BA456 - Emerging Markets
NewBank Microfinance:
Microcredit in the Ukraine
Case
Holly Dice
Andrew Khoo
Sara Kirchhoff
Robert Little
Hartaj 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.
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.
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.
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 poverty[1], 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 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