BA456 - Emerging Markets

NewBank Microfinance:Microcredit in the Ukraine

Case

Holly DiceAndrew KhooSara KirchhoffRobert LittleHartaj Singh

NewBank Microfinance – Case

NewBank Microfinance: Microcredit in the Ukraine

Oleksa Dovbush leaned back in his chair and stared up at the roof of his office in the heart of the financial district of New York City. He was about to turn fifty and was feeling every one of those years. During the most trying times in his life - his family’s flight from Ukraine when he was nine to the sixteen-hour days he had put into building his business over the last twenty years – he had never felt as badly as he did today.

It was the tenth anniversary of his mother’s death and her last wish still lay heavy on his heart. She had a simple request “……help the people of Ukraine, your home. Not the fat-cats, but the ones who need the help the most in these trying times.” His mother had been proud of the history and culture that had been the Ukraine, before free-market economics had been introduced. Since the end of the Soviet Union, Ukraine had lurched from one political crisis to another, while ordinary people saw their savings and wealth devalue. A few got rich, others simply left, but most had to just grin and bear it.

It was these people that his mother had wanted him to help. Now that Oleksa was the President and Chief Executive Officer of the largest luxury goods firm in the world - a firm that had started off with him selling cheap perfume on a New York city street corner – he could afford to act upon his mother’s wishes. Yet he had not, and had instead convinced himself that building his business and making it even larger and more profitable was the most important goal in life. Oleksa could not see how he could benefit his people without opening an office of his company in Kiev, but the economic climate in Ukraine was not conducive to a luxury goods firm being hugely profitable there. He could just donate some money but that didn’t feel right either. Still his mother’s final request hung like a fog around his heart.

If there was one ray of light gleaming through his melancholic thoughts, it was the meeting he had today with a group of young and vibrant Ukrainians. They had broached him with an idea that he could see potential in. Andrew Stoianovich and Sara Kroschenko, two American-born Ukrainians, had worked for the World Bank for a number of years. Their specialty had been in helping set-up micro-credit financing banks in emerging markets all over the world. They had, an idea for the creation of a, not simply sustainable, but profitable micro-credit lending enterprise in Ukraine. Over time they planned to grow this firm into a national bank providing a full range of financial services to Ukrainians.

Since he himself had gotten a start selling cheap perfume by getting a high-interest loan from a neighborhood loan shark, Oleksa understood the importance of access to capital. The question was whether this concept could be viable in Ukraine and whether his money would be more effective elsewhere. This is what he was interested in knowing from this team of young entrepreneurs he had met today. They were going to present their full-analysis to him on the coming Monday.

Overview of the Ukraine

General Description

Ukraine is located in the heart of the former Soviet Union bordering Russia in the east, Belarus and Poland in the north, and a host of countries to the west (Czech Republic, Slovakia, Hungary, Moldova and Romania). It is the second largest European country and covers 240,000 sq. mi. with a population over 51 million.

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NewBank Microfinance – Case

Ukraine’s five largest cities are Kiev (2.6 m), Kharkiv (1.6 m), Dnipropetrovsk (1.2 m), Donetsk (1.1 m), and Odessa (1.1 m). The population, two-thirds of which lies in urban areas, is fairly homogeneous with 70% of Ukrainian descent. Ukranians are also well educated with a literacy rate of 99%. In rural areas much of the land is used for farming (70% of the total country). In addition to arable land Ukraine is rich in natural resource including iron ore, coal, manganese, natural gas, oil, salt, sulfur, graphite, titanium, magnesium, kaolin, nickel, mercury, timber. While Ukraine is nearly self-sufficient in terms of coal it must import three-quarters of its natural gas and 90% of its oil. All imported oil comes from Russia.

Recent History

Shared historical, linguistic and cultural roots have closely linked the politics and economy of Ukraine with Russia. Ties between the two nations originate in Kievian Rus’, an ancient state that existed on the present day territory of Ukraine from the 6th to the 10th centuries A.D. The famed Prince Vladimir defended this early state against the invading armies of Central Asia and also introduced the Christian religion to the Slavic people..

However, by 1169 prince Andrey Bogolyubski conquered and destroyed Kiev and established his capital near present site of Moscow, thus originating present Russian state. Ukraine was destined thereafter to serve the needs of the ever-expanding Russian empire, and intermittently, those of the Polish, Lithuanian and Austrian states. A source of rich natural and agricultural resources, as well as a warm water port at Sevastapol, Ukraine is a strategic asset.

During World War II Ukraine fell under Soviet control that would last for the next fifty years. This was a repressive period for Ukrainian people in which they lost their political autonomy, much of their personal freedom and were forced in the Soviet Union’s collectivization efforts. In response to an overthrow attempt of Gorbachev's government by the conservative hard-line forces the Ukrainian parliament declared the full independence of Ukraine in an emergency session on August 24, 1991. Relative to its neighbors, however, Ukraine has been slow to break away from its Soviet past.

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NewBank Microfinance – Case

Ukraine’s independence initiated a transition to democracy and a market economy culminating in June of 1996 with the adoption of a new constitution. This new constitution guarantees basic democratic freedoms and rights, established a Western-style judicial system, guaranteed the right to private property and the right to own land, and clearly divided power between the executive and legislative branches of power. However, problems persist in the enactment of enabling legislation to support constitutional guarantees. Consequently, there remains rampant corruption and misguided economic priorities have made genuine reform difficult.

While the political transition has been relatively peaceful the economic turmoil since independence has been devastating. Ukraine’s economy is currently a mere 40% of its pre-independence size. Wages have shrunk to roughly half of their previous levels and hyperinflation has rendered the life savings of the Ukrainians’ worthless. This economic collapse has resulted from ineffective government policy decisions (monetary policy, economic structure, and taxation) and an inability of Ukrainian industries to respond effectively to their new business environment. Compounding these problems has been the development of a shadow economy that is estimated at 60% of the Ukraine’s entire economic output.

This is in part due to the fact that throughout the 1990s Russia has repeatedly sought influence over Ukraine. It has vigorously defended the rights of Ukraine’s Russian-speaking population (30% of the population), made claims to the Black Sea Fleet at Sevastopol and asserted its will by restricting the nation’s supply of energy (90% of which originates in Russia).

In 1994, two and a half years after declaring independence, Ukraine held its first national elections. The former prime minister and leader of the , Leonid Kuchma, was elected to a five-year term. During the early 1990’s Kuchma established a moderately pro-Russian foreign policy while pursuing currency stabilization and price liberalization on the economic front.

While Kuchma’s efforts to establish the currency met with some success, the economy continued to crumble – in less than a decade Ukraine’s per capita GDP shrunk to half that of the Soviet era. In addition, deep wage arrears sparked labor unrest and tax evasion became endemic. Not surprisingly, Ukraine has been heavily dependent on foreign aid ever since its independence. In total, the US has sent $2.8 billion in aid along with billions from the IMF and the World Bank.

The 1999 ruble crisis further devastated Ukraine’s economy. In 2000 Ukraine was forced to exchange $2.7 billion in foreign debt due 2000 and 2001 for new seven-year dollar (11% coupon) and euro dollar denominated bonds (10% coupon) issued at face. Then in September 2000, as a prerequisite for more loans from the IMF, the Ukrainian Government arranged with the central bank to reschedule $1.9 billion in debt that the Finance Ministry owed the central bank.  The new bonds with maturation between 2002 and 2010 pay an annual interest in 2001 of 18.86%.

In 2001, the government began to issue new debt for the first time in almost two years. It is expected to reschedule the remainder of the debt set to come due later this year and it hopes to receive a $250 million loan from the World Bank to cover the current budget deficit.

Though the economic crisis may be lifting, Ukraine is now poised for political crisis. Recently, audio recordings have come to light that link President Kuchma with the September 16 death of the outspoken journalist Heorhii Gongadze. On March 1, in an open letter in the Financial Times, the financier George Soros urged President Kuchma to step aside to facilitate a full investigation.

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NewBank Microfinance – Case

Small Business in the Ukraine

In early 1998, about 137,000 small and medium-sized businesses were registered in Ukraine. This group employs about 6% of the total workforce and produces about 4% of the total output. Additionally, unreported smaller operations are estimated to number several hundred thousand. The majority of these enterprises are in trade and catering. These businesses make up 14% of all industry in Ukraine with the highest concentration located in Kyiv (20%). The largest obstacles to growth in these ventures are the inaccessibility of financing, a high tax rates, and an excessive bureaucratic burden.

The hostile environment for entrepreneurial activity in the Ukraine has led to the development of a micro and small enterprise sector that operates largely outside the official framework of business registration and reporting (the so-called shadow economy), thus depriving the whole sector of access to formal finance. Many private micro and small enterprises suffer from a lack of access to capital. They can borrow only from the informal financial sector, or not at all, since the underdeveloped banking sector is neither able nor willing to serve this target group. Currently, micro enterprises largely depend on the unstable and illiquid informal market, i.e. friends, relatives or moneylenders.

Banking in the Ukraine

The Ukrainian financial sector, like those of other ex-Soviet republics, is still characterized by inefficiency and instability. Soviet-era ideas on the role of banking were completely different from what banks are supposed to do in a market economy. Banks were mainly set up to finance state-run production; risk management, client orientation or product innovation were virtually unknown. Much of the growth in domestic credit has been to the government sector and credit to the private sector accounts for less than 10% of the GDP. Lending to the private sector is constrained by its cost (the weighted average of commercial bank’s nominal interest rates was over 50% last year, implying continued high real interest rates) and general uncertainties that limit most maturities to less than six months. Commerical loan rates are around 7-10% above prime for hryvnia denominated loans. Additionally, banks are generally not seen as reliable, professional partners offering a reasonable source of financing. Indeed, banks are often seen as convenient databases for tax inspectors rather than sources of credit.

The Ukrainian banking sector is simply not ready to serve micro entrepreneurs. Bank personnel tend to display a hostile attitude towards micro entrepreneurs. Banks do not have the credit technology necessary to process micro loan applications efficiently. They are unable to accurately assess a micro entrepreneur's ability to repay. Their internal credit procedures impose such high transaction costs that micro credit relationships are simply not economic for either the banks or the micro clients.

The ineffectiveness of the Ukrainian banking sector provides a significant opportunity for an organization that can efficiently deal with microlenders. Currently, there is a vast underserved market of small businesses desiring credit. Utilizing banking procedures from western markets and gaining trust with Ukrainian entrepreneurs would allow for a profitable microenterprise bank.

Overview of Microfinance

With an estimated 500 million households worldwide in poverty1, organizations such as the World Bank are fighting a seemingly fruitless battle against worldwide poverty. Government grants and worldwide financial aid while tremendously helpful are simply not enough. What is required is a form of

1 World Bank web site.

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NewBank Microfinance – Case

aid that allows the poor to lift themselves above and remain above the poverty line. Microfinance is one such methodology.

In its purest state, microfinance is the provision of loans and financial services to the poor, households and individuals. The theory is that the poor in developing countries are suffering from a lack of access to capital which would allow them to start small businesses or microenterprises and raise themselves beyond poverty. Sometimes loans as small as $25 is all that is required to make a tremendous difference but the majority of the poor only have access of funds through informal money lenders. The primary goal of microfinance is the alleviation of worldwide poverty and not profitability. As a result most of the microfinance institutions (MFIs) are typically non-governmental organizations (NGOs) or not-for-profits. Commerical banks and other sources have not been able to successfully service this target market because of the labor and resource intense nature, small sizes of loans, lack and difficulty in obtaining collateral, lack of credit history, risk of default, socio-economic and cultural barriers and internal bank policy issues

MFIs have existed in some form since at least the 1960s but due to the highly fragmented and isolated nature of this business as well as a lack of accounting standards, accurate data is difficult to obtain. In addition, most of the MFIs created prior to the 1980s are no longer in existence as they tended to suffer from “dismal repayment rates, corruption, and heavy subsidization leading to a grant mentality among clients.”2 Support and interest increased substantially throughout the 1980s and the 1990s with the tremendous success of the Grameen Bank in Bangladesh. Established in 1976 by Muhammud Yunus, Grameen Bank has now over 1,100 branches, over 2 million borrowers and over $400 million in assets. In addition, it now provides a whole host of other financial services to the people of Bangladesh and has become the model of success for microfinance. It is now estimated that there are currently over 7,000 MFIs serving some 16 million poor people in developing countries with total cash turnover of MFIs world-wide estimated at US$2.5 billion3.

There exists a whole spectrum of different models used by MFIs but they can be categorized in two broad groups: individual-based lending and group-based lending. Individual lending is the most straight-forward credit lending model where micro loans are given directly to the borrower. It is believed that the individual lending model provides the greater opportunity to achieve cost efficiencies and profitability in the long run. However, it is the riskier of the two models because of the individual nature. The group-based lending philosophy is based upon the belief that the weaknesses at the individual level can be overcome by the social pressures from a group and the cross-guarantees that the group provides. A typical group-based lending system would work as follows. The MFI would establish a number of branches in a developing country. Each branch would consist of several field staff who would be responsible for identifying low-income communities. Within these low-income communities, groups would be formed of similar income and asset holding levels. The group as a whole is responsible for the repayment of what loans any individual in the group takes out, hence the necessity for some level of equality within the group. Interest rates are charged such that it is sufficient to cover the costs of issuing the loan. As the credibility of the borrower is established, loan sizes will increase and so will access to future financial services.

Microfinance loans range in size from $25 for models like that for rural areas in Bangladesh to as high as $100,000 for some small business loans. Because of the small loan sizes they are very labor and resource intensive to administer. Terms are short-term (6 months to 2 years) depending on the size and the credibility of the borrower. In addition, there is typically no collateral given, and even if collateral was available the operating environment is such that it would be extremely difficult for an institution to

2 The World Bank Group, A Worldwide Inventory of Microfinance Institutions, 1995.3 Microcredit Summit

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NewBank Microfinance – Case

seize that asset. Despite the risky nature of this type of lending, default rates have historically been very low, usually less than 5%. The social pressures of the group and the promise of future financial services act as a surprisingly strong deterrent against defaulting on the loans. Finally most MFIs have lent to a disproportionate percentage of women (>90%) because of the belief that women are more reliable borrowers than men.

Since most MFIs operate in environments where the only alternative source of funds are money lenders which charge from 5 to 10% per month, it is theoretically possible for MFIs to charge as high an interest rate as they want so long as they are below the money lender rate. However, one must remember that the primary goal of an MFI is poverty reduction, not profitability and by haphazardly increasing the interest rates we may stagnate the growth in the penetration of the MFI. That being said, interest rates required to cover the costs of issuing the loan in the range of 20% to over 100% annually are not unheard of or unreasonable.

Achieving Financial Sustainability

The greatest problem facing microfinance is financial sustainability. To reach the Microcredit Summit’s4 goal of providing loans to 100 million households will require an estimated $21 billion in funds. There is simply not enough funds from government grants, donations and subsidies to support this. Therefore, MFIs must approach the capital markets and to do so, they will not only have to prove sustainability but also profitability.

All MFIs begin their existence with donations, grants or heavily subsidized sources of funds. After approximately 4 to 5 years of losses the most efficient MFIs are able to achieve financial sustainability. In other words, they are able to operate without additional subsidized funding. There are significant costs involved in starting an MFI and a very high learning curve before financial sustainability can be achieved. Financial sustainability does not imply a significant level of profitability that would be commonly recognized in a commercial venue. There are MFIs in existence that claim to be profitable but certainly not at the level required to obtain funding from the capital markets. To achieve increased profitability, MFIs have focused on either raising the interest rates on their loans or trying to achieve greater cost efficiencies.

Description of NewBank

NewBank is the microfinance institution that is being planned for the Ukriane. NewBank would provide loans to individuals and microenterprises below the ‘high-end’ lending provided by the International Monetary Fund (IMF) and various multinational banks operating in Ukraine. However, it would provide loans above the ‘low-end’ lending provided by institutions like the Grameen Bank. The idea is to target the growing middle-market and small businesses in Ukraine. Over time, NewBank could grow into the low-end and high-end markets.

The ‘high-end’ lending activities of the IMF and multinational banks are plagued by high loan default rates and a volatility engendered by the precarious nature of the political and economic conditions in Ukraine. Also, the competition is especially fierce in this arena, as many institutions - both not-for-profit and for-profit – competed for a small cadre of blue-chip companies in Ukraine. In contrast while the ‘low-end’ market is just as underserved in the Ukraine, these institutions take many years to set-up because of the large number of branches required. Finding qualified people to staff these branches would be a time and capital-intensive activity.

4 The Microcredit Summit is a global association of participants in microfinance.

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NewBank Microfinance – Case

NewBank would focus its lending efforts through 'lending circles'; groups of typically five individuals or microenterprises who are seeking small to intermediate commercial, industrial, and agricultural short-term loans. The group would mutually manage and guarantee the loans within the group. Decentralized lending decisions are made close to the customer via branch locations throughout the Ukraine at the sole discretion of the branch officers.

The loans themselves would be in the range of $1,000 to $100,000 with terms ranging from 6 months to 2 years with an average duration of 18 months. The length and amount of the loan would depend primarily on customer credit worthiness and both would increase with established credibility. Unlike other community based lending institutions and because of the larger sizes of the loans, collateral would be required on a case-by-case basis. The loans would also be in US dollars as opposed to the volatile Ukranian hryvnia.

One of the more difficult questions to answer was what interest rate to charge. Obviously, NewBank would have to charge an interest rate greater than what was charged by banks to commercial lenders because of the added risk. But then it would have to be less than what the informal money lenders charged. Finally, NewBank had to consider pricing such that it could provide the greatest access to capital for these microenterprises. Based upon recent macroeconomic data on the Ukraine, NewBank was expecting to charge an interest rate of [50%]. All debtors would also be required to deposit 10% of their loan balance into an interest bearing account at NewBank to encourage savings and trust in the institution. These deposits along with the repayment of loans and interest would provide sourcing of funds for future loans.

The allowance for loan losses is established through a provision for loan losses charged against earnings on the proforma income statement. The level of the allowance for loan losses is based on management's evaluation of the risk inherent in the loan portfolio at the balance sheet date and changes in the quality of the portfolio. While typical microfinance default rates are less than 5%, for purposes of compiling the proforma financial statements, a conservative 10% provision was utilized because of the loans being US dollar based.

Sources of Funds

Like every other MFI, NewBank would require subsidized financing for at least the first four to five years and that is where Oleksa was being asked to step in. It was anticipated that NewBank would require approximately $2.5 million in interest free debt funding which Oleksa was being asked to donate during the first two years, and approximately $3 million in staged equity funding. This additional equity financing had yet to be sourced but there were a number of potential sources with strong ties to the Ukraine that could be approached. The funding would be drawn down upon as required to support the operations.

Conclusion

Oleksa found the idea of NewBank very intriguing but there were a great deal of issues that still concerned him. First and foremost was the desire to help the people of the Ukraine but the number of years he had spent running his business forced him to consider the more financial issues. Would the bank work and be sustainable when so many microfinance institutions were not? Would other equity investors want to participate in such an investment? And was this really the best use of his funds to help the small businesses in the Ukraine given the risk.

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NewBank Microfinance – Case

Exhibit 9 – Economic Forecasts

I. Forecast – baseline scenarioItems Unit Estimate Forecast Forecast Forecast

1999 2000 2001 2002

Offi

cial

Eco

nom

y

GDP Nominal bn Hrv 127.1 164.5 199.4 233.7

GDP Real (growth rate) % -0.4 2.5 2.7 3.0

Private Consumption % 1.4 2.0 2.2 2.8

Government Consumption % -2.1 -5.0 -1.5 0.0

Investment in Fixed Assets % -0.1 0.0 2.0 4.0

Exports % -7.8 2.6 3.8 4.5

Imports % -14.3 1.0 2.0 3.0

Tota

l Eco

nom

y (O

ffici

al

+Sh

adow

)

GDP Nominal Bn Hrv 190.6 250.0 302.2 352.1

GDP Real (growth rate) % -0.4 0.4 2.0 2.2

Private Consumption % -3.5 1.5 2.0 2.5

Government Consumption % -2.1 -5.0 -1.5 0.0

Investment in Fixed Assets % -5.1 0.2 1.8 3.0

Exports % -6.2 4.1 3.7 2.6

Imports % -17.4 2.0 2.5 3.0

MONETARY INDICATORS

CPI, annual average, growth rate % 22.7 28.0 18.5 14.0

PPI, annual average, growth rate % 31.1 22.0 16.8 13.0

Exchange rate (Hrv/$), annual avrg Hrv 4.1 6.1 7.0 7.5

Money Base (bn Hrv), end of period Hrv 12.0 14.3 17.0 19.5

Growth rate % 38.9 19.4 18.9 14.7

As % of officialGDP 9.4 8.7 8.5 8.3

Interest Rate (commercial), % 53 47 37 28

Real interest rate % 25 15 16 12

BALANCE OF PAYMENTS, $bn

Current Account bn US$ 0.1 0.3 0.5 0.8

Gross Reserves, end of period bn US$ 1.1 1.3 1.5 2.4

Source: Harvard Ukranian Studies Institute

NewBank Microfinance – Case

Forecast – reform scenarioItems Unit Estimate Forecast Forecast Forecast

1999 2000 2001 2002

Offi

cial

Eco

nom

y

GDP Nominal bn Hrv 127.1 164.5 200.0 236.0

GDP Real (growth rate) % -0.4 2.5 1.5 4.4

Private Consumption % 1.4 2.0 1.4 3.0

Government Consumption % -2.1 -5.0 -2.0 0.0

Investment in Fixed Assets % -0.1 0.0 0.2 4.0

Exports % -7.8 2.6 3.1 7.8

Imports % -14.3 1.0 2.0 3.0

Tota

l Eco

nom

y (O

ffici

al

+Sh

adow

)

GDP Nominal Bn Hrv 190.6 250.6 303.5 351.8

GDP Real (growth rate) % -0.4 0.4 1.0 2.5

Private Consumption % -3.5 1.5 0.8 2.0

Government Consumption % -2.1 -5.0 -2.0 0.0

Investment in Fixed Assets % -5.1 0.2 0.0 2.8

Exports % -6.2 4.1 4.0 4.4

Imports % -17.4 2.0 2.2 2.7

MONETARY INDICATORS

CPI, annual average, growth rate % 22.7 28.8 20.3 13.7

PPI, annual average, growth rate % 31.1 22.0 17.5 12.8

Exchange rate (Hrv/$), annual avrg Hrv 4.1 6.10 7.20 7.60

Money Base (bn Hrv), end of period Hrv 12.0 14.3 18.5 23.0

Growth rate % 38.9 19.4 29.4 24.3

As % of officialGDP 9.4 8.7 9.2 9.7

Interest Rate (commercial), % 53 47 37 28

Real interest rate % 25 14 14 13

BALANCE OF PAYMENTS, $ bn

Current Account bn US$ 0.1 0.5 0.6 1.4

Gross Reserves, end of period bn US$ 1.1 1.7 2.6 4.6

NewBank Microfinance – Case

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NewBank Microfinance – Case

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NewBank Microfinance – Case

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Additional Internet Resources

Site name URLACCION International www.accion.orgAssociation for Social Advancement (ASA) www.asabd.orgBRAC www.brac.netCGAP www.cgap.orgFINCA International www.villagebanking.orgGrameen Foundation www.grameenfoundation.orgGrameen Bank www.grameen-info.orgMicrocredit Summit Campaign www.microcreditsummit.orgMicroenterprise Innovation Project www.mip.orgShorebank www.shorebankcorp.comUnited Nations Capital Development Fund www.uncdf.orgThe U.S. Agency for International Development www.usaid.govThe Virtual Library on Microcredit gdrc.org/icm/World Bank www.worldbank.org

www.bank.gov.ua/ELGL/STATIST/MONEY_/mon92-2000.htm National Bank of Ukraine, “Monetary and Banking Statistics”, December 9, 2000

www.bisnis.doc.gov/bisnis/country/000128banks.htm “Largest Banks in Ukraine”

www.corporateinformation.com/uasector/Financial.html, “Industry Analysis Ukraine :Financial”

www.gdrc.org/icm/micro-camel.html , “How to Make Microcredit Organizations Financially Independent”, MicroCAMEL,

www.photius.com/wfb2000/countries/ukraine/ukraine_economy.html , “Ukraine Economy 2000”