UKRAINE: 2007 INVESTMENT CLIMATE STATEMENT

UNCLAS KYIV 000118

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E.O. 12958: N/A
TAGS: EINV ETRD KTDB OPIC USTR UP
SUBJECT: UKRAINE: 2007 INVESTMENT CLIMATE STATEMENT

REF: A) KYIV 114
B) KYIV 113
C) 2006 STATE 178303


1. Refs A and B contained parts one and two of the 2007
Investment Climate Statement (ICS) for Ukraine. The third
and final part of the ICS is below.

Text Continued:

A.9. Efficient Capital Markets and Portfolio Investment

BANKING

The Ukrainian banking system consists of the National Bank
of Ukraine and commercial banks. The NBU is responsible
for monetary policy, licensing of commercial banks, and
oversight of their activities.

The banking sector plays a still small, but growing role in
Ukraine's economy. Bank capital is just over 8% of GDP.
Total bank assets in Ukraine are about UAH 310 billion,
with total loan assets of UAH 238 billion. Money lending
and deposits grew at a fast 52% and 27% respectively in
January-October, 2006. Despite rapid growth, bank deposits
account for 39% of GDP. Interest rates continued to
decline from 16.4% in 2005 to 14.9% in 2006 making credit
more accessible. On December 1, 2005, the Rada amended the
"Consumer Rights Protection" law in favor of borrowers that
lifted the limitation on early loan repayment. There are
166 banks operating in Ukraine, but a handful of banks
dominate the market. The top dozen banks control 61% of the
loans outstanding and own 42% of the total capital of the
system. As the volume of consumer lending more than
doubled during 2006, the share of loans exceeding one year
increased to 58% of the total loan portfolio of the banking
system, up from 53% last year. Non-performing loans were
registered at 2% of the total lending portfolio.

In January 2002, the law "On Banks and Banking Activity"
eliminated discrimination against foreign banks. It
entrusted the NBU with issuing banking licenses and
includes provisions to prevent money laundering. The NBU
sets minimum capital requirements each year to be met by
the banks by the year-end. Current minimum capital
requirements range from UAH 20.04 million ($4 million) to
UAH 133.3 million ($26.3 million). Foreign licensed banks
may carry out all the same activities as domestic banks and
there is no ceiling on their participation in the banking
system. Foreign banks can operate via subsidiaries in
Ukraine. On November 16, 2006 the Rada approved an
amendment to the law "On Banks and Banking Activity"
permitting foreign banks to operate via branch offices.
The law anticipates a transition period of five years and
sets requirements for branches of foreign banks, including
cooperation with Financial Action Task Force and UAH 68.8
million ($13.6 million or EUR 10 million) minimum capital
of the branch. Foreign banks have increased their presence
in Ukraine's banking sector. The second largest Ukrainian
bank, "Aval," was purchased by the Austrian Raiffeisen bank
in October 2005 and medium-size UkrSibbank by French BNP
Paribas in December 2005. In 2006 European financial
groups purchased an additional 10 Ukrainian banks. Foreign
banks now account for approximately 25% of bank capital in
Ukraine.

In May 2002, most provisions of the law "On Systems of
Payment and Money Transfer in Ukraine" came into effect,
making payments more flexible and modern, including the use
of electronic signatures. In July 2001, a law "On
Financial Services and State Regulation of Financial
Markets in Ukraine" was passed which established legal
principles for the provision of financial services and
performance of regulatory and supervisory functions.
Ukraine remains a cash economy, but the use of credit cards
is on the rise. From January through September 2006, the
use of credit cards increased by 48% and use of ATM cards
increased over 46%, despite persistent credit card/ATM
fraud in Ukraine.

INSURANCE

Currently, based on the 1996 law "On Insurance," only
insurance companies registered in Ukraine may carry out
insurance operations. There is a lower minimum capital
requirement for domestic insurance companies than insurance
companies with foreign shareholders. Foreign insurance
companies can invest in local companies, but to operate
locally they are required to open branch offices. In
November 2006, however, the Rada adopted amendments to the
law "On Insurance" that give foreign companies the right to
operate in Ukraine through affiliates five years after
Ukraine accedes to the WTO.

CAPITAL MARKETS

The legal and regulatory framework, as well as financial
disclosure systems for the securities market, continues to
lag behind international standards. Basic market
infrastructure exists as does a competent regulator, but
the legislative basis for capital market operations is
weak. Rulings of the Securities and Stock Market State
Commission (SSMSC) have insufficient enforcement power and
are not always followed by the courts. Investors continue
to face low market confidence, high macroeconomic risk,
transitional accounting standards, a lack of accurate
company information, and inadequate protection of minority
shareholders' rights. Deficiencies in regulations governing
operation of registrars led to frequent cases of double
registration of shares, resulting in low protection of
shareholders' rights.

Ukrainian law allows for the following types of securities:
-- share securities (shares, investment certificates);
-- debt securities (bonds of enterprises, state bonds of
Ukraine, bonds of local loans, treasury obligations of
Ukraine, savings (depository) certificates, bills of
exchange);
-- mortgage securities (mortgage bonds, mortgage
certificates, mortgages, certificates of funds of
operations with real estate);
-- privatization securities;
-- derivative securities;
-- title securities

According to the SSMSC, last year there were 139 collective
investment institutions, 794 securities traders, 143
custodians, 370 registrars, and 12 self-regulatory
organizations (six of which are associations). Nine stock
exchanges were registered in Ukraine. A Ukrainian
securities industry broker/dealer self-regulatory
organization (SRO) and its nationwide electronic trading
system (PFTS) is the largest stock exchange with about 97%
of secondary onshore trading. PFTS Stock Exchange market
capitalization was UAH 125 billion (USD 25 billion) in
early 2006. The Ukrainian government is currently
considering options to consolidate the remaining, mostly
dormant stock exchanges to enhance price transparency, and
improve stock exchanges listing standards to establish
corporate governance and information disclosure based on
international norms.

The absence of a central securities depository complicates
transparent and efficient transfer of ownership records,
protection of ownership rights and clearance and settlement
of trades. Although a 1997 law created a state-owned
National Depository in 1999 which does not perform
depository functions, the market-owned MFS Depository has
been operating commercially as the Ukrainian Depository
since 1997 in line with current international practice. The
Ukrainian government is currently considering reform
options to establish a predominately privately owned
Ukrainian Central Depository through the merging of two
institutions.

Principle laws, decrees, and regulations governing
Ukraine's capital markets include: the law "On Securities
and Stock Exchanges" (1991),replaced in May of 2006 by the
law "On Securities and Stock Market' (2006),the law "On
Business Associations" (1991),"Presidential Decree on
Investment Funds and Investment Companies" (1994),"Law on
State Regulation of Securities Markets" (1996),"Amendments
to Law on Business Associations" (1996),the law "On
National Depository System" (1997),"Law on Accounting and
Financial Reporting" (1999),"Bankruptcy Law" (1992) law
"On Collective Investment Institutions" (2001),and the
"Law on Financial Services" (2001).

A law "On Collective Investment Institutions" encourages
the creation of mutual funds, introduces the idea of a
licensed asset manager, regulates the establishment and
operation of subjects of mutual investment, provides
guarantees of ownership rights to securities, and protects
rights of exchange market participants. The Ukrainian law
"On Circulation of Promissory Notes" (2001) provides a
framework for the circulation of promissory notes in
accordance with the Geneva Convention of 1930.

A new law "On Securities and Stock Market" (2006)
represents a major improvement over the prior law "On
Securities and Stock Exchanges" (1991),especially on the
new internationally compliant disclosure requirements for
listed companies, issues of transparency of ownership, and
the new rules for insider information and insider trading.

The law "On Business Associations" is vague and does not
support basic shareholders rights and facilitates a large
number of corporate governance abuses (including share
dilution, asset stripping, and dubious transfer pricing).
The law is widely recognized to be inadequate and in need
of reform.

Recently, Ukraine has witnessed an escalation in corporate
hijacking activity. Hijackers generally take advantage of
deficient legislation, corrupt courts, and a weak
regulatory system to gain control of companies at the
expense of rightful shareholders. Typically, predatory
groups of shareholders have been able to secure court
decisions invalidating or diluting the voting or ownership
rights of other investors. Around a dozen such attacks
occurred during the year, harming investors, including U.S.
companies and shareholders, and damaging the image of
Ukraine among foreign investors. The GOU recognizes the
seriousness of this problem and has begun to take steps to
address it. However, the government has failed to move
forward quickly with the draft law "On Joint-Stock
Companies," recognized as a key element to better combat
corporate hijacking.

A.10. Political Violence

General parliamentary elections took place in March 2006
without any significant disruptions or violence. The
likelihood of future widespread politically inspired
violence that would affect foreign property interests
remains relatively low.

A.11.a Corruption

Corruption pervades all levels of society and government
and all spheres of economic activity in Ukraine and is a
major obstacle to foreign direct investment. President
Yushchenko has made combating corruption a top priority,
and Ukraine's new government under Prime Minister Viktor
Yanukovych has affirmed its commitment to anti-corruption
efforts, although much remains to be accomplished. Ukraine
improved on Transparency International's Year 2006
Corruption Perception Index (CPI),which was published in
November 2006. The country moved up to 99th place in 2006
on the list of the 163 countries from 107th place out of
158 countries in 2005 and from 122nd place out of 145
countries in 2004. In 2006, Transparency International
rated Ukraine at 2.8 points on the CPI's 10-point scale, an
improvement over the 2005 rating of 2.6 points.

Corruption stems from a number of factors: a lack of
institutional traditions of transparent decision-making and
societal understanding of the importance of corporate
governance and transparency. Low public sector salaries
fuel corruption in local administrative bodies such as the
highway police and tax administration as well as in the
education system. Miniscule salaries in the medical system
mean that the state guarantee of "free medical care" has
been largely supplanted by a system of informal payments
where patients are expected to make extra payments to
receive treatment. High-level corruption ranges from
misuse of government resources and tax evasion to non-
transparent privatization and procurement procedures. In
short, corruption impacts the daily lives of Ukraine's
citizens and important decisions taken at the state level.

Ukraine's prosecution of corruption is based on the law "On
Combating Corruption," which was passed in October 1995.
The law is rarely enforced, and on the rare occasions it is
enforced, it is normally aimed at lower- or mid-level state
employees. In January 2006, the President Yushchenko
signed a decree requiring Ukraine to honor its obligations
to the Council of Europe, which include several anti-
corruption provisions. In September 2006, the President
signed a separate decree adopting a national anti-
corruption strategy that directs all branches of government
to support these efforts. In October 2006, the President
submitted to the Rada a package of draft laws on anti-
corruption and ratification instruments for the Council of
Europe Criminal Law Convention on Corruption. Ukraine in
2006 adopted a Threshold Country program under the U.S.
Millennium Challenge Corporation aimed at preventing
corruption. This two-year program will provide about $45
million in assistance to reform the judiciary, reduce
regulatory problems, institute internal assets declaration
and inspector generals, enhance civil society monitoring of
corruption, and reduce corruption in higher education
admissions through standardized testing.

Although government action is still limited, fundamental
changes have taken place in the GOU's attitude towards
corruption. Gone are the days when GOU officials refused
to admit that corruption existed in Ukraine. Government
and Rada officials now openly discuss the problem of
corruption with USG contacts and with the press and public
at large. In March 2005, Ukraine ratified the Council of
Europe Civil Law Convention on Corruption and became a
member of the Council of Europe's Group of States Against
Corruption (GRECO). Ukraine has not yet ratified the
Council of Europe Criminal Law Convention on Corruption,
signed in January 1999, or the UN Anticorruption
Convention, signed in December 2003. Ukraine is not party
to the OECD Convention on Combating Bribery of Foreign
Public Officials in International Business Transactions.

RULE OF LAW

As discussed above, improvement of the ability of investors
to protect their property and contractual rights is crucial
to the investment climate. The judicial system needs to be
reformed and its independence strengthened. Enforcement of
court decisions also is lacking.

A.11.b. Bilateral Investment Agreements

BILATERAL INVESTMENT AGREEMENTS

The Bilateral Investment Treaty between the United States
and Ukraine came into force on November 16, 1996. The
following countries have also signed bilateral investment
agreements with Ukraine: Albania (2004),Austria (1996),
Argentina (1995),Armenia (1994),Azerbaijan (1997),
Belarus (1995),Bulgaria (1994),Brunei (2006),Canada
(1994),Chile (1995),China (1992),Cuba (1995),Croatia
(1997),the Czech Republic (1994),Denmark (1992),Egypt
(1992),Estonia (1995),Finland (1992),France (1994),
Gambia (2006),Georgia (1995),Germany (1993),Greece
(1994),Indonesia (1996),Iran (1996),Israel (1995),Italy
(1993),Hungary (1995),Kazakhstan (1994),Kyrgyzstan
(1993),Latvia (1997),Lebanon (1996),Lithuania (1994),
Macedonia (1998),Moldova (1995),Mongolia (1992),the
Netherlands (1994),Panama (2005),Poland (1993),Russia
(1998),Saudi Arabia (2003),Slovakia (1994),Slovenia
(1999),South Korea (1996),Spain (1998),Sweden (1995),
Switzerland (1995),Turkmenistan (1998),Turkey (1996),UK
(1993),Uzbekistan (1993),Vietnam (1994),Yugoslavia
(2001),Yemen (2002)..

A.11.c. OPIC and Other Investment Insurance Programs

The U.S.-Ukraine Overseas Private Investment Corporation
(OPIC) Agreement was signed in Washington on May 6, 1992.
OPIC halted support for projects in Ukraine in 1999,
however, after OPIC and the Government failed to reach
agreement on reimbursement to OPIC for its payment of a
claim by a U.S. business whose investment had been
expropriated. Although OPIC resumed activities in Ukraine,
based on progress in negotiations, it again suspended
activities in 2006, but efforts to find a resolution
continued.

On July 20, 2002 the Board of the U.S. Export-Import bank
opened facilities for short and medium-term (up to seven
years) lending for commercial, and sub-sovereign projects.
Ukraine is a member of the Multilateral Investment
Guarantee Agency (MIGA). In 2005 MIGA issued an $18.1
million guarantee to Raiffeisen Bank of Austria to provide
coverage against the risks of transfer restriction and
expropriation its subordinated shareholder loan to Joint
Stock Commercial Raiffeisen Bank Ukraine.

A.11.d. Labor

LABOR AVAILABILITY

Ukraine has a well-educated and skilled labor force with
nearly a 100% literacy rate. The official (registered)
unemployment level is low, 2.3% as of November 2006, but
these figures are misleading. Most experts agree that
reported unemployment is understated: the real
unemployment rate is estimated to be 7.4 %.

WAGES

Wages in Ukraine are very low by Western standards but
increased significantly over the past year. In November
2006, the nominal average monthly wage in Ukraine was UAH
1073.10 ($214),up 19.7% from UAH 896.58 ($178) in November
2005 and up 66.6% from UAH 644.27 ($128) in November 2004.
Real wages grew by 20% between January and October 2006.
The highest wages are in the financial and aviation sectors
while the lowest wages were paid to agricultural and public
health workers.

MINIMUM WAGE

The minimum monthly wage was increased in December 2006 to
UAH 400 ($80),up from UAH 375 ($75) in 2005. According to
Ukrainian legislation, the minimum wage is adjusted
whenever consumer price increases reach 5%. The draft 2007
state budget stipulated further gradual increases of the
minimum wage to UAH 450 ($90) by the end of 2007.

PENSIONS

On January 1, 2004 Ukraine implemented a comprehensive
pension reform program, based on international standards,
which established a three-pillar system: Pillar I, a
solidarity system, Pillar II, a mandatory accumulation
system, and Pillar III, a voluntary private pension system.
The solidarity system, Pillar I, implemented the standard
under which retirement payouts are determined on the basis
of the individual's labor records and contributions.
Despite the major reform, the Pillar I system is complex
with low retirement ages (60 for men and 55 for woman),
full retirement benefits based on 20 years of service for
woman and 25 years for service for men, and many special
early retirement provisions.

Pillar II, the Mandatory Accumulation System, is to be
funded by pension contributions made by individuals and
employers. However, the 2003 legislation provided that
Pillar II would be introduced only if the following
conditions are met:

-- Stable economic growth of at least 2% of GDP per annum
for two consecutive years;
-- The Pension Fund of Ukraine budget is balanced;
-- The specific legislation for implementation of Pillar II
is adopted; and
-- Experience with the operation of private pension funds.

Currently the conditions for the introduction of Pillar II
have been met. The "Draft Law on Implementing the
Accumulation System of the Mandatory State Pension
Insurance and Amending Certain Laws of Ukraine" has been
drafted and it is currently expected that the draft Law
will be submitted to the Verkhovna Rada in early 2007. The
draft Law provides for a gradual phase-in of employee
contributions starting with 2% in 2009 and increasing by 1%
per year reaching the maximum 7% provided by the draft Law
in 2014.

Pillar III, voluntary private pension funds, began actual
operations in September 2005, following the adoption of the
required normative acts by the Financial Services Regulator
in January 2005. For the last year the development of
private pension funds is quite positive, showing a 24%
increase in the last six months.

According to the Financial Services Regulator, Private
Pension Fund assets have increased by an average 48 percent
per fiscal quarter, since becoming available in 2005. In
Q1 2005, assets under management of Private Pension Funds
were approximately $2.65 million, by Q2 2006 assets had
reached approximately $18.75 million, and by Q4 2006 assets
are projected to reach $41.07 million. Unfortunately, due
to the lack of financial instruments in Ukraine, assets of
private pension funds continue to be invested primarily in
bank deposits, which do not meet the long-term portfolio
needs of these funds. If the situation continues, it can
easily be argued that private pension funds will not meet
the payout requirements of future pensioners.

Major impediments for the future development of the pension
industry in Ukraine include: (i) fiscal imbalances
resulting from 2004-2005 revisions of Pillar I; (ii) lack
of quality investments on the Ukrainian capital market that
need to become available to the pillar II and III; and
(iii) weaknesses in the regulatory and supervisory
framework. Also there is an important relationship between
the development of a pension industry in Ukraine and
development of the stock market with respect of market
capitalization and value traded.

LABOR/MANAGEMENT RELATIONS

Ukrainian workers are generally accustomed to "top-down"
management practices and therefore usually do not
demonstrate initiative. A younger, more independent-minded
generation is slowly moving into the workforce, and it is
becoming easier to find professional personnel who function
independently.

Although investors may encounter government resistance to
trimming the work force to an efficient level, across-the-
board demands to maintain employment levels are
disappearing. Ukrainian enterprises often still maintain
much of the social infrastructure of their immediate
community (schools for local children, cafeterias, and
medical facilities). While many local officials are
willing to work with businesses to identify social services
that an enterprise must support, such arrangements should
be clearly spelled out before investments are started.

A.11.e. Foreign Trade Zones/ Free Ports

Until 2005 Ukraine maintained two forms of Special Economic
Zone (SEZs): 11 Free Economic Zones (FEZs) and 9 Priority
Development Territories (PDTs). On March 23 2005, a law
"On the Amendments to 2005 Budget of Ukraine" cancelled all
tax privileges (i.e. land tax, corporate income tax, import
duty, and VAT on imports) to SEZs that had been meant to
encourage investment and production of goods for export.
The IMF and the World Bank had repeatedly expressed concern
about tax evasion and smuggling in the zones, strongly
supported the elimination of tax exemptions, and urged the
GOU to resist pressures to reopen the tax loopholes closed
in the 2005 budget amendments. In cases of foreign direct
investment, where the investing firms had met the
conditions for the privileges, the IMF and the World Bank
suggested that the GOU determine whether compensation may
be due to some investors.

The new government of Prime Minister Yanukovych has
announced its intention to re-establish some tax and
customs privileges for investors and export processors
located within SEZs, through draft amendments to the Law of
Ukraine "On General Principle of Creation and Functioning
Special Economic Zones," and stated it would develop a
compensation mechanism for investors who suffered from the
2005 cancellation. The GOU states that the main goal of
this law is to improve the investment climate in Ukraine
and to launch new, export oriented, innovative projects.
The draft law provides investors in SEZs with tax
privileges, including investment (profits) tax credits and
duty-free imports of equipment. The GOU asserts that the
newly constituted SEZs will operate in compliance with WTO
provisions. By year's end, no action was taken to re-
establish the SEZs, and the planned privileges were not
defined.

FREE PORTS

Porto-Franco FEZ in Odessa Port was a free port until all
FEZ privileges were cancelled by the 2005 budget. The
draft law "On General Principle of Creation and Functioning
Special Economic Zones" anticipates tax privilege renewal
for the Odessa Port. In total, Ukraine has 20 seaports and
10 river ports located on the Black Sea, the Sea of Azov,
and the Danube, Yuzhniy Bug, and Dnipro rivers. They are
currently under the authority of the Ministry of
Transportation's Department of Sea and River Transport.
All seaports are state-owned with the exception of a small
port that belongs to the Mykolayiv Alumina Plant. All
river ports are open or closed joint-stock companies.

A.11.f. Foreign Direct Investment Statistics

FOREIGN DIRECT INVESTMENT

According to Ukraine's State Statistics Committee, as of
October 2006 the total stock of FDI in Ukraine was $19.9
billion, or $424 per capita. This was a 22.3% increase
from the end of 2005, when the total stock of FDI stood at
$16.4 billion, or $341 per capita, and a 136% increase from
January 2005, when FDI was only $8.4 billion. Mittal
Steel's October 2005 purchase of the Kryvorizhstal Steel
Mill represented a major inflow of FDI, at $4.8 billion,
into Ukraine. Purchases of Ukrainian banks by European
banks represented another major inflow of foreign direct
investment in 2005 and 2006.

FDI BY COUNTRY

As of October 1, 2006 Ukraine's major investors included:
Germany (28.6% of total FDI),Cyprus (11%),Austria (8.3%),
the United Kingdom (7.6%),the United States (7%),the
Netherlands (6.9%),British Virgin Islands (4.0%),and
Russia (4.6%). Cyprus is a popular offshore destination
for Ukrainian and Russian enterprises.

FDI BY INDUSTRY SECTOR DESTINATION

Over the first 9 months of 2006, 10.5% of new FDI went to
the financial industry, 10.0% -- to domestic trade, 7.2% --
to real estate, 6.9 % -- to the metallurgy sector, and 6.2%
-- to food processing.

End Text.

TAYLOR