Burundi - A financial sector review

j,~~ . . ,, e--9 9 , , , 9 . ,,, .,,!;,s Report No. 10978-BIJ r .r A j ., Burundi A Financial Sector Review July 28, 1992 Industry and Energy Operations Division South-Central and Indian Ocean Department Africa Region FOR OFFICIAL USE ONLY Document of the World Bank 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 EOUIVALENTS Currency uni; = Burundi Franc (FBu) 199i US$I = FBu 200 (as of Dccember 1991) Period Average: 1990 US$1 = FBu 171 1989 US$1 = FBu 159 1988 USSI = Fbu 140 1987 US$I = FBu 124 GLOSSARY OF ABBREVIATIONS AGCD = Administration Gdn6rale de lN Cooperation au Ddveloppement (Belgian Aid Agency) BANCOBU = Banque Commerciale du Burundi BBC! = Banque Burundaise de Credit et d'lnvestissement BCB Banque de Credit de Bujun.bura BNDE = Banque Nationale de Developpement Economique (Development Bank) BRb = Banque de la Republique du Burundi - Central Bank CADEBU = Caisse d'Epargne du Burundi CAMOFI = Caisse de Mobilisation et de Financement CBD = Central Banking Department (IMF) CCCe = Caisse Centrale de Cooperation Economique (French Aid Agency) CCIB Chamber of Commerce and Industry of Burundi CEC Commission of European Communities COOPECs Cooperatives d'Epargne et de Credit CVS = Credit-Ventes Service EDF = European Development Fund EIB European Investment Bank ESAF = Enhanced Structural Adjustment Facility FAC Fonds d'Aide et ae Cooperation (French Aid Agency) FNG = Fonds Natioaal de Garantie FOSIP Fonds de Soutien I l'Investissement Privd FPHU Fonds de Promotion de l'Habitat Urbain FSTE = Fonds de Solidarite des Travailleurs de l'Enseignement INSS - Institut National de Securite Sociale KfW Kreditanstalt fur Wiederaufbau (German Aid Agency) MBB = Meridien Bank of Burundi MCI Ministry of Commerce and Industry MFP Mutuelle de la Fonction Publique MELECO Meridien Leasing and Construction PE Public Enterprise PSD Private Sector Development PTA = Preferential Trade Agreement SAL = Structural Adjustment Credit/Loan SBF Societe Burundaise de Financement SOCABU Societe d'Assurances du Burundi SOGEAR Societe G<nerale d'Assurane et de Reassurance SOFIDHAR = .ocidte de Financement de l'Habitat Rural SOGEAR = Soci6te Generale d'assurance et de reassurance SOGEFP Societe Gendrale de Ftnancement SSE/APEX Small-Scale Enterprise Project TT = Turnover or Transaction Tax UCAR Union Commerciale des Assurances au Burundi GOVERNMENT OF BURUNDI FISCAL YEAR January I to December 31  FOR OMCIAL USE ONLY PREFACE 'his is one of three reports discussing issues relating to support for the private sector development in Burundi. The other two, entitled "Private Sector Development in the Industrial Sector" (December 31, 1991) and "Private Sector Development in the Agriculture Sector" (September 1992, forthcoming), were distributed separately, and cover issues associated with the strengthening of private initiatives in industry and agriculture, respectively. This third report discusses policies and institutional reforms for a competitive and sound financial system, which would be capable of mobilizing domestic resources and of supporting productive investments. This report is based on the findings of a main mission which took place ir. February 1992, consisting of Messrs/Mme Andre Ryba, Banking Sector Specialist (AFJEF, Mission leader and task manager), Sylvester Damus (Consultant, taxation and financial institution specialist), Pierre Leduc (Consultant, Insurance Companies and Social Security Institutions Specialist) and Isabelle Daverne (Consultant, Financial Analyst), and three previous missions in preparation of the Private Sector Development Froject in March 1991, July 1991 and November 1991, consisting of Andre Ryba and Mohamadou Diop, Senior Operations Officer (AF3IE). A preliminary version of this Report was discussed with authorities in June 1992. Mr. Gerard Caprio (CECFP) served as the Lead Adviser and Messrs. Michel Wormser, Principal Financial Sector Specialist (AFIIE) and Tu Ngoc Dinh, Principal Financial Sector Specialist (AFTEF) as peer reviewers. Mr. Michael N. Sarris is the managing Division Chief and Mr. Francisco Aguirre-Sacasa, the manging Department Director. 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.  BUIUNDI A FINANCIAL SECTOR REVIEW Table of Contents Page Ng EXECUTIVE SUMMARY . .......................................... i INTRODUCTION ................................................ 1 THE FINANCIAL SECTOR - AN OVERVIEW ............................. 3 THE MACROECONOMIC SrIUATION .......... ........................ 4 THE MONETARY, FISCAL AND REGULATORY ENVIRONMENT .... ........... 5 Interest Rate and Monetary Policies ......................... 5 The Impact of Taxation of Financial Institutions and Instruments ................. 10 Regulation and Supervision ......................................... 13 THE FINANCIAL INSTITUTIONS . .................................... 15 Commercial banks .............................................. 15 Other Deposit-Taking Institutions . ..................................... 8 Development Banks ............................................ 19 Specialized Funds ............................................. 21 Leasing and Small Consumer Loan Companies ............................ 26 Cooperatives ............................................ 27 Insurance Companies and Social Security Institutions ......................... 28 Financial Sector: Overall Performance . .................................. 32 RECOMMENDATIONS ................................. 35 Monetary and Interest Rate Policies ................................. 35 Fiscal Issues ................................. 38 The Legal and Regulatory Environment ................................. 39 Government Ownership ................................. 40 Market Structure and Institutional Strengthening . .......................... 41 Sequence of Reforms ............................................ 44  ANNEXES.: Annex I: Revenue Impact of Proposed Fiscal Measures ....................... 47 Annex II: Calculation oif Subsidy Dependence Index .50 STATISTICAL APPEXPIX: Table 1 Degree of Financial Deepening in Selected Countries .52 Table 2 Evolution of TC Auction Market .............................. 53 Table 3 Evolution of Bidding on 1-Month and 3-Month TC Market ............... 54 Table 4 Origin of Bidding on 3-month and 1-month TC Market .5................ 6 Table 5 Total Assets of Financial Institutions ............................. 58 Table 6 Summary Balance Sheet of Commercial Banks (unaudited) ............... 59 Table 7 Financial Performance of Selected Commercial Banks and Financial Institutions . . 60 Table 8 Financial of Performance of Selected Financial Institutions ............... 61 Table 9 CAMOFI - Summary Balance Sheet .62 Table 10 BNDE - Summary Balance Sheet .63 Table 11 SBF - Summary Balance Sheet .64 Table 12 rPHU & SOFIDHAR - Summary Balance Sheet. 65 Table 13 COOPECS: Summary Statistics, 1990 .66 Table 14 Insurance Companies: Summary Balance Sheets .67 Table 15 INSS and MEFP: Summary Balance Sheet .68 Table 16 Demand Deposits by Category of Institutions .69 Table 17 Term Deposits by Category of Institutions .70 Table 18 Distribution of Deposits by Holders. 71 Table 19 Distribution of Credit by Term .72  URUINDI A FINANCIAL SECTOR REVIEW EXECUTIVE SUMMARY i. Burundi benefits from a diversified financial sector for a country of its size. It has a well developed auction market for Treasury Certificates (TC) where interest rates are determined by bids offered by individuals, firms and financial institutions with little Government interference. It is one of the few African countries where development banks are well managed and solvent. Although its commercial banks and insurance companies are facing some financial difficulties, they are far from being in the distress situation that has been the order of the day in many West African countries. A network of savings and credit cooperatives mobilizes r:;ral savings and provides some credit. New commercial banks and insurance companies are entering the market. There is a good supply of long-term funds, albeit from foreign sources. ii. On the other hand, Burundi has a low degree of financial deepening even in comparison to other sub-Saharan countries. The Central Bank does not have full control over the growth of money and credit. The legal and regulatory framework exhibits serious deficiencies, particularly with respect to nonbank financial intermediaries, insurance companies and social security institutions. The existing taxation system constitutes an impediment to the mobilization of domestic resources, competition among financial institutions, deepening of financial intermediation, and conduct of monetary policy. Government presence is pervasive, although thete is less interference with the management of institutions than in many other African countries. Many institutions are facing financial difficulties that, if not corrected, could threaten their long-term viability. All institutions suffer from internal weaknesses (in the areas of loan appr^:sal, registering of collateral, loan monitoring, collection of arrears, asset management, etc.). There are few domestic long-term sources of funds and the availability of venture capital is limited. iii. The financial system of Burundi is at a crossroads. A wrong turn could send it along a path that has plagued many West African countries. Conversely, it could contribute to economic growth and social development. Already, in the context of the liberalization and privatization of the Burundi economy and the adjustment programs pursued in the country with the support of IP:F and Bank financing, increasing demands are being placed on the financial sector to fund growing economic activity. As adjustment begins to bear fruit, the Burundi economy is likely to experience, in particular, expanded exports and imports, new investment, the creation of new companies, and the privatization of public sector enterprises. iv To achieve its objective of economic growth and social development, Burundi needs the support of a competitive, sound, diversified and institutionally-strong financial sector which will mobilize efficiently domestic resources and allocate credit at terms commensurate with the needs of consumers and producers and the risks involved. To this end, a financial sector strategy should include improvements in the monetary, fiscal, legal and regulatory environment, government disengagement from the equity of financial institutions, changes in market structure, and internal strengthening of institutions. Some reforms have already been implemented, including the liberalization of interest rates, the successful launching of the auction market for Treasury Certificates, the introduction of reserve requirements, and revisions to the existing prudential regulation of commercial banks. The pace of reforms must accelerate. v. Monetary policy reforms need to be continued and strengthened with the triple objectives of: (a) developing efficient instruments of monetary and credit control, involving reserve requirements, tightened rediscounting mechanisms, and interventions of the Central Bank in the TC  - ii - market; (b) further liberalizing interest rate determination and linking interest rate movements to the desi.ed growth of monetary and credit aggregates; and (c) developing an efficient money market. To be implemented effectively, these reforms would require strengthening the internal capacity of the Central Bank to devise and conduct monetary and credit policies. vi. Reforms of the taxation system should aim at removing: (a) the double taxation of investment in equity capital; (b) the disincentive to save for low-income people; (c) tax arbitrage linked to lifferentiated taxation of financial instruments and some institutions, and in particular, the tax exemption of interest paid on Government securities; (d) the cascading effect of the transactions tax; and (e) the disincentive to financial investment caused by the lack of tax deductibility of provisioning for bad assets. vii. Further reform of the legal and regulatory environment is needed to foster competition among financial institutions, ensure their solvency and remove impediments to financial innovation. Reforms should encompass commercial banks and nonbank financial institutions that operate under the Banking Law, and for insurance companies and social security institutions. In both cases, reforms would include revision of existing legislation and accompanying regulation and strengthening of prudential supervision. Reforms are ppzdcularly urgent in the insurance sector as there is no supervisory authority currently in charge of monitoring the activities of institutiors in this sector. viii. To be competitive and solvent, institutions must be run on a sound commercial basis with little Government interference. In the context of the liberalization and privatization program currently underway, the Government should disengage itself from the equity capital of financial institutions. Priority should be given to institutions where the State has a strong presence on the Board of Directors and has an influence on the decision making process. ix. Some restructuring is likely to take place within the banking and insurance sectors as the result of increasing competition in this market, with some institutions forced to exit the market or significantly downsize their operations. Government should be only an attentive observer of these developments, ensuring that the savings of citizens mobilized by private institutions are not endangered and that there is no disruption in the funding of economic activity. Further restructuring should be undertaken to remedy existing problems, particularly those that endanger the long-term viability of some institutions. Some institutions could become viable and competitive following such restructuring. Institutions that do not have any prospect of long-term viability should be closed down. Experience has shown that postponing the needed action only increases the costs of adjustment, often dramatically. x. Restructuring would involve, inter aWia, changing the nature of assets and liabilities, recapitalizating, changing the fee structure for guarantee funds, and increasing contributions for social security institutions. With respect to the latter, the issue of funding of future liabilities must be dealt with. All institutions, even those that are currently competitive and viable, would require internal strengthening to permit them to meet the challenges of the coming decades. Finally, the cdevelopment of new markets and institutions should be encouraged to meet the needs of the Burundian economy. The development of sources of venture capital is a case in point. xi. Burundi has a financial infrastructure that must be built upon to contribute fully to the adjustment program and private sector development. Below is a summary of the main measures recommended in the report to be implemented in the short-, medium-, and longer-term:  X ill X Measures for the short-tem. Central Bank (BRB) to constitute a portfolio of Treasury Certificates C) (para. 175); * Develop the primary dealers role in the TC market (para. 176); * Extend reserve requirements to all deposit-taking institutions (pua. 178); * Introduce refinancing ceiling (para. 180); * Set refinancing rate above TC average rate (para. 182); Apply refinancing rate in effect at time paper is being refinanced para. 182); * Begin strengthening BRB (research department, inspection department, systems analysis) with priority on building capacity to design monetary policy and regulate and supervise financial institution (para. 185); * Implement tax deductibility of provisions fbr bad debt (para. 191); * Establish a supervisory authority for insurance compaies and wodal sw-1 institutions (para. 198); * Liquidate the Rural Housing Fund (SOFIDHAR) (para. 209); * Launch comprehensive financial and operational audits of two insurance companies (SOCABU and UCAR), and two social security institutions (MFP and INSS) (paras. 204 and 215). Measures for the Medium-Term * Restructure all specialized fund (paras. 209-213); * Privatize or liquidate the Government Financial Intermediary (CAMOFI) (para. 206); * Privatize a development bank (SBF), SOCABU and commercial banos (para. 201); * Continue strengthening BRB (implement results of systems anaysis; devdeop trading on money market) (para. 185); * Overhaul taxation system (paras. 194 - 197); * Overhaul banking (para. 194) and insurance (para. 199) legislation;  - iv - * Study prospects for rural savings and credit cooperatives (COOPECs) (para. 205); O Develop venture capital finance (para. 217); O Restructure MFP (para. 215). Measures for the Longer-'i erm * Restructure the School Teachers' Fund (FSTEN (para. 205); + Restructure the National Social Security Institute (INSS) (para. 215); * Restructure the Post Office Savings Bank (CCP) (para. 216); * Develop capital markets (para. 2.17).  BURLTND1 - A-FINANCILSCT-OR REVIEW INTRC)DCTION 1. Bunrndi is a small landlocked country in Central Africa. Its per capita GDP is about US$215 (1991). With a population of about 5.5 million growing at 3 percent per annum, Burundi has the second highest population density in Africa (193 persons/square kilometer). Almost 94 percent of the population lives in rural areas and the economy is dependent on agriculture for more than half of GDP, 90 percent of employment and 90 percent of export earnings. Coffee accounts for about 80 percent of total exports. The secondary sector (mining and manufacturing) represents only 14 percent of GDP and 5 percent of exports. 2. Burundi has been implementing an adjustment program since 1986. During this period, per capita GDP growth has remained slightly positive despite the fall in the international price of coffee, the country's main source of export revenue. However, there has been limited export response in other subsectors. The number of products exported by the private sector has increased but the growth in the total volume of exports has been modest. Under the Government's comprehensive adjustment program supported by the Bank, stabilization measures were introduced, and steps taken to bring about structural changes: the exchange rate was devalued and has since been maintained competitive through an active exchange rate policy; most industrial prices were decontrolled; the tariff structure was rationalized; trade was liberalized; and significant budgetary reforms were introduced. In parallel, SAC-II (Cr. 1919-BU) and the SSE/APEX Project (Cr. 1889-BU) have supported improvements in financial sector policies, including liberalization of interest rates, successful launching of an auction market for Treasury Certificates (TCs), and several steps towards rationalizing monetary and credit policy. 3. The adjustment program has not yet stimulated a strong supply response. The critical mass of effective reforms needed to elicit sustainable supply response by the private sector has not yet been attained. The present development strategy for Burundi calls for the creation of a business environment that would enable the private sector to provide the main impetus for growth. Priorities include the removal of institutional, legal and regulatory impediments to private enterprise creation and the further implementation of sharply-focused financial intermediation and financial policy reforms. Most of these priorities are being addressed in the context of SAC-III (Cr. 2376-Bu) and the Private Sector Development Project (Cr. 2359-BU). 4. This report complements two others entitled "Private Sector Development in the Industrial Sector" and "Private Sector Development in the Agriculture Sector" which cover issues associated with the strengthening of private initiatives in industry and agriculture, respectively. The report discusses policies and institutional reforms for a competitive and sound financial system, which would be capable of mobilizing domestic resources and of supporting productive investments. Not all issues are covered in the same depth; greater emphasis was placed on those institutional and policy issues that could lead to specific and implementable recommendations. 5. The financial sector of Burundi has entered a period of major changes that parallel the changes occurring on the real side of the economy. It is undergoing an important process of liberalization, with market forces playing an increasing role in interest rate determination, the mobilization of savings and the allocation of credit. New institutions are being established and existing markets are expanding. The financial sector is at an "-portant crossroads and a wrong turn could send it along a path that has plagued many West African countries. Conversely, it could contribute to economic growth and social development. Already, increasing demands are being placed on the financial sector to fund growing economic activity, particularly imports and exports, new investment, the creation of new companies and the privatization of public sector enterprises.  -2- 6. A series of related questions require attention. At issue is how well the financial sector meets the needs of consumers and producers, savers and investors? How well does it contribute to the determination of interest rates in the country? How well does it mobilize financial resources? Do savers and investors benefit from financial instruments well adapted to their needs? Do they get the best return on their funds? How well does the financial sector distribute credit? Do borrowers obtain funds at the lowest possible cost commcrasurate with their risks? Are financial intex,nediation activities performed at the lowest possible cost and with the greatest efficiency? 7. Tlhe performance of the financial sector in meeting the needs of consumers and producers is directly affected by the following factors whose importance is briefly explained below: (a) monetary and interest rate policies and, more generally, the macroeconomic situation; (b) the legal and regulatory framework; (c) the taxation system; (d) government participation in the equity of financial institutions; (e) the degree of competition; (f) the solvency and self-sustainability of institutions; and (g) the internal sttength of institutions and their capacity to innovate. Monetary and interest rate policies influence the ability of the financial sector to mobilize domestic savings and allocate creait throughout the economy. They also have a direct impact on the profitability and long term viability of financial institutions. 8. The legal and regulatory framework sets the stage for the operations of financial institutions and markets. It determines the capacity of institutions to mobilize financial resources and supply credit on terms and conditions commensurate with the needs of borrowers and their risk characteristics. It has a direct bearing on the solvency and self-sustainability of institutions (through, ijr alij, constraints on portfolio diversification and savings mobilization) and on their ability to compete with one another (as it affects the ease of entry in various markets and the freedom in setting prices of financial services). It also has a direct bearing on the ability of an institution to innovate through its treatment of new activities and instruments. 9. Taxation influences the rate of return on savings, the cost of funds, the cost of financial intermediation and the profitability of institutions. It thus impacts on resource mobilization and credit allocation. By influencing the level of provisions and reserves of institutions, taxation also impinges on the prudential management of institutions. Through its partic.pation in the equity of financial institutions, the Government is present in the boardrooms of many institutions. As a result, these institutions may not be managed solely on the basis of pure commercial considerations. While in Burundi there has been much less government interference than in some other African countries, such interference does occur in directing credits and investments. On the other hand, competition ensures that borrowers obtain the funds they need at the lowest possible cost commensurate with the cost of processing the transactions and the risks involved, that savers obtain the highest returns on their investments, and more generally that financial intermediation activities are performed at the lowest possible cost and with the greatest efficiency. 10. Solvency of financial institutions provides for stability in the supply of financial services to both savers and borrowers. It protects the savings of depositors and .-vestors that have entrusted their funds to financial institutions. Beyond solvency, self-susmainability' of institutions is an important consideration. It involves an institution's ability to cover all its costs (including its costs of operation, provisioning and writing off bad loans and investments) and to provide shareholders with a real rate of return without depending on subsidies (e.g. direct grants, resources mobilized at below market costs, exemption from taxes, exemption from the obligation to pay dividends or to hold reserves). Institutional strength is the capacity to conduct business at hand, keep a tight control on operations and introduce new instruments or processes. It involves the ability to analyze, process, collateralize, monitor and recover loans. It also involves asset management capabilities.  3 - 11. It is clear that the above-mentioned factors are interrelated. The legal and regulatorv framework impacts on competition, solvency and the capacity to innovate, and so does government participation in the equity of institutions. But nowhere does this interrelation come more to a head than in the trade-off between competition and sclvency. Heated competition often leads to the insolvency of some of the combatants. On the other hand, too high a concern with solvency issues could lead to excess}ve conservatism in the management of institutions and to too iittle competition. A proper balance must thus be found between these two important factors which shape the quality of services offered by the financial sector. 12. The Report focuses on the main issues discussed in paras. 7-11. The first section provides a brief overview of the financial sector; the second, the macro-e^onomic background cf the country; the third section discusses the monetary, fiscal and regulatory environment; the fourth section focuses on competition, solvency, institutional strength and the overall ability of the sector to serve savers and users of credit through an analysis of each group of financial institutions; and the fifth section proposes a strategy for the development of the finarcial sector in support of economic growth spearheaded by the private sector. THE FINANCIAL SECTOR - AN OVERVIEW 13. The financial sector of Burundi appears relatively well diversified for a country of its size. -' consists of: (a) the Central Bank (Banque de la Republique du Burundi - BRB); (b) five commercial banks: Banque de Credit de Bujumbura (BCB), Banque Commerciale du Burundi (BANCOBU), Meridien Bank Burundi (MBB), Banque Burundaise pour le Commerce et l'Investissement (BBCI), and the newly established Banque Populaire; (c) three other deposit-taking institutions: Caisse d'Epargne du Burundi (CADEBU), Caisse Centrale de Mobilisation et de Financement (CAMOFI) and the postal savings system - Comptes Courants Postaux (CCP); (d) two development banks: Banque Nationale de Developpement Economique (BNDE), and Societe Burundaise de FinanceL,ent (SBF); (e' four insurance companies: Societe d'Assurance du Bururdi (SOCABU), Union Commerciale d'Assurances et de Reassurances (LUCAR), Bicor and Societe Generale d'Assurance et de Reassurance (SOGEAR); (f) a network of 75 savings cooperatives (COOPECCS) and three credit cooperatives; (g) several funds, specializing chiefly in housing financing and guarantee operations: the Fonds National de Garantie (FNG), Societe de Financement de l'Habitat Rural (SOFIDHAR), the Fonds de Promotion de l'Habitat Urbain (FPHU) - the Government is in the process of creating more of these specialized fands (e.g., Fonds de Soutien a l'Investissement Privd, FOSIP and Fonds de Developpement Communal); (.) t\vo financial establishments Credit-Ventes Services (CVS) and Meridien Leasing Company (MELECO), with a third, Societe Generale de Financement, SOGEFI, seeking a license; (i) and two social secu.ity institutions: the Institut National de la Securite Sociale (INSS), a publicly-controlled pension fund and the Mutuelle de la Fonction Publique (MFP) which provides medicare benefits for salaried employees in the public sector. A joint-venture holding bank with Arab partners and the Gove-nment is in the process of liquidation. The Eastern and Southern Development Bank, the Bank of the Preferential Trade Area for Eastern and Southern African States (PTA), has its head office in Bujumbura.j/ 14. Government participation in the equity of financial institutions is pervasive either directiy or through public sector entities. The Government holds a 42 percent share in the capital of the two 1/ While inforrnal financial sector activities do exist in Burundi, they have not been considered within this financial sector review.  -4 - largest and oldest commercial banks (BCB and BANCOBU), with foreign parent banks (Societe Generale de Belgique and Banque Bruxelles-Lambert) holding 49 percent of thP capital. MBB is 25 percent owned by Meridien International Bank, while the rest of its capital is held by public sector enterprises, private enterprises and individuals. BBCI shares are held by the State (10.3 percent), public sector enterprises, and private enterprises and individuals. The Government and public enterprises have a 30 percent share in the capital of SOCABU and 12 percent in that of UCAR. BICOR and SOGEAR are fully privately owned. The remaining financial institutions are in majority government owned and operated. 15. Although Burundi has a relatively large number of financial institutions, the level of financial intermediation as measured by the ratio of Ml/GDP or M2/GDP remains very low and has not increased much from 1980 to 1990. M1/GDP has hovered around the 12 to 13 percent mark over the period while M2/GDP remained around 17 percent. Appendix Table 1 (all tables are in a Statistical Appendix at the end of the report) shows that M2/GDP in Burundi is lower than that of many countries and lower than the average ratio for Sub-Sahara African countries. Similarly, the ratio of total financial institutions assets to GDP of 35 percent is relatively low. This low degree of financial depth is attributable to: (a) the low per capita income of the country; (b) the low degree of monetization and penetration of financial institutions in rural areas; (c) the lack, until recently, of competition among institutions; and (d) the absence of private sector ownership and management in the financial sector. THE MACROECONOMIC SITUATION 16. Since the beginning of the adjustment process in 1985, Burunui has experienced only slightly positive per capita growth. The economy remains fragile and highly vulnerable to exogenous factors such as climatic conditions and the world price of coffee. Economic growth slowed in 1989, with GDP increasing by only 1.5 percent due to unfavorable weather conditions that sharply cut agricultural production (food and export crops). Production shortfalls pushed the annual inflation rate to 11.6 percent. Coffee earnings declined by 27 percent due primarily to a 21 percent decline in international coffee prices. The full financial impact of the price decline was felt in 1990 when export revenues from ccffee fell by 30 percent. 17. Nevertheless, in 1990 the economy was once again on the upswing: real GDP growth rebounded to 3.5 percent and the inflation rate fell from 12 to 8 percent, despite a 38 percent increase in petroleum prices. Direct and indirect subsidies to public enterprises, primarily in the form of debt service payments, had increased to about 5 percent of GDP in 1989 but they declined to 3 percent in 1990 and are expected to have declined further in 1991 and 1992. The overall external payments position remained comfortable, with gross foreign exchange reserves equivalent to over 7 months of imports (goods) in 1989 and over 5 months in 1990, owing primarily to large external transfers for balance of payments support. With the sharp rise in reserves, money supply (M2) expanded by 27 percent between 1988 and 1990. 18. Despite the positive events of 1990, there were some setbacks: domestic savings fell from 3.9 percent of GDP during 1985-87 to 1.3 percent in 1988-90 mainly because of a reduction in public savings. The overall fiscal deficit remained at an unsustainable level-averaging over 12.7 percent of GDP during 1987-90. Although the deficit deteriorated to 13 percent of GDP in 1990, the latest estimates for 1991 indicate an improvement to 9.7 percent of GDP. The ratio of public expenditure to GDP has averaged about 28 percent over the 1987-90 period and has not declined during the adjustment program despite the Government's commitment to reduce its role in productive sectors and promote private sector development.  - 5 - 19. The Government's reform program is described in the fourth Policy Framework Paper (PFP) for 1991-94. The key macroeconomic objectives, as revised during the mid-term review in April 1992, are to: (a) achieve average annual real GDP growth of 4 percent (implying real per capita GDP growth); (b) maintain inflation at about 7 percent; (c) reduce the external current account deficit from 20.8 percent of GDP in 1990 to 18.7 percent in 1994; and (d) reduce the fiscal deficit (excluding grants) from 13 percent of GDP in 1990 to 6.8 percent in 1994. The surplus on the Government's current operations, which was 3.5 percent of GDP in 1991, is to increase to 5.7 percent in 1994. External budgetary support will be used to reimburse Central Bank advances to the Government by end-1993. Intermediate objectives for 1993 include: (a) an external current account deficit of 19.8 percent of GDP; (b) a fiscal deficit of 7.2 percent of GDP; and (c) an inflation rate of 4 percent. In general, medium-term growth prospects continue to be highly dependent on favorable climatic conditions, the world price of coffee and developments in agricultural production and diversification, but modest sustained progress is expected. 20. Estimates for 1991 suggest that the economy grew by 4.9 percent, an improvement over the PFP scenario. Owing to stable terms of trade, gross domestic income per capita also grew modestly (compared to a decline in 1989 and 1990). Public savings have met the Government's objective of 3 percent of GDP (compared to 0.4 realized in 1990). Coffee export earnings rose by 36 percent owing to a combination of earlier plantings and the sale of stocks accumulated the previous year. The overall balance of payments surplus was equivalent to about 2 percent of GDP, aided in part by US$255 million in external financing assistance. Inflation remained at 8 percent, boosted, in part, by a devaluation in August 1991 (15 percent in SDR terms). The debt service ratio remained high due, in part, to the impact of exchange rate devaluations. Despite the accelerated implementation of reforms since late 1989, more robust economic growth has not materialized. This was due to sharp declines in world coffee prices and to the large size of the subsistence economy, which is not very responsive (at least in the short-term) to changes in incentives. THE MONETARY. FISCAL AND REGULATORY ENVIRONMENT 21. The new policy approach espoused by the Government giving an increasing role to market forces and private sector development calls for radical changes in interest rates and monetary policies, the taxation system and the legal and regulatory framework. This section considers successively these three important components of the environment within which banks and financial institutions operate. Interest Rate and Monetary Policies 22. As noted earlier, the financial sector has embarked in a major process of change moving towards a greater role played by market forces in the determination of interest rates and use of indirect instruments of monetary policy in the context of the Government adjustment program. Change is a lengthy process which requires adjustment by financial and economic operators and institutional building within the Central Bank and financial institutions. While important progress has been achieved, serious short comings still remain in the conduct of interest rate and monetary policies. 23. Interest Rate Policies. Market forces now play a larger role in the determination of interest rates through the auction market for Treasury Certificates (TCs) which was established in April-May 1988 (see paras. 27-33 below). After overcoming some start-up problems the auctioning system works relatively well. The TC average yield influences the structure of interest rates and constitutes the reference rate for bank lending rates.  - 6 - 24. Three important distortions in the establishment of borrowing rates were removed in July, 1991. First the preferential refinancing rate for coffee and other commodities export credit was abolished and aligned to the normal, now unified, BRB refinancing rate. Secondly, the normal refinancing rate which was below the TC rate was raised to 10 percent, i.e. above the TC average yield in that period. As interest rates on TCs continued to rise, the refinancing rate was increased to 12 percent in Spring 1992. Thirdly, bank margins on commodities credits, which were administratively limited to one percentage point have been liberalized. The margin on other credits used to be fixed by an interbank non- binding agreement at 4 percentage points above the TC rate for rediscountable credits and 9 percentage points for other credits. Such practices have been forbidden by BRB. However, bank margins have not changed much. 25. Interest rates on deposits vary from one percent for some sight deposits to 12 percent for term deposits, with the bulk remunerated above 7 percent. Interest charged on commercial bank loans ranges from 7 to 19 percent. Taking into account the official annual rate of inflation of 8 percent in 1991, most interest rates on term deposits are positive in real terms, and substantially so for loans. This raises the issue of the adequacy of the general level of interest rates in the country. 26. There is broad agreement that nominal interest rates must exceed the rate of inflation. However, there is less agreement on what the true rate of inflation is in the country. More work needs to be done in this area. Interest rates must be market determined and the development of the TC market (see below) is a first step in this direction. Interest rates must also be linked to the objectives of monetary and credit policy. Interest rates have risen in the last 18 months because of the continued fast growth in domestic credit. However, the increase in rates does not seem to have made much dent in the growth of credit. This may be attributable to remaining problems with the refinancing mechanism (see para. 35) or to low interest sensitivity of demand for credit, (more analytical work is needed in this area). 27. The Treasury Certificates Market. The market is basically a primary auction market for Treasury Certificates issued by the Government. The Central Bank runs the auctions on behalf of the Government. Initially, one-month, three-month and six-month certificates were auctioned off. The issuing of six-month certificates was abandoned in May 1989. Tables 2 and 3 provide data on the evolution of the TC market. They show the amounts issued and outstanding, the number of bids, the shortfall or oversubscription, the average rate and the interest spread at each auction. Table 4 indicates the origin of bids (individuals, private and public sector enterprises, commercial banks and nonbank financial institutions). 28. The average interest rate on Treasury Certificates increased continuously from 4 percent in May 1988 to 10.5 percent at the end of January 1992 for one-month Treasury Certificates, and from 5.1 to 9.75 percent for three-months Certificates. Interest rate spreads on bids have also increased over time with the latest bids fluctuating between 9.5 and 12 percent for the one-month rate and 8.5 and 11 percent for the three-months rate. 29. The auctioning process has evolved over the past three years. At first, the Central Bank accepted all offers that were made. Subsequently, it announced an amount it sought to raise during each auction. In the early years, when the rate of interest attached to a bid was considered out of line with those of the other bids, that specific bid was not accepted. Subsequently, all bids "'ere ranked according to the rate of interest, and bids were accepted in order until the amount sought had been raised. Once the amount sought had been mobilized, higher bids were rejected. For a while in 1991, the amount raised fell well short of the announced amount of the issue. Subsequently, the Central Bank adjusted the amount sought on the basis of the amount raised in the precedent auction. Until recently, BRB played a passive role in the market, being no more than an auctioneer. It thus forsook the ability to influence  7 - the level of interest rates as an instrument to achieve a desired rate of money and credit growth in the country. Furthermore, the auction process (where all bids were accepted until the full issue had been subscribed) opened the door for a bidder to secure a high remuneration for his funds during periods of low investors' interest. Some investors were already systematically introducing high bids. Since March 1992, BRB is submitting a reserve bid at a rate of interest based on the average rate at the preceding auction. This is the beginning of a more active participation of BRB in the market (see para. 174). 30. In recent months, the minimum TC coupon has been lowered from FBu 500,000 to Fbu 100,000. Bearer certificates and bi-monthly auctions have been introduced. These measures aimed at increasing the participation of individuals and smaller private sector firms in the auctions. In the second half of 1991, the number of bids in the primary market had indeed risen considerably and individuals' participation has increased. Despite growing investors' interest there is still no secondary market in TCs. 3i. The recent introduction of bidding on discount certificates is a technical change that will facilitate the development of a secondary market. At the time of the auction, the discount applied to the nominal (face) value of the certificate corresponds to the rate of interest bid. As a particular certificate gets closer to its date of maturity, the discount narrows and the price becomes closer to the nominal value. The introduction of discount certificates will facilitate the selling of the security before its maturity. The discount or selling price will be determined by the number of days remaining before maturity and by the general level of interest rates at the time of the transaction. 32. The establishment of primary dealers will also contribute to the development of a secondary market in Treasury Certificates. Four commercial banks have been designated as primary dealers. These dealers will hcld a portfolio of Treasury Certificates and be prepared to trade on the secondary market and make a market in these securities. 33. With the increase in the number of participants in the auction market, the rate of interest on TCs has become closer to a market-determined rate. However, it does not yet fully reflect market conditions. For this to be the case, the number of participants in the auctions must remain high, an active secondary market must be developed and links must be established between the TC rate and instruments of monetary policy. 34. Directed Credits. BRB does not have any sector-wide directed credit policies, except for minimum requirements for commercial and development banks to allocate 15 and 60 percent of their lending for investment financing, respectively. By and large, this term lending ratio is not respected by banks which prefer to pay the related penalties as a less costly alternative. 35. Central Bank Refinancing. Changes in the money supply are mainly effected through conversions of external credits and BRB refinancing of commodities marketing, and export and other eligible credits. Commercial banks and financial institutions have not had much recourse to BRB refinancing, with the exception of the financing of coffee crops. In 1990, financial institutions carried Fbu 20.4 billion of rediscountable credits and FBu 15 billion of nonrediscountable loans. Only 24 percent of the rediscountable credits had been presented for refinancing. And this is an unusually large percentage attributable to a liquidity squeeze in that particular year (para. 81). In 1989, only 15.5 percent of the eligible paper had been presented for refinancing. 36. Refinancing at the BRB is demand driven by commercial banks and other financial institutions. Indeed, once a paper has been deemed eligible for refinancing, its actual rediscounting is at the discretion of the financial institution as there are no refinancing ceilings. Furthermore, the rate of interest at which paper is refinanced is the rate in effect at the time the paper has been deemed eligible  -8- for refinancing and not the rate in effect at the time the refinancing takes place. This encourages greater recourse to the rediscounting window at times of rising interest rates and tightening liquidity, thus weakening the grip of the Central Bank on the growth of money and credit. For instance, on June 17, 1992, the amount of BRB refinancing outstanding was Fbu 3,165 million. Less than Fbu 800 million was at a rate of interest of 12 percent, the current refinancing rate. The rest was refinanced at rates starting as low as 5.5 percent. The actual refinancing rate is thus well below the posted 12 percent rate. 37. Control of the quality of credits submitted for refinancing is not as comprehensive as could be expect'd. Prior to 1987, each file submitted was the subject of an extensive review and analysis. This procedure was abandoned in 1987 to speed up the review of the eligibility of paper for refinancing. Moreover, once accepted as rediscountable, the quality of the paper is only occasionally subjected to periodic reviews. The quality review and monitoring by the BRB of paper submitted for refinancing must be improved. As commercial banks often subject the granting of credits to their customers to BRB acceptance of the rediscountability of such credits, there is de facto reliance on the Central Bank judgement on the quality of the proposed credit. Consequently the quality of rediscountable loans both at BRB and banks may be overstated. 38. Reserve Requirements. In view of the rapid expansion of domestic credit in the past two years mainly attributable to a large inflow of foreign aid, the IMF and BRB have agreed to introduce a system of reserve requirements applicable to all deposit-taking institutions. The system, instituted in July 1991, set reserve requirements at 10 percent of sight (demand) deposits and 5 percent of term deposits. Reserves were to be constituted by special deposits held by banking institutions with BRB. Banks had to adhere to this requirement on a daily basis, with the penalty for non compliance set at 10 percent of the shortfall. Several problems had emerged with the implementation of the new system of required reserves: (a) the target level of the reserves was too high; (b) the form in which they had to be held was too restrictive; (c) the need to meet the requirement on a daily basis did not provide for sufficient flexibility; (d) the penalty for non compliance was too low; and (e) there were a number of deposit-taking institutions that escaped this requirement; SBF, BNDE, FPHU and SOFIDHAR, while accepting deposits, were not subject to reserve requirements. 39. Following a joint review of the workings of the system of reserve requirements with the IMF and the Bank in November 1991, the Central Bank decided in principle to: (a) establish a single reserve requirement at 7.5 percent, independently of the category of deposits it is applied to; (b) modify the form in which required reserves must be held to remove the need to establish a special deposit account at the Central Bank and to include cash in vault in the computation of reserves; (c) increase the time span over which the requirement nai*st be met; (d) increase the penalty for non-compliance; and (e) review the situation of deposit-taking institutions not subject to reserve requirements, with a view to either stop their deposit-taking activities or subject them to the requirement. Furthermore, while reserve requirements are a valuable instrument of indirect monetary control, their introduction at a time of a general tightening of bank liquidity without the benefit of an analysis of their impact on the financial situation and profitability of banking institutions had raised many questions. While some banks and financial institutions were holding sizeable liquid assets, this did not necessarily reflect the existence of "excess" liquidity but rather a desire by the institutions to be more liquid as competition heated up and privatization of some important segments of economic activity increased the risk of their portfolio. BRB will, therefore, monitor carefully the impact of the new system on bank liquidity and adopt a flexible policy with regard to institutions that may be hit too hard. 40. The Central Bank and Overall Conduct of Monetary Policy. With a staff of 437 in 14 divisions and 2 branches, BRB is in charge of defining and implementing national monetary and credit policies. It issues currency, manages the foreign exchange reserves and acts as the government banker.  -9 - It is also responsible for monitoring, regulating and supervising financial institutions operating under the Banking legislation (para. 62). It is a highly centralized and compartmentalized institution. There are few training programs, salaries are low compared to banks and turnover of quality staff is high. Few operations and services are computerized and the little that does exist is dispersed among divisions without attempt at coordinating tasks and transferring information from one division to another. 41. The current structure of the Central Bank and the modus operandi of various departments have not yet been adapted to the new policy orientations of liberalization and use of indirect instruments of monetary control. The institutional framework needs time to adapt to the new policy orientation. For the Central Bank, for instance, it means a much lesser role for the Import and Export divisions which were in charge of import and export controls and a greater, but different, role for the Research, Credit and the Government's Cashier divisions, which are involved in activities related to the implementation of monetary and interest rate policies. 42. The Research division is organized in four sections (Money and Credit, Public Finance and Debt, External Trade and the Real Economy). Staff in these sub-sections mainly concentrate on collecting data, providing commentary on past development and writing bank publications, all useful activities, but not fully geared to the design of monetary and interest rate policy. There is no forecasting of economic and financial data; there is no attempt at establishing objectives for credit and monetary policy on the basis of recent economic and financial developments in the country. The Credit division collects data. It also decides on the acceptability of paper presented by commercial banks for refinancing purposes. As noted above it, does not undertake a comprehensive credit analysis of the company whose paper is presented. The Government's Cashier division runs the TC auctions. This is done rather mechanically without yet using this market as a channel to implement monetary policy. Because of a lack of staff and know-how, the Central Bank does not currently have the internal analytical and processing capacity to: (a) forecast the movement of financial and economic variables; (b) derive objectives of money supply and credit growth from macro variables, such as inflation and income growth; (c) translate these objectives into monetary base and interest rate intermediate targets; and (d) achieve those targets through refinancing, changes in reserve requirements and interventions in the TC market. BRB does not have either the internal capacity to trade securities on secondary markets. 43. Because of the above-mentioned institutional weaknesses, there is no global approach to the conduct of monetary policy. The Central Bank does not determine the desired thrust of monetary policy (tight or easy money). There is no link between interest rates and the various instruments of monetary policy (refinancing, reserve requirement). BRB does not intervene on the TC market to influence the level of interest rates. Adjustment to change is a lengthy process, particularly when it involves changes in structures. BRB officials fully recognize the new needs arising from the shift in the direction of economic policy. They have requested Technical Assistance which will be provided by the Bank, IMF and the French. 44. In summary, while good progress has been achieved in liberalizing interest rates, the Central Bank needs to do much more to improve its control over credit and money supply growth. New financial instruments need to be introduced and existing ones (e.g., TCs) need to be strengthened. Furthermore, BRB needs to build the internal capacity to define and implement monetary policy. Links need to be established between the various instruments of monetary policy and interest rates.  - 10- The Imnpact of Taxation ofnandal Institutions and Instruments. 45. A comprehensive reform of the taxation system has not yet accompanied the adjustment process. Currently, the income tax of Burundi is a hybrid of a schedular tax system that taxes each kind of income separately rather than the individuals who receive it, and a global tax, imposed on a taxpayer's inco-me from all sources. There are separate direct taxes on property, rental income, investment income, and so-called professional income that includes wages, salaries, and incorporated and unincorporated business income. Moreover, there is an indirect tax on transactions on goods and services. This report focuses on the professional and investment income tax and the transactions tax because of their impact on financial institutions and transactions. 46. The base of the tax on Investment Income or "impot mobilier" is dividends, interest and incomes other than rent, wages, salaries and active business income of individuals. The tax rate is a flat twenty percent. It is a final tax withheld by the payer at the source. Incomes subject to this tax are not to be included in income subject to the professional income tax of individuals. Interest on government securities is exempt from the investment tax. There are no legal texts establishing the tax-free status of interest paid by the State. Only administrative documents state the exclusion of interest paid by the State from taxable income. Central Bank payment notices state that payment is net of tax. Explanatory note 3 to tax form No. 1104 used for reconciliation of book profits with taxable income states that interest paid by the State is deductible from book profits and excluded from taxable income. The Central Bank is not required to file the form used to remit the investment tax, and this form makes no reference to interest on government debt. 47. For individuals, the base of the professional Income tax or 'impot professionnel" Is the combined wage and salary income of spouses, in money and in kind, plus their unincorporated business income. Taxpayers can take deductions for dependents, pension saving, and insurance premia paid. Marginal tax rates range from zero to 60 per cent. 48. Corporations are taxed globally under the professional income tax on all their income, (including income otherwise subject to the investnment income tax). Corporate income is taxed at a flat 45 percent. Consequently, dividends and interest income received by corporations are taxed at a 45 percent rate, while investment income is only subject to a 20 percent tax when received by individuals. Corporations are subject to a minimum tax of one percent of turnover whenever income tax otherwise payable falls below the amount of the minimum tax. 49. The Indirect tax on transactions on goods and services is set at a standard rate of 15 percent. Financial services are taxed at a reduced rate of 7 per cent. A decree-law of January 31, 1989 provides for input tax credits restricted to transactions in listed commodities by listed industries. Interest and commissions are specifically excluded from the list of untaxed inputs, and the financial sector is excluded from the list of industries that can claim credit for transactions tax on commodities. 50. A review of the taxation of financial institutions and instruments revealed that: (a) there is a lack of knowledge of taxation rules; (b) investment in equity capital suffers from double taxation; (c) the taxation system discourages savings by low income people; (d) different taxation of financial instruments is a source of costly tax arbitrage; (e) the absence of tax deductibility of provisions for bad assets is a disincentive to financial investment; (f) cascading transactions taxes discourage financial intermediation and long term lending; and (g) tax exemptions of certain financial institutions introduce distortions.  - I1 - 51. Lack of knowledge of taxation rules. This lack of knowledge is reflected in different ways. Banks are unsure when to withhold the 20 percent tax on investment income. Many corporations and financial institutions pay a full 45 percent professional tax on Treasury Certificates while these are in fact tax exempt. This results in higher bids in the auctions than warranted. Indeed, given a final 20 percent tax on interest on certificates of deposit ('bons de caisse") one would expect the before-tax yield of such certificates to exceed the yield of TCs of similar maturity by 25 per cent. It is not unusual, however, to find the opposite relationship between these two yields. For instance, the yield of a 30-day bon de caisse fluctuates between 9.5 percent and 10 percent while the yield on a 30-day TC ranges from 10.5 percent to 12 percent. As the TC rate is used as a benchmark for all interest rates, the level of interest rates in the country is higher than it should be. 52. Double taxation of investment in equity capital. Profits of corporations are taxed at a 45 percent rate. Dividend distributions are subject to the 20 percent tax on investment income. That brings the total tax on dividend income to 56 per cent. On the other hand, interest payments on business borrowings are deductible from the professional tax at a 45 percent rate ( up to a 60 pe&ccent rate if paid to finance unincorporated business) but an individual lender is taxed only at 20 per cent. This creates a powerful incentive to debt finance unincorporated and incorporated businesses and to convert common shares into debt instruments. In other countries, the size of the bias in favor of debt finance is uncertain because it depends on the marginal tax rate of the marginal lender. In Burundi the bias is certain because the ultimate individual lender is known to be subject to exactly a 20 percent tax. 53. The taxation system discourages savings from low income people. An Lidividual holder of deposits and securities pays an investment tax of 20 percent even if for other income tax purposes he is a low-income taxpayer in the zero to 19 percent brackets (income less than US$ 2,000 per annum). This is a disincentive to the accumulation of small savings. 54. Different taxation of substitute financial instruments Is a source of costly tax arbitrage. Tax arbitrage is the conversion of an income stream taxed at a high rate into another stream taxed at a lower rate. A business expansion, for example, provides an arbitrage opportunity. The expansion can be financed by a direct infusion of equity. The expansion can also be financed by a bank loan while the equity is diverted to a financial investment. The latter choice would be made if investment income is taxed less heavily than business income, as is the case in Burundi. By such arbitrage, any individual in the 23 to 60 percent brackets of marginal professional tax can profit from schedular taxation at the expense of government. With one hand he borrows money and deducts interest at tax rates between 23 and 60 percent, with the other he buys financial assets that yield income subject to the flat 20 percent tax on investment income. Government revenue is thus reduced by 3 to 40 percent of the yield of capital. Availability of tax exempt assets such as Treasury Certificates and deposits with the FPHU makes tax arbitrage even more attractive. Financial market development and increasing financial expertise of market participants ar' likely to make tax arbitrage a growing problem in coming years. 55. Tax arbitrage can also hamper the conduct of monetary policy. Effective monetary control requires that the Central Bank refinancing rate exceeds the yield of Treasury Certificates, otherwise banks will use low cost Central Bank credit to invest in higher yielding certificates. To prevent this kind of arbitrage already observed in the Bujumbura market, it has been suggested that the refinancing rate be set at two percentage points above the average yield of Treasury Certificates (see para. 181). If Treasury Certificates yielded 10 percent, the refinancing rate would be 12 percent. The two percentage points margin involves, however, a comparison of a tax-free yield with a tax-deductible cost. Interest rate comparisons should rather be made by comparing like with like, namely after-tax cost of borrowing with after-tax investment yield. Such a comparison shows that a two percentage points margin is insufficient when interest paid is deductible at 45 percent while interest earned is tax free. The  - 12 - borrower refinancing with the Central Bank at 12 percent has an after tax cost slightly over 6 per cent, almost 4 percentage points below the tax free 10 percent yield of Treasury Certificates. The present tax free status of Treasury Certificates car, be maintained if there is a much larger margin between the Central Bank refinancing rate and the yield of Treasury Certificates. When Treasury Certificates yield 10 percent tax free and arbitrageurs face a 45 percent tax rate, the refinancing rate would have to be 22 percent so that the after tax cost of refinancing will be 12.1 percent and thus exceed the TC yield by the desired margin of two percentage points. The refinancing rate would thus be driven by tax rates and policy; it would not be fully under Central Bank control. The Central Bank's position is worse when individuals in the 60 percent marginal tax bracket invest in TCs with borrowed funds. The position is worsened by uncertainty about the marginal tax rate faced by the marginal tax arbitrageur. These uncertainties are best removed by taxing interest paid by the State. 56. The absence of tax deductibility of provisions for bad debt is a disincentive to financial Investment. Depreciation of fixed assets is deductible. However, provisions for bad loans are not deductible. Actual losses and insurance benefits paid are deductible. Contributions to actuarial insurance reserves are deducted in practice but the legal allowance of the deduction is doubtful. Equal treatment of equals requires deductibility of provisions for doubtful debts and actuarial reserves. Inability to deduct provisions for doubtfui debts discriminates against financial investment in general, in favor of short-term lending, and against medium-term lending. 57. Cascading transaction taxes discourage financial intermediation and long term lending. Re-lending of borrowed funds suffers a double tax, namely 7 percent charged to the original lender and 7 percent billed to the ultimate borrower and remitted by the re-lending institution. Such a double tax is a penalty for specialization in the credit market and retards financial deepening. The interrelation between insurance companies and other financial institutions is an illustration of this problem. tnsurance companies mobilize medium- to long-term savings These funds are usually placed by insurance companies with other financial institutions for re-lending to ultimate borrowers, as insurance companies do not have the expertise to lend directly to businesses. The transactions tax is levied on the placement of funds by the insurance companies and again on the relending by the financial institutions. 58. The tax exemption of selected financial Institutions is a source of distortions. Exemptions from corporate income tax and from obligation to withhold the investment tax are an obstacle to competition in financial markets and the development of such markets. However, such exemptions appear to be on the whole rather few. Government-owned financial institutions are generally subject to all taxes. FPHU is currently an exception. Following article 18 of the Investment Code, this fund is temporarily exempted from the investment tax due on funds borrowed for land development, improvements, and housing construction. It is also exempt from corporate income tax, from the investment tax on interest earned on funds placed in expectation of disbursement for housing loans, and from a limited amount of import duties and transactions tax on office equipment. In the past, other institutions, such as BNDE have also temporarily benefited from tax exemptions. COOPECs are exempt from corporate income tax by virtue of Article 63 of a decree-law of July 7, 1990. Management interprets this very liberally as meaning that COOPECs are also exempt from investment income tax and are not required to withhold 20 percent of interest paid to depositors. 59. The existing taxation system is thus an impediment to the mobilization of domestic resources (schedular tax system, different taxation of interest from various sources), competition among financial institutions (tax exemptions of institutions and interest on government securities), deepening of financial intermediation (cascading transactions taxes), adequate supply of term and equity finance (double taxation of investment in equity capital), and efficient conduct of monetary policy (tax exemption of interest on government securities).  - 13 - Regulation and Supervision 60. Some reforms in the regulation and supervision of financial institutions, commercial banks In particular, have been undertaken in the context of the government adjustment program supported by the Bank and the preparation of the Private Sector Development Project. Many weaknesses remain that will have to be addressed without delay. 61. Financial institutions are generally regulated by their own letters of incorporation (for private entities - enterprises de droit privd) or decrees (for public entities - or enterprises de droit public) and organic legislation such as the Banking Law and Insurance Legislation. There is, however, no clear mechanism to resolve potential conflicts between organic laws and letters of incorporation or decrees. Institutions deemed as commercial banks or nonbank financial establishments (Etablissements financiers non bancaires) are regulated by the Banking Law (Loi Bancaire). Insurance Companies are regulated by the Insurance Legislation and social security institutions are regulated by their own legislation. COOPECS fall under the general cooperative legislation and their own decree, as do the other financial cooperatives. The Postal Savings Bank is not regulated by any organic legislation. 62. Regulation and Supervision of Financial Establishments. Commercial banks and nonbank financial establishments operate under the Banking Law and are supervised by the Central Bank. The Banking Law is supplemented by a number of prudential directives issued by the Central Bank. Prudential directives were reissued in February 1992 regarding: (a) the classification of loans, the constitution of specific and general provisions, and the treatment of interest due but unpaid; (b) the minimum liquidity ratio; and (c) the minimum capital asset ratio. These directives are adequate by modem standards.2/ The minimum required ratio of term lending (15 percent for commercial banks and 60 percent for development banks) has not been revised. Such a ratio has no credit control or prudential meaning, prevents independent decision-making for investment financing, and should be eliminated. BRB has agreed to abolish the ratio of 15 percent for commercial banks and will review, later on, that of 60 percent for development banks. 63. The Banking Law also needs a complete overhaul. Limits set on concentration of credits is one area, among others, that needs to be strengthened. The risk concentration limit is set at 30 percent of equity, a high figure. In fact, the actual ratio is much higher as credits guaranteed by chattel mortgages and other liens on products and credits guaranteed by a mortgage or by the Government are not subject to any limit. Furthermore, most of the existing prudential rules apply only to banks. For instance, the Banking Law sets minimum capital requirements only for banks. Other financial institutions are not subject to minimum capital standards. While all prudential ratios theoretically also apply to nonbank financial institutions, they have been established with regards to banks and would be of difficult applicability to other institutions. 64. The Supervision Department at the Central Bank, with a staff of 11 (several of which are new recruits) does not have yet the necessary know-how and clout to have a meaningful impact on the institutions it supervises. The level of competence of staff is low; many have little knowledge of financial analysis and most have not much experience in inspections of financial institutions. Turnover of personnel is high, as remuneration is low compared to compensation paid to equivalent officers of / 'The capital asset ratio does not differentiate between the risks of different assets (e.g., loans to Government entities, mortgages, loans to other financial institutions and loans to private sector firms). While this is acceptable in the early stages of development of a modern banking sector, Burundi should consider moving over time to a risk-weighted capital asset ratio.  - 14 - financial institutions. The status of inspectors in the financial community is low. There is no legal department within the BRB which would, inter alia, review draft regulations and legislation and advise the Bank on general legal matters. 65. Off-site supervision is performed on the basis of monthly reporting forms filed by all institutions, sometimes with long delays. In June 1991, standardized reporting forms have been introduced by BRB. In the absence of a unified accounting plan that would apply to all commercial banks and financial institutions, the quality of reporting and the comparability of data posted under the same headings remain questionable. Furthermore, the information gathered is not fully exploited by staff in the Supervision Department. 66. Recently, external audit reports were completed for three commercial banks, two development banks (BNDE and SBF) and one public deposit-taking institution (CAMOFI), as required by an agreement between the Government and the Bank under the APEX/SSE project. The audits were conducted by foreign-based international auditing firms with the support of local specialized companies. All institutions concerned had a comprehansive financial and operational audit covering their financial situation, the quality of their loan portfolio and internal procedures. The quality of the audit was generally good. The reports brought to the attention of the management of the institutions and the supervisory authorities many weaknesses and shortcomings within the audited institutions (in provisioning, loan granting procedures, registering of collateral, accounting systems, internal controls, etc.). While such comprehensive audits are unlikely to be performed on a regular basis because of the expenses involved, they constitute a good start to the monitoring of the performance of financial institutions. 67. On-site supervision is limited. No banking institution has been the object of a comprehensive inspection. Inspection reports c c not available to banks concerned and consequently they cannot comment on them. There is no follow-up to ensure that corrective measures have been taken. 68. Regulation and Supervision of Insurance and Social Security Companies. The legislation is generally sound, but it has not been supplemented by regulations.l/ For instance, the legislation provides for supervision by the Ministry of Finance of insurance companies. However, it leaves to regulations, that were never issued, the details of how supervision should be conducted and what prudential norms must be met by the companies operating under this legislation. Also the minimum capital required from insurance companies (Fbu 30 million) is inadequate. I/ Insurance companies operate under the "Decret Loi no. 1/17 du 29 juin 1977 portant reglementation generale des assurances", "Decret Loi no. 100/61 du 29 juin 1977 portant creation d'une socidt6 d'assurances du Burundi", "Decret Loi no. 1/18 du 29 juin 1977 instaurant l'assurance obligatoire de la responsabilite civile en matibre de v6hicules automoteurs", and "ordonnance ministerielle 540-141 du 9 juin 1983 fixant les conditions minimales pour l'agrement des organismes d'assurances". INSS operates under the 'D6cret Loi no. 1/001 du 26 fevrier 1990 portant modifications du Decret Loi no. 1/17 du 16 octobre 1981 portant refornes du regime gendral de securite sociale", and "Decret no. 100/034 du 26 fevrier 1990 portant modification du Decret 100/222 du 16 octobre 1981 portant reorganisation de l'INSS." MFP operates under the "D6cret Loi 100/107 du 27 juin 1981 portant organization d'une mutuelle de la fonction publique" and "DEcret Loi 1/28 du 27 juin 1980 portant institution d'un regime d'assurance maladie des agents publics et assimiles." The Civil Code as it regulates contracts and the 'Code des ImpBts' also apply to insurance companies and social security institutions.  - 15S- 69. In some respect, the legislation is more advanced than in other African countries, in others it lags behind. For instance, the legislation which makes auto insuranice compulsory does not provide for a schedule of claim settlements ("bar8me"). Such a schedule is now in effect in COte- d'Ivoire. In the absence of such a schedule, settlement is left to the discretion of the courts and, sometimes, inordinately large awards put a severe burden on insurance companies. On the other hand, a short prescription period of 3 years is included in the legislation. Such prescription periods are now being sought in West African countries. 70. The legislation appears to be largely ignored by the companies particularly in their financial operations. For instance, the legislation sets out clearly that different categories of operations should have separate bookkeeping, but this is not generally heeded by insurance companies. To a large extent, this can be attributed to the absence of superision of insurance companies and social security institutions. 71. There is no service within the Ministry of Finance or within any other Ministry with a mandate to monitor and supervise insurance companies and social security institutions. As a result, insurance companies have developed in a kaphazard way. Accounting principles differ from one company to another as do provisioning methods and the constitution of technical reserves. One irsurance company has been operating for several months without the proper license. 72. In conclusion, the fiscal and regulatory environment in Burundi exhibits, as in most African countries, many weaknesses. Reforms have been started in the areas of monetary and interest rate policy and regulation and supervision of banking institutions. These will have to be continued and extended to areas that have not been touched yet, namely, the taxation of financial institutions and instruments, and the regulation and supervision of insurance companies and social security institutions. THE FINANCIAL INSTITUIONS 73. This part will analyze successively the operations and performance of: (a) institutions that operate under the Banking Law, including: (i) commercial banks; (ii) other deposit taking institutions; (iii) development banks; (iv) specialized funds; and (v) leasing and small loans companies; (b) savings cooperatives; (c) insurance companies; and (d) social security institutions. For each category of institutions, the analysis will focus on: (a) the main activities; (b) the quality of the loan portfolio; (c) liquidity; (d) profitability; (e) internal strrngths an weaknesses. 74. The Commercial banks largely dominate the financial sector. Tble 5 shows the relative importance of each institution as measured by its assets. Banks also dominate the deposit market with a 70% share, followed by CAMOFI and CADEBU with a 14% share each. Commercial banks also account for 61% of the loans outstanding fo'-.owed by BNDE and SBF with a 12% share each, CAMOFI and LADOBU with 6%, and FPMU with 1.0%. Commerdal Banks 75. Four commercial banks currently operate in Burundi, BCB, BANCOBU, MBB and BBCI. They will be joined soon by the Banque Populaire which received its license form the Central Bank in Spring 1992. It has a large government and parastatal participation in its capital and will cater to the needs of smaller savers and depositors. An attempt to bring in the Trade Bank, a Kenyan bank, was put on hold because of recent intamrnal difficulties in Kenya.  - 16- 76. The two largest commercial banks, 3CB and BANCOBU, have a long history behind them. For many years, they have operated as wholly-owned subsidiaries of foreign banks. In 1985 the foreign parent companies of these two banks sold 51 percent of their shares to Burundian interests, government and public sector enterprises, but retained control of management. Expatriate management is now being gradually replaced by local personnel with continued involvement of the foreign banks. The policies, procedures, and management practices of these two banks still reflect those of the parent companies, but most financial links have been severed. The two other commercial banks, MBB and BBCI, have started operations in 1988. MBB maintains close technicai assistance ties with its parent, M6ridien International, adopting its procedures and management style. Table I provides summary statistics for the four commercial banks. 77. Commercial banks extend mainly short-term credit in overdraft form with a large proportion of such credits financing export and import operations. Coffee marketing and export financing constitute an important point part of banks lending business. Until recently commercial banks were the only institutions engaged in this very profitable and virtually risk-free activity, but lately, iu line with the policy to improve competition among banks, other financial institutions, such as BNDE and SBF, have become involved in coffee financing. Commercial banks have generally not been able to devote at least 15 percent of their outstanding portfolio to medium-term (2-7 years) and long-term (over 7 years) loans as required by BRB regulation, and the few term loans in their portfolio were granted almost exclusively to well-established clients. 78. Practically, all bank lending is backed by some form of collateral (mortgages, floatkig charges on stocks or other assets, personal guarantees, overseas bank guarantees, etc.), even though the registration and ultimate enforceability of most of these guarantees remain difficult and time-consuming. While many borrowers have difficulty providing the required collateral, demands by commercial banks do not appear excessive and are well in line with normal prudent banking practices. Banks are often prevented by existing regulation from developing new instruments or entering new fields of activity. For instance, the inability to extend loans in foreign currency, particularly in US currency, makes it difficult for banks to finance private entrepreneurs in thie auction market for coffee. Indeed, long delays in shipments of coffee through Dar-es-Salaam, place the foreign exchange risk on exporters who have no practical means to protect themselves. A solution would be for banks to extend loans in US dollars, the currency in which the export sales contracts are denominated. But this is not possible under current foreign exchange regulations. 79. Loan Portfolio. Banks suffer from loan arrears ranging from 3 to 25 percent of their loan portfolio. Doubtful loans have been underprovisioned, to a large eAtent because provisions are not tax-deductible (para. 56).4/ In view of this underprovisioning, the reliability of reported profitability and equity figures is questionable. Recent BRB directives (para. 52) are expected to remedy the situation. Moreover, the high level of credit concentration raises more concern about the vulnerability of some banlrs to a downturn in economic activity. For instance, the five largest users of credit at one large commercial bank account for 40 percent of loans outstanding, the twenty largest for 68 percent. 80. Profitability. Reported profitability by commercial banks varies between 9.5 percent and 20 percent for the rate of return on equity and 0.7 and 1.7 percent for the rate of return on assets. T&CAbS 7 and 8 present margins, operating expenses and profitability ratios for selected financial institutions. They provide a comparison between the\performance of commercial banks and other 4/ Underprovisioning is particularly a serious problem for the bank with 25% of its loans nonperforming. This bank may have some difficulty in constituting rapidly the needed provisions.  - 17 - financial institutions that directly or Indirectly compete with them. The rate of return on equity is higher than the official rate of inflation. Profitability is, however, likely to be overstated because of the inadequate level of provisions. Furthermore, inadequate accounting systems and procedurL. render difficult a reliable assessment of the financial situation and profitability of banking institutions. Problems arise, for instance, with respect to: (a) the treatment of unpaid interest accruals which are sometimes included in income, or consolidated with the loar. principal outstanding, without adequate provisioning; and (b) the lack of distinction between "specific" and "general" provisions, and the inclusion of all such provisions into equity funds. Provisions are thus assimilated to free resources, and profitability and equity generally overstated. To deal with these problems, a new reporting format has been introduced by BRB and a new accounting system for financial institutions will be gradually developed. 81. All banks benefit from a high interest margin. Interest income is supplemented, in certain cases substantively so, by commissions and fees levied by banks. Operating costs vary from a low of about 47 percent of gross earnings margins ( 4.2 percent of assets) to a high of 68 percent of grGss earnings margins (5.9 percent of assets). Interest margins and operating costs have declined between 1988 and 1990. However, they remain high in comparison to those of nonbank financial institutions. The cost of financial intermediation i.e. gross earnings margins, at about 9 percent of total assets, is much higher that of nonbank financial institutions. It is true that commercial banks are involved in retail banking, a costly operation, while other institutions are more involved in wholesale banking. In particular, other institutions do not mobilize small deposits and mainly fund their activities through the issuance of certificates of deposits. Also banks have many more credit files to analyze and process. Banks' operating costs in Burundi are not out of line with those of West African banks, but they are higher than those of industrialized countries and African neighbors. 82. Liquidity. During 1990, most institutions experienced a tightening liquidity situation which resulted in increased recourse to BRB refinancing. The latter more than doubled from FBu 2.1 billion in December 1989 to FBu 4.9 billion in December 1990. Few institutions were able to compiy with the Central Bank required liquidity ratio, even when it included in the numerator non rediscounted rediscountable loan assets.5/ 83. Management and Procedures. There is limited internal capacity to perform reliable flnancial risk analysis. Furthermore, credit analysis is seriously hampered by the absence of accounting within the business community. In many cases lending dec.sions are tWcen on the basis of subjective criteria (the reputation of the borrower, its standing in the community). The taking of collateral is also a problem. While banks lack internal expertise in this area, long de!ays in registering mortgages are also caused by the fact that there is only one notary public for the whole country. Loan monitoring is substandard. Limited staff must monitor a large number of credits on the basis of incomplete information. Loan recovery has been a neglected function with the absence of loan recovery units. Satisfactory internal auditing and control mechanisms do not exist. Bank management is quite aware of these difficulties and is working towards resolving them over time. Some banks are planning to establish special recovery units. Others have hired special staff to register collateral. Credit procedures are being tightened. But mostly, staff needs training in basic banking functions and operations. 84. Overall Situation. The current financial situation of banking institutions appears satisfactory despite the institutional weaknesses discussed in preceding paragraphs. However, because of these eeficiencies, there is a potential for a rapid deterioration in their financial situation that could S/ The newly issued directive does not include non-rediscounted rediscountable credits in the numerator of the liquidity ratio.  - 18 - remain undetected, and uncorrected, for a prolonged period of time. 'The-e is still time to better identify problems and implement corrective measures. The ongoing economic adjustment and liberalization process, which is expected to accelerate, will create new challenges that banks do not appear equipped to cope with. Increased competition (paras. 156-157) is likely to erode margins. Accelerated privatization of many economic activities such as coffee operations, could adversely affect the quality of loan portfolios and profitability prospects. There is an urgent need to strengthen the internal capacity of banking institutions to enable them to implement remedial measures and deal effectively with the coming challenges. Other Deposit-Taking Institutions 85. Three institutions are being considered in this section: CAMOFI, CADEBU, and the Postal savings Systeia, although the latter does not operate under the Banking Law. 86. CAMOFI, a publicly owned financial institution (50 percent government, JO percent BRB) started operating in 1979 with a mandate to channel savings of public enterprises into investments in public sector projects. Table 9 provides summary data on CAMOFI. After a 10 year period of continued growth (1979-89), CAMOFI's activities have contracted over the past two years, significantly so in 1991. In that year, assets declined by 20 percent from Fbu 5.1 to FBu 4 billion and deposits decreased by about 30 percent from Fbu 3.7 billion to Fbu 2.6 billion. This decline is the direct result of the liberalization of the Burundi economy, the diminishing role played by parastatals and the greater freedom given to public sector companies in managing their finances. 87. CAMOFI is profitable (with a rate of return on equity around 12 percent or 4 percent adjusted for inflation, and a rate of return on assets of about 0.8 percent). With 28 employees it has low operating expenses in relation to its net financial product (a ratio of about 40 percent). However, over the last two years, operating expenses have risen much faster than the gross earnings margins. Interest rate margin is low at 1.6 percent, to a large extent attributable to CAMOFI's investment in low yielding Treasury Bills. Liquidity has been declining over the last two years. The ratio of short-term assets to short-term liabilities declined from 84 percent in 1989 to 76 percent in 1991. CAMOFI suffers from a severe lack of portfolio diversification. Assets are highly concenv.rated in two operations: (a) an investment in Treasury Bills of Fbu 1.2 billion yielding 7.5 perccink well below the general level of interest rates and below the yield on Treasury Certificates; and (b) ilong term loans to SIP of Fbu 1.3 billion. Together they represent 68 percent of total loans and investment by CAMOFI.R/ 88. The external audit of CAMOFI performed in 1991 pomnts to several important internal problems: (a) poor shape of accounting records; (b) absence of well ',fined internal procedures; (c) laxity in loan recovery; and (d) lack of adequate internal controls. 89. Although it is a relatively lean and still profitable organizatk,n. CAMOFI is shrinking and its interventions are limited. The rationale for the continued existence of ( AF!OFI as a public institution must be reviewed in light of its increasing costs, declining liquidity, institutional weaknesses and the changing nature of the Burundi economy. Indeed, its function of intermediating between public sector enterprises could be performed as efficiently, if not more so, by commercial banks.