Report No. 9099-UG

UgandaFinancial Sector Review(In Two Volumes) Volume l: Summary and Recommendations

May 7, 1991

Industry and Energy Operations DivisionEastern Africa DepartmentAfrica Region

FOR OFFICIAL USE ONLY

U

Documnt of the World Bank

This document ha,-a restricted distribution and may be used by recipientsonly in the performance of their official duties. Its contents may not otherwisebe discloted without World Bank authorization.

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ACRONYMS & ABBREVIATIONS

ARP Agricultural Rehabilitation ProjectASAC Agricultural Sector Adjustment CreditBAH Booz Allen & HamiltonBOU Bank of UgandaCMB Coffee Marketing BoardCOOP Cooperative BankCPI Consumer Price IndexC&L Coopers & LybrandDFCU Development Finance Corporation of UgandaDFF Development Financing FundDFG Development Finance Group (UCB)DFIs Development Finance InstitutionsEADB East Africa Development BankERC Economic Recovery CreditERP Economic Recovery ProgramESAF Enhanced Structural Adjustment FacilityFY Fiscal YearGOU Government of UgandaHFC Housing Finance CorporationHFCU Housing Finance Corporation of UgandaIMF International Monetary FundLAUB Libyan Arab Uganda BankMDC Manpower Development CenterMFS Mortgage Finance SchemeMOF Ministry of FinanceNBFIs Non-Bank Finance InstitutionsNIC National Insurance CorporationOGL Open General LicensingPFP Policy Framework PaperRFS Rural Farmers' Scheme (UCB)SCC Swedish Cooperation CenterSIP Special Imports ProgrammeUCB Uganda Commercial BankUDB Uganda Development BankUSh Uganda Shillings

CURRENCY EQUIVALENTS

Currency Unit = Ugandan Shillings (USh)

US$ 1.0 = USh 570

GOVERNMENT OF UGANDA FISCAL YEAR

July 1 - June 30

FOR OFFICIAL USE ONLY

PREFACE

This report is the result of a collaborative effort between theGovernment (the Ministry of Finance and the Bank of Uganda) and the WorldBank Group (the International Bank for Reconstruction and Development (IBRD)and the International Finance Corporation (IFC)) and is based on a missionthat visited Uganda in March 1990. The members of the mission, led by Mr.Irfan Aleem, were Messrs. John Roberts (corporate and development financeissues), Roy Karaoglan (commercial banking specialist), Jacob Yaron (ruralfinance issues), Yaw Osafo-Maafo (housing finance specialist), Alan Roe(macroeconomist), T. N. Iyer (central banking specialist), James Mallyon(central banking specialist), Harry Sasson (development finance issues) andMs. Diane Coogan (researcher). Although there has been extensive collabora-tion with Government, the conclusions of this report are ultimately theresponsibility of the mission.

While Mr. Irfan Aleem is the principal author of this report,there are many people who greatly assisted in its preparation. In additionto the other members of the mission, they include staff of the variousgovernment agencies, parastatals, and the Bank of Uganda, and many individu-als from the private sector. It is not possible to name all of thenm here,but their assistance is gratefully acknowledged. The World Bank team would,however, specifically like to acknowledge the valuable advice and inputsprovided by the Government team, including Dr. Suruma and Mr. Opio-Okello,from the Bank of Uganda, and Dr. Zake from the Ministry of Finance. From theIMF, the team received valuable advice from Mr. Niepoort (Central BankingDepartment) and Mr. El-Waleed Taha (African Operations Department). Withinthe World Bank, the contributions of Mr. Patrick Honohan (who acted as LeadAdvisor), Mr. K. Loganathan (Senior Financial Analyst, who advised the teamon crop financing issues), Mr. A. Chandarvakar (Consultant, Central BankingSpecialist), Mr. Owaise Saadat (Principal Economist), and Mr. Carlos Montes(Consultant, who contributed to macroeconomic aspects of the report), aregratefully acknowledged, as is the excellent administrative and secretarialsupport, including report compilation, provided by Mr. William R. Wright.

The report is made up of an executive summary (Volume 1), and themain report (Volume 2) consisting of eight chapters containing detaileddescriptions and recommendations, an ager . 'or action, and a series ofannexes.

This document has a restricted distribution and may be used by recipients only in the performanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

U G A N D A

FINANCIAL SECTOR REVIEW

VOLUME I: SUMMARY AND RECOMMENDATIONS

TABLE OF CONTENTS

I. Context for a review of financial sector performance . . . . . 1

II. Credit Management Policies: Implications forStabilization and Growth .5.. . . . . . . . . . . . . . . . S

III. Institutional Issues . . . . .18

IV. Sequence of Reforms in an Action Program . .30

ANNEX: Action Plan for Financial Sector Reforms

WUMMARY AND RECOMMENDAMIONS

I. Context for a review of financial sector pr Xormance

1.1 The objective of this report is to review the key issues to beaddressed in formulating a strategy for reform and development of the financialsector in Uganda consistent with the Government's Economic Recovery Program(ERP). In terms of the ERP, in addition to broader and longer term questionsabout allocative efficiency and the range and quality of financial services, theneed for carrying out a financial sector review has been motivated by moreimmediate concerns. At the macro level these concerns are related to thecontribution that financial sector inefficiencies are making to macroeconomicinstability. At the same time, at the micro level, there are questions about theextent to which the sector is facilitating the supply response from the growthsectors in the economy. Very little work, if any, has been done to-date on theseissues.

1.2 The Economic Recovery Program (ERP) initiated in July 1987 facedthe monumental task of re-building an economy devastated in both its productiveand financial sectors by almost 20 years of severe political instability. Theresults of the ERP, now entering its fourth year have been mixed. In relationto rehabilitation and restoration of economic growth, significant progress hasbeen miade in reviving economic activity and creating a climate for expansion: GDPgrowth rates of 5 percent or better have been achieved in all years since FY88.However, progress towards stabilization objectives of restoring price stabilityand a sustainable balance of payments, has been more problematic and achievementshave yet to be fully consolidated. Despite recent improvements, the rate ofinflation is still too high and uncertain to encourage the long term business andother initiatives needed for sustained economic development. The year on yearrate declined to 29 percent in June 1990, as against 163 percent in December1987, but has risen again over the past three months to about 35 percent. Inaddition, the external payments situation is more precarious now than it wasthree years ago, largely due to a decline in coffee prices. Export earnings inFY90 of $185 million were less than half the $383 million level achieved in FY87,while the debt service ratio, before rescheduling, had almost doubled -- risingfrom 54 percent in FY87 to 89 percent in FY90.

1.3 The problems and limited economic successes of the recent pastboth emphasize the fragility of Uganda's economy and the major problems thatstill need to be resolved. Savings and investment are still far too low and thisholds back both growth rates and the pace at which infrastructure can be rebuilt.While overall budgetary performance in the past two years has not beenparticularly expansiornist, the restraint has been achieved in part by imposingundesirably tight cur-bs on expenditures for critical economic and socialservices, while defense expenditures continued to rise. Although inflation hasbeen brought down sharply, it is still too high to generate the long-termexpectations of low and stable inflation needed to encourage investment.Finally, the recent sharp decline in the coffee price has again highlightedUganda's overdependence on this crop and the critical need to encourage theemergence and growth of other productive-sector activities.

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1.4 Against this broad background, the Government seeks as its medium-term objective: to sustain a 5 percent growth rate, to reduce inflation to 6percent by FY93, to strengthen external payments to permit a build-up of foreignreserves of $15 million a year, and to reduce external arrears by $20 million peryear. The main weakness lies in the balance-of-payments strategy. As indicatedin the most recent Policy Framework Paper, to meet the Government's objectiverequires annual net capital inflows for the next three years of nearly $500million - a formidable challenge for Uganda. Th- funding requirement is made allthe more daunting because of the increased uncertainty about oil prices andbecause the projections assume non-traditional exports will grow from the presentlevel of $8 million (5 percent of export earnings) to $80 million (30 percent ofexport earnings), a ten-fold increase in three years.

1.5 In addition to questions about the balance of payments, there arealso some fundamentals of policy, and especially financial sector policy, whichneed to be clarified as the basis for getting a firmer grip on the macroeconomicstability of the economy in the future. It is relatively easy for an economysuch as that of Uganda to achieve short term gains in output even with anunstable macroeconomic environment and a seriously impaired financial sector.The experience of the past three years is evidence of this. However, those gainsare likely to be based on existing capacity; to rely little if at all on newinvestment; and to emphasize traditional forms of economic activity rather thanthe diversification and modernization associated with a more robust economy.Thus these gains are unlikely to be easily sustained. It is also unlikely in theextreme that the long term investment decisions needed to produce a moreresilient economic structure (i.e. which is less dependent on coffee) will occurwhile the financial sector is shallow and impaired as now. This assessment isthe main context in which a fundamental reform and strengthening of the financialsector needs to be considered.

Problems facing the financial sector

1.6 The problems facing the sector should be seen in the context ofa system whose development has been setback and in many ways reversed as a resultof the socio-political dislocations of the past two decades. While there is awide range of institutions (commercial banks, development banks, buildingsocieties, etc.) there are only a limited number of financial instruments for themob::lization of savings, diversification of risks, and management of liquidity.There are also no capital markets, or merchant banks, and only a limited moneymarket involving a small outstanding stock of government bonds. The interbankmarket is also conspicuous by its absence. The institutional system of payments(involving checks, invoices, etc.) is inetficient and ineffective and there isa heavy reliance on barter as well as on informal market transactions involvingcash. Finally, an important point to note is that Government involvement is thesector is considerable. The significance of this involvement through substantialshareholdings in the key banks was given an additional boost when BOU took overcrop fineacing responsibilities from the commercial banks (CBs) in December 1988.This action, which has recently been reversed, led to the situation in 1989 whereover 40 percent of institutional credit in the economy was owed to the Governmentand thus outside the allocative n.echanism of the market.

1.7 The sector review mission found the financial sector in a deepstate of crisis and which, despite some recent improvements, continues to face

serious problems. The basic problems confronting the sector are deep rooted andinclude;

(a) Lack of confidence in the financial system: This is reflected in anunusually high reluctance to use checks as a system of domesticpayments or to hold financial assets denominated in Ugandan shillings.The number of checks cleared at the Bank of Uganda has been on adownward trend since 1970 and the low ratio of M2 to GDP of 6 percent,represents lack of financial depth and one of the lowest propensitiesto hold financial assets in the world. A variety of factors havecontributed to the lack of confidence in the institutions and assets ofthe financial sector including civil strife, weaknesses in lawsgoverning financial transactions, and (until recently) highly negativereal interest rates. The lack of financial depth implies that evenrelatively small domestic financing of fiscal deficits will have amajor impact on monetary expansion.

(b) Lack of control on credit expansion: Growth in recent years has beenaccompanied by rapid credit expansion. In 1989 this growth in creditcan in large measure be traced to the explosive effect of creditextended for coffee financing by the Bank of Uganda (BOU) and theinadequate banking discipline at the Uganda Commercial Bank (UCB) andthe Cooperative Bank (COOP). This has contributed to the high rate ofinflation and the difficulty in achieving stabilization. Against thisbackground the Government is reviewing its credit policies which in thepast have yielded some short-term gains but have left behindinflationary pressures, insolvent or near-insolvent financialinstitutions and wasted resources (as revealed by the large number ofUganda Development Bank (UDB) projects which are lying dormant orworking at extremely low levels of capacity). Without a shift incredit policies, so that there is more stress on monetary restraint,and on the quality rather than quantity of credit extended, economicgrowth is unlikely to be sustainable.

(c) Internal and external constraints facing the Bank of Uganda (BOU): Theability of the BOU to assume its proper role at the apex of thefinancial system has been seriously compromised by (i) uncertaintyabout its role, (ii) anomalies in the law which erode its authority andinfluence, (iii) ambiguities about the assignment of responsibilitiesbetween the Ministry of Finance and the Bank, (iv) involvement inactivities, at the behest of Government, that are seen as inconsistentwith both monetary and supervisory policy, and (v) weaknesses in itsinternal organization especially in the areas of bank supervision,accounting, and internal coordination. These problems have underminedBOU's ability to supervise and protect the soundness of the financialsystem. Unless its authority is strengthened and its capacity to carryout its functions effectively is augmented, BOU cannot effectivelycarry out the role and functions of a central bank.

(d) The high risk of financial system instability arising out of solvencyproblems at the two largest banks. The two largest banks, UCB andCOOP, which between them account for more than half the assets of thefinancial system, are insolvent or on the verge of insolvency and need

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to be restructured and their management strengthened. Restructuringthese institutions to place them on a sound financial footing is likelyto have significant budgetary implications. The Government needs toexplore options to reduce this impact. The Government also faces adilemma regarding the timing for restructuring these banks: If thesebanks, which represent such a large proportion of the commercialtanking system, are not restructured at an early date their precariousposition could destabilize the whole financial system (witt anattendant impact on the real economy) through a further erosion inpublic confidence in the financial system and in the use of financialassets as a payments mechanism. On the other hand, unless the economystabilizes, there is a danger that rcHapitalized banks will once againbecome insolvent by lending to firms that risk becoming insolvent as aresult of the on-going adjustment process.

The solvency issue of the banks illustrates the complexity of theproblems facing the economy through a two-way link to the financialsector. Thus, while the financial sector has added to macroeconomicinstability through lack of monetary control, point (b) above, the on-going macroeconomic adjustment process has in turn made a majorcontribution to the problems facing the commerciil banks through theimpact of corporate distress and closures on the loan portfolios of thebanks. Dealing with the problem of bank insolvency must go beyondrecapitalization. The underlying causes of insolvency must beaddressed including (i) the need to achieve macroeconomic stability,and (ii) restructuring or closing insolvent firms.

The financial sector mission also found that many of the losses in thepublic sector institutions are interlinked and that the financial costsof restructuring the banks could be reduced if account is taken ofthese interlinkages in drawing up a restructuring plan. Theseconsiderations suggest that the timing and nature of restructuringplans need to be carefully considered by the Government.

(e) Unsustainability of DFI operations The portfolios of the DFI's are inserious trouble given the low rerovery rates (20 to 30 percent) beingfaced by these institutions. The low recovery rates combined withinterest rates which have been highly negative in real terms impliesthat the resources available to the banks in real terms (for recyclingto other projects) has been declining with disastrous consequences fortheir liquidity and solvency. As a consequence the DFI's have becomelittle more than agencies for extending loans made by external donorsand are not functioning as effective intermediaries. Radical changes tothe management and the mode of operations of DFI's are needed torestore them to a sustainable basis. The number of such institutionsand their role needs also to be rcviewed.

Issues addressed in the review

1.8 Based on the above findings, and the understandings reached withthe Government, the Financial Sector Review mission focussed its efforts on thefollowing five issues: (a) the link between the financial sector and the

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macroeconomy, (b) the distress in the commercial banking system, (c) the role andfunctioning of the Bank of Uganda, (d) adequacy of working capital and otherfinancial services to support real economic activity, and (e) the role andviability of developmental finance institutions. These issues are addressedcomprehensively in the main report (Volume II). For ease of presentation, andreflecting the Government's priorities, the mission's findings on these issueshave been grouped in this summary report (Volume I) into three categories: (a)Credit management policies and their implications for macroeconomic stabilizationand growth; (b) Institutional strengthening and restructuring; and (c) Sequencingof reforms in an action program. The next three sections cover these topics andare followed by a detailed action plan for the sector in the form of a policymatrix.

II. CREDIT MANAGEMENT POLICIES: IMPLICATIONS FOR OTABILIZATION AND GROWTH

2.1 The erosion of confidence in the financial system and theassociated lack of monetary depth, as reflected in the low ratio of M2 to GDP,has a direct impact on credit management policies both at the macro and the microlevels.

2.2 The mission's diagnosis of the present dilemma facing theGovernment at the macro level is that the financial sector and the macroeconomyare struggling in a vicious circle. Negative real interest rates, highinflation, and expectations of devaluation have undermined confidence in thefinancial sector, resulting in a low savings rate, and a lack of monetary depth.In turn, the lack of monetary depth and other inefficiencies in the financialsystem have contributed to macroeconomic instability. Monetary discipline hasbeen difficult to enforce, and even relatively small fiscal deficits havegenerated large monetary and inflationar- pressures because of the small monetaryholdings in the economy; for example financing a deficit equal to 4 percent ofGDP -- not an unusually figure -- when M2 to GDP is only 6 percent would resultin a monetary expansion of almost 70 percent. Although the Government nowappears to be coming to grips with stabilization, the damage done in earlierunstable periods, in terms of the effect of instability on the financial sector,continues to make fiscal deficits unusually dangerous. While a deeper financialsystem will make the Government's task of macro management immeasurably easier,this respite is unlikely in the short term especially in an environment ofcontinuing high inflationary expectations. In such a situation the question is:what are the financial levers or instruments available to the Governmentcurrently to manage liquidity in the economy and thereby influence the rate ofinflation?

2.3 The need to curb monetary growth in an environment where thedegree of monetization of the economy is limited and a relatively largi share ofthe money supply is held as cash outside the banks, in turn leads to policyquestions about the allocation of available credit between the public and privatesectors and specifically, at the micro level, about the adequacy of availablecredit to support growth in key sectors. The mission was made aware of thegovernment's concern that economic growth is being restrained by the inadequacyof credit and that growth would have been lower if IMF credit expansion targets,agreed in the context of the Enhanced Structural Adjustment Facility (ESAF), had

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been adhered to. The Government argues that capacity utilization remains low inmuch industrial and agricultural activity and that more credit is the key toputting capacity back to use and thus to increasing output.

2.4 As a background to discussing these policy questions, it is usefulto review recent patterns of credit use in Uganda as well as alternativescenarios for future credit expansion.

Recent credit expansion patterns and monetary developments

2.5 Patterns of credit expansion With its low deposit base, theUgandan economy is undersupplied with bank credit. While there are no reliableobjective standards of credit adequacy, the ratio of sectoral credit to sectoralvalue added gives some indication of how different sectors of the economy aretreated relative to each other and relative to the situation in other countries.Bank credit-to-sectoral-value-added ratios in Uganda show that most sectorsoperate with little bank credit. Trade, including crop marketing, however, isa major exception. The trade sector uses of bank credit amounted to 13 percentof sectoral value added in recent years (Table 2.1). Crop marketing, mainlycoffee, has for a long time been the largest user of bank finance in Uganda. Itis the biggest business activity in the country and credit to the CoffeeMarketing Board, secured on coffee export bills which the banks negotiated, wasregarded as relatively risk free and profitable. Its heavy use of credit is alsoa reflection of inefficient operations (see Chapter II in Volume 2). Agriculturecontains a large non-monetary sector (accounting for about half the total valueadded) and peasant agriculture usually makes little use of formal credit. Inmanufacturing, if turnover is on average twice value added, credit use appearsto have been a mere 2.5-3.5 percent of turnover. This is low compared withdesired credit use, as revealed in a recent sample survey (see below) of 1-2months' turnover. Use of credit in the construc.ion industry, where there aretypically delays of 12-18 months between outlays and receipts from sales, is alsosurprisingly low.

Table 2.1: Ratios of Bank Credit to CDP(in USh billion)

fY 1980 FY 1989Value Value

Credit Added Ratio Crodit Added RatioMarketing andtrade 6.85 40.9 18.1X 15.14 120.2 12.65

Agriculture 0.84 242.8 0.8X 2.81 610.8 0.4XManufacturing 1.08 14.9 7.8X 2.06 42.2 4.95Transport 0.B7 9.1 4.05 1.62 28.0 7.0XConstruction 0.22 14.8 1.4X 0.67 86.2 1.05

Source: Bank of Uganda. Figures Include Bank of Uganda londing.

2.6 The shares of economic sectors in net bank advances have fluctuatedover the last three years. The share of manufacturing has been fairly constant;that of agriculture (excluding crop finance), after rising in FY88, hassubsequently dropped; while the shares of transport and construction have risen.

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Trade has taken the largest share if bank lending, but not to the exclusion ofhealthy increases in advances to oLher sectors (see Table 2.2).

Table 2.2s Net Bank Advence, to Economlc Sctore(X Sher"s)

1037 1030ff 1989June Jne Doc Juno Doc

Agriculturo 9.2 22.6 20.2 16.1 14.2Trado 69.4 89.1 48.7 41.6 44.2Manutacturlng .,7.6 21.6 17.1 16.7 17.1Trensport 6.8 7.6 9.8 17.1 14.2Constructlon 5.8 4.9 4.8 6.8 8.6Other 2.4 4.8 4.9 2.6 1.9

TOTAL _l 10. Ulu AMR ag

Source: Bank of Uganda. Figures Includo Bank of Uganda lending.

2.7 Credit expansion to the economy-- excluding Government and cropfinancing--has risen very fast in nominal terms and, in real terms, faster thanthe growth of GDP (see Table 2.3). The volume of outstandinig bank credit to theeconomy has risen faster, as inflation has abated, and its rate of expansion, inreal terms, reached an estimated 45 percent in calendar year 1989 and 58 percentin the 12 months to June 1990. In the twelve months to December 1989, manufa-cturing and trade received real inc.eases in bank credit of approximately 45percent. Credit to the transport and construction sectors rose by 110 percentand 190 percent respectively. However, real credit to agriculture (other thancrop financing), having expanded fast in 1988, stagnated in 1989.

Table 2.8: Credit Expansion to Economy(oxcluding Government and crop financing)

Period Nominal growth (S) Roal growth(U)'1

Juno 1987-June 1988 287 e.8Juno 1988-June 1989 191 6 .0Doc 1988-Dec. 1989 163 46.1June 1989-Juno 1990 104 58.1

s/ Deflated by the middle-income consumer prico index.

2.8 A rapid real expansion of credit to the economy has been consistentwith the Government's macroeconomic targets. These envisaged a 50 percent realinc ease in lending to the non-governmental sectors, including crop financing,d' ring June 1988-June 1989 and a further 20 percent expansion in the fiscal yearending June 1990. Actual real increases in credit have been equal to, or highevr,than indicated in macroeconomic targets (84 percent in FY89 and 20 percent inFY90), and until recently, there has been little evidence that lending to thebusiness sectors has been systematically crowded-out by higher than intendedcredit to the Government. The Government has not made use of some of theinstruments of monetary control available to it to restrain bank lending. Thestructure of interest rates was until recently highly negative in real terms.

Now that inf'lation has declined to about 35 percent, and with the prices of somegoods actually falling, interest rates (which allow for lending rates up to 45percent) have turned positive in real terms and become a more effective tool formanaging credit demand.

2.9 An instrument that the Government has consciously used to mop-upliquidity outside the banks is the sale of donor-provided foreign exchangethrough the Government's Special Import P-ogrammes (SIP). These periodic saleshave reduced banks' liquidity, as firms have scrambled to draw down theiraccounts to purchase foreign exchange during the brief periods when it has beenavailable. With a low 42/GDP ratio, the volume of liquid financial assets in thehands of the public is low, and periodic SIP foreign exchanie sales havetemporarily aggravated the pervasive, inflation-related, shortage of liquidity.The central issue is whether the low level of liquidity has translated itselfinto an insufficiency of working capital and whether economic grcwth has beer.seriously harmed thereby. The mission has attempted to address this questionusing the results of a ccmmissioned credit needs survey of some 60 public andprivate enterprises carried out in March 1990. These results are discussed below.

2.10 Monetary projections and their implications In addition the missionhas examined alternative scenarios for future credit expansion to FY93. Asummary of these projections is given in Table 2.4 below and discussed in moredetail in Chapter II in Volume 2. These projections help to throw some light onthe issue of the volumes of credit that might realistically be available to meetparticular needs during the next few years. Scenario 1, used in the PolicyFramework Paper (PFP), assumes no change in financial depth (M2/GDP) whileScenario's 2 and 3 a';sume that financial depth increases by 25 percent and 50percent respectively.

2.11 The projections done by the mission indicate that in the absence offinancial deepening, it may be difficult to meet program targets and provide areasonable real rate of growth of credit for the private sector after FY91without a severe credit restraint on the Government. Furthermore, even thisresult is based on the enforcsment of restricted levels of credit-use in relationto crop financing, which may be difficult to achieve in practice. The hope forsome easing of the credit restraint on the Government, consistent with anadequate rate of expansion of private sector credit, depends on the achievementof some degree of financial deepening in the economy. It seems likely, forexample, that in FY93 there would be USh 50 billion more credit availableconsistent with growth and inflation targets, if financial depth can be increasedby 25 percent compared to its present levels. In the projections this increasehas all been allocated to the private sector. However, in practice, theGovernment will have the choice to decide how much of the credit available shouldbe allocated to the private sector and how much to its own budgetary needs. But,this easing of credit restraints could only be achieved by a stable environmentand the use of interest rates and other policies that would make the holding ofdomestic financial assets more attractive.

2.12 In the mission's view the targeting of credit to the public andprivate sectors is of doubtful effectiveness in the Ugandan financial context.As discussed in para's 2.7 and 2.8 above and in more detail 'n Chapters VI andVII of Volume 2, the past few years have seen relatively high rates of growth ofprivate credit, but its benefits are far from clear because of the poor quality

of much of this lending--a situation which has brought two banks to the state ofbankruptcy. There is absolutely no point in squeezing government credit to allow

Table 2.4Monetary ProJections of the Bankina System

(USh bilions)

FY90 FY98

Sconario 1 Scenario 2 Sconario 8

Foreign assets (net) -181.7 -119.7 -119.7 -119.7

Domestic credit 74.0 112.1 165.8 266.6

Govt. (not) 8.7 -88.8 -86.8 -86.8

Privnt. 66.8 148.9 202.6 298.8

of which crop financing 19.2 29.9 29.9 29.9

Other Itom net 147.7 167.4 157.4 167.4

Money supply (M2) 90 149.8 208.4 294.1

Mmo: Financial depth 6.2 6.2 8.8 12.0(M2/ODP)

Sources: BOU, IMF, andWorld Bank estimate.

an expansion of private credit if this will repeat past experiences. Aprecondition for a policy based on a rapid expansion of private credit has to bethe reestablishment of sound management, especially of credit allocationprocedures, in the problem banks. In these circumstances, in choosing betweenthe allocation of available credit between the public and private sectors, theGovernment faces a complicated social choice.

Adequacy of financial services to support the real economy

2.13 The question of whether credit shortages are the dominant cause oflow capacity use in industry and agriculture or whether there are other moreimportant factors has been examined by a small survey. This survey yieldedillustrative, though not statistically significant, answers. A sample of 60enterprises was drawn: 30, mostly small, were in the private sector; 15 werepublic sector firms in manufacturing, transport, trade, construction, andservices; and 15 were agro-industrial enterprises, mostly medium-large in sizeand in the public or joint-venture sectors. The survey also covered 9 companieswith entitlement to foreign exchange under the Open General License (OGL) scheme;S of these firms were in the public, and 4 in the private sectors.

2.14 In summary, the survey provides evidence that the cash shortages inthe economy arise, to an extent, from deliberate and logical business decisions

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in an inflationary environment where physical security has been poor. Itcorroborates the view that there are multiple restraints on higher production andthat expanding credit would not automatically engender a supply response. Mostof the firms that complain of working capital shortages appear to beuncreditworthy, either because of insolvency or because their collateral has beenexhausted as a result of a history of output problems, losses, and pastborrowing. The survey results also suggest that a lower inflation and lowerinterest rate environment would be more conducive to growth because firms wouldbe less reluctant to hold cash and to commit themselves to long-term businessdecisions.

2.15 The only well-attested area where credit per se inhibits activity isin importing goods using LCs. (Another area, which the Government felt stronglywas a bottleneck in the past, has been credit for crop financing which led toBOU's involvement in this area.) The slow procedures tie up large volumes ofworking capital, and foreign exchange releases through the SIP are episodic andhence lumpy. Judicious credit expansion should accompany SIP releases toaccommodate the needs of beneficiaries--provided that the increase issubsequently absorbed when the imports are received and the goods manufacturedwith them are sold. The Government has devised a Special Credit Facility withthis aim in mind. Better still, the release of foreign exchange should besmoothed and made more regular and predictable.

2.16 Other financial services. There are legitimate complaints in thebusiness community in Uganda about poor communications within the barLking system,the difficulties in the use of checks and the inconvenience of cash transactionsusing large volumes of low denomination notes. Because of poor communicationswithin the networks of the main banks with rural branches, checks drawn on ruralbranches may take up to 4-6 weeks to clear. The banks with branch networks havealso given poor cash withdrawal service. Depositors are commonly unable towithdraw their deposits, after giving the required reasonable notice, because ofdefective cash management by the banks and because the banks centralize theiroperations in Kampala instead of regional centers. Long delays have been commonin transferring accounts between branches and even in cashing drafts in onebranch drawn on another branch. These features have been a deterrent to the useof the banking system and to the use of credit instruments instead of cash.These delays cause uncertainty and are expensive in an inflationary environment.They could be reduced by better internal communications and greater sensitivityto customer requirements. Improved computer links, currently being installed bysome of the major banks, should lead to some improvements. For the rural areas,the revival of the network of the Post Office Savings Bank should be reviewed asa major option in the medium to longer term for improving money transmission andsavings facilities especially in areas facing a paucity of commercial bankbranches.

2.17 Another problem that adds to the costs of business--and to insecurityin money transmission--is the fact that checks are not trusted in businesstransactions. Many transactions are consequently carried out in cash. Thisarises because of the prevalence of fraud and the legal difficulties, underpresent legislation, in prosecuting perpetrators. The problem is compounded bythe low denomination of the bank notes currently in circulation, the highestbeing USh 100, or US$ 0.26. Few firms and banks have armored vans, so simpleoperations, such as the payment of weekly wages, require the conveyance and

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storage of large volumes of currency in insecure conditions. The lowdenomination of bank notes discourages business from depositirg cash because ofthe time taken to count it v,hen it is deposited and when it is subsequentlywithdrawn. It is an important factor in the poor quality of counter services.Legislation is now under preparation to repress check fraud more severely. Ifenforced this should eventually help restore confidence in the use of checks,which will reduce the cost and risk associated with financial transactions andcontribute to the revival of the banking habit. Full confidence in the use ofchecks, however, will only revive when the process of check clearing has beendrastically accelerated.

2.18 Transactions involving letters of credit. There are also complaintsfrom the business community about the slowness and high cost of import trans-actions involving letters of credit (LC). Commercial banks seek LC because theybring in high margins which compensate the banks for their low deposit base andlow real margins on lending. However, only certain banks have extensive networksof overseas correspondents, which restricts competition in this field. At thesame time, with its tight controls on foreign exchange allocation, the BOU hasto process all LC applications, which adds to the time and cost of transactions.Importers have claimed that LC procedures lock up expensive working capital forlong periods of time (up to nine months for long delivery items), with the everpresent risk that they will have to increase their local cover if the Ugandanshilling is devalued.

2.19 Overall assessment and recommendations Use of credit in mostsectors of business is low. Because of the recent history of high inflation,high nominal interest rates, and other structural factors undermining creditwor-thiness, bankable effective demand for credit in Uganda is now below normallevels. The economy has accommodated itself to operating at low levels ofworking capital and has nevertheless achieved strong growth over the past threeyears.

2.20 There are many factors other than credit that inhibit production.Sample survey results indicate that these factors predominate. Businesses thatstate that their main problem is a lack of working capital have often had ahistory of production problems leading to a current loss of creditworthiness.At the same time the release of foreign exchange for lmports should be smoothedand made more regular and predictable.

2.21 Business decisions under inflation, with high nominal interest ratesare based on short term considerations. In the interest of long term growth andof the more productive use of credit to facilitate expansion, inflation must becontrolled, and inflationary expectations must be reduced. This requiresmonetary restraint even though this may lead some firms to feel a temporaryliquidity squeeze. Subject to the overriding need to reduce inflationpermanently, however, the current policy of allowing credit expansion to theproductive and commercial sectors to expand faster than to the economy as a wholeis to be endorsed.

2.22 Some firms that supply the Government experience serious delays inpayment and problems in clearing Government checks, which cause them severeworking capital shortages. The banks have given them some accommodation, butthis has impaired the firms' profitability and ability to carry on business. To

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avoid damaging domestic industry, the Government should take active steps toreduce delays in payments and problems in clearing Government checks by improvingits expenditure authorization procedures and financial controls.

2.23 While giving priority to productive and private sectors, as mentionedabove, the Government should continue to avoid directing credit on a sectoralbasis. Credit is fungible. Many businesses are in trade as well as manufactur-ing. While giving credit to monopoly traders can finance speculation andprofiteering based on artificial supply shortages, this can just as easily happenby granting credit to monopoly domestic manufacturers. Increasing competition,rather than the direction of credit, is the answer to these problems. Ascounterinflationary policy takes effWct, there will be less incentive forbusinesses to seek short-run speculative profits. Lower nominal interest rateswhich should follow the fall in inflation will make longer maturing businessopportunities seem relatively safer and more profitable.

2.24 The Government should particularly avoid, in present circumstances,and in the light of the overriding policy to create a soundly-based and bettercontrolled banking system with a less impaired loan portfolio, to direct thebanks to lend to non-bankable borrowers, such as overindebted public enterprisesand firms without adequate property titles. In the present circumstances, theemphasis should be to exercise stern discipline on delinquent borrowers so thatcredit can revolve and be used more efficiently, and so that the credit needs ofefficient borrowers be better and more promptly satisfied.

2.25 With regard to other financial services, Government action isrequired to facilitate the legal repression of check fraud and to accelerate theclearance of checks through the BOU. The Government should also quicklyintroduce higher value bank notes--which would not only reduce business costs,but would also cut the cost of note printing for the monetary authorities.

2.26 The Government, as an important shareholder in the commercial banks.should also press bank managements to improve the quality and speed of theirservices to customers, particularly in respect of money transmission and checkcashing facilities.

2.27 In the long term, the Government should seek revival of the networkof Post Office Savings Banks. Apart from contributing to the remonetization ofthe economy, which will assist the conduct of macroeconiomic policy, these bankswould provide small savings and money transmission services to complement thoseof the commercial banks. They might also offer outreach facilities, on an agencybasis, to the banks, which could thereby extend their operations withoutincreasing their overheads.

Financial policies to facilitate stabilization

2.28 At the macro level, as indicated above, a deeper financial systemwill make the Government's task of macro economic management easier. However,this respite is unlikely in the short term. In the interim the Government hassome levers to use to control inflationary pressures. These includet (a)enhanced discipline in the banking system; (b) reforms of system of cropfinance; (c) use or introduction of instruments such as open market operations

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to manage liquidity in the economy; (d) interest rate policy; (e) controls onbank lending; (f) restructuring of insolvent financial institutions.

2.29 Banking discipline In relation to banking discipline the policymessage is clear: successful stabilization will require far stricter enforcementof the monetary policy controls on the banking system than in effect prior toSeptember 1989. This argues for the BOU to be positioned with greater authorityin the economic policy making process to give it a better chance for resistingpolitical pressures for short term, but ill-considered expansion. The modalitiesof implementing this recommendation are outlined in the next section.Enforcement of banking discipline should aim to avoid the rapid boost in creditthat occurred in 1989 when UCB and COOP expanded their loan portfolios byoverdrawing on their accounts at the BOU; by August 1989 the net overdraftposition of these banks revealed that their deficiency of reserves relative totheir statutory requirements was equivalent to more than 30 percent of theirtotal deposits. The resulting monetary stimulus was greater than that arisingfrom the fiscal deficit in taat year.

2.30 The importance of banking discipline is enhanced in the Ugandancontext because of the extensive use of arrears not only of the Government itselfbut also of parastatal enterprises, including the Coffee Marketing Board.Whatever the cause of payments arrears--bad financial management, lack ofadequate legal recourse, and so forth.--since they have come to be accepted asnormal, attempts to tighten the monetary stance may merely lead to a furtherincrease in arrears and defeat the objective of stabilization. For example, atightening up on the Government's own finances may cause the basic shortages ofsavings in the economy to reveal themselves elsewhere. Thus, if the Governmentwere to repudiate the responsibility for the debts and deficits of the parastatalenterprises, then the financial positions of those enterprises would deteriorate,and they would become directly dependent on credit from the banking system ratherthan indirectly through the Government. In short, extensive payments arrears asin Uganda are a basic reflection of an inadequate financial system in which manynonfinancial organizations are being forced to operate, in effect, as quasi-banks. The authorities acceptance of widespread domestic arrears is destructiveto the functioning of the financial system. It must be tackled urgently.

2.31 Reforms in the crop financing system The credit explosion that cameabout because of the change in coffee financing regime in 1989 again illustratesthe vulnerability of an economy with a small financial sector and the potentialfor improved monetary control through reforms in the crop financing system. In1989, as a result of difficulties in the crop financing system, there was concernwithin Government that adequate credit was not filtering down to enable fullprocurement coffee crops at the farm level. This included the inability ofseveral of the 19 credit unions in the country to establish their creditworthiness for normal commercial-bank credit. To overcome this difficulty, BOUat the behest of Government took over the responsibility of coffee financing fromthe commercial banks. This responsibility included BOU: (a) acting as a bdnkerto the Coffee Marketing Board (CMB), (b) providing guarantees to commercial banksfor lending to unions considered uncreditworthy by the banks, and (c) lending tosome primary societies through commercial banks. As a result of thisinvolvement, BOU's outstanding loans for crop finance jumped from USh 2.3 billionin December 1988 to 18.7 billion in December 1989. As was the case with thecollapse in lending discipline at in the UCB and COr , the resulting monetary

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stimulus from this expansion was far greater in that year than the stimuluscoming from the budget deficit (see Chapter II in Volume 2). The explosion incrop finance in FY89 may thus have contributed co short term growth, but in doingso compromised prospects for successful stabilization by adding significantly toinflationary pressures.

2.32 Crop financing in general, and coffee financing in particular, hasalways been problematic in Uganda, and previous approaches to allocating credithave been fraught with problems. Many, if not most, of the past and presentproblems in this area are associated with the presence of a parastatal that hassimultaneously had monopoly powers over coffee exports and monopsony powers inthe purchase of coffee from local producers. The more immediate problems ofcoffee financing also reflected fundamental weaknesses in both the financialarrangements for Coffee Marketing Board (CMB) and its management more generally.To address these weaknesses the Government has recently enacted a number ofmeasures as part of Agricultural Sector Adjustment Credit (ASAC) operations.These include the transfer of crop financing facilities, including financing ofCMB, to the commercial banks from FY91 with BOU's role restricted to theprovision of refinancing facilities for commercial banks involved in cropfinancing (with risks to be borne by commercial banks). The package of measuresalso involves a financial restructuring of CMB, including substantive new equityinjection, to reduce its need for borrowing and to place it on a firmer financialfooting. At the same time CMB's monopoly on coffee exports is being terminated,and measures are being put in place for the cooperative unions to undertakeexport marketing on their account.

2.33 The above considerations suggest that the Government is moving in theright direction to put crop financing on an efficient basis. It should maintainthese efforts, in particular the momentum toward a competitive and market basedarrangements where the coffee board competes with other entities for exports andprocurement. At the same time, credit extension at all levels should be basedon commercial creditworthiness criteria, rather than administratively imposedallocations or restrictions. In the short term, however there are two problemsthat need to be addressed to avoid difficulties in the resumption of crop financeby the commercial banks and to keep crop financing requirements in line withthose agreed as part of ASAC discussions. First, the reforms will not moderatecredit requirements if the Coffee Marketing Board persists with the largequantities of barter sales of coffee and continues to experience substantialdelays in achieving the payments for these from the central Government budget.The coffee board has to borrow on a one-for-one basis for every one dollar ofbarter sales not reimbursed by the Government. Thus barter sale result in yetanother, albeit disguised, form of potential credit expansion.

2.34 Second, the mission has concerns about the modalities of theparticipation of commercial banks in crop financing. Although there is agreementin principle that commercial banks as a group should take over crop financing,the degree of participation by the UCB and COOP--the two illiquid banks--is notclear. The other, mainly foreign, banks are liquid but most of the rural-branchnetwork needed for crop financing is currently owned by the UCB and COOP. Thereare also several other failings in the credit process, evident before December1988 that may still cause problems even after the implementation of the proposednew reforms. The quality of management at branch-bank level of the UCB and COOPand their general disregard for sound banking principles is just one example.

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These and other factors suggest that, while some reduction in crop financingrequirements relative to the December 1989 figure (USh 25 billion) are likely,there is potential for further reductions, but t.his will depend upon theeffectiveness with which the Government resolves some of the remaininginstitutional and policy uncertainties.

2.35 Use of open-market operations In the short run, the only open marketoperation that is sufficiently developed to be used for monetary control purposesis the market for foreign exchange. The link between monetary expansion andinflation involves a role for the foreign-currency market. Additional moneyinjected into the economy from whatever basic source probably causes a rapidportfolio adjustment: money balances in excess of the needs for financialtransactions within Uganda are converted into dollars in the parallel market.This is because alternative forms of asset holdings that offer equivalentprospects for profit such as equity securities, simply do not exist in Uganda.The resulting higher demand for dollars raises its market price and with it theprices of goods it is used to purchase. The authorities have thus another usefulmonetary control lever at their disposal with which to manage inflation.Specifically, the Special Import Program II which involved the sale of foreignexchange in an effective open market operation at a rate higher then the officialmarket rate, successfully demonstrated it can help to drain liquidity from thesystem and stabilize or lower the demand for parallel market foreign exchange.The potential here is quite considerable (provided foreign exchange wasavailable) because of the small size of Uganda's monetary base. For exampleUS$40 million sold at the official exchange rate in 1989 would have removed Ush16 billion, or 25 percent of M2, from circulation. In the medium term the BOUshould actively promote the development of inter-bank and money markets formanaging liquidity. The issues related to the development of these instrumentsare addressed in Section III.

2.36 Interest-rate policy Interest-rate policies have a much greater roleto play in Uganda's fight against inflation than they have so far been accorded.Until recently all key interest rates have been highly negative in real terms.However, with the reduction of the inflation rate to below 30 percent for FY90,interest rates had become highly positive and were adjusted downwards in June1990. The maximum deposit rate was reduced to 32 percent and the lending rateto 45 percent. Even more importantly, the Government had indicated its intentionthat, beginning October 1990, interest rates will be adjusted each month on thebasis of the average twelve-month inflation rate for the preceding three months,in order to maintain positive real deposit rates of at least 4 percent. Thisrecent development reverses policies from the past, and should encourage domesticsavings as well as the deepening of the financial sector. This appears to be asensible approach and the question is whether there is any room for buildingfurther on this policy.

2.37 It is a complex matter to devise a "correct" interest rate policy inthe highly inflationary circumstances faced by Uganda. However, to encouragesavings in financial assets, interest rates will need to be positive in realterms so that depositors can earn real positive returns on their financialinvestments. At the same time this policy, by increasing the real cost ofborrowing, will restrict the demand for credit to match the supply contractionassociated with greater discipline by commercial banks and better supervision byBOU. In the specific area of coffee-financing, relatively high interest rates

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would be an important mechanism to help to achieve the improved adherence toAgricultural Policy Committee benchmarks and the reduction of waste on coffee-sector credits from the past. High interest rates also give unions andprocessors a strong incentive to use their own funds in coffee-financing, to theextent assumed in ASAC projections (see Chapter II, Volume 2). In addition,higher interest rates should add to financial depth by dampening demand forholdings of private wealth in parallel foreign currency rather than in domesticfinancial assets.

2.38 The dangers of excessively high nominal and real interest ratesshould, however, not be ignored. If real interest rates become highly positive,then given the low return on capital in many of Uganda's productive sectors(including coffee), the burden on enterprises and cooperatives would beunreasonable. The majority of credit used in these circumstances would be forspeculative purposes or would be linked to distress borrowing. Many borrowerswould have no intention or ability to repay their loans, and hence this couldfurther worsen the bad debt situation facing the banks. For these reasons,lengthy periods of high and positive interest rates (above 10-15 percent real)should certainly be avoided. The danger of excessively high interest rates forprolonged periods is best avoided by ensuring that interest rates are not invokedas a single policy instrument to do all the work to control the fiscal deficitand monetary expansion. However, if the fundamentals of inflation determinantsrelating to the budget deficit and other sources of monetary expansion areprogressively being brought under control, then short periods of highly positiveinterest rates would be a potent indicator that the government is committed todrive inflation from the system. Related to the policy issues concerning thelevel of interest rates, there are also a variety of issues that need to beaddressed concerning the structure of rates. These are discussed in more detailin Volume 2.

2.39 Limits on commercial bank lending Many of the conventionalInstruments to control the money supply will not work, at least until the currentdistress in the commercial banking system has been resolved. Thus reserve andliquidity ratios cannot be an effective policy instrument if the main banks, UCBand COOP, continue to avoid compliance. Similarly, discounting and rediscountingfacilities at the BOU have limited use in a situation where some banks arerelatively flush with funds, while others totally illiquid. Mopping up liquiditythrough open market operations involving the sale of foreign exchange (as in theSIP operations), is possible but cannot be relied upon due to uncertainties aboutthe availability of foreign exchange. Finally, our earlier discussion, whilerecommending the use of interest rates, has cautioned against the over-vigoroususe of this instrument. So, what should be done? One alternative, at the leastfor the time being, would be to extend the arrangement that the BOU already hasfor reigning in the UCB and COOP. This provides for strict limits on commercialbank lending. 'Corset" type limits on bank lending are inefficient anddistorting if allowed to persist for any length of time. In the interim, however,physical controls on bank lending seem to be the most appropriate instrument.

2.40 Fiscal consequences of bank restructuring The restructuring andrecapitalization of insolvent financial institutions will have important fiscalimplications. Recent estimated of the new capital needed to be injected frompublic sources in the two commercial banks (UCB and COOP) are of the order ofUSh 10 billion; the cost of recapitalizing UDB could eventually also turn out to

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be high. To avoid a massive disruption of the Governments fiscal and monetaryprogram it is recommended that the injection be carefully designed and includesuch options as private sector participation, and the provision of new Governmentsecurities in which only interest costs would represent an immediate claim onpublic finances.

2.41 Recommendations A number of main recommendations follow from the theabove analysis. The first of these recommendations relates to inflation.Altiiough the trend of the recent months has been encouraging, Uganda's record oninflation-management during the ERP period has been inadequate, and there is noguarantee that single digit annual inflation can be attained unless assisted byappropriate policies. For this reason, a short-term priority is to build on thesuccesses of the recent past and maintain a concentrated effort to driveinflation down to the low levels targeted for the next few years. In additionto the continued use of tight credit restrictions overall and a refusal tomonetize the fiscal deficit, the authorities should resist the temptation for apremature lowering of interest rates to recognize that a short period of modestlyhigh real rates can be a powerful complement to institutional measures (such asstronger BOU supervision of the banks) to achieve greater financial disciplinein the economy. The distress in the financial system, explained in Volume 2, hasoccurred during a period of extremely easy money and highly negative interestrates, and not because of high interest rates and tight money. Thus, while thewarnings about the damage that can be brought by high interest rates must betaken seriously, they are not a reason for continuing with policies of loosemoney and low interest rates.

2.42 A useful by-product of a period of tight money is likely to be arecovery of public confidence in the institution of money, and financial assetsmore generally, and so in higher ratios of broad money balances to GDP. If lowrCinflation and reasonably high nominal interest rates can both persist for sometime, it is realistic to hope for an increase in monetary depth. This conjunctureof events would assist the Government's financing operation in two ways. First.,lower inflation would ensure enhanced revenue collection at any level of collec-tion-efficiency. Second, a greater depth would result in a smaller inflationaryimpulse for any budgetary deficit still needed to be financed using domestic bankcredit.

2.43 Third, the government needs to refine and extend its use ofinstruments such as the SIP (for open-market operations) to gain greater controlof the liquidity in the economy and of the parallel-market exchange rate and theinflation rate. The defined interest rate policy will be an important elementand establish more attractive domestic financial assets to reduce parallelforeign currencies from portfolios. However, given the several limitations ofSIP that arise from the country's chronic shortage of foreign exchange,alternative instruments of intervention which are more directly controllable bythe authorities need to be developed. The treasury bill is an obvious candidatefor this role; and reforms of the method of issue, the interest rate structure,and the eligibility to hold such bills are needed in order to extend its use.

2.44 Fourth, as a means of enhancing banking discipline the Governmentshould give a high priority to the restoration of monetary control, eliminationof payments arrears (both of the Government and parastatal enterprises), andstrengthening prudential supervision by the BOU. Financial discipline of the

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banking system, enforcement of laws, contracts and accounting rules, and theeffective supervision by the BOU, which is discussed later, are as critical tothe development of the Ugandan financial system as attaining macroeconomicstability. A financial system depends primarily on the confidence of the public:confidence not only in how the economic authorities handle the economy but on thereputation of the financial institutions. Given the past performance of Ugandanfinancial institutions, this process of confidence building will take time todevelop.

2.45 Fifth, the Government should ensure the implementation of itsdecision to transfer coffee financing back to commercial oanks in FY91. To bringthis about, among other things, the Government should facilitate therestructuring of the UCB and COOP at an early date.

2.46 There is little to be gained by squeezing Government credit to allowan expansion of private credit if, as in the past, the quality of such lendingremains poor. A precondition for a policy based on a rapid expansion of privatecredit has to be the re-establishment of sound management, especially of creditallocation procedures, in the problem banks and DFI's.

III. Institutional issues

Overview

3.1 In terms of institutional issues while there has been someimprovement in the financial system since the time of the reconnaissance missionin October 1989, the basic problems remain unresolved. Since last October BOUhas enforced a number of containment measures to stabilize the situation at bothCooperative Bank (COOP) and UCB. These measures include restrictions on newlending and opening of new bank branches. As a result of these measures theliquidity crisis at these banks also eased significantly and they were able toreduce their overdrawn position at the BOU by Ush 4787 million (i.e. Ush 4297million by UCB and Ush 490 million by COOP) during the last four months of 1989.At the end of 1989 the combined balances of the two banks stood at an overdrawnposition of Ush 1247 million, equivalent to only 5Z of their combined deposits.Indeed, at the end of 1989, UCB had a positive balance of Ush 866 million.However this was still well below the minimum cash reserve requirements (i.e. 101of deposit liabilities). At the same time BOU has enacted a number of measuresto improve its internal operations including the backlog of accounts.

3.2 While the above measures are a step in the right direction, it needsto be stressed tnat most of the basic problems remain including (a) criticalweaknesses in the authority and capacity of the BOU to supervise and maintain thefinancial system, (b) the insolvency, in all probability, of more than half ofthe commercial banking system, (c) the apparent non-sustainability of the presentmode of operations of the DFI's, and (d) lack of confidence in financialinstitutions. The implications of these problems, which are discussed below andhave also been touched on in the previous section, are extremely serious and callfor urgent remedial measures by the Government.

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The Bank of Uganda and its role in the financial sector '

3.3 A Central Bank should play a substantial role in the formulation ofeconomic policy generally, and monetary and supervision policy in particular.At present in Uganda this is not the case. There appears to be a number ofcritical weaknesses in both the authority and capacity of the Central Bank. Fora country so heavily dependent on overseas financial assistance to facilitatenecessary development, perceptions of the strength and performance of the CentralBank are extremely important.

3.4 (A). AUTHORITY OF THE BANK OF UGANDA The Bank of Uganda (BOU) appears tohave less authority than is usua:ly the case for a Central Bank. For it to bean effective organization, the role of the BOU in formulating economic policy -its inputs in this process are at present largely :;nformal - should bestrengthened. The BOU should have prime responsibility in the implementation cfmonetary policy, prudential regulation and supervision as well as other policiesdirected at financial institutions. The BOU's capacity to effectively influencethe operations of financial institutions is weakened substantially by bothuncertainty about its role (e.g., in determination of interest rates), reinforcedby ambiguities about the assignment of responsibilities between the Bank and theMinister of Finance (e.g. approval of new branches). This has been a situationthat banks exploit. The capacity of the BOU has in the past also been weakenedby being involved in activities on behalf of the Government (e.g. crop financing)that are seen as being inconsistent with both monetary and supervisory policybeing implemented by the Bank of Uganda. Finally, the present position whereappointments to the position of heads of department are subject to the approvalof the Minister of Finance represents a serious dilution in the authority of theGovernor.

3.5 To overcome these deficiencies it is suggested that legislative and otherchanges be incorporated such that (a) all matters pertaining to areas where BOUhas prime responsibility, as mentioned above, should be the decided by the BOUwith clearance by the Minister in the case of predefined politically sensitivematters including licensing and closure of banks and interest rate policy, (b)BOU's role in economic policy formulation should be strengthened and formalized,(c) in circumstances where consensus cannot be reached between the Governor andthe Minister of Finance on policy issues, the Government should have the powerto direct the Bank but BOU should have the option to have the facts pertainingto the differences revealed in an appropriate public forum, such as the annualreport of the BOU, (d) BOU be required to inform Government of its views on, andapproach to, monetary policy after each regular meeting of the BOU board, and (e)the Governor's status and powers should be fully commensurate with that of achief executive with full responsibility for administration (with reference, asnecessary, to the Board)

3.6 (B) CAPACITY OF THE BANK OF UGANDA TO FULFILL ITS ROLE For a Governmertto delegate substantial authority to a central bank and for financ'alinstitutions (both domestic and overseas) to recognize the central bank as having

I This section takes account of the results of the diagnostic study ofthe BOU carried out by the consultants, Booz-Allen and Hamilton.

K .,

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authority, the latter must be clearly seen to be fulfilling its taskseffectively. THe Bank has made some significant improvements in a wide range ofareas including accounting and research but more are necessary. Examples of pooroperational performance detracting from the status of the Bank include itsfailure to produce annual accounts in a timely manner and the long delays inposting to the bank accounts of both Government and banks. BOU should clear itsbacklog of accounts as soon as possible and strengthen its accounting controlprocedures; BOU must be able to balance its books daily and promptly provide upto date bank statements to its clients (banks and the Government). At the sametime BOU should improve its clearing house operations. This would also help toreduce the delays in posting transactions to bank exchange settlement accounts.In consultation with Government, it should also consider introducing higher valuebank notes at an early date.

3.7 In addition to improving performance, there is a clear need for workin a number of areas of the Bank to be expanded and, or, rationalized. Theanalytical/ monitoring work in the research and the foreign exchange departmentsshould be expanded to provide a strong basis for policy discussions. Thisexpansion should include a unit to be set up in the research department tomonitor monetary and credit developments. The research department should alsobe in a position to conduct credit market su.veys to augment the excellentinformation on sectoral distribution of credit contained in the QuarterlyBulletin, a document with which the mission was impressed. In parallel withthese changes, the research department should consider phasing out the work itis currently doing on compiling of the consumer price index and the monitoringof export proceeds as and when other [Government] departments are in a positionto take over this work. Other areas where capacity needs to be upgraded orrationalized include (i) bank supervision (see below), (ii) work of theAgricultural Secretariat, (iii) coordination of functions between departments,and (iv) staff training and the associated introduction of new technologies.

3.8 Additionally, organizational changes are needed; for example groupingdepartmental responsibilities under Executive Directors to streamline operationsand reduce the number of staff reporting to the Governor; enhancing the statusof the budgets and accounts department by giving the Chief Accountant the statusof an Executive Director; avd the appointment of two non-executive advisors tothe Governor - one could help upgrade policy work in the Bank, while the othercould inject urgency and cohesion into the many changes that are being proposedin the work of the BOU - as well as a number of other experts. The abovechanges should be implemented in the context of a reorganization of the Bank.A possible restructuring of the BOU, showing a clearer division between t!Ieeconomic, technical, and administrative functions of the Bank than Lheillustrative structure set out in the Booze-Hamilton study, is shown in Chart 4.2on page 66 of the main report.

3.9 (C) MONETARY POLICY The overall economic environment in which monetarypolicy has been conducted has been quite difficult. Two important reasons forthis are: (a) the need for BOU, on behalf of the Government, to provide financefor the FY89 and FY90 coffee crops, and (b) the need for BOU to provide financebecause of the distress in the commercial banking system. The situation has beenstill further aggravated by the low repayment rates on loans being experiencedby many financial institutions. Consequently, credit growth has been higher thanwould otherwise have been the case. A first priority for the future is to e-pand

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substantially the analytical work underlying policy discussions and decisions,as already outlined above. If this can be done, then several of the policyInstruments available to the BOU could be used far more actively than in the pastto provide strong control on economic developments. In the short term, asdiscussed earlier, the most effective Cool is likely to be controls on banklending in conjunction with changes in interest rates as well as the use of openmarket interventions along the lines of the SIP II program when feasible.Restoration of monetary control also calls for the enforcement of reserverequirements, in particular the early elimination of BOV overdrafts to COOP andUCB.

3.10 In the medium to longer term, as the distress in the commercialbanking system is alleviated, BOU should begin to make more active use ofconventional instruments including (a) liquidity and reserve requirements, (b)fostering of an inter-bank market to provide overnight and short notice funds,(c) removal of restrictions on commercial banks on the holding of Treasury Billsand increasing the upper limit on the value of Treasury Bills that can be issued(currently USh 2 billion), (d) promoting development of money markets andinstruments including securities issued by BOU on its own account, (e)introduction by the BOU of rediscount facilities to impLove the quality ofcommercial paper and the range of possible holders of it. To enhance the roleof reserve requirements as a tool of monetary policy the Government should giveconsiderntion to renamerating commercial banks for reserves held at the BOU; thiswould also help to improve the efficiency of intermediation by reducing what iseffectively a tax on the banks.

3.11 BOU should also review the controls and targets it uses to implementmonetary policy consistent with the evolution of financial markets in Uganda (forexample in the medium to longer term, it should consider the use of more indirectcontrols, such as open market operations, and possibly use elements of itsbalance sheet, rather than say M2, as an intermediate objective of monetarypolicy).

3.12 (D) PRUDENTIAL REGULATION AND SUPERVISION OF FINANCIAL INSTITUTIONSPrudential regulation and supervision of banks and other financial institutionsis essentially directed at maintaining stability in the financial system. Giventhe present distress in the Ugandan banking system, prudential supervisionclearly has not been working. In the mission's assessment, the main factorscontributing to this state of affairs in the past would seem to have included:(1) perceived lack of status of the Bank of Uganda, (2) difficulties in earlyidentification of emerging weaknesses in the system, and (3, inability orunwillingness on the part of BOU to use its existing enforcement powerseffectively. The step3 needed in the immediate future to correct the situationinclude the followings (a) BOU should be more ag£,ressive and effective in usingits existing supervisory enforcement powers to prevent unsafe and unsound bankingpractices, (b) its bank supervision department should be substantially expandedso that it can carry out more on-site examinations to keep abreast of theperformance of individual banks, (c) BOU should strengthen its off-sitesurveillance capability, (d) improve its loan classification procedures, and (e)require banks to employ much more rigorous accounting standards and practices byamong other things prohibiting the accrual of interest on non-performing assetsand by requiring banks to make adequate provisions.

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3.13 In tenms of restructuring the commercial banks facing solvencyproblems, if it becomes necessary to remove the banks' non-performing assets aspart of their restructuring, and liquidate these assets, it would be best if someGovernment agency, other than the BOU, be given this responsibility. This wouldavoid placing a significant burden on the BOU's supervision department, andprevent a conflict of interest between the department acting as a liquidator oftroubled assets and its role as a supervisor of banks that are potential buyersof these assets.

3.14 In addition to these immediate actions, the Government should, overthe near term, undertake a comprehensive review of the content of prudentialregulations. At present responsibility for carrying out prudential regulationis shared by the Ministry of Finance and the BOU. This arrangement has sappedthe authority of the BOU and should be eliminated. BOU should be given sole (orpredominant) responsibility for the prudential supervision of Banks. There isalso a gap in the coverage of financial institutions subject to prudentialregulations. This gap must be filled by bringing the Building Societies and theDFI's under prudential supervision. While the legal framework for prudentialregulation is generally adequate to cope with most problems, there are certainshortcomings that need to be addressed. These include an absence of lendinglimits to a single borrower, gaps in the coverage of insider lending, and gapsin existing supervisory enforcement powers which limit the effectiveness andauthority of bank supervisors. The mission has made specific recommendations ineach of these areas (see paras 5.5 - 5.20 in Volume 2). Finally there is a needin the longer run to improve supervisory policies and procedures including theestablishment of effective capital adequacy guidelines, revisions by BOU'ssupervision department of its bank examination manual, and the development of abaik rating system.

3.15 (E). DEVELOPMENT FINANCE BOU should phase out of its involvement indevelopment finance to end the present conflict of interest in this area: The lowrecovery rates achieved on term loans facilitated by the Development Finance Fundshow that the BOU has been promoting lending that has been either ill-judged orill-managed. As the risks are borne by the commercial banks, the Fund's activityhas therefore played a role in impairing these banks' portfolios, therebyundermining the role of the BOU's supervision department. As inflation abates,the Development Finance Department should concern itself primarily withfacilitating the emergence of a market for wholesale term funds and eventuallyequity markets (see below).

Distress and restructuring in the commercial banking system

3.16 In the commercial banking system there is a pressing need firstly toresolve the insolvency problems facing the UCB and COOP, and secondly to restorethe health of the system by introducing reforms aimed at improving the efficiencyand stability of the system.

3.17 Restructuring of commercial banks The domestic banking sector inUganda had in recent years adopted a dynamic stance, including the establishmentof much needed programs for branch expansion in rural areas with an emphasis ondeposit mobilization. This particularly applies to the UCB but also to a morea limited extent to the COOP. However it is the mission's assessment that given

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their inadequate capital and deposit base, the shortage of management andprofessional staff, and the absence of adequate control and screening proceduresfor investment and portfolio decisions, these two banks should have followed morerrudent policies towards the establishment of new bank branches and expansion ofloan portfolios. Growth in both areas appears to have been too fast and has beenachieved at the expense of reduced liquidity and likely insolvency. Thesituation at UCB, while it has improved slightly since August 1989 as a resultof the containment measures imposed by the BOU and MOF including some changes inits top management, is still worrying because it dominates ti._ financial systemand poses a threat to its stability. The long term viability of UCB is not inquestion. What is in question is the decision making process, organizationalstructure, and inadequate procedures that allowed this situation to develop.These need to be altered to restore the bank to a liquid and solvent state andprevent a recurrence of these events. The situation of COOP is more serious asits viability is also in question. To overcome difficulties faced by both UCBand COOP and bring about a sustained improvement, a plan of action needs to beimplemented that signals a clear break from the past; incremental changes willnot be enough to turn the situation around.

3.18 According to the diagnostic studies recently undertaken by Coopersand Lybrand, both UCB and COOP are techxiically insolvent due to the significantimpairment of their loan portfolios. In the case of UCB, Coopers and Lybrand(C&L) estimated that at the end of December 1989 additional loan loss provisionsof about USh 7.5 billion were needed to be written off against shareholders'funds of USh 425 million, making the bank insolvent. These estimates should beseen in the context of UCB's reserves, which could conceivably be increased byas much as USh 31 billion if its fixed assets were to be revalued at currentmarket prices. Revaluation of UCB's fixed aosets, which include its headofficebuilding in Kampa'a, will however not resoi%e UCB's liquidity and profitabilityproblems. Its fixed assets cannot be easily liquified, especially at the assumedmarket price, and UCB will not be able to generate enough income to cover itscostb unless the non-performing loans are replaced by performing assfts. Inother words unless UCB is recapitalized, it cannot generate any profits. Thefinancial situation of the COOP is considercKl.y more critical. The additionalloan loss provrisions of USh 1.7 billion recoi;.Lnded by C&L, even after allowingfor the revaluation of fixed assets, would more than wipe out the entire sharecapital of the bank.

3.19 By and large UCB's financial problsms have been caused by two majorsets of management and associated operational deficiencies. On the lending side,significant potential loan losses have been incurred due to poor loan extension,monitoring, supervision, and control coupled with the unprofitable terms of itsadministered lending. On the expenditure side, costs have been excessive due tolack of strict control over cash management and branch operations, the high levelof expenditure on the fast expanding and loss making new branc-h network, and theexcessive expansion of its heed office staff; during the past two financialyears, head office staff increas?d by 48 percent and currently head office costsrepresent about 59 percent of 'JCB's total operating costs, a relatively highfigure by international standards. Consequently if UCB is to improve itsperformance in future, it would have to improve the overall efficiency of itslending operations, better control its branch network, and reduce its operatingcosts. To accomplish this the mission recommends that a number of urgent stepsbe undertaken including:

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(a) UCB's senior management team and associated decision making processshould be strengthened (beyond recent changes) includings separationof the roles of chairman and managing director, enhancing the roleof the board, and regrouping below the level of managing director toallow stronger management contro';

(b) UCB should be given more autonomy from the Government to avoidpressures for unsound development lending and its developmentlending operations should be separated from the bank's commerciallending operations.

(c) UCB should freeze expansion of branches and close (or change mode ofoperation of) loss-making branches to reduce costs, and new lendingshould be restricted. Its operations should be streamlined toreduce overstaffing and costs particularly at the head office.

(d) A special loan recovery unit should be set up reporting to themanaging director to classify the whole loan portfolio andlaunch an intensive loan recovery campaign.

(e) Procedures for extending new loans should be tightened includingimprovements in credit control, management information systems, andinternal, audit. At the same time management should seek injectionof new capital from the Government to improve liquidity as part ofa detailed reorganization plan.

3.20 For the COOP, similar measures (as for the UCB) should be introduced.However. given that its situation is more precarious, the priority here is toreview whether a combination of new management (from the Swedish CooperativeCouncil), conversion of BOU's overdraft into equity, and injection oi any newprivate funds from the unions will offer a credible alternative to liquidation.The new management should formally be asked to present their strategy forconverting COOP to a viable enterprise to the shareholders for approval,including a timetable and resource requirements.

3.21 Enhancing the long term efficiency of the banking system With therecent licensing of two new domestic banks, Centenary Bank and Teefe Trust, thenumber of commercial banks has risen to 11. This is more than sufficient toprovide competition within the system, now and in the foreseeable future.However, the mere increase in the number of banks will not by itself increase thecompetition and efficiency of the system. The inefficiency of the banking systemas a whole is highlighted by intermediation costs, as measured I, the ratio ofoperating costs to average total assets. This ratio averaged ls 4 percent forthe system as a whole in 1989 and represents one of the higi et costs ofintermediation in the world. In part, high unit costs are due to the current lowlevel of financial intermediation. As the economy recovers, a higher level ofintermediation, should allow fixed costs to be spread over a larger loanportfolio, thereby reducing net operating costs on a unit basis. However, thefact that the figure for the most efficient bank (9 percent) was roughly one-third that of the least efficient bank (26.1 percent), implies that there isconsiderable room for reducing the cost of intermediation in Uganda; althoughsome differences will remain due to structural factors, in particular differencesbetween b&nks stemming from the size of their rural branch networks.

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3.22 To improve the efficiency of the cowmercial banking system and reduceintermediation costs, a first step is the restoration of the solvency andliquidity of the distressed banks or their linuidation. The prevailing interestrate structure implies that the average spread between the cost of funds and thereturn from commercial loans in Uganda is of the order of 28 percent. This highadministratively set spread or margin reflects the need to keep the twodistressed banks, which have above average intermediation costs, afloat, asituatior. which allows other banks to accrue rents and reduces their incentiveto provide improved and expanded services to their clients. Over the medium-termthe development of efficient interbank and money markets will help to reduce thecosts of intermediation by providing more efficient instruments for managingliquidity. Reduction in excess unrenumerated liquidity (currently kept by mostbanks) will cut the costs of intermediation. At the same time, the presence ofmoney markets will provide a more efficient basis for setting margins andspreads. Competition for funds should help to reduce the interest spread betweendeposits and loans and thus add to the incentive to reduce the costs ofintermediation.

3.23 However, the development of money markets will not eliminate all theinefficiencies in the banking sector. Effective competition requires othercomplementary and fundamental changes. A competitive banking sector requires theremoval of exit and entry constraints, not only to and from the subsector, butalso within the subsector itself. A genuinely competitive banking sector alsorequires policies that are geared to encouraging the development of a 'levelplaying field" for all participants. Implementation of these ideas over thelonger-term would imply, among other things, that: (a) an insolvent and non-viable bank should be liquidated even if it is part of the public sector, (b)commercial banks should be allowed, if they so choose, to become multipurposefinancial institutions (or universal banks) offering a range of financialservices, including insurance, hire-purchase venture capital, etc., and (c)foreign banks should be allowed to compete on an equal footing in any profitableventure such as crop financing or expansion of operations in particular ruralareas. Government should also g3ve consideration to allowing foreign banks tomaintain part of any new capital injection denominated in foreign currencies asa hedge against future depreciation of the Ugandan shilling.

Problems facing Development Finance Institutions

3.24 Containing the present erosion in investible resources The DFIs,including the Uganda Development Bank (UDB), the Ugandan operations of the EastAfrica Development Bank (EADB), the Development Finance Corporation of Uganda(DFCU), Ugadev Bank, and the development finance and rural credit divisions ofthe UCB and COOP, have been experiencing serious and mounting problems in thelast few years. The key symptom of their problems is to be found in the low rateof recovery on term loans. The low recovery rate, which points to a seriousproblem of poor portfolio quality, combined with (until recently) negative realinterest rates that they charge on their loans, have condemned these development-lending institutions to a steady and rapid erosion of their net worth. Theimplication is that most of these institutions are not operating as banks inrespect of the funds they administer and they are not accumulating funds forfuture term lending from interest and principal reflows. They are also unlikely

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in the near future to be able to mobilize significant amounts of domestic savingsgiven institutional and policy constraints including (i) restrictions preventingfree standing DPIT from accepting deposits, and (ii) existing interest ratepolicies, whereby term credits are received and on-lent with implicit subsidiesby the DPIa, and which nave constrained the development of a market for termfunds. As a consequence the DPI's are likely, for the foreseeable future, tocontinue essentially as agencies for on-lending donor funds and must thereforebecome more accountable for these funds. In particular, there is an urgent needto arrest the erosion of investible resources and to ensure that funds donatedfor this purpose revolve and maintain their value in real terms.

3.25 The difficulties encountered by the DFIs have been exacerbated byUganda's foreign exchange problems. The monetary authorities' inability toservice in timely fashion, external debts owed to the providers of lines ofcredit to the DFIs have caused repeated suspension of credit lines. The DFIshave had, in these circumstances, to suspend disbursements of subloans to theirborrowers, the implementation of whose projects has thus been interrupted, somepermanently so as the promoters equity and local cost financing has in themeantime been eroded by high inflation. The UDB has been worst affected by thesesuspensions. EADB and DFCU have had similar problems and their difficulties havebeen compounded by the fact that their loans are denominated in foreign exchangeand that their borrowers face a foreign exchange risk from delays in debt serviceexternalization during which period they are exposed to losses from devaluations.

3.26 The poor loan recovery performance, however, also raises questionsabout the quality of their portfolios and the appropriateness of their managementstyle. A review of the portfolio of the DFIs reveals that many of the projectsare operating well below capacity, and are thus unprofitable, and that newventures have a worse repayment record than established ones. Problems for UDBand EADB borrowers commonly start during project implementation. As a result ofinflation, finance for meeting local costs, although sufficient at the time ofappraisal, turns out to inadequate during implementatior.. Frequentimplementation delays, due for example to shortages of materials in the localmarket, exacerbate these problems. After start-up, production remains well belowappraisal estimates because of local raw material and foreign exchange shortagesand, increasingly, because of deficient market demand and strong competition fromparallel-market imports of competing products. Insecurity has also adverselyaffected projects situated in rural areas. Numerous loans financed in the early1980's by the AfDB for ranching have failed to perform as livestock has beenstolen in times of civil disturbance. However post-1986 projects also displaya disturbing trend of non-performance. Shortages of power have seriouslydisrupted development loans to the cement sector. Failures have beenparticularly common in rehabilitation projects, especially in the public sectorand in agricultural enterprises. Some 10 large sub-loans to parastatals accountfor about half of the post-1986 non-performing loan portfolio of the UDB.

3.27 At the behest of external financiers, the DFIs pay close attentionto formal project appraisal which is in general carried out thoroughly andsystematically. However, appraisal assumptions are commonly optimistic aboutmarket prospects and likely output performance, and insufficient account is takenof the management track record of the promoters of the project. Appraisals havealso paid insufficient attention to the consequences for profitability and loan

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recovery of delays in project implementation. The DFI's are subject to pressurefrom external financiers and from government shareholders to lend their resourcesquickly to enhance the rate of investment in the economy. This is likely toproduce an undesirable effect on project selection. Nevertheless, theirappraisal and approval processes are slow with an elapsed time of up to 24 monthsbetween application and final approval. The time delay is a deterrent tosuccessful businesses in the private sector which have needed quick decisions,particularly in times of high inflation.

3.28 The managements of the DFIs are aware of the need to devote moreresources to supervision during project implementation and follow-up aftercommissioning, but have not found sufficient staff or finances for thesepurposes. Supervisory visits are, in the difficult business environment ofUganda, infrequent. Even where, as in the case of the UDB, detailed operationalinformation is available, problems that threaten to undermine project viabilityare allowed to fester. With Uganda's chronic cash shortage, it is also importantto collect debt service payments regularly before arrears accumulate. Yetcollection endeavors have lacked vigour, except during periodic drives to collectoverdue payments. Government guarantees of debt service and loan repayment havealso not been honored. DFI managements have been reluctant to take steps torealize the collateral of defaulters. At the UDB, the legal department isseriously short of legal staff. However, in the few instances where legalenforcement steps are threatened, payments have been forthcoming. It is evidentfrom this that poor collection performance is not only due to an impairedportfolio but also to management weaknesses. These have been exacerbated by theabsence of any effective regulation and supervision of the DFI's

3.29 In the case of the DFIs, the short-run priority is to contain thep-esent erosion of existing investible resources and enhance financial discipline?.rough;

(a) a more expanded and concentrated effort on the part of DFjmanagement on supervision and collection, and more vigorous pursuitof legal action against willful defaulters.

(b) changes in screening and approval process by the DFIs - they shouldresist pressures to lend, and screen new project proposals morecarefully with preference being given to applicants with a goodtrack record, and projects with debt equity ratios of less than 50percent, and in preselected sectors with good economic prospects;

(c) upgrading of accounting standards, to obtain a more reliableindicator of performance, especially on loan classificationprocedures and accrual of interest through bringing the DFI's underthe prudential supervision of the BOU;

(d) phasing out of at the earliest opportunity of the subsidy element onthe funds received by DFIs as well the funds on-lent by them[Government should require DFIs to acquire all funds at commercialrates of interest (with any concessional element accruing toGovernment) and review interest rates on term loans with a viewtowards eventually phasing out rigid prescription of ceilings onlending rates];

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(e) the Government absolving DFIs and their clients of any foreignexchange losses arising out of delays involved in theexternalization of funds, once the local counterpart funds have beenlodged with the BOU; and

(f) the definition of a restructuring plan in the free standing DFIs,including an assessment of necessary recapitalization.

3.30 Long term institutional change In the perspective of growingdomestic savings (in the form of bank and Non-Bank Financial Institution savingdeposits and the holding of other saving instruments), there will be a case forthe Government to review the institutional structure of term lending.Specialized institutions, segregated from the rest of the financial sectoradministering earmarked donor funds, should only be seen as a temporary expedientfor supplying term funds to the economy. Such institutions are satisfactory onlyas long as there is a serious dearth of locally generated, loanable funds.Before long, however, such institutions frustrate the purposes for which theyhave been established. The rigid earmarking of funds for particular classes ofborrowers (as often stipulated by donor preferences) can easily promote themisallocation of term loans in the sense that alternative allocations would haveproduced higher rates of return. So long as term credits are received and on-lent with implicit subsidies, the domestic market for term funds will beblighted. At best the market will develop in a separate compartment from donorfunds. Furthermore, as was apparent from the mission's credit survey,businessmen prefer dealing with commercial banks that offer them a range ofservices rather than with highly speciali ones like the DFI's.

3.31 The above considerations suggest that the institutional structure ofthe supply of term funds should evolve (i) to permit the development of themarket for term funds, (ii) to offer business borrowers a more comprehensiverange of services, comprising those of commercial banks as well as those of thetraditional development finance institutions. To implement this approach theDFIs, conditional upon improved performance, should be allowed to provide workingcapital loans and to take deposits as a means of generating local funds and forshort term (and eventually longer term) lending. DFIs should also be allowed tooffer a wider range of financial services to borrowers and to evolve intouniversal banking institutions if they so choose. Their restructuring shouldcontemplate a broader ownership structure then is presently the case, includingexternal institutions. Over the longer run, the Government should plan fordeveloping the market for term funds (in the context of capital marketdevelopment, see below) and encourage the development of instruments for thewholesale and retail trading in these funds, including certificates of depositand bonds. Institutions, which would no longer be rigidly specialized, couldacquire funds from either retail deposits, or wholesale certificates of deposit,or from sale of bonds to other deposit taking institutions, or to savers outsidethe financial sector. In this environment, the supply of donor funds for termlending would be passed on by the Government to all intermediaries at wholesalemarket rates. If the Government wished for promotional purposes, to provideloans on temporary concessional terms to certain classes of borrowers (such aspeasant farmers), it would have to explicitly subsidize the lending institutionsfor this purpose.

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3.31 Rural credit The mission examined a variety of issues relating tothe future of rural credit in Uganda. First, there is a clear caie forincreasing the access of the rural economy to institutional financial marketsfrom its current low levels. However, given the high overhead cost of existingrural-credit schemes (such as the Rural Farmers Scheme), these schemes shouldonly be expanded at a measured pace governed by the supply of concessionalassistance and by the development of management capabilities in the institutionsin charge of these schemes. In particular, institutions engaged in agriculturallending should adopt a guideline of not allowing bank branches that haverecovered less than 80 percent of the previous season's loans from extendingfurther agricultural credit. The Government should at the same time encouragethe development of new and radical schemes to reduce the administrative costs andrisks of lending in the rural economy. To increase the access of the ruralpopulation to institutional credit and savings instruments, the Governmentshould, as a long run objective, also seek the revival of the Post Office SavingsBank, a suggestion already made earlier.

3.32 In conjunction with changes in interest rate policy, the Governmentshould review the rates charged on rural credit schemes. Interest rates andcharges should reflect the full cost of administering rural credit, including thecost of funds. Experience in other parts of the world suggests that interestrates aimed at recovering the full cost of these schemes, while higher than forother types of loans, will still be substantially cheaper than the cost of loansfrom informal lenders. At the same time to ensure that these schemes can becontinued on a sustainable basis, it is important to ensure that participatinginstitutions do not suffer losses. The concessional element in the cost of fundsfor these schemes should be seen by the banks as a once for all subsidy torecover the learning costs involved in starting-up the operation in a new area.Once relationships have been built with farmers, the costs of administrationshould decline, and recovery rates should improve so as to eventually permit theremoval of the subsidy in the future. In practice this will involve a continuingprocess of graduating farmers from these schemes to normal commercial overdrafts.

3.33 Agricultural lending should be developed from within the institutionsthat handle it at present. A new, specialized agricultural bank would in themission's assessment be unnecessarily costly and risky.

3.34 Housing finance and Non-bank financial institutions Independentdeposit-taking institutions, including building societies and the Housing FinanceCorporation, should be allowed to offer indexed savings accounts to theirdepositors and to extend indexed loans to borrowers.

3.35 Capital Market Development The time frame for developing a capitalmarket should be the medium to longer term and should preferably be preceded bythe emergence of active markets in short-term securities and medium term debt.To bring forward the time for the establishment of an equity market, theGovernment should over the long run take a range of actions including (i) sellits shareholdings in healthy enterprises to domestic savers as part of itsproposed divestiture program, (ii) make :ax policy changes to increase returnsto equity - for example by allowing firms to depreciate their plant on areplacement cost basis, and (iii) undertake the development of primary andsecondary markets for medium term debt to tap supply of insurance and pensionfunds through bonds issued by Government, DPI's and commercial institutions.

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These steps are in addition to the short term measures to improve informationflows on prospects and risks posed by individual projects, without which thedevelopment of a viable capital market cannot be successful.

IV. SEQUENCE OF REFORMS IN AN ACTION PROGRAM

Obiectives of, and strategy for, financial sector reforms

4.1 The main objectives of financial sector reforms in Uganda should beto support the stabilization of the economy and encourage a more efficientmobilization of savings, while at the same time ensuring that adequate financingis available to key sectors to sustain economic growth. To achieve these goals,this chapter proposes a comprehensive strategy for the reform and development ofthe financial sector. There are two main issues to be addressed in defining sucha strategy. First, there is the question of how to integrate financial sectorreforms within the on-going Economic Recovery Program (ERP); in particular thisinvolves issues of coordination with two separate sets of measures, one designedto achieve macroeconomic stabilization, and the other, parastatal reforms.Second, the success of the financial reform requires not only the coordinationof these reforms with components of the ERP, but also coordination betweenindividual components of the financial reform package: to effectively implementthe wide ranging measures recommended in this review, it is important to considerthe priority to be attached to individual reforms and sequence than in an actionprogram which distinguishes short-term measures from those to be implemented inthe medium- to longer-term.

4.2 Coordinaticn of financial sector reforms with the on-goingstabilization program and proposed parastatal reforms. In designing a strategyfor reform, an important factor to consider at the outset is the link, discussedearlier, between the financial sector and the macroeconomy. A change infinancial policies, by itself, cannot achieve a more efficient allocation andmobilization of financial resources. The health of the financial sector and theprofitability of its clients, particularly parastatals, depends on the confidenceof economic agents, on the stability of their environment, and on the credibilityof policy makers. A firm commitment to stabilization is fundamental to influenceinflationary expectations of private agents.

4.3. A successful program of financial reforms therefore needs to go handin hand with a stabilization program that firmly pursues macroeconomic stability,the control of fiscal deficits and inflation. A comprehensive plan for marketoriented financial sector reforms should give priority to measures that willdeepen the financial system and support stabilization. Consistent with thisapproach it would be unwise to launch liberalization measures without consideringtheir short run effects on macroeconomic imbalances. A specific policy measureto which this applies is the deregulation of money markets. Deregulation ofmoney markets to an extent which allows banks and other financial institutionscomplete freedom to set interest rates on deposits and loans should be avoidedin the near term because of the continuing presence of high inflation rates.While moving to a regime of positive real interest rates is important to instilldiscipline in the economy, the dangers of excessively high interest rates, which

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deregulation could bring about, should not be ignored particularly for thecredibility and effectiveness of the stabilization program; it could put anunreasonable burden on productive sectors and this could intensify the bad debtsituation of the banks.

4.4 It is also important to note that the link between the effectivenessof financial sector reforms and the macroeconomy goes beyond the short term.Since the financial sector operates within a larger economy, any attempt atstructural change of the sector assumes macroeconomic equilibrium and theexistence of appropriate policy instruments to deal with any imbalances that mayoccur. In this context it is worth emphasizing that if current efforts, asoutlined in Section I, towards macroeconomic equilibrium are not successful orif imbalances emerge again at a later stage, then they may arrest the structuralchange process while equilibrium is re-established.

4.5 The Government also faces the question of how to coordinaterestructuring the portfolio of distressed banks with its plans for restructuringparastatals who are major customers of the banks. This issue again illustratesthe complexity of the sequencing problem facing the Government because of thelink between the financial sector and the state of the macroeconomy. Theportfolio problems of the distressed banks cannot be resolved independent of theresolution of financial distress and insolvency facing the corporate sectorbecause of the on-going adjustment process. The restructuring of distressedbanking institutions would be ineffective and wasteful, without a serious reformor liquidation of insolvent public enterprise debtors.

4.6 The Government thus faces a dilemma regarding the timing forrestructuring these banks: If these banks, which represent such a largeproportion of the commercial banking system, are not restructured at an earlydate their precarious position could destabilize the whole financial system (withan attendant impact on the real economy) through a further erosion in publicconfidence in the financial system and in the use of financial assets as apayments mechanism. On the other hand, unless the economy stabilizes, there isa danger that recapitalized banks will once again face financial difficulties bylending to firms that risk becoming insolvent as a result of the on-goingadjustment process. The financial costs of restructuring the banks could bereduced if account is taken of these interlinkages in drawing up a restructuringplan. There are no simple solutions to this problem as there is uncertaintyabout the how long it will take for the economy to stabilize and for theassociated restructuring of distressed firms. It would therefore be unwise tohold off restructuring of bank portfolios for too long. A pragmatic approachwould be for the Government to move on both fronts simultaneously, rather thanfollowing any rigid sequencing plan. This matter should be monitored carefullyby BOU's bank supervision department. It may for example prove necessary toremove non-performing or more riskier assets of the commercial banks, especiallythose relating to loans made to parastatals whose viability is most questionable.and have them managed by a Government agency especially set up to handleliquidation.

4.7 Sequencing and timing of individual financial sector reforms. Theseverity of the problems facing the financial sector, and the far reaching natureof the reforms, call for a phased approach to the reform program. Using thisapproach, and taking account of the comments made above, the recommended strategy

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would be to embark first of all on an urgent program of reforms to restoreconfidence in the financial system and support the Economic Recovery Program.The emphasis initially would be on measures to enhance discipline in thefinancial system and help stabilize the economy followed, as stabilization takeseffect, by reforms aimed at restructuring of financial institutions. While themain emphasis for action is the short to medium term, it is also necessary todefine a longer term vision for the sectcr as an objective to aim for. Sectoralpolicies will need to be implemented in the next three to five years to encouragethe development of this long term vision, which the mission recommends should befor the development of an efficient and diversified financial sector.

4.8 The thrust of the proposed strategy is to:

(a) introduce measures in the immediate future to restoreconfidence in the financial system. To restoreconfidence, the Government should give the highestpriority for action to reinforcing financial disciplinethrough (i) enforcement of banking laws, financialcontracts, and accounting rules, (ii) strengtheningcentral bank control of monetary aggregates and thesupervision of financial institutions, and (iii)elimination of payments arrears, both of Government andparastatals. A recovery of confidence in the financialsystem is critically dependant on the restoration offinancial discipline both directly as well as indirectlythrough the positive effect that enhanced disciplinewill have on a reduction of inflation; indeed it isdifficult to envisage a sustained reduction in inflationwithout enforcing financial discipline.

(b) over the near term implement financial sector policiesto augment and facilitate stabilization. The Governmentshould design and implement monetary and creditpolicies, including interest rates, that will in theshort-run assist stabilization, restore incentives tohold financial assets (financial deepening) and furtherenhance the discipline in the financial system;

(c) over the medium term implement Plans to restructuringfinancial institutions. Beyond the next 18 months totwo years, and stretching into the medium term, theGovernment should aim to restructure the operations andbalance sheets of the distressed banking institutions,(including temporary containment measures) in parallelwith macroeconomic stabilization policies and therestructuring of insolvent firms; and

(d) introduce sectoral policies aimed at encouraging thedevelopment of the Governments's long term vision forthe financial sector. The mission recommends that thelong term vision should be the emergence of acompetitive financial sector, offering clients a diverserange of financial services and instruments. The

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Government's involvement in the sector, in this vision,should be largely confined to a promotional ordevelopmental role in addition to prudential regulationand supervision.

4.9 The above four elements of the proposed strategy are developedfurther below, and where the main recommended reforms are grouped under short.and medium-to-longer-term measures. The table following this description presentsa more detailed action plan for the sector in the form of a policy matrix.

Short Run Priorities

4.10 As indicated above, in the short-run, emphasis should be placed onmeasures that will restore confidence in the financial system and facilitatestabilization. The mission recognizes that come of these measures, includingthose with respect to coffee finance reform and COOP, have already implemented,partly as a result of the continuing dialogue on these issues between the Bankand the Government.

4.11 Measures to enhance financial discipline and restore confidence inthe financial system A first step towards the restoration of financialdiscipline is the enforcement of accounting rules, financial contracts andbanking laws. There is currently an acute lack of up-to-date and accurateinformation relating to the accounts of financial institutions and firms. As aresult, it is difficult to monitor developments in the financial sector to permitremedial measures to be taken at an early stage. It also increases the risks oflending. Accordingly the Government should give priority to improvements in theavailability of accounting information for both financial institutions andbusiness enterprises. In this respect the BOU should provide a lead byimmediately clearing its backlog of accounts and strengthening its accountingcontrol procedures. The Government and the BOU, in conjunction with the localaccounting profession, should also give priority to raising accounting standardsand increasing the quality and quantity of qualified accountants. Theimprovements in information flows, which will result from actions, will help tobetter define the risks of financial contracts and make banking more attractive.

4.12 To restore confidence in financial instruments and institution, inaddition to improving information flows, the Government should also take earlyaction to reduce inefficiencies incurred in financial transactions: as indicatedabove, there are legitimate concerns in the business community in Uganda aboutpoor communications within the banking system, the lack of confidence in the useof checks and the inconvenience and insecurity of cash transactions using largevolumes of low denomination notes. The Government, as an important shareholderin commercial banks, should press bank managements to significantly improve thequality and speed of their services to customers, particularly in respect ofmoney transmission and check cashing facilities. BOU should simultaneouslyimprove its clearing house operations to reduce delays in posting transactionsto bank exchange settlement accounts. At the same time the Government shouldintroduce higher value bank notes. This would cut the cost of note printing forthe monetary authorities, reduce business costs (by making transactions moreefficient and lowering conveyance and storage costs), and encourage the bankinghabit (4s low denomination notes currently discourage firms from depositing cash

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because of the time to taken to count it when it is deposited and subsequentlywithdrawn).

4.13 Other actions should also be taken to enhance the trust in checks incarrying out business transactions and thus contribute to the revival of thebanking habit. This includes actions to reduce the prevalence of check fraud,and re-ioving difficulties, experienced under current legislation in prosecutingperpetrators. It is therefore important that legislation, currently underpreparation, to repress check fraud more severely, is introduced as soon aspossible. These measures, together with changes in the law governing theenforcement of financial contracts to safeguard both lenders (through measuressuch as enhanced legal recourse for loan recovery) and depositors (throughpenalties on banks unable to service depositors requests for withdrawals aftergiving required reasonable notice) will help to better define the risks offinancial contracts.

1.14 To restore financial discipline, institutional reforms are alsourgently needed to strengthen BOU capacity to supervise the financial system andexert better control over monetary aggregates. The required measures for banksupervision are outlined in the policy matrix and discussed in detail in volume2.

4.15 To restore financial disciplinie, monetary control by the BOU shouldbe strengthened. BOU should be positioned with greater authority in the economicpolicy making process to give it a better chance for resisting at least some ofthe political pressures for short term but ill-considered credit expansion thatit has faced in the past. This calls for a strengthening of the authority andthe status of the BOU and in its role in the formulation and implementation ofmonetary policy through changes in the BOU Act (see page 4 of policy matrix fordetails). These changes, to be effective, will also need to be complemented bystrengthening the capacity of the BOU in a number of areas some of which havealready been mentioned above - bank supervision and accounts. In terms ofmonetary control, another key area, a first priority for the future is to expandsubstantially the analytical work underlying policy discussions and decisions,carried out preferably within a unit in the research department. Second, theeffectiveness of many of the available monetary policy instruments has in thepast also been limited by weaknesses in bank supervision. In this respectrestoration of monetary control calls for the enforcement of reserverequirements, in particular the early elimination of BOU overdrafts to COOP andUCB. Restoration of monetary control also requires that the widespread problemof payments arrears (both of Government and parastatals) and BOU losses arisingout of its commercial and developmental lending activities during FY 1989 beresolved at an early date.

4.16 Reforms to facilitate stabilization Over the next 12 to 24 monthsthe Government should formulate and implement a monetary program consistent withthe objective of a steady and significant decline in the rate of inflation. Themission's projections for the period FY91 - FY93 indicate that a substantialincrease in private sector credit is feasible within current targets forinflation and GDP growth and which should ensure adequate financing for theproductive sectors as well as for trade related needs. This program will befacilitated by the achievement of fiscal targets which envisage no bank financingof Government operations during FY91, and significant reductions in its

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indebtedness in both FY92 and FY93. Furthermore, if positive real interest ratesare maintained, they will provide incentives for private savings and, to theextent that the latter will bring about an early Jeepening of the financialsector, provide the Government further room in the choice between how much of thecredit available should be allocated to the private sector and how much for itsown budgetary needs. Higher interest rates will also improve the efficiency inthe use of financial resources and further enhance discipline in the financialsector.

4.17 The control in credit expansion also requires that the Governmentkeep crop financing operations of the banking system under close scrutiny toensure that they are in line with the targeted level of credit expansion. Thepolicy of the Government is to begin the process of transferring crop financingoperations, including the financing of CHB, to commercial banks from the FY91.The mission endorses this policy although it questions the speed of the intendedtransfer given the distressed situation of UCB and COOP which between them managemost to the rural branch network of the financial system.

4.18 To cope with the uncertainties in the monetary outlook the BOU, inits conduct of monetary policy, should use instruments which will be effectivein the unstable macroeconomic environment currently facing Uganda. For examplethe crop financing "benchmarks" presuppose that all credit for crop financing nowoutstanding is recovered. This is unlikely to be the case. Similarly theprojections depend upon exemplary fiscal performance which will probably not berealized. These and other uncertainties imply that the monetary projections mayexaggerate the scope for lending to the private sector. In this situationmonitoring and control of non-governmental credit will be vital for successfulstabilization. However, as noted earlier, many of the conventional instrumentsto control the money supply will not work, at least until the current distressin the commercial banking system has been resolved. In the interim, despite itsinefficiencies, physical controls on bank lending seem to be the most appropriateinstrument. At the same time the Government should encourage commercial banksand DFI's to tighten up screening of loan applications to discourage lending toprojects or enterprises whose viability is questionable.

4.19 Other short-term institutional and policy reforms While the focusof the reform program should, in the short-term, be on measures to restoreconfidence in the system and facilitate stabilization, the Government should alsoinitiate a number of changes whose effect will be more fully felt in the mediumterm, but which need to initiated in the next 12 to 18 months. These changespertain to reorganization of the BOU, restructuring of the commercial banks andDFI's, and changes in policies pertaining to rural finance.

4.20 The recommendation made above to strengthen BOU's capacity in thearea of bank supervision, accounts and monetary control needs to be implementedas part of an overall reorganization plan for the BOU, if it is to be theeffective and credible in long run. The reorganization plan should aim toupgrade and rationalize BOU's capacity in all key functions. Such areorganization should also aim to strengthen the senior management team andimprove coordination between BOU departments (for details see paras 4.20 - 4.30in the main report, Volume II). BOU should develop this plan in the next 12months, Including a schedule for implementation.

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4.21 Institutional reforms are also needed for the rehabilitation of thecommercial banks currently in distress and the restructuring of DFI operations(in particular those of UDB). In addition to the formulation of a viablefinancial restructuring plan for these institutions, major changes are needed intheir management teams and practices, including loan collection, credit controls,and internal audit. In implementing reforms at UCB, COOP, and the DFI's, asindlcated earlier, Government should note that incremental changes will not besufficient to turn the situation around. A sustained improvement can only bebrought about by implementing a credible plan of action that signals a clearbreak from the past. These measures are not only necessary for stability but,in the case of the UCB and COOP, will facilitate an effective and efficienttransfer of crop financing from the BOU. As this restructuring will take timetwo steps are necessary in the short run. First, a restructtiring plan should bedrawn up outlining changes to be made, the resources required, and the timeschedule for implementation. Second, and within the context of thisrestructuring plan, temporary containment measures should be introduced. Thesevary from institution to institution and have been outlined above in Section III.

4.22 In parallel with rehabilitation of financial institutions, Governmentshould take early measures to rehabilitate public enterprises whose financialdifficulties impinge on the performance of the distressed banks, since loanrecovery is critical for the restructuring of the distressed banks.

4.23 Finally in conjunction with changes in interest rate policy, theGovernment should review the rates charged on rural credit schemes. Interestrates and charges should reflect the full cost of administering such loans. Atthe same time expansion of these schemes should be closely linked to theenhancement of management capabilities in the institutions implementing them; inparticular branches with low recovery rates (less than 80 percent) should not beallowed to extend further credit.

Medium to Long Run Policies

4.24 For the medium to longer run the main priority for the Governmentshould be to encourage the efficiency of the sector and an enhancement in therange and quality of services provided by banks to their clients.

4.25 The current costs and risks of intermediation are high in Uganda.A pre-requisite for -educing intermediation costs is the restoration of thesolvency of the UCB iad COOP through the restructuring of the operations andbalance sheets of these banks. Experience elsewhere in Africa suggests that afull in.plementation of a restructuring plan for these institutions could easilytake five years to implement (or even longer if current progress in achievingmacroeconomic: stabilization is not maintained). Over the same time frame UDBshould also be restructured and recapitalized. To avoid a massive disruption ofthe Governments fiscal and monetary program, as discussed earlier, it isimportant that injection of new capital be carefully designed and include suchoptions as private sector participation, and the provision of new Governmentsecurities in whiLh only interest costs would represent an immediate claim onpublic finances.

4.26 Beyond the restructuring of financial institutions, the Governmentshould actively consider the development of interbank and money markets and other

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instruments, such as discounting facilities to reduce the need felt by the banksto maintain excessive liquidity. These markets will help to reduceintermediation margins, which are currently set administratively. As a pre-requisite to the development of an active money market, the present restrictionson commercial banks from holding Treasury Bills would have to be lifted.Together with the development of money markets, the Government should encouragebanks and NBFI's to introduce new savings instruments (such as indexed savingbonds and accounts). This will provide a more diversified set of choices fordifferent financial needs including savings, risk management, and liquidity. Inconjunction with these developments, the Government and the BOU should also beginto relax the rigid prescription of interest rate ceilings on lending and depositrates to sub-borrowers and depositors. The BOU can then focus on monitoringcharges to prevent undesirable monopolistic practices. These measures will alsocontribute to enhancing the number and effectiveness of the instruments ofmonetary control of BOU.

4.27 However, the development of money markets will not eliminate all theinefficiencies in the banking sector. Effective competition requires othercomplementary and fundamental changes. A competitive banking sector requires theremoval of exit and entry constraints, not only to and from the subsector, butalso within the subsector itself. The implications of this policy including theconcept of a "level playing field", in which all banks will have equal access toprofitable ventures in the economy, have been elaborated above.

4.28 At the same time the DFIs, conditional upon improved performance,should be allowed to provide working capital loans and to take deposits as ameans of generating local funds and for short term (and eventually longer term)lending. DFIs should also be allowed to offer a wider range of financialservices to borrowers and to evolve into universal banking institutions if theyso choose. Their restructuring should contemplate a broader ownership structurethen is presently the case including external institutions.

4.29 In parallel with the restructuring of banks and DFI's, BOU shouldalso fully implement its reorganization plan to place it on a stronger footingin implementing its role as a central bank.

4.30 In rural finance the Government should not only increase the accessof the rural economy to institutional financial markets but encourage thedevelopment of new and radical schemes to reduce the administrative costs andrisks of lending in the rural economy. To increase the access of the ruralpopulation to institutional credit and savings instruments the Government should,as a long run objective, also seek the revival of the network of the Post OfficeSavings Bank.

4.31 The reform of Housing Finance should also be undertaken andBuildings societies and other deposit taking institutions should be allowed tooffer indexed savings accounts to depositors and extend indexed loans toborrowers.

4.32 Finally, over the medium- to longer-term, the Government should takethe necessary policy actions to bring forward the establishment of primary andsecondary markets in bonds and equities.

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ACTION PLAN FOR FINANCIAL SECTOR REFOR(

TIMINC OFOBJECTIVES AND POLICIES STRATEGIES & MEASURES MEASURES

Institutional Strengthening the Substantially strengthen and *nhance statuo 1991/92Retorms capac ty of BOU to of Bsank Supervislon of BOU through:

*upervise financialsystem Expanding staffing substantially to Increase

freqjency of on-site examination

BOU to improve off-site surveillance by get-ting better quality and more timely reportsfrom CBs.

BOU to Install new loan classification proce-dures, and upgrade accounting st ndards (by,among other things, prohibiting accrual ofInterest on non-performing loans and requir-Ing banks to make adequate provisions forloan losses).

BOU should use existing supervisory powersmore aggressively and closely monitor bankcompliance with proposed corrective actions.

Bonking Act should be amended to Increasemonetary penalties and give BOU board, actingon advice from bank supervisors, explicitauthority to remove or suspend bank managersfound engaging In unsound banking practices.

Building Societies and DFI. should be broughtunder supervision of BOU.

Upgrade existing supervisory and examination 1992/93policies by (1) establishing basic guidelinesfor capital adequacy, and (2) develop a bankrating system using CAMEL approach

Clear backlog of annual accounts and review 1990/91accounting control procedures.

Formulate and Implement plan for reorganizing 1991/93BOU Including strengthening of senior manage-ment and a reduction in the number of depart-ment heads reporting directly to the Governorthrough appropriate groupings of departmentsunder Executive Directors.

Rehabilitation of com- In the case of UCB:mercial banks that arecurrently In distress Strengthen senior management 1990/91(UCS and C0OP)

Freeze expansion of bank branches and close 1990/91(or change mode of operation of) loss-makingbranches

Restrict new lending 1990/91

Set up special loan recovery unit reporting 1990/91to Managing Director

Hive off development lending operations 1991(which Includes a large component of adminis-tared loans) from the rest of the bank'soperations

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TIMING OFOBJECTIVES AND POLUCIES STRATEGIES A MEASURES MEASURES

Institutlonal Rahabilitation of Streamlino operations to reduco high Head 1991/92Reforms (contd.) commercial banks Offic- costs

(contd.)

Strengthen credit control, internal audit and 1991management Information systema

Government should refrain from asking UCB to 1990 onwardsImplem nt policies that may be sociaIlydenirble but conflict with sound bankingprinciples (see also below)

In the case of COOP:

As tho only rlternative to liquidation, the 1990/91Government should approach Swedish Coopera-tive Council to take ovor management of COOPfor a specified period; the new managementshould Identify strategy for converting COOPinto a viable enterprise and pr-esnt toshereholdere for approval

BOU overdraft to COOP should be converted to 1991/96equity as part of above plan and unlons givenopportunity to raise funds and repurchaethoir shareholding from Government

New COOP managoement, as part of Rehabilita- 1991/92tion measures, should be sked to tntensifyloan recovery drive launched In 1989, andstrengthen accounting and internal auditsystems.

If In a specified period (preferably five 1996years), viability cannot be restored, COOPshould be liquidated

For both UCB and COOP

Formulate and Implement restructuring plan 1991 - 1992for CBO through financial restructurling,capital Injection and organizatlonal changes.

Reform of development To arrest erosion of existing investible 1991/92finance Institutions resources and promote financial discipline In(DFIz) the DFIo:

DFIs should concentrate moro managementeffort on supervision and colloction Includ-ing incressed legal recourse against wilfuldefaulter.

Accounting standards especially on loanclassification procedures and accrual ofInterest should be upgradod.

New funds, both oxternal and domestic, shouldbe onlent to OFIs at commercial rates ofInterest.

Pressures to lend should be resisted by OFIs,and projects should be carefully screenedwith more emphasis on track record of appli-cants, and projects with debt/equity ratiosof less than 50 percont should become thenorm.

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TIMING OFOBJECTIVES AND POLICIES STRATEGIES & MEASURES MEASURES

Institutional Reform of development BOU should phase out of Its involvement inReforms (contd.) finance Institutions providing development loons to avoid conflict

(DFIs) of Interest as It takes over supervision ofOFIs (see below)

DFIs should be allowed to provide workingcapital loans, and to tako deposits as ameans of generating local funds for shortterm (and eventually longer term) lending

A plan shculd be drawn up and implemented for 1992/93restructuring and recapitalizing UD3 with abroader ownership structuro including *xter-nal Institutions.

Exchange risk arising out of delayed *xter- 1991/92n&lization of funds should be borno by Govt.DFIs should mak- escrow arrangements for*xternal debt service payments a rule for allexport oriented projects.

DFIs should be allowed to offer a wider r:n9e 1992/93of financial services to borrowers In *ssoci-ation with a strengthening of their manage-ments.

Leasing reforms Tax authorities should recognize depreciation 1990/91on leased equipment as an allowable expensefor tax purposes

Restructuring of rural Interest rates and charges should reflect the 1991/92finance full cost of administering loans, including

the cost of funds.

Agricultural lending should be expanded, but 1991/92from within existing Institutions. Expansionshould be linked to the enhancement of man-agemnt capabilities in the InstitutionsImplmenting agricultural credit schemes;bank branches with recovery rates of lessthan 80 percent should not be allowed toextend further credit. While lending toviable agricultural projects should beexpandeJ through existing institutions, a newspecialized agricultural bank appearsunjustified at the moment.

Government should encourage the development 1991/96of new and radicel schemes designed to reducethe administrative costs and risks of ruralcredit and to increase the access ofthe ruraleconomy to Institutional financial markets.

Reform of Housing Building societies and other deposit taking 1991/92Finance institutions should be allowed to offer

indexed savings accounts to depositors andextend Indexed loans to borrowers. The Hous-ing Finance Company should be authorized toexperiment with pilot sche for indexedsavings and loans.

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TIMING OFOBJECTIVES AND POLICIES STRATEGIES A MEASURES MEASURES

Legislative ond Strengthening of Review prudential regulations with a view to 1990/1991regulatory prudential regulations implemnt more stringent requirements forchanges commercial bank operations Including capital

and reserve requiremnts, exposure limits toindividual customers, accounting standardsfor reporting financial performance, loanclassification procedures, etc.

Changes in legislation Review 8OU Act to otrengthen authority of BOU 1991/92to strengthen the and formalize its role in policy-making.authority of BOU and Such a review should recognize that some ofclarify its role the desired enhancemnt in authority can also

be achieved through changes in existingpractices. In particular the ACT should beroviewed, and where necessary changed, toensure that:

All administrative matters relating to BOUincluding senior appointments should be theresponsibility of the Governor (with theapproval of the Board, in some cases)

The role of 8OU in the formulation of mone-tary policy in particular and economic policyin general should be strengthened. BOUshould have primary responsibility for theformulation and implementation of monetaryand supervisory policy, and right ofparticipation in negotiations on these issueswith international organizations.

BOU should be required to inform Governmentof its views on, and approach to monetarypolicy, after each regular meeting of the BOUboard.

All matters pertaining to areas where BOU hasprime responsibility should be decided by theBOU with clearance by the Minister in sensi-tive areas including interest rate policy andlicensing and closing of banks.

In circumstances where consensus cannot bereached between the Governor and the Ministerof Finance on policy issues, the Governmentshould have the power to direct the Bank butthe BOU should have the option to have thefacts pertaining to the differences revealedin an appropriate public forum such as theBOU's annual report.

Introduco changes to BOU Act. 1992

Sector Policies Improving efficiency and Current restriction on CS. holding of Trea- 1991/92effective competition in sury Bills should be removed.financial sector.

Setting up of inter-bank and money markets as 1991/93well as re-introduction of rediscountingfacilities at BOL to provide new instrumentsfor managing liquidity in the economy and abenchmark for interest rates.

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TIMING OFOBJECTIVES AND POLICIES STRATECIES A MEASURES MEASURES

Sector Policies Improving efficiency In conjunction with the development of Inter- 1992/93(contd.) (contd.) bank and money markets, the Government/BOU

should relax the rigid prescription of Inter-est rate ceilings on lending and depositrates to sub-borrowers and depositors respec-tively and instead monitor charges to preventundesirable monpolost;c prectices.

Foreign banks should be allowed to maintain 1992/93part of their share capital in foreign cur-rencies

Changes in tax laws to allow loss provisions 1994/97to be treat.' as expenses.

Review entry and exit conditions for commer- 1994/96cial banking sector to improve competition.Government should allow mergers as a mode ofentry; allow private sector to take equityparticipation in state-owned banks; allow CBsto become multipurpose institutions.

BOU to reduce delays in the clearing of 1991/92checks

Design and Maintain momentum for Transfer crop finance responsibilities from 1990/91implement restructuring crop BOU to CBs.monetary and finance and transferringcredit policies it to a competitive Restrict sales of coffee on barter. 1990/91 onwardsto assist market-based allocativestabilization mechanism. Equity injection Into CUB to meot its minimum 1990/91and encourage seasonal working capital needsfinancialdeepening Effective competition to CUB from other 1991/95

players to be encouraged to eliminate CUBmonopoly

Control credit Net domestic credit to Government to be 1992/93requirements of restricted.Government and allowmore availability ofcredit to private sector

Design (and gain greater Enhance compliance of reserve requirements by 1990/91control of) reserve eliminating BOU overdrafts to UCB and COOP.requirements as aninstrument of monetary Consider remunerating CBs for reserves 1991/92policy. (maintained at BOU) to reduce taxation

component and enhance efficiency ofintermedistion.

Enhanco the use of Consistent with sector policies (se above) 1990/91 onwardsinterest rates and other review level and structure of interest ratesinstruments for more frequently (at least on a quarterlyeffective basis) In light of changing market conditionscredit management, and inflationary developments, and ensure

they remain positive in real terms.

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TIMING OFOBJECTIVES AND POLICIES STRATEGIES A MEASURES MEASURES

Design and Enhance the use of More effective use of other monetary policy 1991/93implement Interest rates (contd.) instruments through (i) changes in liquiditymonetary and and reserve requirements; (ii) introducecredit policies general re-discount window; (iii) an increase(contd.) In the upper limit on the value of T bills

that can be issued (currently USh 2 billion);(iv) issue of Interest-bearing securities byBOU on its own account; and (v) conductingopen-market operations.

Strengthen other Ways and Means advances by BOU to be 1991 onwardsinstitutional aspects of restricted to 18 percent of Government'smonetary control. recurrent expenditurer (as per BOU ACT).

Take steps to reduce payments arrears (both 1991/92of the Government and parastatal enterprises)and resolvo problem of BOU losses.

Enhance technical aspects of monetary 1991/93management, including creation of monitoringunit in the research department at BOU. Thisunit should monitor monetary and creditdevelopments and policy actions to achieveprogram targets. Targets should be monitoredtaking account of changes in financial depth(M2/GDP). Over the medium term theGovernment should also review the use ofindirect monetary controls for managingliquidity in the economy (including openmarket operations) and possibly the use ofelements of BOU's balance sheet asintermediate objectives of monetary policy.

Increase the effective- Government/BOU should maintain policies of 1990 onwardsness of credit policies allowing credit expension to productive andto facilitate supply commercial sectors to expand faster than theresponse rest of the economy.

Release of foreign exchange for imports 1991 onwardsshould be smoothed and made more regular andpredictable/

Delays in payments and problems in clearing 1991/92Government checks (for supply to Government)should be reduced by improving expenditurecommitment authorization procedures andfinancial controls.

Government should avoid influencing banks, 1990 onwardsdirectly or indiroctly, to lend to non-bankable customers Including overindebtedpublic enterprises and firms without adequateproperty titles.

Government should strengthen legislation to 1991repress check fraud more rigorously andintroduce higher value bank notes.

Government as an important shareholder in 1991/93commercial banks should SIs* press bankmanagement to improve the quality and speedof thoir services to customers in respect ofmoney transmission and check cashing facili-ties.

Government should seek revival of the network 1994/96of the Post Office Savings Bank.

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TIMING OFOBJECTIVES AND POLICIES STRATEGIES A MEASURES MEASURES

Development of Reduce risks by improy- Accounting standards to be raised as part of 1992/96term lending and Ing Information flows plan in conjunction with local accountingCapital Market and strengthening law profession to Increase both the quantity and

governing financial quality of qualitfid accountants.transactions.

Legal resource for loan recovery, including 1992/93access to collateral, to be reviewed andstrengthened.

Law regarding enforcement of financial con- 1992/93tracts to be reviewed and strengthened (tosafeguard lenders and depositors).

Encourage the develop- CBn and NBFIs to be encouragd to offer 1991/93ment of savings instru- greater varlety of savings Instrumentsments including indexed savings bonds and accounts;

the interest rates on these instrumentsshould of course conform with prevailing aoUrequirements.

Development of wholesale Once money market has been established, the 1993/96market for term funds Government/BOU will undertake the development(bond market) of primary and secondary markets for medium

term debt to tap supply of insurance andpension funds using Government and commercialbonds and bonds issued by DFIs.

Steps to bring forward Tax policy changeo to increase return to 1994/97development of capital equity; in particular over the medium to longmarket term Covornment should consider allowing

firms to depreciate plant and equipment onreplacement cost basis.

Government to sell its equity shares In 1992/96healthy and viable enterprises to domesticsavers as part of its proposed program ofdivestiture.