams) foreign consultants will be placed in all four selected oblasts for the first two years of the project.

- 20 - Other controversial aspects include: Initial lay-offs in restructured companies may be controversial. However, the criteria for selection of restructured companies will lirmit the effects. Criteria for consideration will lirnit the negative effects if this. The strict selection criteria in the screening process will ensure that only private companies with a strong up-front commitment to thorough restructuring program by owners/managers are eligible. There could be possible conflicts between newly trained managers and managers opposed to company restructuring based on market principles. Minimizing this risk will depend upon selecting managers who have a clear and rational understanding of what is needed to ensure the future sustainability and profitability of the company. A Financial crisis in the regions could damage macroeconomic stability in Ukraine. The Project will closely monitor progress in related adjustment programs, particularly in the areas of banking and tax reform, and deregulation.

G. Main Loan Conditions 1. Effectiveness Condition The only additional condition of effectiveness is the execution of the Subsidiary Grant Agreement between the Borrower and UCER. For the Loan to become effective following the signing of the Loan Agreement, the Borrower will need to confirm that the Loan Agreement has been ratified by the Borrower's Verkhovna Rada and the Bank would need to receive a legal opinion in a satisfactory format from the Borrower's Minister of Justice confirming that the Loan Agreement has been duly authorized or ratified by, and executed and delivered on behalf of the Borrower and is legally binding on the Borrower in accordance with its terms. The following additional matters would need to be reflected in the legal opinions furnished to the Bank prior to loan effectiveness: that the Project Agreement has been duly authorized or executed by UCER, and is legally binding upon UCER in accordance with its terms; and that the Subsidiary Grant Agreement has been duly authorized or executed by the Borrower and UCER, and is legally binding upon the Borrower and UCER in accordance with its terms.

2. Other [classify according to covenant types used in the Legal Agreements.] Conditions of NeRotiations 1. All financial resources to cover project preparation are in place, the PPF Letter-Agreement is signed, and a separate foreign currency account is opened for deposit of PPF funds. 2. The Borrower contribution to the Project is defined and agreed. 3. Tax obligations applicable to the following transactions involving PSDL proceeds are clarified: * Operating costs; * Procurement of goods under international and national shopping; * Procurement of consultants services: i. local and foreign individual consultants; and

- 21 - ii. local and foreign consultants - legal entities. 1. The Terms of the PSDL are defined. 2. The PIU Operations Manual, including PIU staffing structure and duty responsibilities have been reviewed and approved by the Bank. 3. The PIU financial management system, capable of producing Financial Monitoring Reports, has been approved by the Bank. 4. The Project Procurement Plan for the PSDL has been approved by the Bank. 5. Separate UAH account is opened for funds from the local budgets and beneficiary enterprises. Agreements reachedat Negotiations: 1. Project financial management issues: (i) formats of Financial Monitoring Reports (FMRs); (ii) timetable for submission of FMRs to the Bank; and (iii) terms of reference (TORs) for UCER and the project annual audits. 2. Procurement would follow the procedures described in Annex 6 of this document and in Schedule 1 of the Project Agreement. 3. Project implementation, monitoring and reporting would follow the procedures described in Section C4 of this document and in Schedule 2 of the Project Agreement. 4. Project disbursement would follow the procedures described in Annex 6 of this document and in Schedule 1 of the Loan Agreement. 5. The Borrower will have the financial records, accounts and financial statements related to the Project for each fiscal year audited and will submit a certified audit report to the Bank within six months after the end of each fiscal year and also at the closing of the Project. 6. UCER will maintain policies and procedures adequate to monitor and evaluate on an ongoing basis, in accordance with indicators satisfactory to the Bank, the carrying out of the Project and the achievement of the Project's objectives, and the measures under the Program. 7. UCER will prepare, on the basis of guidelines acceptable to the Bank, and furnish to the Borrower and to the Bank, not later than six (6) months before the Closing Date or such later date as may be agreed for this purpose between the Borrower and the Bank, a plan for the future operation of the Project. 8. UCER will adopt the new Financial Monitoring Report (FMR) System - instead of the Project Management Report System - that was identified during the Project Appraisal. The FMR should be produced by UCER every 6 months beginning 6 months after the date on which the Loan becomes effective. For purposes of the form and substance referred to in Section 4.02 of the Project Agreement, in addition to the 3 FMRs generated from UCER's accounting system (as specified in the Operations Manual), UCER will also furnish to the Bank a report linking physical progress with expenditures incurred to date. 9. The Borrower will submit its annual work plans and Project budgets for each next year of Project implementation not later than November 30 of each year for review by the Bank. 10. UCER will select a long list of enterprises in each oblast of Ukraine, and consultants shall select enterprises for restructuring from this list subject to UCER's approval. 11. Advance payment to consultants will be made for enterprises' diagnostics and drafting of the action plan. Every action plan shall contain, among other items as deliverables, the planned:

- 22 - * increase in taxes paid by the enterprise; increase/decrease in jobs; * increase in sales; and * decrease in enterprise debts. 12. Payment for consultant services shall be made on a quarterly basis triggered by progress on deliverables under the action plan. 13. Salaries for UCER staff shall be competitive enough to attract sufficiently high qualified staff from the local labor market. 14. UCER staff shall be selected on a competitive basis and hired pursuant to contracts.

H. Readiness for Implementation

5 1. a) The engineering design docurnents for the first year's activities are complete and ready for the start of project implementation. Z 1. b) Not applicable.

Z 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. 1 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality. El 4. The following items are lacking and are discussed under loan conditions (Section G):

1. Compliance with Bank Policies 2 1. This project complies with all applicable Bank policies. O 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies.

aled Sherif Luca Barbone Team LeHr Sector Ma4el Country Director

- 23 - Annex 1: Project Design Summary UKRAINE: Private Sector Development Key Performance Data Collection Strategy Hierarchy of Objectives Indicators Critical Assumptions Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission) Sustainable economic Share of GDP and Publicly available statistical Macroeconomic stability growth through private employment generated by data at central and selected maintained, strengthened sector development the private sector oblasts level fiscal position of the central and local governments

Program Purpose: End-of-Program Indicators: Program reports: (from Purpose to Goal) To foster private sector Increased industrial output Bank and independent Business environment development in Ukraine and GDP growth studies, official statistical improved; competitiveness data of the Ukraine's private sector increased

Project Development Outcome / Impact Project reports: (from Objective to Purpose) Objective: Indicators: Increase competitiveness of *rate of growth of SMEs in Bank and independent Genuine support to private the Ukraine enterprise pilot oblasts; studies sector on political, sector *rate of growth of output of legislative, and central and private sector in pilot oblasts administrative levels oblasts; and 0 value/added per employee in restructured enterprises

Output from each Output Indicators: Project reports: (from Outputs to Objective) Component: About 200 restructured * the number of Bank and independent Availability of reasonably privatized enterprises; new restructured enterprises; studies, data from the efficient enterprises as SMEs as spin-offs of * the number of created implementation agency candidates for restructuring. restructured enterprises SMEs; * the number of trained managers, and * the number of trained consultants. Professionally trained Availability of good managers able to respond to managers ready and able to market challenges; and participate in secondments on-the-job trained Ukrainian abroad. enterprise restructuring

- 24 - consultants

Business friendly Cost of doing business Improvement in overall regulations and institutions surveys business climate for SMEs

Project Components / Inputs: (budget for each Project reports: (from Components to Sub-components: component) Outputs) Enterprise Restructuring USD 24 million Data from the Visible improvement in (market adjustment) implementation agency, selected companies due to supervision missions' the intensive TA reports Managerial and Consulting USD 11.5 million Data from the Visible improvement in Secondments implementation agency, selected companies due to supervision missions' the buildup of new reports managerial and consulting skills

Monitoring and Project USD 1.38 million Financial Monitoring Effective implementation of Administration reports, supervision the project and providing missions' reports information on the project results

Improvement of Regulatory USD 0.82 million Regulatory indicators from Ability of the Bank and the Environment bi-annual oblast-level cost PIU to stick to of doing business surveys predetermined exit criteria of the Projects from the oblasts

- 25 - Annex 2: Detailed Project Description UKRAINE: Private Sector Development By Component:

Project Component I - US$24.00 million Enterprise Restructuring (market adjustment) - US$ 24.00 million (of which US$ 19.00 mln. is Bank financing ) Obiectives (i) To support and help accelerate Government's reform effort by: (a) providing advisory services through a local non-profit agency (Ukrainian Center for Enterprise Restructuring and Private Sector Development - UCER) aimed at improving the profitability, productivity, and general operational, financial and managerial efficiency of private and privatized enterprises; (b) supporting and facilitating development of a highly qualified domestic consulting industry, which thoroughly understands the unique local business and political climate in the process of economic development and transition; and (ii) To strengthen constituency for reform at the oblast level consisting of entrepreneurs, managers, local academia, consultants and other stakeholders benefiting from enterprise restructuring and market-friendly business environment. Background: The majority of Ukrainian newly privatized enterprises are facing a severe crisis situation. First, the lack of coherent state policies to support private sector development, together with the myriad of existing tax laws and administrative procedures make any conduct of legitimate business almost impractical and unprofitable. Secondly, enterprise owners have deferred downsizing of business in anticipation of possible re-emergence of various forms of state support. Therefore, old channels and methods of doing business continue to prevail, and the little restructuring, which has occurred is only a passive response to the rapidly changing business environment. Confronted with this range of insurmountable obstacles, together with the underproduction of marketable products, scarcity of working or investment capital, lack of skills needed to penetrate foreign markets, and predatory business environment - many new owners/managers opt for short-term rent seeking, which results in pushing enterprises deeper into crises. Uncertain business conditions keep foreign investors at bay, while local investors focus on those few sectors (metallurgy, chemicals, energy), which can still turn a profit, primarily due to continued subsidies and other privileges, which permnit below-market pricing. It is only in the past two years that the Ukrainian enterprise sector has begun to register economic growth after almost 1O years of contraction. The Govemment of Ukraine is determined to accelerate this enterprise adjustment process by funding the training of about 600 Ukrainian business consultants who will provide solid business advice to about 200 enterprises. To achieve a critical mass of restructured enterprises, the first phase of this project will focus on four selected oblasts - Chemovtsy, Khmelnitsky, Volyn and Zhitomnir. The pilot oblasts were selected because they have demonstrated their commitment to project objectives by taking significant steps to eliminate those administrative and regulatory barriers within their control, which impede enterprise development, including minimizing predatory and corrupt actions of local officials. To this end, administration officials in these oblasts have agreed to participate in regular and continuing dialogue with interested parties of the private sector (entrepreneurs and other leaders), the process of which will be institutionalized through the creation of oblast-level NGOs. Enterprises will be selected as recipients of advisory services financed under the Loan in accordance with

-26 - the following criteria: (a) the degree to which shares of the enterprise are owned by non-insiders (i.e., investment funds or banks), and where shareholders' commitment to real restructuring with the goal of increased profitability and efficiency of the enterprise is demonstrated; (b) the willingness of management to: collaborate with the external consultants, to pennit access to all necessary company information/data, and to contribute to the costs of such advisory services (including in kind support); (c) the degree to which profitability improvements can be reasonably achieved within the constraints of existing equipment and technology, through managerial, organizational, accounting, financial and marketing improvements, and require little or no initial capital investment; and (d) the degree to which enterprises are free from state control, such as price controls, restrictions on sales, and dependence on monopoly state-owned supplier. The participating enterprises will be expected to: (a) vest the new management team with appropriately broad authority to sell assets, reduce the workforce, cut costs, renegotiate debts, enter into new contracts and discontinue unproductive contractual relations with suppliers and buyers; (b) provide consultants with all requested information and data; and (c) implement the tumaround program recomnmended by the consultant and agreed with UCER, or sell assets to cover payments for overdue tax obligations in accordance with orders of the State Tax Administration. Financing and Costs Recovery. The advisory service costs for each assignment will be estimated by UCER and approved by the World Bank. UCER will pay the consultants from the Bank's Loan proceeds. UCER will be responsible for direct payment of 100 percent of the fees and expenses of the advisory services to the consultant selected for the assignment. Participating enterprises are required to reimburse UCER no less than 10 percent of total costs of advisory services paid to the consultant, subject to justified exceptions in UCER's discretion. The proceeds collected from the contribution of the enterprises shall be used to cover UCER's operational costs. It is expected that by the end of the third year of operation, at least 30 percent of UCER's indirect operating costs (i.e. excluding domestic consultants employed by UCER and working on particular projects) will be covered from the revenues and no less than 50 percent of the costs will come from the UCER's revenues after its third year of operation. The amounts to be paid by beneficiary enterprises to UCER shall be explicitly stipulated, along with a schedule of payments, in a contract signed between UCER and the enterprise before the start of the consulting assignment. The following incentives have been built into the project: Incentives for the Government to minimize its involvement in the enterprise selection process The risk of political interference in the process of selecting subject enterprises is minimal as the Project works only with 'best of the worst' enterprises - firms in which the rents have already been exhausted and the bureaucrats have no interest in (they are the worst in terms of rents opportunities) yet with the management eager to restructure (in this sense they are the best). An additional safeguard is a two-stage procedure of selection. Out of initial candidates for restructuring, consultants select short list of potential enterprises. Short-listed enterprises are visited and assessed by two groups of consultants. Such 'second opinion' for short-listed enterprises assures impartial objectivity of selection, minimizes possible selection bias of consultants and raises credibility of selection process in the

- 27 - eyes of the government. Incentives for stakeholders to maximize cost recovery of consultants' services Since in the beginning of restructuring many enterprises are loss-makers, to impose a predetermined schedule of the fees is unrealistic. Instead, a graduated fee schedule will be used to provide incentives for stakeholders (consultants, managers and government officials) to maximize cost recovery. Incentives for consultants Consultants are reimbursed 100% of the costs of services. A fixed percentage of fees they raise from the enterprise is their to keep as a high power incentive to maximize cost recovery. Incentives for managers Managers would have more flexibility in selection of the scope, terms and areas of consulting services provided. Incentives for the government Government contribution to the project comes from the cost recovery. This means that the government will have every incentive to maximize cost recovery and reduces the risk of the government insisting on restructuring of unviable enterprises (the cost for which would be unlikely). Incentives for developing the local consulting market. TORs for intemational consulting firms will contain a provision specifying that foreign companis should sub-contract local consulting companies or individuals for particular tasks in which they have comparative advantage. For example, such tasks might include local market research, business-planning, legal analysis, and other areas. In this way, local consulting firms and idividuals weill have opportunities for professional development under competitive circumstances. Incentives for foreign consultants to train and mentor the local consultants The main use of expensive foreign consultants will be for on-the-job training of local consultants, and, as needed, in the application of special skills, not available locally, to individual, specialized enterprise problems. To assure efficacy and efficiency of the on-the-job training (foreign consultants as coaches to local consultant teams) the project suggests to place foreign consultants, in all four selected oblasts, at least for the first two years of the project.

Project Component 2 - US$11.50 million Managerial and Consulting Secondments - US$ 11.50 million (of which US $9.00 mln of Bank financing) Objective: The objective of this component is to expose the managers and consultants to new concepts of market-oriented management, marketing and production through practical intemships in leading firms abroad. This will be followed by dissemination of main lessons learned abroad to participating as well as non-participating firms in Ukraine. In this way, this program will offer a more broadly-balanced approach to company restructuring than that practiced today in which restructuring experts come from primarily Westem developed countries. It has become apparent that company restructuring in a transition economy requires more specialized skills and experience than in Westem economies. This program will endeavor to send large numbers of Ukrainian managers and consultants to advanced companies in developed countries or countries with transition economies, which have successfully restructured their enterprises. The program has its precedence in the very successful post- world war II Marshall Plan TA Component when West European managers visited the USA. As a direct consequence of the original Marshall Plan non-capital

- 28 - productivity increased in individual firms by 25 to 50%. In the participating oblasts -- none of which has access to energy generated rents-- the expected improvement is likely to be higher due to the severe misallocation of assets inherited from central planning, the low current level of management training, and the huge drop in production over the last 10 years. Synergy with the Enterprise Restructuring Component Company turn-around (i.e. achieving financial sustainability through restructuring), to be accomplished by the first component of the project will increase the demand for management training and the need for more customers and supplier from more developed market economies. Successful management training, including placement of Ukrainian managers into foreign companies, financed by this component will radically increase effectiveness of restructuring work and performance of companies. Under this component, the implementing agency, UCER, will design, subcontract and supervise in-house training courses for selected candidates including: study of one major commercial language, computer skills (word processing, spreadsheet, presentation package, Internet), and basic management and business communication skills. It is expected that approximately 400 participants will complete these introductory courses, from which candidates will be selected for secondment to selected foreign firms to see how skills, organization and technology are combined to respond to the continuously changing market demands. Candidates will be required to complete a rigorous and demanding work program. To ensure transparency, the final secondment assignments will be made by a Selection Committee representing UCER, the Government, self-regulating consulting organizations (SROs), as well as leaders of the banking and enterprise sectors. To minimize costs and maximize the synergy effect, participants will be required, upon the completion of their consultant training and secondment programs, to proactively contribute to disseminating their knowledge and experience to the business community at large. Participants will be organized into groups, which will consist of up to three members visiting the same host firm. For training purposes, two to four groups can be combined. The secondment period will be divided into two modules: a 6 to 12-week Basic Module and a 4 to 8-week Optional Module. A standard week work load will be as follows: (a) four days in the host firm on-the-job training, (b) one day of in-class training based on case studies and specific management courses, and (c) one day of report preparation. The second (optional) module would consist of visits to other leading firms. Upon return and completion of the modules, the groups will prepare, with the assistance of UCER, a written report on the operations of the visited firm, including quality control, job structure and management, accounting and financing systems, marketing channels and techniques, and export promotion. They will convene a series of workshops, wide enough to secure a broad dissemination of new know-how acquired by the seconded participants. They will also assist UCER in the preparation of further secondments and follow-up activities. The targeted participants are medium-to-senior-level managers of private and privatized enterprises from industrial and agro- processing sectors with a strong motivation to leam, and consultants with exposure to enterprise restructuring. They must have basic competency in English or another commercial language, basic computer skills and knowledge of management techniques or they could have successfully completed the pre-placement training. Eligible firms willing to designate managers for the program have to be without any overdue obligation to the state budget, or privatized firms in the process of restructuring. The participating firms would be expected to cover all local costs during the first and the last blocks of

- 29 - training (pre-placement training and dissemination of lessons learned). To secure participation of SMEs - which can economically justify only very small expenditures on training - in exceptional cases and upon a decision of the Supervisory Board of UCER, a larger part of secondment costs may be covered by the PSD Loan funds or grant financing. Costs of local training (approximately US$ 2,000) would be borne by participants themselves or their companies. Placement of some 350 managers into Central European countries would cost some US$ 4.7 million, including the costs of establishing and maintaining training related UCER activities for three years (four senior local staff, 10 part-time, young professionals involved in secondments as interpreters and learning on their own, partly financed from the Program, two support staff, and start-up costs). The German Technical Assistance NGO now operating in Moldova ("GTZ"), which has substantial experience in placing Moldavian managers in secondment assignments, has offered to place a pilot group of Ukrainian managers on a trial basis. The announcement of this possibility in pilot regions has already generated large demand.

Project Component 3 - US$ 1.38 million Monitoring and Project Administration - US$ 1.38 mln. (of which US$ 0.88 mln. of Bank financing) The project will be administered by a non-profit organization, the Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER). UCER will sub-contract restructuring assistance to be provided to participating enterprises to the best available international, turn-around consulting firms. UCER has five principle functions: (a) Selecting appropriate enterprises, and ensuring rational implementation of a restructuring framework plan, which sets forth the various obligations and commitments of the enterprise (with specific targets, dates and deadlines), realistic financing plans, and agreed sanctions for non-compliance; (b) Managing the work of consulting teams including: preparation of Terms of Reference (TORs); selection of consulting firms; supervision of consultants' work progress and deliverables; intermediation between enterprises and consultants in cases of the conflict; final quality of approval of consultants' work; and payment for consultants services; (c) Perpetuating continuous and productive dialogue between the Govenmuent and private sector (through the UCER Supervisory Board) concerning necessary reform measures to facilitate enterprise adjustment to markets; (d) Selecting, recruiting and training local specialists that will team-up with foreign consultants to ensure the advice/resources of foreign consultants are most effectively utilized and directed where needed; (e) Organizing on-the-job training for managers of participating enterprises in the leading firms abroad; Activities: Contracting Consultants. UCER will prepare TORs for the assistance provided by international consulting firms. TORs under which such foreign assistance will be provided, will be funded and approved by the Bank, and used to procure consulting services under the proposed Loan. UCER will conduct open, competitive tenders for the advisory services of outside consultants. Contracts will be awarded through Quality and Cost-Based Selection (QCBS) to those firms that have a proven record of work in transition economies, and according to the procedures specified in the World Bank's "Selection and Employment of Consultants by World Bank Borrowers" dated January 1997, revised

- 30 - September 1997 and January 1999. An Evaluation Committee will be formed to review the proposals submitted by consultants and select the winner according to Bank procedures. The Evaluation Committee will include representatives of the UCER Supervisory Board, UCER Executive Director, and an independent observer. The results of the selection will be forwarded to the World Bank for review and no-objection before final contracts are awarded. UCER may also contract ad hoc consultants as needed, in accordance with Bank procurement rules and no-objection procedures. Selecting Enterprises. UCER staff, supported by outside consultants as needed, will carry out the initial diagnostic studies of enterprises that are candidates for receiving assistance under the project. The purpose of the diagnostic study is to identify and prioritize the enterprise's needs for the advisory services, and assess the receptivity of management to outside consulting advice, which will ultimately require difficult restructuring decisions. The diagnostic study will deternnine whether the efficiency of the enterprise can be improved without a significant capital investment. If it is determined that this is not possible within the circumstances, UCER will provide no further consulting assistance to the company. The duration of the diagnostic study will depend on the size and complexity of the enterprise and other factors.

Project Component 4 - US$0.82 million Improvement of Regulatory Environment- US 0.82 mln. (of which 0.82 mln. of Bank financing) Objective To assist Ukrainian Government and provide strong incentives for oblast authorities to improve regulatory environment. This will be achieved by: * Introduction of performance based incentives into the oblast-level policy process - linking and exit from the project to the improvement of regulatory environment, monitored through bi-annual surveys; * Enhancement of institutional capacity of SCRPE to effectively implement State regulatory policy through its regional offices; and * Empowering institutions of Civil Society and especially professional associations in their relations with local authorities and building local capacity to conduct credible policy research, analyze data and use it for the policy purposes. Sub-component: Performance-basedincentives for regional deregulation The key element of this sub-component is regular monitoring of the quality of regulatory environment in the regions. It will be assessed by using the series of indicators that will be measured by the survey-based research and analysis. The values and dynamics of these indicators will be used as criteria for the exit from the project of the oblasts where efforts of Regional Administrations to improve regulatory environment will be lower then in other regions. Regulatory environment indicators can be best used in regional comparison or in the time-series that allow assessment of their dynamics. In other words, absolute values of these indicators, despite significant utility in rising awareness among government and community about the levels of the regulatory problems that regulators face, are not entirely reliable tool for policy purposes. Research errors and shortcomings can subject them to serious criticism and undermine their reliability. Their comparison across regions and especially their dynamics over time, on the other hand, minimize embedded research errors and serve as a reliable illustration of the outcomes of regional governments efforts to reform their regulatory environment. In order to use such indicators, annual surveys will be conducted for the duration of the project in all

- 31 - regions. In the pilot regions, however such surveys will be conducted on a semi-annual basis. Every time the survey is conducted and analyzed, an aggregate indicator of the overall costs of regulations for an average enterprise will be assessed. The value of this indicator will be used as a key element of an exit strategy from an under-performing region. Exit strategy is characterized by three features: * Credible threat of exit. At most, the project will exit from one region only. It is the credible threat of exit, which acts as a performance incentive for regional administrations to decrease the regulatory burden; * Possibility of reallocation of project activities from the dropped oblast into other oblasts of the project. In case of exit, the project (i.e. public subsidies for consultants' activities) will reallocate its activities to better performing oblasts. Consultants' activities in the dropped region will continue if the enterprises are willing to hire the consultants on full cost recovery basis; and * Transparent criteria of exit. In 18 months after the project effectiveness, the worst (by absolute cost of doing business) of the 4 original oblasts in accordance with the survey methodology stated in Box 4 would be dropped from the project, and the consultants from the unsuccessful oblast would be re-located to a performing oblast; unless the worst of the original four oblasts is either one of the six best oblasts of Ukraine by absolute cost of doing business or one of the six best oblasts that shows the better improvement in reducing cost of doing business. The regional survey will cover the following main groups of indicators (full description of the survey methodology available in project files): 1) Business registration - cost (for all areas, cost includes in time and formal and informal types of payments and contributions, including bribes), procedures required, delays 2) Business licensing - number and type required, cost, time and payments required 3) Obtaining business premises - procedure, costs, constraints, delays 4) Import and Export regulation, Customs - procedures, costs, delays 5) Product, input and equipment certification - types, incidence, procedures, costs, delays 6) Tax administration - requirements, constraints, costs, number of taxes and forms 7) Business inspections - types (and agency responsible), costs, number, process followed. Box 4 Regulatory Cost Assessment Methodology Sampling Each survey will be conducted among representative semi-structured sample of at least 70 active businesses per region. In order to ensure time-series reliability these samples will be drawn from the regional sample pool of 300 enterprises that in tum will be drawn from the database of the State Tax Administration. The sample pools will be structured by 3 size classes of enterprises (1- 10 employees; 11- 50 employees; and more than 50 employees). Each class will have a quota that will correlate with the total number of respective active enterprises in the region. All survey samples will be randomly drawn from within these quotas in the sampling pool. Conducting the survey

- 32 - An organization will be selected by open competition which will be responsible for conducting all surveys. The selection criteria will include: 1. Availability of trained professionals with prior experience in similar survey research; 2. Access to the national framework of trained interviewers (preferably these interviewers should be organized by local business associations or other civil society institutions). Interviewers cannot be state employees; 3. Effective system of quality control; 4. Availability of hardware and software for data input and analysis; 5. Preferably this organization should be not for profit and have prior record of policy work and cooperation with business associations and governmental institutions; 6. Quality of methodological suggestions; and 7. Price for conducting the survey. After organization is selected, it will review the questionnaire and methodology with UCER, SCRPE and the World Bank representatives. This will be followed by instruction session for interviewers managers from all regions. Pilot surveys will be conducted with three-five interviews in every region. This will be followed by the final review of the questionnaire and the beginning of survey interviews. Surveys will be conducted in the face-to-face interviews with operating managers of sampled businesses. A questionnaire with exclusively close-ended questions will be filled by interviewers and sent to Kyiv for the centralized data input and analysis. UCER will require selected research organization to execute effective quality control through selective contacts with respondents and confirming the fact of interviews. Data analysis and presentation The purpose of this survey vehicle is to assess the values of regulatory costs indicators (by type of regulation) and the value of aggregate indicator of overall regulatory cost for an average enterprise. Survey will assess the costs of the following types of regulations: I. Business registration in all required agencies; 2. Regulations of the premises and their use: Land usage Construction Renovation and remodeling Change of function Other usage permits 3. Licensing; 4. Imported equipment regulations; 5. Export/Import regulations; 6. Certification of production and services; 7. Tax administration;

- 33 - 8. Price regulations; 9. Employment regulations; 10. Regulations of contracts and trade; 11. Regulations that require other additional reporting. Assessed costs will consist of Direct Costs of following regulations (DC), and Indirect Costs (IC). 1. DC of compliance with any procedure is the amount of payment that an enterprise has to pay in order to comply with the procedure (e.g., obtaining registration certificates, licenses, other certificates or permits). It includes both official and unofficial payments aimed to accelerate a procedure or facilitate its consequences for the enterprise. Direct Official Cost, consists of the following types of payments: official fees, notary fees, other official payment needed to comply with procedures. The second component is Direct Unofficial Cost, consisting of "voluntary contributions" and bribes. Sometimes businesses must obtain permits or comply with procedure of several state agencies. In that case, they will be asked about the direct cost for each body and each type of payment. These costs will be calculated for each enterprise and then the average will be taken. Only those enterprises that reported at least one cost component will be taken into account. This method is more precise than simple summing of averages for each component. 2. IC is all indirect expenses that enterprise has in order to comply with a given procedure. First of all, this includes the Staff Time Cost. Interviewers will calculate staff Time at the field stage of the survey. Then it will be multiplied with the average wage for the whole economy (excluding agriculture) at the time the survey is conducted. Total Cost (the sum of DC and IC) will be calculated for each enterprise, with following calculation of the mean for all enterprises.

-34 - Annex 3: Estimated Project Costs UKRAINE: Private Sector Development

Local Foreign Total Project Cost By Component US $million US $million US $million Enterprise Restructuring (market adjustment) 6.00 18.00 24.00 Managerial and Consulting Secondments 0.54 10.96 11.50 Monitoring and Project Administration 1.20 0.18 1.38 Improvement of Regulatory Environment 0.72 0.10 0.82 Total Baseline Cost 8.46 29.24 37.70 Physical Contingencies 0.00 0.00 0.00 Price Contingencies 0.00 0.00 0.00 Total Project Costs' 8.46 29.24 37.70 Front-end fee 0.30 0.30 Total Financing Required 8.46 29.54 38.00

Local Foreign Total Project Cost By Category US $million US $million US $million Goods 0.10 0.28 0.38 Works 0.00 0.00 0.00 Services 7.36 28.96 36.32 Incremental Operating Costs 1.00 0.00 1.00 Total Project Costs' 8.46 29.24 37.70

Front-end fee _ 0.30 0.30 Total Financing Required 8.46 29.54 38.00

Identifiable taxes and duties are O (US$m) and the total project cost, net of taxes, is 38 (US$m). Therefore, the project cost sharing ratio is 78.95% of total project cost net of taxes.

- 35 - Annex 4: Cost Benefit Analysis Summary UKRAINE: Private Sector Development

[For projects with benefits that are measured in monetary terms]

Present Value of Flows Fiscal Impact Economic Financial Analysis Analysis Taxes Subsidies Benefits: 20,946,525.43 20,946,525.43 20,946,525.43 n/A in USD

Costs: 20,911,908.47 20,911,908.47 20,911,908.47 n/a in USDI Net Benefits: 34,616.96 34,616.96 N/A n/a in USD IRR: 9.733% 9.733%

The assumed discount rate is 10%

If the difference between the present value of financial and economic flows is large and cannot be explained by taxes and subsidies, a brief explanation of the difference is warranted, e.g. "The value of financial benefits is less than that of economic benefits because of controls on electricity tariffs."

Summary of Benefits and Costs: I. Costs A. To Society: 1. Monetary a. For one enterprise assumed costs of technical assistance are the following: Assumptions on the costs of enterprise assistance

Direct costs of assistance per enterprise USD 100,000 Direct costs including overheads of Project USD 115,000 management Full costs (including the Marshal plan training and USD 187,450 all other project components)

b. The total cost for restructuring each of 100 enterprises is the present value (PV) of the cash outflows starting from the year 1 to year 20. These are: (a) one percent front-end fee payable at the commencement of the project; (b) interest on the US $30,000,00 for first five years and then interest on remaining principal; and (c) repayment of the principal from the year 6 to year 20. (These are assumptions that are likely to overstate the actual costs,i.e. the actual net benefit could be higher)

- 36 - The table in the end of this Annex presents the calculation of the project's net present value (NPV) with the sensitivity analyses. The outcome of analysis is based on uncertain future events. The following variables critically affect the stream of discounted cash flow: i. Sales per year at a starting time of the project; ii. Percentage increase of the sales in the first year of the project; iii. Percentage increase of the sales per year in the remaining 19 years, in the enterprises that survive; iv. Percentage decrease of the sales per year, in the enterprises that fail after 5 and 10 years; v. Discount rate. 2. Non - Monetary and Indirect Monetary costs: a. Increased number of unemployed in a short-run after downsizing, break-up or closure of companies; b. Enhancement of populist policy argument that IFIs are "destroying the industrial power" of the country. 3. Forgone opportunities: a. Forgone interest revenues; b. Other use of money that would affect private sector development as: restructuring and privatization of state enterprises, support development of business incubators, etc. 4. DistributionalEffects: The project can not cover all enterprises that could qualify for the restructuring assistance. The competitive position of the remaining enterprises may be adversely affected by the project, although they will be under pressure to improve performance in order not to lose the local market share. While in this increased competition some enterprises may further contract and even close with social consequences (lost jobs, redistribution of welfare etc.) more enterprises are expected to "pick up" positive restructuring experiences from project beneficiaries and initiate turnaround processes. B. Costs to enterprises: 1. Monetary Costs: US$ 6,000-10,000 per enterprise should be paid for services received (or 10% of the technical assistance); 2. Forgone opportunity to finance business. 11. Benefits A. Direct and Indirect Monetary Benefits 1. To enterprises a. Increased incremental positive cash flow, which can be used for financing of the business and which then increases chances for medium-term survival: in the absence of post-privatization restructuring, enterprises likely to continue contracting and eventually

- 37 - die; b. Increased productivity: value added per employee of 30 percent or more; c. Increased profitability of enterprise: profit margin, return to assets, etc.; d. Increased market share; e. Increased exports; f. Reduction of production costs; g. Increased investments in the human capital of an enterprise, which eventually increase a return to financial investments; h. Reduction of future costs for qualified consulting services, since the enterprises can afford to pay consultants trained by the project. 2. To society: a. Increase in the overall performance of the enterprise sector in the region; b. Increased revenues to the budget directly from enterprises benefiting from the project, and indirectly from enterprises, which improves their performance through spillover effect; c. Increased exports through improved competitiveness of enterprises; d. Increased number of local highly qualified consultants in finance, management, marketing, and operations, which saves finances for education, and enhances local quality of business management expertise; e. Shift from a barter dominant mode of operation to a cash mode; f. Reduced spending on foreign consultants, substituted by Ukrainians trained through this project. B. Non-monetary benefits to society a. The project helps to reveal problems in the real sector; it addresses lack of understanding of processes at the micro level that can mislead economic policy decision-makers; b. Better understanding of reforns at micro level and strengthening of pro-reform lobbies; c. Immediate demonstration effect locally and spreading demonstration effect nationally; d. Release of unused and underutilized assets to new owners who are more likely to use them productively - creation of a market for machinery and industrial/services space; e. Accelerated entry of SMEs through break-up and spin-offs of non-core businesses; f. Spinning of 3-5 viable SMEs per enterprise. The spin-offs eventually increase the number of SMEs in real sector. g. Significant energy savings for the economy; h. Strengthening of consulting business. The calculation of NPV only of the monetary part shows that from the fiscal point of view, the project has a strong positive impact. (see table below).

-38 - Main Assumptions: Taking into account the experience of similar projects in Georgia and Moldova, the assumptions used for this analysis are quite conservative. (A) Both countries achieved increases in sales and value added per employee were higher than the figures used for this calculation; (B) In both countries, the degree of the contraction of the industrial output was higher (enterprises in Ukraine are generally in better shape today than was the case in Moldova in 1994 or Georgia in 1997 when post-privatization restructuring projects were started), and (C) The size of the Ukrainian market is over 10 times bigger than in Georgia or Moldova. It is assumed that: (1) In 20 percent of restructured enterprises which would participate in the project, there would be very limited positive monetary impact (negative impact can be excluded) and these firms would close after year five. The assumption is based on the results of the current project in Georgia. In Moldova, after restructuring was completed under a similar project, in the first fifty restructured companies restructured, only one failed (but over 300 new SMEs were created - see Box 3). The analysis considers the increase in sales, and consequently in value added tax (VAT) payments to the government as the only positive monetary outcome of the project, although cash payments to the government may come also from the increase in profits, salaries, employment, debt payments to the budget, etc. (2) VAT does not change during the 20 years from the beginning of the project. (3) After ten years from the beginning of the project additional 20 percent of restructured enterprises are likely to close. (4) Assumed interest rate is 6.0 percent, grace period is 5 years and the government makes the repayments of principal from year 6 to 20. (5) Hyper-inflation and other macro crises that could ruin the economy are excluded. (6) Discount rate used is 10 percent. The lowest commercial lending rate used in FSU by the commercial banks with EBRD credit lines is above 20 percent. That gives the basis to consider 20 % as an opportunity cost for the government granting 187,450 US$ to enterprises. (7) Barter is not excluded from sales, however it is assumed that the incremental sales resulting from successful restructuring are increasingly cash sales.

Sensitivity analysis / Switching values of critical items: Sensitivity analyses uses different values for the discount rate and the factors that affects the amount of sales needed to get positive NPV for the project. The calculations show that in order to get positive NPV (discounted for 20 years at 10%), a yearly incremental VAT payment per enterprise of about US$ 20,000 is required. Since the Project in 20 percent of enterprises fails after five and in 20 percent after ten years, the table below tracks the costs and expected benefits of restructuring of 100 enterprises. Enterprises are divided into three groups: 1. 64 enterprises that survive 20 years, 2. 16 enterprises that survive 10 years, and 3. 20 enterprises that survive only five years.

- 39 - Given that restructuring assistance will be provided to the best enterprises only these assumptions are considered conservative.

YEAR COSTS VAT NET in current US$ in current US$ in current US$ 1 2,099,440 2,691,456 592,016 2 1,799,520 2,650,145 850,625.3 3 1,799,520 2,614,567 815,046.9 4 1,799,520 2,584,220 784,700.3 5 1,799,520 2,558,646 759,126.2 6 3,559,052 2,352,632 -1,206,416 7 3,439,084 2,353,884 -1,085,199 8 3,319,116 2,356,928 -962,187.7 9 3,199,148 2,361,640 -837,504.4 10 3,079,180 2,367,913 -711,266.8 11 2,959,212 2,212,497 -746,714.7 12 2,839,244 2,234,620 -604,620.5 13 2,719,276 2,256,968 -462,307.1 14 2,599,308 2,279,538 -319,769.5 15 2,479,340 2,302,332 - 177,005 16 2,359,372 2,325,355 -34,016.14 17 2,239,404 2,348,608 109,207.4 18 2,119,436 2,372,096 252,660.4 19 1,999,468 2,395,816 396,350.8 20 1,879,500 2,419,775 540,275.9

-40 - Annex 5: Financial Summary UKRAINE: Private Sector Development Years Ending June 30 (USD million) IMPLEMENTATION PERIOD | Year I I Year 2 | Year 3 | Year 4 | Year 5 1 Year 6 | Year 7 Total Financing Required Project Costs Investment Costs 1.3 5.3 14.5 5.2 9.8 0.0 0.0 Recurrent Costs 0.2 0.4 0.4 0.4 0.2 0.0 0.0 Total Project Costs 1.5 5.7 14.9 5.6 10.0 0.0 0.0 Front-end fee 0.3 0.0 0.0 0.0 0.0 0.0 0.0 ,Total Financing 1.8 5.7 14.9 5.6 10.0 0.0 0.0 Financing IBRDIlDA 0.6 4.4 12.3 4.2 8.5 0.0 0.0 Government 0.1 0.2 0.4 0.5 0.3 0.0 0.0 Central 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Provincial 0.1 0.2 0.4 0.5 0.3 0.0 0.0 Co-financiers Beneficiary Enterprises 0.1 0.1 0.2 0.9 1.2 0.0 0.0 Others 0.5 0.5 1.0 0.0 0.0 0.0 0.0 Others 0.5 0.5 1.0 0.0 0.0 0.0 0.0 Total Project Financing 1.8 5.7 14.9 5.6 10.0 0.0 0.0 Main assumptions:

-41 - Annex 6: Procurement and Disbursement Arrangements UKRAINE: Private Sector Development

Procurement

General Project procurement arrangements shall include the procurement of goods and consultants' services and shall follow latest edition of the Bank guidelines "Procurement under IBRD Loans and IDA Credits" and "Selection and Employment of Consultants by World Bank Borrowers" accordingly. The project components not financed by the Bank shall be procured in accordance with respective guidelines of the co-financing institutions. Procurement under the project shall be managed by the Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER) using relevant Bank standard procurement documentation and Operations Manual, developed by UCER and approved by the Bank. The project elements, their estimated cost and procurement methods are summarized in Tables A and Al of this Annex 6. Procurement information, including capacity of the implementing agency, estimated dates for publication of GPN and the Bank review process is presented in Tables B and B1. Procurement plan detailing the packaging and estimated schedule of the major procurement actions is presented in Table B2. 1. Procurement of Goods (US$ 0.38 mln) Procurement of goods shall follow the World Bank Guidelines "Procurement under IBRD and IDA Credits" dated January 1995, revised January and August 1996, September 1997 and January 1999. Goods (US$ 0.38 million) consisting of hardware/software, minor office equipment and furniture, materials and publications for selected four pilot oblasts are grouped to the extent possible considering project objectives and encouraging competitive bidding. The following methods of procurement will be followed: (i) International Shopping (IS) procedures will be used for readily available off-the-shelf goods of standard specifications estimated to cost less than US$ 100,000 equivalent per contract up to an aggregate of US $0.279 million. These procedures require to obtain at least three quotations from qualified suppliers from at least two different Bank-member countries. The ECA Regional sample format for international shopping "Invitation to Quote" available on the ECA Procurement Web Site will be applied. International Shopping total packages estimate is about 73% of all goods. (ii) National Shopping (NS) procedures will be used for small contracts valued under US $50,000 each up to an aggregate amount of US $130,000. Contract awards will be based on comparison of price quotations obtained from at least three qualified suppliers to assure competitive prices.The ECA Regional sample format for national shopping "Invitation to Quote" available on the ECA Procurement Web Site. National Shopping total packages estimate is about 27% of all goods. 2. Selection Procedures for Consultants' Services (US$ 28.82 mln) Contracts for Consulting Services required for the Project will be awarded following the World Bank Guidelines "Selection and Employment of Consultants by World Bank Borrowers" dated January 1997, revised September 1997 and January 1999. Contracts will be packaged to include a combination of related skills and services, in order to make them attractive and increase competition as well as to reduce the number of contracts to be managed by UCER. The following methods of procurement will be followed: (i) Quality and Cost-Based Selection (QCBS) procedures will be used for 8 consulting services contracts up to an aggregate amount of US$ 16 million equivalent. QCBS procedure will be used

-42 - for more than 52 % of all services procured. (ii) Fixed Budget Selection (FBS) procedures will be used for 10 management training consulting services contracts up to an aggregate amount of US$ 9 million equivalent. FBS procedure will be used for more than 30 % of all services procured. (iii) Least Cost Selection (LCS) procedures will be used for auditing services, and several contracts on similar assignments of standard or routine nature estimated to cost less than US$ 200,000 equivalent per contract, up to an aggregate amount of US$ 500,000 equivalent (less than 2% of all services). (iv) Selection Based on Consultant Qualifications (CQ) procedures will be used for 4 consulting services contracts to conduct survey ana research on enterprise restructuring process estimated to cost less than US$ 100,000 equivalent per contract, as well as for 1 contract of training for regional staff. Total CQ selection procedure will be up to an aggregate amount of US$ 400,000 equivalent (less than 2% of all services). (v) Individual Consultants (IC) will be hired under Section V of the Guidelines estimated up to cost less than US$ 100,000, up to an aggregate amount of US$ 3,000,000 equivalent. Services of individual consultants constitute approximately 11% of total services amount. 3. Notification of Business Opportunities A General Procurement Notice (GPN) was published in "Development Business" in July 2001 issue and will be updated annually. For consultants' contracts above US $200,000 the Requests for Expression of Interest will be advertised in "Development Business" (in the English language) and in a major local newspaper (in National language). 4. Review by the Bank of Procurement Decisions Scheduling of Procurement. Procurement of goods and services for the project will be carried out in accordance with the agreed procurement plan. UCER has drafted a Procurement Plan as part of the Project Operations Manual (see also Table B2). This plan will be updated as necessary and included in the periodic project management reports for Bank review and comment. Prior Review by the Bank. The Bank will require prior review for all contracts with firms above US$ 100,000 and first two contracts below US$ 100,000, as well as first two contracts for IC and all IC contracts above US$ 50,000 per contract. Request for Proposals (RFP), Short Lists (SL), terms and conditions of contracts, evaluation reports and recommendation for award, and negotiated contracts will be prior reviewed by the Bank for such contracts with firms and with individual consultants. For procurement of goods the first two contracts for IS and the first two contracts for NS will be subject to prior review by the Bank. The Bank will prior review a report on comparison and evaluation of quotations received and a copy of the specifications along with the draft contract. Post Review by the Bank. Contracts that are not subject to prior review will be post-reviewed by the Bank prior to delivery to the Bank of first withdrawal application of funds or Special Account replenishment application in respect of such contract.

Procurement methods (Table A)

Table A: Project Costs by Procurement Arrangements (US$ million equivalent)

-43 - Procurement Method Expenditure Category ICB NCB Other2 N.B.F. Total Cost 1. Works 0.00 0.00 0.00 0.00 0.00 (0.00) (0.00) (0.00) (0.00) (0.00) 2. Goods 0.00 0.00 0.38 0.05 0.43 (0.00) (0.00) (0.38) (0.00) (0.38) 3. Services 0.00 0.00 28.82 6.95 35.77 of Consultants (0.00) (0.00) (28.82) (0.00) (28.82) 4. Incremental Operating 0.00 0.00 0.50 1.00 1.50 Costs (0.00) (0.00) (0.50) (0.00) (0.50) 5. Front-end fee 0.00 0.00 0.30 0.00 0.30 (0.00) (0.00) (0.30) (0.00) (0.30) Total 0.00 0.00 30.00 8.00 38.00 (0.00) (0.00) (30.00) (0.00) (30.00) "Figures in parenthesis are the amounts to be financed by the Bank Loan. All costs include contingencies. 2'Includes civil works and goods to be procured through national shopping, consulting services, services of contracted staff of the project management office, training, technical assistance services, and incremental operating costs related to (i) managing the project, and (ii) re-lending project funds to local government units.

- 44 - Table Al: Consultant Selection Arrangements (optional) (US$ million equivalent)

Selection Method Consultant Services Expenditure Category QCBS QBS SFB LCS CQ Other N.B.F. Total Cost A. Firms 16.00 0.00 8.90 0.47 0.36 0.00 4.00 29.73 (16.00) (0.00) (8.90) (0.47) (0.36) (0.00) (0.00) (25.73) B. Individuals 0.00 0.00 0.00 0.00 0.00 3.09 2.95 6.04 (0.00) (0.00) (0.00) (0.00) (0.00) (3.09) (0.00) (3.09) Total 16.00 0.00 8.90 0.47 0.36 3.09 6.95 35.77

_ (16.00) (0.00) (8.90) (0.47) (0.36) (3.09) (0.00) (28.82) 1\ Including contingencies

Note: QCBS = Quality- and Cost-Based Selection QBS = Quality-based Selection SFB = Selection under a Fixed Budget LCS = Least-Cost Selection CQ = Selection Based on Consultants' Qualifications Other = Selection of individual consultants (per Section V of Consultants Guidelines), Commercial Practices, etc. N.B.F. = Not Bank-financed Figures in parenthesis are the amounts to be financed by the Bank Loan.

-45 - Prior review thresholds (Table B) The following thresholds are suggested for the prior review by the Bank: (i) GOODS: IS - first 2 contracts; NS - first 2 contracts (ii) CONSULTANTS' SERVICES: All contracts with firms above US$ 100,000; First two contracts with firms below $100,000; First two contracts and all contracts with individual consultants above $50,000 All Termns of Reference Table B: Thresholds for Procurement Methods and Prior Review'

Contract Value Contracts Subject to Threshold Procurement Prior Review Expenditure Category (US$ thousands) Method (US$ millions) 1. Works Not Applicable

2. Goods below 100 IS first 2 contracts below 50 NS first 2 contracts 0.3 3. Services of QCBS first two contracts Consultants FBS regardless of cost, then all below 100 LCS contracts above $100,000 below 100 IC first two contracts and all contracts above $50,000

All Terms of Reference 4. Incremental operating Not Applicable Not Applicable Not Applicable costs

Total value of contracts subject to prior review: US$ 26 mln (70% of total project cost of US$ 38 mln)

Overall Procurement Risk Assessment

High

Frequency of procurement supervision missions proposed: One every 6 (supervision mission should include procurement specialist to conduct post-reviews, especially on numerous contracts for individual local consultants services) months (includes special procurement supervision for post-review/audits) Table BI: Procurement Information This Table is prepared in accordance with ECA Regional Procurement Management Guidelines.

-46 - Section 1: Procurement Review Goods (G) ICB NCB IS NS Minor Other Percentage and Civil Works methods of loan Works (W) amount subject to prior review Procuremen N/A N/A G: G:< N/A N/A 85% t thresholds: <$100,000 $50,000 individual up to up to and $0.279 mln $0.101 mln aggregate W: N/A W: N/A Prior N/A N/A First two First two Review contracts contracts Consultants QCBS QBS Fixed LCS CQ Single Individuals Budget Source (SS) Procuremen >$100,000 N/A >$100,000 <$200,000 <$100,000 N/A < $100,000 t method thresholds Prior All contracts above US$ 100,000 N/A First two Review First two contracts below US$ 100,000 contracts. All TORs All contracts > $50,000 and TORs Ex-post Explain briefly the ex-post review mechanism: one post-review in every 6 months to Review be conducted. 30% of contracts will be ex-post reviewed Section 2: Capacity of the Implementing Agency in Procurement and Technical Assistance requirements Brief statement UCER as a legal, non-profit entity, created by the Government resolution, shall be responsible for overall project procurement. Legal and Procurement Unit of UCER shall conduct all procurement in coordination with its Regional Units and shall monitor all procurement/contract management related issues. UCER shall procure goods for central and regional capacity building needs, and shall hire the consultants for enterprise restructuring and management training. UCER has an experience in implementation of EDAL TA component of the WB loan, continues procuring goods under shopping procedures and contracting many consultants financed from the Japanese PHRD grant and PPF during project preparation. UCER has gained certain practical expertise in the Bank procurement. UCER staff was trained during WB procurement and disbursement workshops. UCER staff is proficient in English, willing to learn, dedicated and motivated to implement the project. Capacity of UCER and its regional branches is adequate to conduct and monitor procurement procedures and selection of consultants without external support. Country Procurement Assessment Report or Country Are the bidding documents for the Procurement Strategy Paper status: CPAR was finalized in procurement actions of the first year November 200 1. ready by negotiations: Yes No X Section 3: Training, Information and Development on Procurement

- 47 - Estimated date of Project Date of publication of Indicate if there is Domestic Domestic Launch Workshop: June General Procurement procurement subject to Preference Preference 2002 Notice: mandatory SPN in for Goods: for Works, July 16, 2001 Development Business: Yes * if Yes X No X applicable: No Yes-

______N o X Retroactive financing: Yes No X Explain: Advance procurement: Yes No X Explain: Explain briefly the Procurement Monitoring System: UCER at central level, with only administrative assistance from Regional Units, shall have full responsibility for preparation of procurement documentation and contract management. Monitoring of 4 major QCBS packages, several LCS, ten FBS, four CQ contracts and more than 300 local individual consultants contracts will require UCER procurement monitoring system be effective. Existing Financial Management System includes Procurement Monitoring section, in addition to separate software (MS project, Sure-track, etc.). Operations Manual details procurement monitoring responsibilities within the UCER internal structure. It is planned that each Consultant firm shall restructure total about 15 enterprises from two different Regions. As a result two different Consultant firms will be restructuring different set of enterprises within one Region to ensure competitive output. 4 Regions will be covered at two consequent phases of two parallel QCBS. UCER will hire local individual consultants who will work as team leaders in each enterprise under restructuring in collaboration with the selected Consultant firms. UCER shall be responsible for approval of Consultants reports. Documentation and records shall be retained with the UCER at central level. Co-financin : Explain briefly the procurement anrangements under co-financing: Project components not financed by the Bank shall be procured under respective guidelines of the co-financiers. National legislation shall apply for procurement in case of any procurement out of state funds. Contracts between two residents are govemed by the applicable law of Ukraine. Section 4: Procurement Staffing Indicate name of Procurement Staff or Bank's staff part of Task Team responsible for the procurement in the Project: Name: Alexandre Roukavichnikov, Procurement specialist, ECC10. Ext: 5762+2033 Explain briefly the expected role of the Field Office in procurement: Procurement service support for whole portfolio and fiduciary functions for given PSD loan. Projects covered by fiduciary procurement functions were approved by OCSPR memorandum of January 20, 2000 for ECSPF and ECSHD projects below mandatory RPA review thresholds. Delegation arrangements annually reviewed by RPA.

Table B2: Procurement Plan The Procurement Plan has been removed from the PAD in accordance with agreements reached at Negotiations.

Procurement Plan PSD 14.05.01.:

-48 - Table B3: Summary of Findings and Actions on Procurement Capacity Assessment This Table is prepared in accordance with ECA Regional Procurement Management Guidelines and serves as additional information.

UCERCapacityAttachment2.c

Thresholds generally differ by country and project. Consult OD 11.04 "Review of Procurement Documentation" and contact the Regional Procurement Adviser for guidance.

- 49 - Disbursement

Allocation of loan proceeds (Table C)

Table C: Allocation of Loan Proceeds

Expenditure Category Amount in US$million Financing Percentage 1. Goods 0.32 100% foreign expenditures, 100% local expenditures ex-factory cost 80% other goods procured locally 2. Consulting Services 28.53 100% 3. Incremental Operating Costs 0.25 100% until June 30, 2004 90% until June 30, 2005 80% until June 30, 2006 and 0% thereafter 4. Refunding of the Project Preparation 0.60 100% Advance Total Project Costs 29.70 Front-end fee 0.30 Total 30.00

Use of statements of expenditures (SOEs): Loan proceeds will be disbursed under the Bank's established procedures, including Statements of Expenditure (SOEs) and Summary Sheets. Use of Statements of Expenditures: Withdrawal applications will be fully documented, except for expenditures under: (a) contracts for goods valued at less than US $ 100,000 each; (b) contracts for consulting firms costing less than US $ 100,000 equivalent, and contracts for individual consultants costing less than US $50,000 equivalent; and (d) all incremental operating costs.

Special account: The Borrower will open a Special Account in a foreign commercial bank acceptable to the World Bank to receive the Loan funds. For payments in hard currencies the Special Account may be used directly. To facilitate local payments in national currency, a separate transit account will be opened in a local commercial bank acceptable to the World Bank. To minimize potential losses arising from currency fluctuations, balances in the transit account will be maintained at a level not greater than that required to meet requirements in national currency for one month. The Special Account will be audited annually and the results will be available to the Bank. The authorized allocation of the SA amounts is US $ 1 million equivalent. Upon effectiveness, the Bank will provide for an advance of US $ 0.5 mln equivalent representing 50% of the authorized allocation. When the total funds withdrawn from the Loan Account amount to US $ 3 million equivalent million, the beneficiaries may withdraw the remaining balance amounting to US$ 0.5 mln equivalent. Replenishment applications should be submitted not later than every three months. These applications would be fully documented, except in the case where disbursements on the basis of Statements of Expenditure (SOEs) is permitted, and would be supported by a reconciliation statement and commercial bank statements.

- 50 - Financial Management FinancialManagement Assessment: The financial management capacity within Ukraine has not been the subject of a detailed review by the Bank. Any weaknesses that may exist in the country's financial management capacity have been mitigated by the use of a specialized project implementing agency - the Ukrainian Center for Enterprise Restructuring and Private Sector Development (UCER), for project preparation and implementation, and drawing upon experience of projects of this nature. The project satisfies the Bank's minimum financial management requirements. During pre-appraisal, the Bank and UCER agreed upon a series of measures to strengthen the intemal control environment and to improve the quality financial reporting; all measures have been implemented by UCER prior to appraisal. Complete Operations Manual Completed Implement IAS Chart of Accounts (general financial Completed accounting) Account Mapping (project account) Completed Appoint Finance Manager Completed

Input Test Data and Check System Integrity Completed Produce FMRs Completed

FinancialMonitoring Reports (FMRs): Management-oriented FMRs will be used for project monitoring and supervision. The formats of the FMRs, which have been agreed with UCER, are included within the Operational Manual and have been confirmed during Negotiations. The UCER will produce a full set of FMRs semi-annually throughout the life of the project beginning not later than the period ending 6 months after project effectiveness date. Audit Arrangements: Extemal audits by independent private auditors acceptable to the Bank, and on terms of reference acceptable to the Bank will be procured by UCER. Annual audited financial statements of UCER and of the Project will be provided to the Bank within 6 months after the end of each fiscal year and also at the closing of the project. The contract for the audit may be extended from year-to-year with the same auditor, subject to satisfactory performance. Terms of reference for the audit of UCER and of the project financial statements were agreed during negotiations.

- 51 - Annex 7: Project Processing Schedule UKRAINE: Private Sector Development

Project Schedule Planned Actual Time taken to prepare the project (months) 24 28 First Bank mission (identification) 03/09/1998 03/10/1998 Appraisal mission departure 10/12/2000 02/12/2001 Negotiations 11/15/2000 01/28/2002 Planned Date of Effectiveness 03/01/2001

Prepared by: Vladimir-Goran Kreacic, ECSPF, Task Team Leader

Preparation assistance: Gheorghe Efros, Consultant (Executive Director ARIA, Moldova) Nana Adeishvili, Consultant (Executive Director CERMA, Georgia)

Bank staff who worked on the project included: Name Speciality Andrei Mikhnev, ECSPF Projects Officer Cari Votava, ECSPF Project processing Michael Gascoyne, ECSPF Financial Management Yevgeny N. Kuznetsov, LCSFR Institutional analysis and development; monitoring and evaluation Alexandre Roukavichnikov, ECC I0 Procurement Nicholay Chistyakov Disbursement Claudia M. Pardinas Ocana Lawyer

- 52 - Annex 8: Documents in the Project File* UKRAINE: Private Sector Development

A. Project Implementation Plan Project Implementation Plan on a Proposed Loan in the amount of US$60 million to Ukraine for Private Sector Development Project

PSD PIP.doc

B. Bank Staff Assessments * Country Assistance Strategy for Ukraine, August 16, 2000. * TOR, dated 30 March 2000 [for Ira Lieberman, from Paul Siegelbaum] * BTO, dated 30 March 2000 [w/Aide Memoire by V. Kreacic] * BTO, dated 7 Oct 1999 [w/Aide Memoire by V. Kreacic] * Letter, dated March 22, 1999 [from Ukrainian Center for Enterprise Restructuring, RE: Amendment on PHRD Grant Agreement] * World Bank Discussion Paper No. 408: Economic Growth with Equity: Which Strategy for Ukraine? 1999. John Hansen (IBRD), and Diana Cook (Intemational Centre for Policy Studies). * World Bank Country Study; Ukraine: Restoring Growth with Equity: A Participatory Country Economic Memorandum, October, 1999. * Executive Summary of World Bank Country Study; Ukraine: Restoring Growth with Equity: A ParticipatoryCountry Economic Memorandum, October, 1999. * TOR dated Nov 23, 1998 [Pre-Appraisal Mission] * PCD dated 8 Nov 1998 * PID, September 18, 1998 * PID, March 6, 2001

C. Other * The State of Small Business in Ukraine, an IFC Survey of Ukrainian Small Enterprises (May 2001)

IFC Ukraine Biz Survey 2000 Eng.p * Minutes of Negotiations, January 31 2002

Agreed Minutes.doc *Including electronic files

- 53 - Annex 9: Statement of Loans and Credits UKRAINE: Private Sector Development 06-Feb-2002 Difference between expected and actual Original Amount in US$ Millions disbursements Project ID FY Purpose IBRD IDA GEF Cancel. Undisb. Orig Frm Rev'd P069858 2002 SF 50.21 0.00 0.00 0.00 50.21 0.00 0.00 P035786 2001 LVIV WATERNWW 24.25 0.00 0.00 0.00 24.25 0.62 0.00 P055738 2001 SEVASTOPOL HEAT SUPPLY IMPROVEMENT 28.20 0.00 0.00 0.00 28.19 3.50 0.00 POSS739 2000 KIEV PB ENERGY EFFIC 18.29 0.00 0.00 0.00 17.41 3.82 0.00 P049174 1998 TREASURY SYSTEMS Prject 16.40 0.00 0.00 0.00 9.24 8.16 0.54 P044728 1998 ODS PHASE-OUT (GEF) 0.00 0.00 23.20 0.00 9.37 10.44 -4.22 P044832 1998 KIEV DISTRICTHEAT. 200.00 0.00 0.00 0.00 182.18 101.25 34.95 P044851 1997 EXPORT DEVELOPMENT 70.00 0.00 0.00 0.00 16.36 15.81 0.00 P038820 1995 HYDROPOWER REHAB 114.00 0.00 0.00 14.16 25.92 40.08 2.78

Total: 521.35 0.00 23.20 14.16 363.13 183.69 34.06

UKRAINE STATEMENT OF IFC's Held and Disbursed Portfolio OCT-2001 In Millions US Dollars

Committed Disbursed IIFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1998 Creditanstalt Uk 0.00 2.28 0.00 0.00 0.00 2.28 0.00 0.00 1996 FUIB 0.00 5.00 0.00 0.00 0.00 5.00 0.00 0.00 2000 MBU 0.00 1.70 0.00 0.00 0.00 1.70 0.00 0.00 1994/96 Ukraine VC Fund 0.00 1.50 0.00 0.00 0.00 1.15 0.00 0.00 Total Portfolio: 0.00 10.48 0.00 0.00 0.00 10.13 0.00 0.00

Approvals Pending Coimmitment FY Approval Company Loan Equity Quasi Partic 2001 Okean Shipyard 10.00 0.00 0.00 0.00 2000 MBU 5.00 0.00 0.00 0.00 1998 Creditanstalt Uk 5.00 0.00 0.00 0.00 1996 FUIB 10.00 0.00 0.00 0.00

Total Pending Commitment: 30.00 0.00 0.00 0.00

-54 - Annex 10: Country at a Glance UKRAINE: Private Sector Development Europe & POVERTY and SOCIAL Central Low- Ukraine Asia Income Development dlamond' 2000 Population. mid-year (millions) 49.5 475 2,459 Life expectancy GNI per capita (Atlas method, US$1 790 2,010 420 GNI (Atlas method, US$ billions) 39.3 956 1,030 Average annual growth, 1994-00 Population (%) -0.7 0.1 1.9 Labor force (%) -1.1 0.6 2.4 GNI Gross per primary Most recent estimate (latest year available, 1994-00) capita \ enrollment Poverty (%of population below national Povefty line) 28 Urban Dopulation (%of total PoDulation) 68 67 32 Life exoectancy at birth (vears) 68 69 59 Infant mortalitv (per 1.000 live births) 12 21 77 Child malnutrition (%of children under 5) Access to improved water source Access to an improved water source (%of population) 100 90 76 llfiteracy (%of population age tS+) 2 3 38 Ukraine Gross primary enrollment (%of school-age population) 100 100 96 Male 100 101 102 I Low-income group Female 100 99 86

KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1980 1990 1999 2000 Economic ratlos' GDP (US$ billions) .. 91.3 39.4 35.3 Gross domestic investmentUGDP .. 27.5 17.4 18.6 Trade Exports of qoods and services/GDP .. 27.6 53.7 61.5 Gross domestic savinqslGDP .. 26.4 23.0 23.0 Gross national savinos/GDP .. 35.9 22.6 23.3

Current account balance/GDP .. -5.5 4.0 4.2 Domestic //smn Interest pavments/GDP .. .. 1.4 1.7 savings Investment Total debt/GOP .. .. 35.5 35.6 svn Total debt servicelexoorts .. ,. 17.1 19.3 Present value of debt/GDP .. .. 32.2 32.3 Present value of debt/exports .. .. 72.8 56.3 Indebtedness 1980-90 1990-00 1999 2000 2000-04 (average annual growth) GOP .. -9.4 -0.2 5.8 3.5 Ukraine GOP per capita .. -8.9 0.6 6.7 4.3 Low-income group Exports of goods and services .. -3.2 .7.9 13.8 3.6

STRUCTURE of the ECONOMY 1980 1990 1999 2000 Growth of Investment and GDP (%) (%of GDP) 45 Aqriculture 25.6 14.3 13.8 20 Industry .. 44.6 37.7 38.5 0 Manufacturing .. 8.5 5.0 4.6 Services .. 29.9 48.0 47.7 0 7

Private consumption .. 57.1 57.2 58.2 as General government consumDtion .. 16.5 19.8 18.7 -G * GDP Imports of goods and services .. 28.7 48.2 57.0

1980-90 1990-00 1999 2000 Growth of exports and imports 1%) (average annual growth) Aqriculture .. -5.8 -4.2 5.9 ISO Industry -11.4 3.0 10.9 I05 Manufacturing . -11.2 5.5 12.8 Services .. -11.3 0.3 5.5 S

Private consumption .. -6.6o 2.8 5.1 0o o General aovernment consumDtion .. -5.4 -17.6 -1.9 -s0 Gross domestic investment .. -20.2 -14.4 21.8 Exports C Imports Imorts of goods and services .. -2.7 -19.1 17.5

Note: 2000 data are preliminary estimates. * The diamonds show four kev indicators in the countrv (in boldl comoared with its income-grouD average. If data are missino. the diamond will be incomplete.

- 55 - Ukraine

PRICES and GOVERNMENT FINANCE 1980 1990 1999 2000 Inflation (%) Domestic Prices . (%chanqe) 1.500 Consumer prices .. .. 19.2 25.8 o Implicit GDP deflator .. 16.4 27.4 25.3 . , \ Government rinance (%of GDP, includes current qrants) o. _- Current revenue .. 33.6 35.6 95 96 97 98 99 oo Current budqet balance .. .. -1.9 -0.9 -GOP deflator * CPl Overall surplus/deficit .. .. -2.0 -1.3

TRADE

(USS millions) 1980 1990 1999 2000 Export and import levels (USS mill.) Total exports (fob) .. .. 13,189 15,722 25,000 Ferrous and non-Drecious metals .. .. 4.874 6.468 .0. Mineral products .. 1.419 1.377 20.00 Manufactures .. .. 1.981 2.584 15.00 Total imports Icif) .. .. 12.945 14.943 * Food .. .. 902 908 Fuel and energv .. .. 5.441 6.419 5.000 Capital goods .. .. 2.255 2.625 a 94 99 94 97 98 99 55 Export price index (1995=100) .. .. 95 97 ImDort price index (1995=100) .. .. 113 115 *Expons *lImports Terms of trade (1995=100) .. .. 84 84

BALANCE of PAYMENTS

(USS millions) 1980 1990 1999 2000 Current account balance to GDP (%) Exports of goods and services .. .. 16.960 19,522 . ImDorts of aoods and services ., ., 15.237 18.116 Resource balance .. .. 1.723 1.406.

Net income .. .. -869 -942 2 . Net current transfers .. .. 706 1,017

Current account balance .. -5.063 1.560 1.481 2-E W E '99 0 Financinq items (net) .. .. -1,277 -1.083 Changes in net reserves .. .. -283 -398 J Memo: Reserves including gold (USS millions) .. .. 1.094 1.431 Conversion rate (DEC. locallUSS) .. 1.83E-5 3.3 4.9

EXTERNAL DEBT and RESOURCE FLOWS 1980 1990 1999 2000 (USS millions) Composition of 2000 debt (USS mill.) Total debt outstandino and disbursed .. .. 14.019 12.579 IBRD 1.954 1.991 G:604 A: 1,991 IDA .. .. 0 0

Total debt service .. .. 2,994 3,914 IBRD .. .. 96 142 / IDA . .. .. 0 0 .

Composition of net resource flows F: 4,895 . . I _ Official grants .. .. 38 Official creditors .. .. 287 -1,060 Private creditors .. .. -130 332 13:377 Foreign direct investment .. .. 496 750 Portfolio ecuitv .. .. 0 80 E: 2,639 World Bank program Commitments .. .. 600 18 A-IBRD E-Bilateral Disbursements .. .. 422 113 8 -IDA D -Other multilateral F -Private Principal repaVments .. .. 2 24 C -IMF G -Short-term Net flows .. .. 420 88 Interest Davments ,. .. 94 118 Net transfers .. .. 326 -29

Development Economics 9/501

- 56 -