Uganda - Third Reconstruction Program Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-3733 -UG REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT OF SDR 47.2 MILLION TO THE REPUBLIC OF UGANDA FOR A THIRD RECONSTRUCTION PROGRAM April 19, 1984 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of January 1984) Currency Unit = Uganda Shillings (USh) US$ 1.00 = USh 240 (First Window) US$ 1.00 = USh 300 (Second Window) USh 1.00 = US$ 0.0042 (First Window) USh 1.00 = US$ 0.0033 (Second Window) From October 1975 to May 1981, the Uganda shilling was tied to the Special Drawing Right (SDR) of the IMF (SDR 1.00 = USh 9.66). However, the Ugandan shilling was devalued by 90% in June 1981 and has subsequently been float- ing in relation to a basket of currencies. Since August 1982, the Bank of Uganda has operated a dual exchange rate system, including a second window at which foreign exchange is traded more freely. The first and second window exchange rates are expected to approach each other and merge in the near future. FISCAL YEAR July 1 - June 30 ABBREVIATIONS AND ACRONYMS BOU Bank of Uganda CTB Central Tender Board EAC East African Community EDMO External Debt Management Office ICA International Coffee Agreement IPA Institute of Public Administration MF Ministry of Finance MPED Ministry of Planning and Economic Development MPSCA Ministry of Public Service and Cabinet Affairs RRP Revised Recovery Programme UABT Uganda Advisory Board of Trade UDC Uganda Development Corporation  FOR OFFICIAL USE ONLY UGANDA THIRD RECONSTRUCTION PROGRAM SUMMARY Borrower: Republic of Uganda Amount: A Credit of SDR 47.2 million (US$50 million equivalent) Terms: Standard Project The proposed credit would (a) provide financing for the Objectives and importation of essential raw materials, intermediate goods, Description: spare parts, minor capital equipment and drugs for high priority sectors in line with the Government's Revised Recovery Programme (b) support urgent policy and institutional reforms and (c) generate counterpart resources for the government budget. A list of beneficiaries requiring government loans or guarantees which would account for not more than 20% of the credit has been agreed upon at negotiations. The remainder of the credit would be sold through foreign exchange auction procedures currently applied at the second window, to finance specified imports. The program supported by the credit comprises actions in the areas of economic management and planning, foreign exchange and debt management, parastatal reform and public administration. Risks: The principal risks are that the security condition in Uganda could again deteriorate or that shortfalls in financing could further reduce import levels and delay recovery. In 1984 and 1985, shortfalls in foreign exchange could jeopardize Uganda's progress in rationalizing its exchange policies and given the sensitivity of economic performance to the availability of recurrent imports, seriously threaten the momentum of economic recovery. These risks have been reduced by the Government's clear commitment to improving law and order and to its economic and financial programs. The Government has continued to respond positively to the concerns of the principal donors, as evident at the recent Consultative Group meeting in January 1984. Estimated Dec. 1984 June 1985 Dec. 1985 Disbursements: (US$ million equivalent) 10.0 30.0 50.0 Cumulative Rate of Return: Not applicable Appraisal Report: None This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED CREDIT FOR A THIRD RECONSTRUCTION PROGRAM TO THE REPUBLIC OF UGANDA 1. I submit the following report and recommendation on a proposed credit for a third reconstruction program for the equivalent of SDR 47.2 million (US$50 million equivalent) on standard IDA terms, to the Republic of Uganda. PART I - THE ECONOMY 2. An economic mission visited Uganda from May 23 to June 5, 1983 and its report, entitled "Uganda - Country Economic Memorandum" (Report No. 4733-UG) dated December 9, 1983, has been distributed to the Executive Directors. A summary of social and economic data is given in Annex I. Background 3. Uganda achieved independence in 1962 with a number of important advantages: (a) a favorable climate, fertile soils and a rich mineral base for economic development; (b) an established indigenous smallholder sector providing a widening range of export crops and an ample domestic food supply; (c) a small but rapidly growing industrial sector, contributing exports of copper and textiles; (d) a well-developed transport system, including facilities shared with Kenya and Tanzania under the East African Community (EAC); (e) an exportable surplus of hydroelectricity, with substantial scope for further development on the Victoria Nile; and (f) one of the most advanced education systems in East Africa. The initial years after independence clearly demonstrated the economic potential of the country. Real GDP grew by 4.8% per annum from 1963 to 1970, implying an increase in per capita terms of at least 2% per annum. The country was also able to maintain a reasonable savings rate (averaging 13%) which permitted implementation of an ambitious investment program  without undue pressure on domestic prices or the balance of payments. Although Uganda's export volumes grew slowly, export earnings were more than, adequate to cover import requirements and the country maintained a current account surplus in most years. The Government's budgetary position was also sound~: revenue increased faster than recurrent expenditure during the latter half of the 1960s and, together with non-bank domestic borrow- ing, helped finance a significant proportion o. development outlays. 4. However, after the coup in 1971, the situation quickly deterio- rated. Under the military regime, many skilled personnel left the country, the parastatal sector became bloated with the addition of many abandoned or confiscated industries, and professional standards within the administra- tion were eroded. On top of these largely self-imposed problems, the Ugandan economy was shaken by a series of shocks: the sharp rise in petroleum prices after 1973, the breakup of the EAC in 1977, and the damage and looting which occurred during the 1978-79 war. As a result, real GDP stagnated through 1977 and then fell over the next three years. Import levels had to be cut by 50% from 1970 to 1979, due to lower export volumes, worsening terms of trade (except during the coffee boom years of 1977-79) and dwindling aid receipts. The Government's budgetary position also became increasingly untenable, as the revenue base was undermined and expenditure control collapsed, The resultant deficit was financed increasingly by bank borrowing, leading to monetary expansion and price inflation (averaging 74% per annum from 1977 to 1979). Not surprisingly, critical shortages developed and a large share of economic activity was diverted to the pervasive parallel market system called "magendo". Recent Economic Performance 5. By April 1979, when the military regime was overthrown, the Ugandan economy was in ruins. Initial efforts to promote recovery were constrained by an unstable political situation, administrative weaknesses and a severe shortage of foreign exchange. As a result, many of the adverse trends evident during the 1970s continued through 1980. In partic- ular, real GDP continued to decline while the inflation rate rose above 100% per annum. Then, in mid 1981, the Government made a dramatic break with the past by announcing a major devaluation of the Ugandan shilling and related price adjustments. Through a series of financial programs, sup- ported by assistance from the IMF and other donors, further policy reforms have been introduced over the past two years (see paragraphs 7 to 9). As a result, there has been a marked improvement in economic performance, despite the negative impact of internal security problems and adverse conditions in the world economy. The difficult security situation results from the disintegration of law and order during the 1970s and the need to rebuild the security forces after the 1978-79 war. Although most of the country is now at peace, periodic incidents have occurred, especially in the areas surrounding Kampala, disrupting production and transport activi- ties amd diverting budgetary resources for security-related activities. As regards the world economy, although Uganda's terms of trade have improved sincea 1981, the index remains at less than half the peaks achieved during the coffee boom years of 1978-79, and only 65% of the level in 1970. Equally important, Uganda's export earnings are now constrained by the quotas on coffee sales imposed under the International Coffee Agreement  (ICA). During 1982/83, for example, Uganda's estimated coffee production was 40% higher than the quota limit; the balance was either stocked or sold on non-quota markets at discounts of up to 50%. The combination of economic recession and tighter fiscal policies in developed countries has also affected the availability of external assistance. For Uganda, aid mobilization has been made particularly difficult by the legacy of inter- national isolation imposed during the 1970s and continuing concern overseas about the security situation in the country. 6. Despite these difficulties, an economic recovery is now evident: (a) GDP grew on average by 5% per annum during 1981 and 1982, and this growth rate was probably sustained into 1983 (Table 1). The recovery was initially concentrated in subsistence agriculture but has been more generalized over the past two years; (b) Export volumes rose by an estimated 45% from 1980 to 1983, and would have recovered even more without the coffee quota con- straint. This export growth, together with improved aid utiliza- tion during 1983, has helped to finance a much-needed expansion of import volumes since 1981; (c) Government revenue has increased more than fourteenfold over the past two years, from 0.8% to 6.3% of GDP. Expenditure growth on the other hand has been less rapid, because the Government has restricted cash releases to ministries in order to remain within the IMF ceilings. Consequently, the budget deficit was held to about 2% of GDP during 1982/83; (d) The resultant restraint on bank borrowing by the Government has reduced the rate of monetarv expansion. This, together with falling import prices, has helped to control general inflation, which is down from an estimated 100% per annum in 1980-81 to 45% in 1982 and about 30% in 1983. Despite this progress, overall levels of economic activity and trade remain substantially below the peak levels achieved in the early 1970s. As a result, per capita GNP is still only two thirds of the 1970 level. The burden of this income loss falls most heavily on wage and salary earners, especially in the civil service, who often have to resort to secondary employment or unofficial activities in order to survive. PART II - GOVERNMENT POLICIES AND PROGRAMS Policy Measures 7. The Government's primary goal is to restore law and order, a basic prerequisite for future economic progress. Second only to this, however, is the goal of rehabilitating the productive sectors. The first step towards rehabilitation was the introduction of the financial program for 1981/82, which has been followed by similar programs during 1982/83 and  - 4 - Table 1: Uganda: Selected Economic Performance Indicators 1970-82 1970-80 1981 1982 1982 Share of Growth rates (% per annum) GDP (x) National accounts GDP growth -1.5 3.9 6.1 100.0 o.w. monetary agri- culture a/ (-2.5) (-0.1) (11.5) 22.1 industryb! (-10.7) (-4.8) (12.2) 4.6 Gross domestic investment -10.0 22.3 27.1 8.3 Gross national savings -12.0 -16.0 44.7 4.8 Money and prices Money supply (end of period) 27.9 76.9 24.8 5.5 Bank credit to govern- ment (end of period) 38.6 97.5 16.3 4.9 GDP deflator (1966 = 100) 40.6 92.8 44.9 - Merchandise trade Exports -11.0 23.9 36.6 4.6c/ Coffee - 5.4 16.5 35.7 Cotton -29.7 -47.8 50.0 Tea -28.9 -- 140.0 Imports -38.3 -29.7 19.5 7.6c/ Government finance 1971/72 1981/82 1982/83 Revenue/GDP (%) 13.5 4.3 6.3 Deficit/GDP (%) 8.1 2.7 2.0 Notes: a/ Including forestry, fishing and hunting b/ Including agro-processing, mining, manufacturing and construction c/ Including non-factor services  1983/84. These programs have been supported by three stand-by arrangements with the IMF (for a total of SDR 320 million), drawings from the First and Second IDA Reconstruction Credits (providing US$145 million after June 1981) and assistance from other donors. Major actions taken by the Government are summarized below. (a) The official exchange rate was devalued from under USh 8 to USh 78 per US dollar in June 1981, and has subsequently been steadily depreciated further to USh 240 per US dollar in January 1984. Since August 1982, the Government has also opened a second window where foreign exchange is more freely traded in an auction system. The rate established at the second window has fluctuated between USh 230 and USh 330 per US dollar over the past year. These exchange rate adjustments have led to a substantial reduc- tion in the premium and importance of the unofficial market for foreign exchange. (b) The initial devaluation in June 1981 was accompanied by the removal of most price controls. The major exceptions were for producer prices of traditional export crops, retail prices of petroleum products and utility tariffs. For these controlled items, significant price increases have been introduced over the past year. Petroleum prices have increased more than twentyfold since December 1980 to reflect fully the impact of window-one exchange rate changes. Producer price adjustments have been more moderate, with increases of about tenfold for most major export crops. However, these increases are still substantially higher than general inflation and net returns from the production of all major export crops are now positive. The most serious lags in price adjustments have been for utility tariffs. Although all major tariffs have been increased by at least 100% since 1980, further large adjustments will be required in most cases to reflect present costs of supply, to provide resources for future development and to encourage efficient utilization of services. (c) Various measures have been introduced to improve monetary and fiscal discipline. To help control the demand for money and allocate credit, most interest rates have been nearly doubled over the past two years (although they still remain negative in real terms). As part of its obligations under the IMF stand-by arrangements, the Government has agreed to and met ceilings on the growth of net domestic credit and net credit to the Govern- ment. On the fiscal side, a number of measures were taken in mid 1981 to streamline and improve the elasticity of the taxation structure. Strict control has also been maintained over cash releases to ministries, although this has sometimes been at the cost of underfunding critical functions and the accumulation of domestic arrears. The Revised Recovery Programme 8. During the latter part of 1981, it became apparent that the availability of foreign exchange would be substantially less than required  - 6 - to effect a rapid rehabilitation of the economy and hence a rapid recovery to early 1970s living standards. The Government, therefore significantly scaled down its earlier investment plans, and, in April 1982, with assis- tance from the Commonwealth Fund for Technical Cooperation, produced its Recovery Programme 1982-84. This program constituted a project-specific rehabilitation plan for .1982/83 and 1983/84, the resource requirements for which (US$736.5 million including a "tail" of expenditures overlapping into 1984/85) were held within a realistic assessment of Uganda's export and external assistance prospects. The strategy was to concentrate resources on the sectors producing tradeables, especially export agriculture, and on activities likely to increase production and foreign exchange earnings rapidly, by mobilizing underutilized capacity and by rehabilitation. The highest priority sector iis, therefore, export crop production, supported by transport and communications infrastructure, and the production of basic consumer goods, building materials and agricultural inputs by the industrial sector. The REecovery Programme also included commitments to policy and institutional reforms. This program was presented to, and received commendation from, the May 1982 meeting of the Consultative Group. 9. In October 1983, following a progress review, the Government published a Revised Recovery Programme (RRP), which was presented to a further meeting of the Consultative Group in January 25 and 26, 1984. The review concluded that implementation of the original program had fallen short of targets: actual expenditure during 1982/83 was only US$152 million, less than two thirds the level proposed. There are several reasons for this shortfall: (a) the Recovery Program was not properly integrated into the foreign exchange or government budgets, and the Government had not established the machinery to keep track of aid flows and expenditures. Monitoring and hence management of the program were therefore weak; (b) many of the projects were loosely defined in terms of implementation responsibility and costs; (c) in terms of the lead time required for preparation and financial mobilization the program was probably optimistic; and (d) while external aid commitments averaged US$415 million in 1982 and 1983, only marginally short of the requirements estimated by the World Bank at the 1982 Consultative Group meeting (US$425 million average for those two years), not all these commitments supported the Recovery Programme; the Government estimates external resources secured for the original program at US$623 million, US$114 million less than required. Except for this mismatch of donor commitments and Recovery Programme requirements, these factors reflect a general weakness in the Government's administrative capacity, particularly in aid administration which is now being addressed and supported by various donors, includingIDA (paras. 44-48). 10. The RRP attempts to take account of these resource constraints and implementation problems, while maintaining the same broad objectives and strategy. The essent:Lal change is a one year extension of programmed expenditures (see Table 2). The focus on the short-term revival of the productive sectors remains, and priority in all sectors is given to rehabilitation and improved utilization of existing capacity. Although provision has now been made for preparatory7 work on a number of new projects, most of these dci not involve large expenditures before the end of 1985 and are essential to maintain momentum in later years. The foreign exchange and budgetary requirements of the program, which are based on projections consistent with those presented below (paragraphs 19 and 21),  - 7 - are realistic, provided the coffee export quota can be increased by about 13% in 1985 and new external assistance commitments can be increased by about 10% over the next two years. Resources have been reallocated somewhat towards industry and social infrastructure, partly reflecting experience during 1982/83, partLy donor sector and project ?references and partly the allocation of US$80 million of balance of payments support to the industry sector. The RRP does, however, give greater strategic emphasis to rebuilding the industrial sector, especially large-scale industries, and to improving social services. Table 2 Comparison of Investment Plans 1982-85 (in US$ million)a/ Recovery Revised Program Recovery 1982-84 Program Change By fiscal year 1982/83 240.1 152.1b/ - 88.0 1983/84 316.4 270.6 - 45.8 1984/85 180.0C/ 376.0 196.0 Total 1982-85 736.5 798.7 62.2 By sector Agriculture 220.0 215.3 - 4.7 Industry & tourism 211.5 281.6 d/ 60.1 Mining & energy 41.4 27.3 - 14.1 Transport & communication 155.0 113.8 - 41.2 Social infrastructure 108.6 160.7 52.1 a/ Recovery Program 1982-84 is in 1982 prices; the RRP is in 1983/84 prices. b/ Estimate. c/ Balance to complete 1982-84 projects only. d/ RRP allocation includes US$80 million of balance of payments support. Sectoral Programs 11. Agriculture dominates the Ugandan economy, providing livelihood to 90% of the population and supplying almost all Uganda's exports in recent years. Ugandan agriculture is largely dependent on small- and medium-scale peasant farms; no attempt was ever made to encourage expatri- iate settlements, and even today, large-scale estates are only significant in tea and sugar production. With its favorable natural conditions, Uganda produces an overall food surplus in most years, though areas like Karamoja in the north-east, which are vulnerable to drought and which depend on a traditional trade of cattle for grain, have suffered periodic food  -8- shortages as a result of low rainf all and insecurity. The rehabilitation of agriculture is the top priority for UgarLda's economic recovery. Coffee, cotton, tea and tobacco exports could all continue to grow rapidly over the next three years (although the previous peak levels are not likely to be reached until later in the 1980s and coffee exports will probably remain subject to ICA quota constraints). In addition, scope exists for expanding non-traditional exports (e.g., hides and skins, foodstuffs and fertilizers) t:o neighboring countries. The revival of cotton and other agricultural production would also supply some domestic industrial needs. During the rehabilitation phase, the Government has decided to give top priority to improving incentives, including changes in producer prices and the market- :Lng system. Closely related to this is the supply of inputs, implements, spares for processing and transport, and consumer goods to stimulate the production of surpluses. Over the longer term, agricultural services, Lncluding research and extension, will also need more attention, 1L2. Although Uganda's industrial sector has always been relatively small, it did in the past make a valuable c.ontribution towards supplying 'he domestic market with basic goods and, in some instances (e.g., textiles and copper), produced a surplus for export. However, the sector largely collapsed during the 1970s. Although industrial production did begin to recover during 1982, performance of the sector remains very uneven, with maay enterprises still closed down and average capacity utilization of only about 30%. At present, the most obvious arnd generally binding constraint is still the severe shortage of foreign exchange. However, the longer-term decline in the sector reflects more fundamental constraints which are :reemerging as the foreign exchange situation improves. These include: shortages of qualified managerial and technical expertise, problems of creditworthiness (resulting from ownership uncertainty, financial indisci- pline and, more recently, the impact of devaluation on costs), over- expansion and political interference in the management of the parastatal sector, and significantly more deteriorated. plant and machinery than had been realized. The Government has now declared its intention to follow a ''mixed economy" strategy, with only essential public services reserved exclusively for the public sector. In othetr areas, domestic and foreign private enterprise is to be encouraged, either wholly privately owned or in joint ventures with the Government. The Government expects to close down or sell off a number of the existing industrial enterprises, while the financial viability of the remaining parastatals is to be restored through ;increased tariffs, asset revaluation and injections of new capital. The modalities for restructuring the parastatal. sector are spelled out further 'below (paragraphs 53-55). 13. Uganda's transport system, formerly one of Africa's best, deteri- orated rapidly during the 1970s for the same general reasons outlined ear- lier: the departure of skilled personnel, political interference, and in- adequate provision of resources for essenti.al functions like maintenance. In addition, the breakup of the East African Community (EAC) in 1977 had a serious effect, especially on Uganda's access to international trade routes. As a result Uganda lost virtually all railway rolling stock and aircraft and her part-ownership of railways and port facilities in Kenya and Tanzania. This both necessitated heavy new investments by Uganda, and seriously disrupted international traffic rovements while increasing their  - 9 - cost. Transport was moreover the sector possibly most seriously affected by the war and the widespread looting which followed. The vehicle fleet in particular was decimated. Rehabilitation of the transport system and sector institutions thus becomes a key requirement for economic recovery. 14. The World Bank recently completed an assessment of Uganda's energy sector. Energy use is primarily based on electricity, petroleum and woodfuels. At the present time, Uganda's electric generating capacity is underutilized. However, the surplus could be quickly absorbed as the economy recovers and the opportunities are taken to substitute for more expensive fuels (such as petroleum products) and to secure long-term export agreements with neighboring countries. As a result, the Government has initiated two studies on the power subsector, one on the rehabilitation of the Owen Falls Station and the other to help prepare a least-cost power development program. As regards petroleum, the Government has succeeded in reducing the cost of imports over the past two years, through the impact of higher retail prices on domestic consumption and smuggling as well as improvements in supply arrangements. Preliminary work to ascertain the extent and economic viability of petroleum resources in the Lake Albert area has also been started, although local oil production remains very much a longer-term and uncertain prospect. Woodfuels are estimated to account for 95% of total energy and 71% of commercial energy consumption in Uganda. There is, therefore, mounting concern that uncontrolled cutting will eventually deplete the most accessible forest resources and lead to further soil erosion problems. 15. In the social sectors, the RRP emphasizes equipment, materials (including drugs) and essential repairs for schools, hospitals and clinics, and the rehabilitation of water and sewerage facilities, limited recon- struction of war-damaged towns and routine repair and maintenance. Following nearly a decade in which public education and health services deteriorated, and the gap was filled increasingly by spontaneous private and community-based initiatives, the Government's strategy is to encourage further innovation of this kind as well as to develop government programs, such as primary health care and immunization, that are able to use resources efficiently. The findings of a Bank Group PHN sector assessment, under preparation strongly support the health sector programs outlined in the RRP. 16. A number of steps are envisaged to improve implementation and monitoring of the program. First, the design, costing and phasing of the projects is more realistic, though further changes and improvements must be expected as detailed preparation of individual projects proceed. Secondly, implementation responsiblity is clearly identified, as are the financing already secured and balances required for each project. The only major gap is a complete review of foreign exchange costs and recurrent import requirements, which had been included in the original program. Improvements in monitoring of the program and of recurrent foreign exchange requirements are envisaged under the program for the proposed Third Reconstruction Credit. 17. The RRP represents a significant advance in the Government's efforts to provide a framework for its own decision making and for  - 10 - mobilizing external assistance. The priority now is to strengthen the a,lministrative framework for implementing thie Government's programs, for carrying them forward and making them more effective. The administrative weaknesses faced by Uganda (and many other Sub-Saharan African countries) are inherently difficult to, tackle and progress will be slow. The steps already undertaken and envisaged to address these weaknesses are outlined below (paragraphs 40-57). Not surprisingly, given the severe erosion of the country's productive base and infrastructure during the 1970s, much remains to be done before Uganda's recovery can be considered complete. But the Government's RRP and evolving policies are headed in the right d:irection, and, combined with the financial programs undertaken since mLd-1981, merit support from the international community. Assistance needs 13. While Uganda's economy has startecl to recover, the recovery is still a fragile one, and even on optimistic assumptions, the prospects for the remainder of the decade are for a continuing tight foreign exchange situation. In 1983, petroleum imports, scheduled debt repayments, the reduction of payments arrears and interest, and repayments to the IMF accounted for US$284 million, or 86% of export earnings. All other imports are being financed by capital inflows, largely aid and debt relief. Of these, only government imports which absorbed over US$100 million in 1983, could be reduced in the future without detriment to growth prospects. i). We expect Uganda's GDP to grow by 4.7% per annum through 1985 and 3.6% per annum over the subsequent five years provided there is a steady improvement in the internal security situation, continued progress on economic reforms, and sufficient foreign exchange to finance recurrent imports and priority rehabilitation projects. The recent recovery in export performance is expected to continue, provided Uganda's coffee quota can be increased from 2.3 million bags in 1983 and 1984 to 2.5 million bags in 1985. These assumptions imply that the current account deficit, in real terms, will rise in 1984 and then decline steadily over the remainder of the decade (Table 3). Scheduled debt repayments will fall to about half the 1983 level, and there is only limited scope for future debt relief. Even if Uganda continues to receive IMF support after mid-1984, (the end of the current program), IMF resources available will be much reduced. Therefore, the financing situation will be particularly difficult over the next two years. Among the risks to the scenario described above, the most im1portant concerns the coffee quota. Over the longer-term, sustained export growth is dependent upon a diversification of exports but over the short-term, an increase in the coffee quota along the lines mentioned above, is crucial. Yet, as of now, and despite Uganda's strong case for an increase, based on historical production levels and recent performance, there is no guarantee that this will materialize. There is also a risk thal: import growth may not be restrained by reduced government imports as assumed in the Drojections. Should the internal security situation deteriorate, this reduction will be difficult to achieve. Uganda will therefore continue to depend on external assistance, commitments of which musl amount to US$444 million in 1984 and then continue at around that level if required import levels are to be met.  - 11 - Table 3: Ugaida: Balance of P!nts and External Assistance Prcepects (US$ mtlo) 1970 1980 1981 1982 1983 1984 1985 1990 estinEtae projected Mrchandise exports f.o.b. 262 319 246 335 330 364 435 859 Merdcamdise imports c.i.f. -205 -504 -415 -458 -497 -547 -613 -1,040 Trade balance 57 -185 -169 -123 -167 -183 -178 -181 Invisibles (net) - 44 - 63 - 85 -133 - 95 -117 -121 -191 Carrent accomt balmce 13 -248 -254 -256 -262 -300 -299 -372 Official grant receipts 7 93 103 88 102 130 123 192 Public M&LT loans (net) 21 82 1 151 103 159 147 176 - Disbursements (27) (134) (93) (257) (236) (233) (227) (259) - Scheduled repayments (-6) (-52) (-92) (-106) (-133) (-74) (-80) (-83) Use of IMF credit (net) - 27 125 82 104 65 29 -5 Other capital (net) -37 -107 74 79 -27 - - - Financdrg gap - - - - - - 53 30 Overall balance of payments 5 -154 50 145 20 54 53 21 (o.w. arrears reduction) (-) (-141) (40) (86) (20) (40) (40) (-) External assistance comnitmnts Concessional assistance 278 276 240 333 369 342 467 of which program aid (153) (53) (94) (27) project aid (49) (156) (111) (257) Debt relief - 9 168 79 15 16 22 Private loars 15 - 21 50 15 16 22 Gap finandrg - - - - 45 32 30 Total 293 285 429 462 444 406 541 Debt service ratioa/ (%) 8.2 18.9 50.4 46.8 52 46 46 31 a/ Irnludirg IMF  - 12 - 20. The composition and phasing of commitments is at least as :Lmportant as the amounts; increased levels of balance of payments support, -Ln particular, will continue to be essential at least during 1984 and 1985. given that debt service and petroleum imports are expected to absorb mSre t:han two thirds of merchandise exports and given that only program-type assistance can be disbursed quickly enough to fill the 1985 gap of $53 million. It is particularly important to have enough assistarnce to man-age t:he expected reunification of the exchange rate without pressure to resort t:o controls. Project aid has a role to play in the short term, provZded it- is consistent with the rehabilitation priorities in the RRP,and will become increasingly important during the second half of the decade. Technica' asSistance, while not as large in dollar terms, is important for impro'rFiqg public administration and making other forms of aid effective. The net benefit to Uganda of higher commitments could soon be eroded if they are not provided on concessional terms. This does not preclude the possibility of utilizing some commercial bank loans or suppliers' credits in association with concessional assistance, but only for selected projects which generate additional net foreign exchange earnings to cover fully the related debt obligations. 21. The pressure on the Government's budget will also be consider- able. The 1982/83 expenditure targets were met by dint of strong restrictions which squeezecl operating ministries and local counterpart financing of the development budget severely. On the other hand, revenue performance was good in 1982/83. Revenue growth in subsequent years Wi_i depend on maintaining a rapid recovery and on improving tax administrat- ion. If, however, the present high rates of coffee export taxation are to be reduced and if the two exchange rates are to be merged some time dur.ng 1984, as at present envisaged by the Government and the IMF, the revenaue position will remain highly constrained. To the extent that Uganda can generate counterpart funds from the use of external assistance by applying those funds to uses which generate quick returns and repayment of local funds to the government, these budgetary pressures can be eased. 2.2. These conclusions regarding aid requirements were endorsed by the Consultative Group meeting on January 25 and 26, 1984, at which the strategy and priorities of the RRP were again welcomed. While indications oi- external assistance still fell somewhat short of these requirements, this reflected tighter bilateral donor budgets rather than misgivings over Uganda's performance. In view of the difficult external financing situation which Uganda faces over the next few years, and particlarly in 1985, every effort should be made to encourage bilateral donors to provide more program assistance to the country. Debt 23. Uganda's external debt outstanding and disbursed had reached an estimated US$713 million by the end of 1982. Of this amount, 3.5% was due to IBRD (for Uganda's notional share of EAC loans) and 13.5% to IDA. Fortunately for Uganda, the terms of new aid commitments since 1979 have been highly concessional, wiLth about half being grants and the balance of loans having a grant element of 60%, However, other debt obligations, such as war-related assistance and IMF purchases, have helped to raise the overall debt service ratio l:o around 50% during 1981-83. Under the  - 13 - base-case scenario in the Country Economic Memorandum, the debt service ratio is projected to fall back to 46% in 1984 and 31% by 1990. This, however, is still high. Further, the down-side risks are very real: Uganda's export structure is still heavily dependent on coffee, earnings from which could be constrained by an even tighter quota and unfavorable price movements; the Government may find it difficult to reduce the import requirements of security-related activities; and adequate amounts of assistance, on concessional terms, may not be forthcoming to support the recovery effort. This outlook reinforces the importance of improved aid and external debt management (paragraphs 47 and 48). PART III - BANK GROUP OPERATIONS 24. Bank Group operations in Uganda began with an IBRD loan of US$8.4 million for hydroelectric power development in 1961. Between 1967 and 1971 Uganda received seven IDA credits totalling US$48.0 million for projects in education, roads and agriculture (tea, tobacco and beef ranching). In addition, Uganda benefitted from 10 loans totalling US$224.8 million which were extended for the development of the common services and the East African Development Bank operated jointly by Kenya, Tanzania and Uganda through their association in the former East African Community (EAC). Annex II contains a summary statement of Bank Group operations, IFC's first investment in Uganda, in a textile company, was sold to the Government in 1970. The second, to help finance two lodges in the national parks was cancelled in 1972 before construction began. In FY83 and 84, IFC approved new investments in the Toro and Mityana Tea Company, the Uganda Tea Corporation and the Lugazi Sugar Factory. 25. There was a hiatus in Bank Group operations from 1971 until February 1980, when a First Reconstruction Credit of US$72.5 million (including a participation of US$17.5 million by the Netherlands) and an EEC Special Action Credit of US$20.0 million were approved (Nos. 983/983-1-UG and 54-UG). The Association also acted as Administrator of a Can$3.0 million grant from the Government of Canada and of a US$5.0 million program loan from the OPEC Fund. In addition, the Association has provided US$323.0 million through the First Technical Assistance Credit (No. 1077-UG), a Water Supply Engineering Credit (No. 1110-UG), a Phosphate Engineering Credit (No. 1228-UG), an Industrial Rehabilitation Credit (No. 1248-UG), a Second Reconstruction Credit (No. 1252-UG), an Agricultural Rehabilitation Credit (No. 1328-UG), a Third Education Credit (No. 1329-UG), a Posts and Telecommunications Rehabilitation Credit (No. 1367-UG), a Second Technical Assistance Credit (No. 1434-UG), and a Third Highways Credit (No. 1445-UG). 26. A comparison with other portfolios in the Eastern Africa Region indicates that the disbursement rate in Uganda has been higher than average, ranging as a proportion of outstanding commitments from 43% in FY80 to 30% in FY83 (compared with 19% and 26% in the same years for the Region as a whole). Performance under the First and Second Reconstruction Credits is described below (paragraphs 28-35). Disbursements under the  - 14 - Water Supply Engineering Credit are continuing and have started satis- factorily under the Phosphate Engineering Credit. There are no disburse- ments yet from the Industrial Rehabilitation Credit due to the time needed to appraise sub-projects; in detail. Progress under the Agricultural Rehabilitation Project is good and after some initial delays disbursements have begun to improve. Disbursements have recently commenced under the Third Education and the Posts and Telecommunications Projects. The Bank Group administers an Agricultural Reconstruction Program (No. 80-UG) of US$20 million equivalent financed by the International Fund for Agricultural Development and has appraised a second. It also administers a [JNDP--financed Planning Assistance Project. Bank strategy and expected future operations are described below (paragraph 37). 27, Developments affecting the East African Community (EAC) were outlined to the Executive Directors in a memorandum dated December 29, 1977 (R77-312) and in a statement made on May 6, 1980 (SecM80-364). Negotiations based on the Mediator's proposals, which started in December 1981 and continued through 1982 and 1983, culminated in a meeting of the three Heads of State in Arusha on November 15 and 16, 1983 at which full agreement was reached on all outstanding issues. The agreement provides equity shares of 42% for Kenya, 32% for Tanzania, and 26% for Uganda. As a result of this formula, Kenya and Tanzania have excess assets over their equity shares, while Uganda has a shortfall. The Presidents agreed there!fore that Kenya and Tanzania will pay compensation to Uganda. The miethod of payment of this compensation is being worked out at the ministerial level and an agreement formalizing the arrangements is expected to be signed by the three Presidents in May. PART IV - THE THIRD RECONSTRUCTION PROGRAM CREDIT The First Reconstruction Credit 28. The First Reconstruction Credit (US$100 million equivalent including cofinancing) was approved in February 1980 and fully disbursed by June 30, 1983. It financed a variety of recurrent imports, including spare parts, packing materials, agricultural tools, educational materials and telecommunications equipment. These resources were a sizeable proportion of Uganda's foreign exchange inflow, having financed 8.4% of Uganda's non--fuel imports in 1981 and 13.7% in 1982 while accounting for 16.6% of all loan and grant disbursements in 1981 and 29.7% in 1982. The only major policy condition of the Credit was devaluation, which was seen as the key first step to eliminatingr "magendo" (paragraph 4). This was finally fulfilled in June 1981 with the introduction of the financial program. 29. The principal categories of beneficiaries were the food- processing, beverage, clothing, wood and paper, construction and metal industries and government ministries. A report on the impact of the Credit prepared by the MPED estimated that IDA-financed imports accounted for about 64% of the total imports utilized by these beneficiaries during 1981-82. Since these beneficiaries are a majority of Uganda's operating enterprises, they account for the improved performance of the whole industrial sector (see Table 1). A major determinant of increased production appears to have been creditworthiness. In a survey, carried out  - 15 - by Bank staff in October 1983, of' a representative sample of 17 more creditworthy firms, average capacity utilization had increased from 17% in 1981 to 30% in 1982, mostly as a result of IDA-financed foreign exchange. On the other hand, 19 financially weak beneficiaries of IDA funds with a 10% average capacity utilization in 1981 were, for reasons outlined below, only able to maintain output levels and performed no better than a third group of 14 larger firms that didi not receive IDA support. Some firms, such as Nyanza Textiles Limited, have operated at levels in excess of 55% during the past four years. Without the support of the reconstruction credits, their production would almost certainly have declined. 30. It is evident that the First Reconstruction Credit had a positive impact on industrial production. This impact would have been greater had it not been for several implementation difficulties. Disbursement was slow due initially to political disruptions, then to delays in releasing the second tranche and finally to delays in allocation ani -. weak government machinery, unfamiliar with Bank Group procurement guidelines and other procedures. The Credit was spread too thinly and benefitted a number of users that later turned out not to be creditworthy. In some instances, the amounts allocated to beneficiaries were used to purchase inappropriate capital equipment or were insufficient to raise production to break-even level. Some beneficiaries were unable to raise local credit, while some overexpanded in relation to the market. Several beneficiaries unfamiliar with tendering procedures experienced slow procurement. Finally, the full extent of the deterioration in productive capacity in many enterprises only became apparent in the course of resuming manufacture. Under the conditions prevailing when these allocation decisions were taken -- rapidly changing prices, exchange rate and market conditions, new management in many enterprises and the inexperience of the inter-ministerial committee -- such difficulties were inevitable. 31. The net foreign exchange impact and the linkage effects of the Credit cannot be assessed for lack of reliable data. Information on the management, financial, and marketing constraints on industrial enterprises in Uganda also remains inadequate. Thus detailed recommendations for improvement in these aspects at the enterprise level are still not possible. To improve the basic information in this regard, the Government plans to undertake an industrial sector survey (which will form the basis for a Bank Group Industrial Sector Memorandum during 1984/85), as well as a parastatal accounting study. The fiscal benefit of the Credit has been moderated by the failure of firms to pay local counterpart funds of approximately US$38 million equivalent as of March 31, 1984. Most of these arrears are owed by financially weak parastatals, reflecting the problems described above. Long-term solutions to these problems must be found in the context of an action program for the parastatals generally. Meanwhile loan repayments by these delinquent borrowers have been rescheduled and government has concluded an agency agreement with the Uganda Commercial Bank to manage these loans. The Second Reconstruction Credit 32. A Second Reconstructiorn Credit of US$70 million was approved in May 1982. The Dutch and Canadiarn Governments also provided grants of US$4.9 million and US$4 million equivalent, respectively, in January 1984, which are being administered by the Bank Group. The Credit supported the  - 16 - financial program and the Recovery Programmee but many of the weaknesses ;n administration and policy formulation described earlier hiad also become evident. In addition to financing high priority recurrent imports, the Government's capacity to perform these functions in a number of areas critical for economic recovery was supported. Particular attention was given to programs aimed at improving the pricing and marketing of export crops; administration, plainning and foreign exchange allocatlon; parastat.:al organizations; and external debt management. Thnese programs are proceeding successfully, and although progress was ini,:ially slow, implementation ls now accelerating (see paragrapns 40-57 below,). 33. Recognizing the problems of credit: allocation under the First Credit, a preliminary allocation of credit proceeds among a broader range of imports was agreed at negotiations, and criteria for allocations to inidividual enterprises were established. Technical assistance was provCded to the Central Tender Board (CTB) to improve implementation. Despite t,lesa efforts, improvements were not as rapid as anticipated. First, technical assistance to the CTB was delayed. Secondly, beneficiaries were not notified of allocation decisions until late 1982 and thirdly, it provred difficult to reconcile the need to support high priority indulstrial and irnfrastructural enterprises with financial viability. 34. During 1983, a number of measures were taken to improve implementation. These incluided reallocation of credit funds from poor performers and financially weak beneficiaries to better performers and strengthening the coordinating unit in the B.ank of Uganda. The CTB was provided with additional technical assistance personnel to expedite the tendering process and potential beneficiaries were required to demonstrate their creditworthiness. With these improvements in place, the Bank Group agreed to extend the closing date for the Credit to December 31, 1984 and to establish a special. revolving account of US$5.0 million to expedite dis bursements. Much progress has since been macle in all of the above key areas and implementation has improved significantly: as of March 31, 1984 approximately US$25.0 million equivalent has been disbursed under the Second Credit, and an additional US$35.0 million equivalent has been committed. Tenders equivalent to the total amount of the IDA credit and the supplemental grants have been awarded by the CTB and it is expected that all funds will be fully committed by the end of May 1984. The Government will therefore need further commitment authority if the support provided by the first two reconstruction credits is to be sustained and their impact on the economy consolidated. 35. Since implementaiton is still a little behind schedule, it is premature to assess its impact. However, allocations to financially weak parastatals have been reduced, and the technical assistance to CTB has not only strengthened its procurement control, but also provided valuable procurement advice and guidance to many Ugandan enterprises, both public and private. Given the evidence now available demonstrating the positive impact of the First Credit, it is likely that the impact of the Second will be at least as great. Backcground to the Third Reconstruction Credit 36. Anticipating further needs for fast--disbursing assistance, the Government requested a third reconstruction credit during the annual  - 17 - meetings in September 1983. A pre-appraisal mission which visited Uganda in October/November 1983 concluded that, provided execution of the Second Reconstruction Credit accelerated and an action program for further reforms was agreed, the Board should be asked to consider a third credit as early as possible. A mission visited Uganda again in January 1984 to discuss the government'- Memorandum of Understanding (Annex IV) and conclude arrangements for execution of the proposed credit. Negotiations were held in Washington in April 1984 with a government delegation headed by Hon. E.R. Kamuntu, Ambassador in the Office of the President. There is no separate staff appraisal report for this credit. A credit and project summary is at the front of this report and supplemental data are contained in Annex III. 37. The Bank Group's strategy in Uganda is to continue to finance an adequate share of the immediate import needs of the economy through 1985 and to support the Government's efforts to reform economic policies and institutions. Some investments in new capacity (e.g. hydro-electricity) are planned to relieve bottlenecks that might otherwise inhibit development after the preliminary rehabilitation phase is complete. These aside however, project lending will for the time being emphasize rehabilitation and fast disbursing assistance, including related recurrent import requirements, in the context of institutional development. The emphasis will gradually shift to projects, with agriculture, industry, transport and energy as priority sectors. Technical assistance will continue to complement these operations, either through projects or as part of our own economic and sector work. At the last Consultative Group meeting, it was also evident that cofinancing with bilateral donors will require increasing emphasis if the projected gap in Uganda's foreign exchange requirement over the short-term is to be met. We intend to actively pursue this objective through our dialogue with bilateral donors, and through seeking out cofinancing of our own assistance. It is important that donors continue to support Uganda's efforts towards recovery with adequate balance of payments assistance and project lending in priority sectors. We therefore plan to review our own strategy in this context during September and, if appropriate, prepare a follow-up program credit. Besides the Third Highway Project, which was approved on March 13, projects are currently under preparation in the power, water supply, tea and sugar sectors. Objectives and Description 38. The proposed credit is central to this strategy. To consolidate the economic gains and the policy reforms achieved under the first two reconstruction credits, this credit would have the following principal objectives: (a) to provide financing for the importation of essential raw materials, intermediate goods, spare parts, minor capital equipment and drugs for high priority sectors in line with the RRP; (b) to continue the support for policy and institutional reforms initiated under the second reconstruction credit; and (c) to generate counterpart resources for the government budget. There are also prospects that, as with the first two reconstruction credits, this proposed operation will prove a useful catalyst for cofinancing. In the Memorandum of Understanding, the Ugandan Government has expressed its commitment to these objectives. During implementation of the program, the Government and the Bank will exchange views, on the basis of a report prepared by the Government, on progress achieved in implementating the program (Development Credit Agreement,  - 18 - Section 4.03). The complete program supported by the proposed credit is summarized in Table 4, p. 24. Coordination with the IMF 39. Uganda has received three stand-by credits from the IMF starting in June 1981. The last review of stand-by was in November 1983, following which a program for the remainder of the fiscal year 1983/84 was agreed. Following agricultural producer price, public utility and petroleum price adjustments, the IMF Board approved this program in February 1984. Uganda has consistently met IMF performance criteria to date. The roles of the Bank and the Fund have complemented each other; the IMF programs have stressed exchange rate marnagement, short-term fiscal policy and foreign exchange management, pricing policy and domestic credit control. The Bank's involvement has emphasized strengthening of core institutions, especially the process of Recovery and Revised Recovery Programme preparation, the development of capacity to analyze and decide on key sectoral policies, (e.g. agricultural prices), sectoral advice, especially in energy, and database improvement. At the same time, there have been aireas of overlap which have been mutually reinforcing: on the parastatal study, on strengthening the MF and external debt management, and on agricultural price policy recommendations. Policies and Institutional Reforms (a) Exchange rate, taxation and pricing policy 40. The dual exchange rate system has been a useful transitional arrangement which has helped determine an appropriate value for the Uganda Shilling, control the parallel market and provide a more competitive environment for allocating foreign exchange. It has, however, introduced a number of distortions which, if allowed to persist, would misallocate resources and slow down recovery. In particular, (i) market prices tend to reflect the window two exchange rate, giving rise to windfall profits for those with access to window one (mainly ministries and parastatals), while squeezing the returns to those whose prices are related to window one rates (niotably coffee and cotton producers); and (ii) the rapid depreciation at window one, combined with lengthy procedures for importation (see paragraph 30 above for the experience of importers supported by IDA reconstruction credits) has created uncertainties and led to unanticipated increases in domestic credit requirements. A unified market-clearing exchange rate in a less inflationary environment is less likely to cause such problems. 41. The Government intends to reunify the exchange rate at an early date and has an understanding with the IMF about the schedule for doing so. In the Memorandum of Understanding (Annex IV) for the proposed third reconstruction credit, the Government has stated its desire to minimize, as far as possible, administrative allocation of foreign exchange after the ex:pected merger of the two windows. The Government intends to maintain a flexible and market-responsive exchange regime, using an auction system and to depend mainly on fiscal and monetary policy to contain foreign exchange dermand. Indirect tax adjustments will also be required to offset the revenue loss from merging the exchange rate, while avoiding an excessive  - 19 - burden falling on those industries, like the breweries, which are already taxed heavily. An IMF tax study has recently been prepared and its recommendations will provide the basis for these adjustments. The Government expects to decide the details of the exchange regime and tax revisions in consultation with the IMF in the context of a possible stand-by credit for 1984/85. 42. Export crop producer prices, which were increased substantially in June 1983 and January 1984, are now at levels which ensure at least positive net returns. Further adjustments will be required in due course to reflect changes in the exchange regime, world prices, comparative returns among export crops, quality premia and improvements in the efficiency and capacity of the marketing system. Under the programs supported by the Second Reconstruction and Agricultural Rehabilitation Credits, the Government established an Agricultural Policy Committee, assisted by an IDA-supported Agricultural Secretariat, to review and recommend on agricultural pricing policy. Export crop sub-sector studies supported under the Agricultural Rehabilitation Credit, which will provide essential data and recommendations for agricultural pricing policy, are nearing completion. Under the Agricultural Rehabilitation Credit, the Government is committed to annual consultation with IDA on agricultural producer prices. The first such consultation is expected in April 1984 in preparation for the 1984/85 crop season and financial program. 43. In the context of the current financial program, supported by an IMF stand-by credit, the Government has adjusted retail petroleum prices so as to reflect import parity at the window two rate, and has eliminated cross-subsidization among petroleuim products. Interest rates have been raised substantially, but remain negative in real terms. However the Government has requested IMF assistance to study debt instruments and rediscounting facilities. The Government has also made interim adjustments in electricity, telephone, water, railway and airline charges, but in all cases, further study is needed to determine costs and management strength- ening is required to improve bill collection. Tariff studies are being programmed in the context of IDA-supported or proposed projects for power, telecommunications and water supply while tariff issues will be considered for the railways and airlines under the parastatal accounting study (paragraph 54). (b) Strengthening Economic Management and Planning 44. The RRP places strong emphasis on the need to strengthen Government administration generally, but particularly the machinery for economic and financial control and for project implementation. Economic management involves principally the Ministries of Finance (MF) and of Planning and Economic Development (MPED) and the Bank of Uganda (BOU). The BOU is the most effective of these organizations at present, and is being reinforced by IMF technical assistance. Ministry of Finance 45, The MF is responsible for preparation and implementation of the Government budget, external assistance agreements and loan approvals, Government accounts, parastatal financial control and revenue collection.  - 20 - Its effectiveness has improved over the past two years, most evidently