What policies should be implemented and what has to be done in the farms themselves to es-tablish a sound rural finance system? In the following we address a range of problems, from the creditworthiness of rural enterprises to the banking sector and legislation.
5.1 Securing repayment
The solvency of borrowers is a major precondition for their creditworthiness, and profit is the main source of credit repayment. In addition, banks require collateral to secure loans. The effective-ness of the use of collateral depends on the legal framework. This is discussed in the following sub-section.
5.1.1 How to improve the creditworthiness of Ukrainian farms and other rural enterprises The high and ever increasing number of unprofitable farms in the second half of the 1990s led to a lively discussion: Are these enterprises unprofitable because they did not receive any credits for years, or did they not receive credits because they were unprofitable. In fact, profitability is a precondition for borrowing. Commercial banks want to know for certain that the lender is capable of repaying.10 This implies that the managers of agricultural and other enterprises must demonstrate
10 In Germany it is almost impossible for an unprofitable enterprise to get credit, with exceptions only made if there are strong indications that the enterprise has a good business concept and/or has collateral to secure the loan. The latter is sometimes the case for agricultural enterprises that own land.
that they are able to streamline the organisational structures of farms, reduce the labour force and increase productivity – i.e. tap the existing potential of the farm – before they apply for a loan. As many projects in Ukraine and other CIS countries such as Russia have shown, many of these im-provements are possible without borrowed money.
The low profitability of the majority of Ukrainian farms has a number of causes. Ukrainian farmers often praise the wonderful conditions (i.e. subsidisation of agriculture) in the EU, and argue that they need similar subsidies to become profitable. However, it is very likely that the overwhelm-ing majority of Ukrainian farms would not survive under EU conditions! Consider, for example, the development of the former kolkhozes (LPG) in the former GDR. Those former LPGs that survived under EU conditions11 had to reorganise completely. The labour intensity of the successor farms of the former LPGs was reduced by 80% from 13.5 workers per 100 ha in 1989 to 2.7 workers per 100 ha in 1994/95 (THIELE, 1998). Decision-making processes were reorganised and the number of dif-ferent levels in these processes reduced. And unit costs were reduced substantially by adopting ad-vanced production methods. Only if all these measures were applied did the successor farms survive.
Most of these restructuring measures have not taken place at all in Ukraine, or were started late at the end of 1999 and in 2000. There is still a long way to go. The following measures have to be applied to improve the creditworthiness of farms:
1. Ukrainian farms still suffer from monopolised sales structures and/or export barriers that reduce farm gate prices.12 The only solution is a liberal trade and investment regime.
2. Although the procedure for transferring the social sphere to local governments is regulated by the Resolution No. 1060/96 of the Cabinet of Ministers and Presidential Decree No.
398/00, more than 4% of all schools and almost 55% of pre-school institutions were still listed in the fixed assets of agricultural enterprises as of January 1, 2001. Farms spent 407 mUAH financing the social sphere and providing public services to households in 1999, out of which 277 mUAH were not reimbursed (SABLUK 2000). This amounts to roughly 7%
of the total losses incurred by farms in that year.
3. The main obstacle to the profitability of Ukrainian farms is their low productivity, whether it is labour, land or input productivity. The number of farm workers per 100 ha was 8.3 in 2000 in Ukraine. It is clear that this number will shrink to at most 5 in the coming years. The Ukrainian Government has still not developed a consistent policy to deal with the social con-sequences of this change. Such a policy is needed to help both the employees who are going to be dismissed and the agricultural enterprises that must reduce their labour forces to in-crease labour productivity.
4. The land and input productivity is also very low in Ukraine. All relevant physical productiv-ity figures for Ukrainian agriculture (the yield of field crops per ha, milk yield per cow, feed use for the production of 100kg of meat etc.) fall far behind corresponding figures for Central or Western European countries.13 It is very often claimed that the lack of funds, the lack of modern machinery and the lack of inputs is the reason for this problem. Without going into detail here there are strong indications that this is simply not true. Instead, is the wrong use of these inputs. In Germany, for example, the quantity of fertiliser applied per ha has been shrinking constantly throughout the nineties, but yields continue to increase by 2% per year!
In Ukraine, many farms have not begun to question whether old production technologies
11 EU agricultural policy was implemented almost in full in the former GDR as of July 1, 1990, i.e. just eight months after the fall of the Berlin wall.
12 See chapter 7 on Price Determination and Government Policy on Ukrainian Grain Markets and chapter 10 on Re-gional Agricultural Trade in Ukraine.
13 See chapter 1 on Ten Years of Agricultural Transition in Central and Eastern Europe: Some Lessons for Ukraine and chapter 6 on Can the Crisis in Ukrainian Agricultural Be Attributed to Price Disparity?
veloped in the 70s or 80s are still appropriate. Consider, for example, the seed density in Ukrainian grain production. In Western Europe seed density has been reduced constantly in recent years, and now amounts to 250 to 300 seeds/m2. In the Eastern part of Germany, farmers adopted lower densities soon after reunification. Lower densities are more produc-tive due to lower costs and stable yield but healthier plants. Western experts believe that seed density in Ukraine could easily be reduced by at least 30%. Hence, from the 2.88 mill. t seeded in 2000/01 Ukrainian farms could save 860,000 t, worth 600 to 700 mUAH! This po-tential in Ukrainian agriculture, like many others, cannot be tapped by subsidies, but instead by well educated and efficient managers.
5.1.2 Mortgages for short-term and long-term crediting
The creditworthiness of any borrower depends on the lender's ability to secure repayment of the loan, if need be in the form of collateral. Many forms of collateral that play an important role internationally are not used in Ukraine. Examples are warehouse-receipts and mortgage crediting.
These will be considered subsequently.
Creating a warehouse-receipt system
Grain receipts or warehouse receipts are a proven way to finance the working capital needs of agriculture. Agricultural produce has to be stored and financed from harvest until it is processed or consumed. Banks can finance this stock through separate agreements with borrowers and the warehouses in which it is deposited, or by using a system of grain receipts and licensed warehouses, which are regulated and inspected by independent bodies. The latter has been working successfully in the USA since 1916, and in other countries as diverse as Indonesia, Ghana and Argentina (E USE-BIO & BRYDE, 1999). In Slovakia and Bulgaria a legislative framework was established in 1998, and in Hungary 30% of current production was financed by this instrument as early as in 1996. Ware-house receipts are a seasonal financial tool that works according to the following mechanism:
After harvesting, the farmer delivers his products, e.g. wheat, to a licensed warehouse and receives Certificates of Title (CT) and Pledge (CP). The warehouse will only release the crop to the owner of both documents. When the farmer borrows against the crop, the bank keeps the CP as se-curity and the CT for safekeeping (to ensure that the bank knows who the owner of the crop is). Be-fore the maturity of the loan (typically up to nine months) the farmer sells the crop to a primary processor (or to a trader) by 'selling' the CT (upon consultation with the bank). At maturity, or when it needs the crop, the primary processor redeems the CP from the bank by repaying the loan, and the processor, now owner of both CT and CP, can collect the crop from the elevator. If the loan has de-faulted, the warehouse will release the crop to the bank upon presentation of the overdue CP (E USE-BIO & BRYDE, 1999). The warehouse receipts system allows the producer to use his harvest as col-lateral, e.g. for financing the autumn sowing campaign, without being forced to sell his/her products immediately. Hence, the producer can independently determine the time of sale but is able to use the corresponding revenues in advance.14
In Ukraine a type of warehouse receipt system was established by the Decree of the President of June 29, 2000 No. 832 and the accompanying resolution of the Cabinet of Ministers No. 1141.
These documents are aimed at fulfilling two tasks: Mortgage crediting and state grain purchases to serve the needs of the internal market. Both tasks are to be carried out by the state agent – Khlib Ukrainy. Hence, unlike in other countries such as Hungary, for example, the Ukrainian system is supposed to perform two separate functions simultaneously.
14 For a comprehensive discussion see SECRETARIAT OF THE AGRICULTURAL COMMISSION AND GERMAN ADVISORY GROUP ON ECONOMIC REFORM: The Further Development of Rural Financial Markets – A Strategy for Ukraine. Kyiv, May 2001.
On the one hand, there is an intervention element that has much in common with the loan rate system in the USA. This system must be seen as rather problematic for Ukraine.15 The second element is the pledge system. This gives agricultural producers the opportunity to sell their grain at the pledge price with the possibility of redeeming it at this price if it can be sold on the market at a more favourable price. This meets the idea of the warehouse receipt system. But in many respects this system contradicts the preconditions for a functioning warehouse receipt system. The most im-portant difference is that functioning warehouse receipt systems elsewhere in the world function without direct state participation. Instead, the state's role is limited to the provision of the legal framework, support for licensing, registering, monitoring and arbitration.
Mortgage crediting system
A mortgage credit is secured by real estate, i.e. by an immovable asset. As the value of real estate is less volatile and an immovable asset cannot be taken away, real estate serves as a relatively secure collateral for banks. Hence, it reduces the lender's risk, which in turn enables the lender to provide credits at lower interest rates. In Germany, for example, the average interest rate stood at 11% as of April 2001, whereas banks asked for only 6% on mortgage credits.
In Ukraine the legal foundation for a functioning mortgage credit system is being created, as the Verkhovna Rada considers drafts of the following laws: “On mortgage”, “On registration of the title of immovable property ownership” and the “Land Code”. Nevertheless, the system of mortgage crediting is developing very slowly in Ukraine.16 As long as the land code is not adopted and as long as a set of other preconditions is not fulfilled, a mortgage credit system will not develop. Thus, it is unrealistic to assume that Ukrainian farmers will be able to make use of mortgage credits in the near future. The following factors should be considered:
Mortgage credits are typically given for long periods, in Germany for example for 15 to 25 years. Any bank that secures a loan on an immovable asset therefore wants to know what the value of this asset will be in five or even ten years. Although, this cannot be predicted precisely even in stable market economies, the lender is on the safe side if he provides mortgage credit on just a cer-tain percentage of the current value of that asset. In Germany this is typically 60%.
Even if the Land Code were adopted this would not mean much for banks, because it is diffi-cult or even impossible to predict what will be the value of a specific hectare of Ukrainian farm land in 2006, for example. The value of land is a function of many variables including legal and political circumstances.17 Political and legal instability translates directly into lower land values and, hence, lower collateral values! Without legal and political stability, banks will hesitate to provide long-term credit.
If commercial and bank credits are to become the principal source of financing for agricul-ture, policy makers will have to place greater emphasis on the creditor protection. This is why bankruptcy laws in Western Europe and the US emphasise the creditors' rights. As table 3 indicates, secured lenders in the USA have their claims honoured 'off the top', i.e. they get dollar for dollar on their claims. Next in line are priority claims, which include administrative expenses associated with bankruptcy and other tax and wage claims. In the Netherlands, creditors claiming damages arising out of bankruptcy have first priority. Next in line are secured lenders, followed by tax and social security authorities. In Hungary, Poland and Czech Republic, the first and second orders of priority are granted to secured lenders and administrative costs related to the bankruptcy procedure. In Rus-sia, however, secured creditors' rights are rather weak compared with other nations. This is one rea-son why commercial credits have a bleak future in the productive sector in Russia.
15 See chapter 7 on Price Determination and Government Policy on Ukrainian Grain Markets.
16 The current legal framework is provided by the Law of Ukraine "On mortgage" passed on in 1992 and numerous changes and amendments to this law.
17 See chapter 14 on A Market for Agricultural Land in Ukraine.
Table 3: Claim priorities under bankruptcy laws in various nations (1995-1998)
Claim category Russia USA Germany
Nether-lands Hungary Poland Czech Republic
Court fees 1 2 1 1 1 1 1
Administrative
ex-penses 1 2 1 1 1 1 1
Secured creditors 4 1 2 2 2 2 1
Other creditors 6 3 4 4 5 5/6 3
Employee claims 2/3 2 1 1 1 1 1
Fiscal claims 5 2 3 3 4 1 2
Social security 5 2 3 3 4 4 2
Source: EUROPEAN EXPERTISE SERVICE ASSISTANCE TO THE RUSSIAN FEDERATION MINISTRY OF AGRICULTURE AND FOOD in Restructuring of Farm Debts Russian Federation Project No. RF27. Discussion Paper Farm Insolvency in Russia: Identified Problems and Possible Solutions (Restricted distribution)
5.2 Financial intermediaries in Ukraine – the need for further reorganisation
Ukraine has one of the smallest18 banking sectors of all the transition economies in CEE.
Nevertheless, this banking sector is by far the single most important lender in the country. Loans provided by banks to the private sector amounted to 11.8 bUAH in 1999. Leasing, investment funds and credit unions provided just 0.45, 0.2 and 0.04 bUAH respectively.
The attraction of savings from enterprises – although it improved considerably in 2000 and 2001 – is insufficient due a lack of trust in banks and financial institutions in general. The volume of deposits stood at 12.2 bUAH or 9.6% of GDP at the end of 1999, and increased to 18.6 bUAH or 10.6% of GDP in 2000. The bank loans issued to enterprises in 1999 amounted to 11.8 bUAH or 9.3% of GDP, and 19.1 bUAH or 11% of GDP in 2000. However, Ukraine lags behind other transi-tion economies in this regard. In Poland, for example, the share of commercial credits in GDP was almost 25% in 1998, and comparable figures for Slovenia and the Czech Republic are 35 and 55%, respectively.
5.2.1 Development of the banking sector in Ukraine
The poor condition of the Ukrainian banking sector cannot be understood in isolation from the malaise in the productive sector. Furthermore, as a consequence of the 1998 crisis, Ukrainian banks suffered from direct losses on T-bill holdings and other severe effects (seeROE ET AL.,2000, p. 29). Thus, the business environment for banks was rather weak in Ukraine, but it has been im-proving constantly since 1999.
At the same time, the very low efficiency of many Ukrainian banks is an impediment to the development of the sector. In figure 7, interest rates and interest rate spreads in Ukraine and Hun-gary are compared. Not only are interest rates in HunHun-gary lower, the interest rate spread in HunHun-gary remained at about 5% or even lower between 1996 and 2001. Interest rates in Ukraine have been three times as high as in Hungary, and the interest rate spread was always well above 20%.
High interest rate spreads reflect a range of cost factors, such as the risk of bad loans and high operating costs. ROE (2000) estimates that Ukrainian banks have to charge an interest rate spread of at least 20% just to cover their high operating costs. Figure 8 shows that the ratio of costs to income-earning capacity averages 20% in Ukraine compared with less than 5% in the Czech
18 The Ukrainian banking system consisted of 195 commercial banks as of February 1, 2001, of which only 153 were actually operating. The banking system of Ukraine is characterised by a high level of concentration. The seven largest banks own 50% of all assets, and the 120 smallest banks have only 15%.
public, Poland and Estonia, and less than 10% in Hungary and Latvia.19 Nevertheless, there is also good news for Ukraine. This is that the best banks perform much better than the average. They have costs of less than 10%, which is comparable to the Hungarian average. Hence, there are good banks in Ukraine which are capable of development, and poorly performing banks, which must restructure or leave the market. This is why banking sector reform is so important. Ukraine's new banking law provides the sector with a good legal foundation. If restructuring is carried out and the number of banks reduced, the sector will develop on a sustainable basis and will play an important role for eco-nomic growth for the rural areas.
Figure 5: Interest rates on credits and deposits
in Ukraine and Hungary Figure 6: Ratio of costs to income earning as-sets in different Transition Economies
0 10 20 30 40 50 60 70
1996 1997 1998 1999 2000 2001
Interes rates in %
Spread Hungary Spread Ukraine Hungary Deposit Hungary Credit Ukraine Deposit Ukraine Credit
0%
5%
10%
15%
20%
25%
30%
35%
40%
Ukraine Czech Republic
Hungary Poland Estonia Latvia
Ratio of costs to income earing assets
best average worst
Source: NATIONAL BANK OF UKRAINE AND NATIONAL
BANK OF HUNGARY. Source: ROE ET AL.2000.
5.2.2 Strengthening credit unions and establishing co-operative banks
The further development of SMEs in rural areas – among them the private agricultural enter-prises and household plots – will greatly depend on their access to financial institutions. Especially start-up enterprises with no credit history face difficulties in securing the small loans they need. Not only high interest rates but also high transaction costs are an obstacle to obtaining credit. The many documents that have to be provided for a loan application, the time spent and the travel expenses incurred, especially in remote areas, make a micro-credit of a few hundred or thousand Hryvnia ex-pensive, especially when the decision making process within the bank takes two to three months.
The experience gained by the Micro-Finance Bank (MFB), founded in Kyiv in January 2001, shows that these problems can be solved with appropriate credit technologies. While the MFB has its com-parative advantage in urban areas, in rural areas other types of financial intermediaries have proven that they can fill a niche, namely credit unions (CU) and co-operative banks (CB). Of course, CUs and CBs will never be the only financial institutions in rural areas, nor must they be the most impor-tant institutions. But by increasing the competition among rural financial institutions, they can en-hance the efficiency of the whole rural finance sector.
UNASCU, the Ukrainian National Association of Savings- and Credit Unions, estimates that there are about 500 CUs in Ukraine. More accurate data are not available as there is no national reg-istry of CU and as there is no national system to supervise CU activities. The UNASCU represents 105 CU with a total membership of 75,000, and total assets of over 10 mUAH. So far the legal envi-ronment for the existence of CUs and CBs has been weak. Along with the problems faced by all financial intermediaries in Ukraine, the development of CUs was impeded by a lack of regulation,
19 These figures can, to a certain extent, be explained by the low share of income earning assets to total assets which was as low as 50% in Ukraine, but reached almost 90% in the Czech Republic and over 80% in Hungary and Estonia in 1998.
by a lack of political support by local and national authorities, and by unequal tax treatment. As of May 2001, a law that has been submitted to the Verkhovna Rada which at least meets the minimum requirements of regulating CUs activity, has not been adopted. If adopted, this law would regulate the use of the term 'Credit Union' and it would be the normative basis for the functioning of the na-tional CU association etc. CUs and CBs should be given the right to do business with non-members, and they should be subject to general banking supervision.
5.2.3 The development of leasing
Leasing is an efficient means of using long-term assets such as machinery when enterprises lack the liquidity needed to purchase these assets. Hence, leasing could be an attractive instrument for agricultural producers and other enterprises in rural areas. However, the volume of leasing opera-tions in Ukraine lags far behind expectaopera-tions. According to data from the NBU, leasing operaopera-tions amounted to 450 mUAH in 1999, and UKRLEASING – the Ukrainian Leasing Association – esti-mates that the volume of leasing transactions was even smaller in 2000, not exceeding 300 mUAH.
As of today, there are over 50 leasing companies in Ukraine, of which not more than 25 actually operate. About 16 leasing companies, most of which were founded by agricultural machinery pro-ducers or banks, work in the agricultural sector.20
The volume of leasing transactions in the agricultural sector amounts to almost a half of all leasing transactions in Ukraine. This is caused mainly by involvement of the state in this sector.
With the Resolution of the Cabinet of Ministers No. 1031/97, the State Leasing Fund was initiated to provide agricultural enterprises with machinery and equipment produced in Ukraine. However, from the very beginning this Fund was very inefficient. Agricultural enterprises received altogether 8,345 units of equipment worth 391 mUAH from the State Leasing Fund as of March 2, 2001. However, the Fund could collect no more than 20.6% of due payments as of January 2001! This is the main reason why the Fund has also failed to make timely settlements with the producers of agricultural machinery. The company Ukragroleasing became the successor of the State Leasing Fund in July 1999, and is now responsible for managing its funds.
The funds that were channelled via the budget and the Leasing Fund towards agricultural producers have enabled them to purchase some machinery. But as the low payment rates show, the Leasing Fund was unable to assess the creditworthiness of lessees. Hence, the establishment of this organisation did nothing for the sustainable development of a market-based leasing system. Indeed, it is very likely that it was counterproductive, as it blocked private initiatives to develop the leasing market.
Leasing operations in Ukraine are regulated by the 1997 Law on leasing No. 723/97-BP. This law has many disadvantages that are addressed in a new law on leasing that was approved in second reading by Parliament on April 5, 2001. The adoption of this law is a priority.