Uganda - Financial Sector Adjustment Credit Project

fonim)_t of The World Bank FOR OFFICIAL USE ONLY RSmt No. P-5954-UG REPORT AND RE NTION OF THE PRESIDENT OF THE INTERNTIONAL DEVELOPMNT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED IDA CREDIT OF SDR 72.8 MILLION (US$100 MILLION EQUIVALENT) TO THE GOVERNMENT OF THE REPUBLIC OF UGDmA IN SUPPORT OF A FINANCIAL SECTOR ADJUSTMENT CREDIT MARCH 5, 1993 I r A. , A '. ' ' l*- 1 ' , 1 -! , 1; ,, This document has a reticted distibution and may be used by reipiens only in the performance of their official duties. Its contents ma ot otedrwse be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit - Uganda Shillings (USh) US$ 1 - USh 1214 (December 1992) USh 1 - US$0.000832 SDR I - US$1.3689 (December 1992) GOVE:RNMNT FISCAL YEAR July 1 - June 30 ABBREVIATIONS AND ACRONYMS ASAC - Agriculture Sector Adjustment Credit BOU - Bank of Uganda CG - Consultative Group CMB - Coffee Marketing Board CML - Coffee Marketing Limited COOP - Cooperative Bank CPI - Consumer Price Index EDP - Enterprise Development Project EEC - European Economic Community EFMP - Economic and Financial Management Project ERC I - First Economic Recovery Credit ERC II - Second Economic Recovery Credit ERP - Economic Recovery Program ESAF - Enhanced Structural Adjustment Facility FSAP - Financial Sector Adjustment Program GDP - Gross Domestic Product ICA - International Coffee Agreement ICB - International Competitive Bidding IDA - International Development Association IFC - International Finance Corporation IMF - International Monetary Fund MFEP - Ministry of Finance and Economic Planning MPS - Ministry of Public Service NGOs - Non-Governmental Organizations NRM - National Resistance Movement OGL - Open General License PAP3CA - Program for the Alleviation of Poverty and the Social Costs of Adjustment PE - Public Enterprise PFP - Policy Framework Paper SAC - Structural Adjustment Credit SAF - Structural Adjustment Facility SDA - Social Dimensions of Adjustment SIP - Special Import Program UDB - Uganda Development Bank UNDP - United Nations Development Program URA - Uganda Revenue Authority USAID - United States Agency for International Development  FOR OFFICILL USE ONLY REPUBLIC OF UGANDA FIANCIAL SECTOR ADJUSTMENT CREDIT PREMEDENrS REPORT1/ TAML OF CONTENTS Page CREDIT SU ARY .............................................. PART I. COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY .. 1 A. The Recovery and Adjustment Pros ........................... 2 B. Economic Performance since 1987 ............................ 4 C. Key Development ssues and Policy Agenda ........................ 6 D. Medium-Term Prospect and External Capital Reurements ......... ..................... 9 E. Country Assstace Strategy ........... ..................... 11 Objectives ........................................... 11 Economic and Sector Work (ESW) and Lending Program ..... ......... 13 Ongoing and Proposed Bank Adjustment Operatons ..... ............ 15 Aid Coordination ....................................... 17 IFC Operations ......................................... 17 F. Relations with the IMP and Other Donors .18 G. Summary Assessment .18 PART I. THE FINANCLAL SECTOR. KEY ISUES AND PERFORMANCE .... 19 A. Sector Structure ............. ........................... 19 B. KeyIssues . .......................................... 20 C. Sector Performance ................................ .... 22 PART m. PROPOSED FINANCIAL SECTOR ADJUSTMENT PROGRAM .... .. 23 A. Objectives and Strategy ..... .............................. 23 B. Policy Reforms ........................................ 24 Fiscal Policy ........... ............................... 24 11/ This report is based on the findings of an Appraisa Mission which visited Uganda in July/August 1992, comprising Ms. F. Ayuw Sumer, AF2PE (Mission Leader and Task Manager) and Messrs. Chukuma Obidegwu, AF2UG, Vincent Rague, CAFCM, James Mallyon, Chris Barltrop (Consultants) and Pad Popiel, AFTEF. Mr. Andrew Sheng, CECFP, was the Lead Advisor and Messrs. Roy Karaoglan, CCMD1, and Paul Murgatoyd, ASTIF, were the peer reviewers. The Counry Strategy Stmet was prepared by Mr. George Gebhart, AF2CO. Mr. Robert E. Hindle and Mr. Francis X. Colaco are the managing Division Chief and Dement Director, respectively. This document has a restricted distribution and may be used by recipients only in the performance of their oMcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  Managementof MonetarY Policy ,, ........................ 25 Interest Rate Policy ....................... 26 Rediscount Policy ............. ....................... 27 Directed Credit Policy ............ . . 27 Policies to Encourage Comeon, Efficieny and Private Sector Participation in the Fmancial System .................... 27 C. Legal and Regu!atory Reforms .............................. 28 The New Bank of Uganda Act ............................... 28 The New Financial Institutions Act ................ ........... 28 The Building Societies Act ........ ................. 29 The Insurance Industry Act ....................... 29 The Lasing Fiance Act ...................... 29 D. Institutional Reforms .............,.,,.,,,,.. 29 Central Bank (BOU) Reforms ............................... 30 UCB Restructuring .................... 32 Non-Performing Loans Recovery Tust (NPLRT) ....... ............ 35 COOP Bank Restructuring ............................... 35 Financial Markets Development .............................. 36 PART nV. FEATURES OF THE PROPOSED CREDIT. .36 A. Credit Objectives and Rationale .............................. 36 B. Credit Amount and Description ......... ..................... 37 C. Procrement and Disbursement .............................. 37 D. Management, Reporting and Audiing .......... .. .............. 39 E. Monitorable Actions and Tranche Release Conditions ................ 39 PART V. EFITSANDRM .................................R. 42 A. EconomicImpact ....................................... 42 B. SociaImpact ................ ..,, , , , ,. 42 C. Risks .,.....,,,,,,,,,,,,,.... 43 PART VI. RECONDIENDATION ................................... 43 ANNEXES 1. Key Economic Indicators 2. Monetary Survey 3. Balance of Payments Projections 4. External Financing Reuiremen 5. FSAC: Technical Assistance Program 6. Staement of Pinancial Sector Development Policy 7. Timetable of Key Credit Processing Events 8. Status of Bank Group Operadons in Uganda 9. Supervision Plan IBRD Map 24729  UGANDA FINANCIAL SECTOR ADJUSTMNT CREDIT (MSAC) CREDT SUMMARY Borrower: The Republic Of Uganda Exeeung Aguey: The Bank of Uganda (Cental Bank) Amount: SDR 72.8 million (US$100 million equivalent) Te : Standard IDA terms with a 40 year maturity Desiption of Credit: The proposed credit would support the Government's first Financial Sector Adjustment Program (PSAP) for the period FY93-95. The principal objectives of the program are: (i) to help maintain a coherent macroeconomic policy aimed at continued stability; (ii) to improve mobilization and allocation of financial resources and foster monetary depening through appropriate interest rate policies, includng maintenance of positive rates on deposits and preferential credits; lowering of non-preferential lending rates and further reductions in directed credit programs; (iii) to strengthen competition ad e.iciency within the banking system through reducing market concentration and encouraging greater private sector participation in all banks; sltrngthenng bank supervision and fostering financial discipline through new legislation and regulations on loan classification, provisioning and capital adequacy; (iv) to enhance the authority and the capacity of Central Bank through legal reforms; a reorganization of its structure; strengthening of its procedures and capabilities and improving its financial position; (v) to improve the efficiency and profitability of problem banks (the UCB and the COOP Bank) through restucuring and recapitalization; (vi) to assist with the development of money and capital markets; and (vii) to help develop the profession of bankers, accountants and auditors in Uganda. Bendks and Ris: The policy, legal and institutional reforms under the proposed credit are expected to establish the conditions for a deeper, more effici-it and diversified financial sector with a stronger banking system at its core. Through the measures proposed, the bandkng system as a whole would be stregted to provide services more efficiently and to a wider spectmr of clients thus spreading the benefits of access to institutional finance and enhancing the system's abilit; to finance invesment and growth. Strengtening the analytical and operational capacity of the Central Bank would increase its effectiveness as the  - ii - monetary and supervisory authority. i'Ris in turn would make the task of managing macroeconomic adjustment easier. Restructuring of problem banks, along with an improved regulatory framework and stronger prudential supervision would help to reduce the economic and social costs of bank failures and increase depositor confidence in the financial system. Enhanced financial performance of banks would also contribute to a reduction in spreads and lending rates, ihus cost of borrowing by the real sectors. The development of capital markets would facilitate savings mobilization and investment, and support the Government's ongoing divestiture efforts. The main risks stem from the uncertainties in the control of inflation. Resurgence of inflation would undermine the financial health of the enterprise sector, public and private, and delay the recoveiy of the problem banks. The persistence of high levels of inflation would also create a major obstacle to the reduction of interest rates. Delays and deficiencies in enforcing the prudential regulations and creating an effective mechanism to deal with the restructuring of insolvent banks would also adversely affect the rehabilitation of the banking system. However, these risks are considered manageable in light of significant up-front actions already introduced by the Government, and its strong commitment to the IMF/IDA supported stabilization and adjustment programs. Rate of Return: Not applicable. Disbursement: The sector reform component of the credit will be disbursed in two tranches; US$45 million equivalent soon after credit effectiveness and US$45 million equivalent after a performance review expected to be carried out about 12 months after effectiveness. The technical assistance component (US$10 million), which would not be tranched, is expected to be fully disbursed by the end of FY96. Map: IBRD 24729.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE WNTERNATIONAL DEVELOPM ASSOC N TO THE EXECUTIVE DIRECTORS ON A ROPOSED FINANCIAL SECTOR ADJUSTMENT CR MAO IN ANAMOUN EOUIVALENT TO SDR 72.8 MILLION (US100 MILLON) TO THE GO VEINT OF THE REPUBLIC OF UGANDA 1. I submit the following report and recommendation on a proposed Financial Sector Adjustment Credit (FSAC) to the Go"-rnment of the Republic of Uganda for the equivalent of SE it 72.8 million (US$100 million) to prov-..e financial support for the Government's Financial Sector Reform Program (FSRP). The proposed credit would be on standard IDA terms with a maturity of 40 years. 2. The proposed adjustment program would build on and complement the reforms already undertaken by the Government under the two Economic Recovery Credits (ERCs) provided by IDA, and the Structural Adjustment Facility (SAF) and Enhanced Structural Adjustment Facility (ESAF) arrangements supported by the IMF. The Government's medium-term economic reform program has been described in its sixth Policy Framework Paper (PFP), 1992/93-1994/95, which was discussed by the Fund's Executive Board on November 25, 1992. An economic report entitled 'Uganda: Managing Public Expenditure" (Report No. 10512-UG) was distributed to the Executive Directors in July 1992. 3. Since 1987, Uganda has made significant progress in restoring peace and security, facilitating general economic recovery and achieving greater financial stability. Over the past two years the Government has moved to address major structural constraints to growth and balance of payments viability. Under these recovery and adjustment programs, the Government has almost fully liberalized the exchange and trade regime; diomantled marketing monopolies in coffee and other cash-crop sub- sectors; lifted all price controls at the wholesale and retail levels; and provided substantial price ncentives to agriculture by continuously passing on the benefits of exchange rate adjustments to producers. To improve efficiency in the public sector, the Govermment has increased the revenue effort, improved the management of military spending and embarked on a major civil service reform. The proposed financial sector adjustment program has been designed to contribute to the ongoing stabilizadon process while complementing the adjustment measures implemented in real sectors. 4. Part I of this memorandum gives an overview of Uganda's economic performance since 1987; the country's medium-term macroeconomic and structural policies for the period of the proposed credit; the Bank's assistance strategy in Uganda; and the Bank's ongoing and proposed adjustment operations. Part II discusses the key issues and performance in the Financial Sector. The proposed Financial Sector Adjustment Program is outlined in Part m. Part IV and V describe the specific features of the credit. PART I. COUNTRY POLICIES AND BANK GROUP ASSISTANCE STRATEGY1/ 1.1. With a per capita income of only about US$160 (1991), Uganda is among the lowest income countries in Sub-Saharan Africa. The major causes of poverty include disruptions brought on by civil 1/ Part I is extacted in substance from the CSP for Uganda (1993), which is under preparation.  -2- war and political istability, unfavorable deveiopments in the world economy and serious economic mismanagement. The country has good growth potential, however. ft is blessed with fertile soils and a good climate. Agriculture is the mainstay of the economy, accounting for more than 50 percent of GDP, about 75 percent of export eaings and around 80 percent or more of employment. It also provides in1 ,ts for a number of n ng and processing industies. The sector is largely subsistence, with the over 80 percent of fammers cultivating less than 2 hectr. The counrry itself is predonantly rural: only 15 percent of the population live in towns and cities. Although it has grown rapidly in the past five years, the industrial setor's contribution to GDP is sfill only about 10 percent, with manu accounting for about half of that share. 1.2. The years immediately following indendence i Octobe 1962 were marked by reasonably strong economic performance. Real GDP growth averaged close to 6 percent between 1963 and 1973. In addition, the balance of paymens was in surplus during most of this period and inflation was low and stable. The advent of the repressive Amin regime changed all that. Large nmbers of business, government and professional people fled the country or were klled and a process of economic decline set in. After the overthrow of Amin in 1979, attempts were made to implement an economic recovery program with the support of the Bank, Fund and other donors. These efforts were soon ovetaken by a renewed civil war in 1981-1985 which resulted in escalating military expendiu, rising inflation and overvaluation of the domestic currency. Much of the country's economic and social infrastutre was destroyed, especially in rural areas, and production stagnated. The present Govenment, which assumed power in mid-1986, has committed itself to sweeping political and economic reforms. A. The Recovery and Adjusbent Program 1.3. Objectives. Uganda embarked upon an Economic Recovety Program (ERP) in May 1987. The objectves of this program are to alleviate poverty and improve standards of lving generally. To achieve these objectives, the progrm includes policy and structural reforms aimed at: (a) regoring internal and extnl financial stability and lowering inflation through improved fiscal and monetary performance; (b) accelerating growth in production and exports by providing incentives through liberalized pricing and less regulation of economic activity by govenment and by encourang savmg and invenent (c) restoring, rehabilitatng and selected expansion of social and economic ifrtuure; and (d) enhancing the prospects for long term growth and efficiency, with a major goal being to reduce the direct role of the government and enhance that of the private sector. 1.4. Progress Achieved. Considerable progress has been achieved during the past six years in implementing the program. The first priority has been to stabilize the economy. Government's goal is to reduce inflation to a level comparable to inflation rates in the country's major trading partners. To this end, measures have been taken to conain both fiscal deficits and monetay growth. Greater conrol is being exercised over public yxpdu and efforts are underway to improve tax a on, broaden the tax base and eliminate losses of parastatal enterprises and marketing boards. In October 1990, Government undertook to maintain positive real interest rates of at least 4 percent. rTis has generally been observed, although rising inflation towards the end of 1991 led to some slippage in implemaion. A major step was taken recenly when lending and deposit rates were linked to the Treasury Bill rate, which is determined on an auction market. The Government intends to phaw out interest rate controls as soon as possible under the Program. Two important sources of monetary instability were eliminated recendy when the Bank of Uganda (BOU)- the Central Bank- withdrew from financing coffee marketing and the Government began to reduce its borrowing from BOU. The Govemment is taing strong  -3- measures to reduce its budget deficit and is planming large repaymens to the banking system over the PFP period. 1.5. Success in reaching the fisca and monetary targets, while at the same time providing adequate public services and a liveable wage for civil servants, will require a substantial increase in public revenues. At present, the domestic revemne effort is exceptionally low. The ratio of revenue to GDP was 5.4 percent at the beginnig of the BRP, and has since risen to about 7 percent as a result of changes In the structure of taxes and, more importantly, improvements in tax administraton following the establishment of the quasi-independent Uganda Revenue Authority (URA). This ratio is still very low compared to the average of about 20 percent for Sub-Saharan African countries. The problem in part was caused by the demise of the coffee eport tax, which had long been the mainstay of domestic revenues. The loss of this tax hurt the revenue effort significantly, but from an incentive point of view the tax had become unsusainable in the fce of very low intenational coffee prices. Even assuming a very strong effort by the URA, revenues are expected to rise to only 12 percent of GDP by PY1994/95, and are not expected to reach 20 percent until the year 2001. Within its fiscal constaints, the Government is protecting the priority public services (health, education, water and sanitation, road maintnce, agricultural reseach and extension) from budget cuts mainly as a poverty alleviagion measure. At the same time, it has iitiated a program to demobilize a large part of the army, which is expected to result in significant savins in future defnse budgets. 1.6. On the external sector, a mnmber of important reforms have been taken to boost exports and improve the balance of payments performance. The foreign exchange system bas been substantially libealized. A foreign exchange auction was introduced in January 1992 to allocate import support. This provides an important complement to the forex bureau (introduced in July 1990) which allocate non- coffee export receipts, private remitc, etc., to a variety of uses according to market demand. Those few transactions for which the Bank of Uganda (BOU) remains responsible, i.e., goverment imports, imports of pznroleum products and debt srvice, take place at the average bureau exchange rate. Consequently, exchange rates are now essentlay market-detemined, although the markets are not fully integrated The rate difference between the auction and bureau markets is about 10 percent. In addition, with minor exceptions, quantitve restictions on trade have been removed. As a result of the reforms, the real effective exchange rate (REER) has depreciated by about 85 percent since the ERP was introduced, substantially increasing Uganda's competitveness in external markets. This is reflected in the strong growth in non-traditional exports during this period. 1.7. In a further effort to stimulate expors, the Government has begun dismantling the existing marketing board arrangements, including those govering the country's traditional export crops, e.g., cotton and tea. The Coffee Marketng Board (CMB), which long held a monopoly on exporting coffee, has already been tructured and is now optng as a commercial organization. A number of private operators have been authorized to ene in the ccffee export trade. The regulatory function, to ensure qualiy, etc., has been shifted fom CMB to an indepeMent body, the Uganda Coffee Development Authority (UCDA). A similar rmesuing process is underway in the cotton subsector and the major tea estates in goverment hands are to be sold off to private buyers as part of the privatization program. 1.8. It will not be possible to accelerate economic growth significanty in Uganda without full imvolvement of the private sector. Governmen ownershp of commercial activities, including expropriated propeties, has proven very costly for the economy. Recognizing this, the Government has introduced measres to stimuate private investnent and growth. Price controls have been totally abolished. A new Investment Code providing fiscal incentives for private entrprens bas been adopted and the Uganda Invesuent Authority (UIA) has been established as a "one stop shop" for investors to  -4- spearbead the investment promotion effort. As evidence of the Govermnent's commitment to the rule of law and to improving the business climate, large numibers of properties expropriated by the Amin Government in the early 1970s have been returned to their original owners. Studies are currently underway to determine the disposition of properties for which no repossession claim has been filed. Also, Uganda has begun a far-reaching parastatal reform and divestiture program, under which a large number of public enterprises are to be privaized and non-viable ones closed down. Nine enterprises have already been offered for sale and two have been sold. Lasdy, much of the country's basic infrastructure has been rehabilitated, especially in the transport sector where nearly all of the major tunk roads have been improved. 1.9. The Government has also embarked on a comprehensive civil service reform, which is expected to have a major positive impact on the efficiency of govermment operatioss. To date, the number of ministries has been reduced from 28 to 18 and the Government has begun the functional rationalization of ministries. This latter is designed to focus the ministry's efforts on essential functions and ta slim down the public sector by eliminating umecessary tasks and redundant employees. Prior to initiating this program, the Govermnent retrenched about 5,000 employees who were either past retirnent age, had entered the service ilegally, had disciplinary or drinkdng problems, or were not capable of handling their job. In addition, ghost employees have been culled from the civil service payroll, including from the teachers payroll, and the number of group employees (day workers) has been reduced by about half. Lastly, the Government is working out a strategy for implementing the remaining civil service reform agenda. B. Economk Perfornance Since 1987 1.10. Growth and Sbiliain. The response of the real economy to the reforms has been encouraging. Real GDP grew at the amnal average rate of 5.9 percent over the past five years compared to 1.9 percent during the preceding five year period. One of the more important factors underlying this strong growth was the restoration of peace and security over most the country which allowed farmers access to their lands. Other significant factors include greater reliance on market forces as exemplified by the virtual elimination of price controls and the introduction of a market-based exchange and trade system, and the measures taken to improve the investment climate. This contributed to a strong recovery in the manufacturing sector. Also, mainly becase of the large real depreciation of the Uganda Shilling (USh) associated with the trade and exchange reforms, Uganda's competitiveness in international markets has improved substantially. Non-traditional exports have expanded ten-fold during the period. The rehabilitation of basic infrastructure, particularly roads, has also made an important contribution to the supply response. 1.11. While Uganda's growth performance has been good, its record on stabilization has been mixed. When the ERP got underway, inflation was riming at about 240 percent. Durng the next two years imflation was slow in coming down, but then the Government began to tighten fiscal and monetary policies, causing inflation to decelerate sharply. By January 1991, year on year price rises had fallen to an annual rate of less than 20 percent. Unforuntely, during the second and third quarters of FY92, a widening gap between Government revenue and expendte financed by the Central Bank, coupled with drought-induced food price rises, reignited inflation. By May 1992, the year-on-year inflation rate had risen to 66 percent. Once aware of the problem, the Government took drastic measures to tighten fiscal policy and slow monetary growth. Through the remainder of 1992, prices remained essentally steady and the annual rate of inflation had fallen to about 30 percent in January 1993.  -5- 1.12. Impact of Exogenous Factors on Economic MPeformance. Uganda's economy is highly vulnerable to oxternal shocks. As a landlocked nation, it is dependent upon its neighbors for outlets to the sea. Its vulnerability in this regard was highlighted recently when Kenya closed its borders with Uganda because of its own internal political uneertainities. Although this has nothing to do with Uganda per se, it disrupted the country's external trade. The only other alternative is the longer routing through Tanzania, which is significantly more expensive. Also, the country is over dependent on a shigle commodity for its export earnings. Because of its high dependence on coffee at that time (95% of export receipts), Uganda's balance of payments was hit hard when world coffee prices collapsed following the suspension in July 1989 of the quota arrangements under the Iternational Coffee Agreement. Coffee export receipts have consequently declined sharply, from US$286 million in FY88 to US$117 million in irY92. The Government responded by removing the remaining internal biases agawist coffee exports and by accelerating the liberalization program. It abolished the requirement that coffee export proceeds be surrendered to Bank of Uganda at a rate less favorable than the market rate and it opened up coffee export marketing to competition from private operators. It also moved quickly on the trade, payments and exchange rate reforms to increase non-traditional exports and expand the export base. Thus, in spite of the sharp decline in export earnings, imporns continued to rise in line with GDP growth (until recently), thanks to import support inflows, rapid gains in nontraditional export receipts, a rising level of private transfers, official debt rescheduling and, unfortunately to an accumulation of arrears. Imports fell slightly in FY91, followed by a more pronounced contraction last year, mainly reflecting slower absorption of both project aid and import support, and some reduction in the dependence of the economy on imports. 1.13. Povert Alleviation. Real GDP per capita has increased significantly in both rural and urban areas over the past five years. Recent Bank poverty work has estimated that on average the welfare of the rural and urban poor improved in real terms by 14 and 16 percent, respectively, during this period. Although there has been some redistribution of income in favor of rural areas since the early 1980s, a rural inhabitant is more likely to be poor and his degree of poverty is more severe. The extent to which the improvement in welfare is attributable to the adjustment program, as opposed to other extraneous events (e.g., increased security), is unclear. There has been recent improvement in the terms-of-trade (TOT) for the producers of cash crops, due to the exchange, trade, and marketing reforms that have taken place in these areas. On the other hand, the TOT of food items produced for the market have deteriorated because of the increased supplies on the market. The increases in output of food crops exceeded the price declines, however, thereby raising producers incomes. The reduction of the inflation "tax" has certainly helped all Ugandans. There has also been some improvement in the access to public services in Uganda as a result of increased spending on these services at the national and local levels, although an enormous amount remains to be done. 1.14. Debt Reduction Program. Uganda has serious problems in servicing its external debt. The stock of debt outstanding and disbursed (DOD) was estimated at US$2.6 billion as of June 30, 1991, of which approximately US$371 million was in arrears. The DOD was over 100 percent of GDP that year. Approximately 63 percent of this debt is owed to multilateral organizations, with the World Bank and IMF accounting for about 80 percent of the multilateral debt. Although the debt has been contracted on largely concessional terms, scheduled debt service substantially exceeded exports of goods and services in 1991 and 1992, and is projected to average nearly 70 percent of exports through 1996. Because of the high proportion of multilateral and Paris Club post cut-off date debt, a relatively small proportion of the debt service is reschedulable using the normal avenues for rescheduling.  -6- 1.15. The Government, assisted by a team of international financial advisers, has developed and is currently implementing an external debt strategy with the aim of resolving this problem within a three year period. The strategy has five elements: (a) year-by-year rescheduling of eligible Paris Club debt; (b) maximum annual deferral, on a bilateral basis, of post cut-off date debt; (c) write-off or long-term rescheduling of arrears and debt owed to non-OECD bilateral creditors; (d) buyback of uninsured commercial debt; ani (e) mobilizing bilateral donor assistance for servicing multilateral debt. Good progress has been made in executing this strategy. The Government requested, and IDA agreed to, the use of the Debt Reduction Facility for IDA-only Countries to purchase part of the debt outstanding to uninsured commercial creditors. Some $153 million of commercial debt (about 6 percent of total debt) was bought back at 12 cents on the dollar under this program. Uganda also received favorable treatment in a Paris Club rescheduling ii June 1992. Successfil implementation of the full strategy would reduce the country's debt service obligations to less than 50 percent of total exports of goods and services in FY1993/94 and reduce external arrears to about $80 million. In parallel with the debt strategy, the Government has begun improving the institutional framework for debt management and aid coordination. C. Key Development Isu and Policy Agenda 1.16. The Government's economic recovery and reform program is specified in the Uganda Medium- term Economic and Financial Policy Framework Paper, FY93-95, dated October 30, 1992. The key development issues facing the country are described below. 1.17. Achieving Balace Betwee Sabizaon and Growth. As discussed above, Uganda has been successful in containing inflation over the past six months, although at a high cost to public services and development programs due to expenditure constraints. It is essential that the Government stay-the-course on stabilization and that inflation remain under control. This must be the first priority of macroeconomic policy. It is also important that the economy grow as much as possible within a stable framework in order to create jobs and income opportunities. The Government has the delicate task of mangii;g monetary and fiscal policy to achieve these sometimes conflicting objectives. As a means of doing so, it has chosen to reduce sharply the overall budget deficit (the major source of past inflationary pressure) in order to allow for an expansion of credit to the private sector, the main source of productive jobs. Achieving this will require close monitoring of the budget and monetary aggregates and close cooperation between the Ministry of Finance and the Bank of Uganda. 1.18. Growing out of Poverty. To make a serious dent in poverty over the next decade, Uganda will have to accelerate economic growth and employment creation. Investment in human capital and targeted delivery of key services will be needed to ensure that the poor are able to participate in that growth. The development strategy currently being pursued by the Government is designed to achieve these objectives. There is strong commitment to reform in the country, so the principal challenge ahead lies in building the capacity to ensure that the needed policies and programs are implemented efficiently. Of primary importance are actions to promote investment backed by domestic savings and actions to ensure high rates of literacy and mmeracy, and improved health. Increased access to priary education and technical training, improved labor market information services and enhanced labor mobility, rapid dissemination of improved technology (especially in agriculture), and greater attention to gender-specific issues designed to raise the productivity of women are all critical to broad participation in the benefits of growth. Expanding key services to the poor will require gready increased tax revenues and much greater focus of govermnent expenditures on high priority programs.  -7 - 1.19. Enhncing Private Sector Devdopment. It will not be possible to accelerate economic growth significandy in Uganda without full involvement of the private sector. Experience in Uganda has shown clearly that the public sector is not capable of operating commercial enterprises efficiently; government ownership, including the expropriation of properties, has proven very costly for the economy. At present, the National Resistance Movement (NRM) is reducing government's direct involvement in the economy and adoptig policies to promote private activity. The private sector reforms need to be continued. 1.20. However, while the right policies and programs have been introduced, there are still serious problems of implementation that are suppressing private initiative. The Investment Code needs to be strengthen to enhance its promotional focus. The operations of the UIA need to be reviewed with a view to increase their effectiveness. Many investment approvals have been granted by the Authority, but little in the way of investment has taken place. A start has been made on the divestiture/privatization program, but progress has been slowed recently. Efforts need to be made to involve more local private entrepreneurs and investors in the privatization process as purchasers. In agriculture, which is mainly private smallholders, government services, e.g., research and extension, need to be improved substantially and land tenure issues need to be addressed to improve access to land. The lack of credit for working capital and term lending for invesatent is a major constraint on private sector activity, so early and effective reform of the financial sector is critical. Entrepreneurial, management and worker traimng to raise productivity is essential if Uganda is to be able to compete in international markets. Lastly, the rule of law must prevail, and be seen to prevail, if investors and businessmen are to have the confidence to undertake investment and business activites in the country. The progress made in reurning expropriated properties needs to be extended by disposal of those properties remaining in government hands. 1.21. Publc Ad trton Reform of the civil service is a key element of the Governiaent's economic recovery program. It is difficult to see how the program can succeed without a revitalized civil service. The goal is a slimmed down, highly professional and well-remunerated civil service, that is free of corruption and political interference. The issue is not one of commitment, but one of implementation. It is basically a lack of capacity to design and carryout this type of comprehensive reform. For the Govemment to retrench large numbers of employees in a situadon of widespread lack of jobs requires quite a bit of political courage and commitment. In addition, retrenchment is financia''y costly for government and little in the way of budgetary savings will be fordtcoming from Le cment because salaries are so low to begin with. There is also the cost of the salary enhancement program, which is expected to be quite high. The latter will be phased in, probably over a three to five year period, but to the extent that this is dragged out it defeats the urgency of the reform. The rGovermnent hopes to receive substantial donor fmancial support for civil service reform, but the donors have indicated reluctance to finance retnchment and salary enhancement. This places an even greater urgency on the mobilization of domestic resources by the URA. The immediate step, however, is to complete the ongoing studies and develop an implementation strategy and plan. 1.22. Aelerating Domesic Resource Mobzon. The need to provide adequate public services, especially for the poor, is critical. AIDS will add tremedly to public health care needs in the future and there will be ever larger numbers of children clamoring to find places in public schools. Infratucur rehabilitation, particularly improving feeder roads to open agricultural areas, will require large amounts of public funding. The rehabilitation needs of the northern areas of the country, which have just recenty become secure, are massive. There is also the existing development budget which is financed largely by donors, but requires domestic countepart. Goverment efforts to broaden the tax base and improve tax collections need to be intensified. Expenditure rationalization must also receive  -8- high priority, so that the most pressing needs are met and resources are not wasted. All of this must be accommodated within the parameters of the stabilization program and thus will require adroit economic management. 1.23. Since private initiative is expected to be the engine of growth, the mobilization of resources in the private sector is important. In this regard, the continued maintenance of positive real interest rates to encourage savings is critical. It is important that government not absorb a large proportion of this savings through deficit financing by the banking system. Strengthening of the banking system to ensure effective intermediation of financial resources is also crucial. 1.24. Achieving External Balance and Reducing the Dependence on Foreign Savings. Uganda has been highly dependent on foreign savings for the past few years, especially since the demise of the ICA. Practically all of this savings has come in the form of grants and credits from the international community, with little coming as direct foreign investment. Not only does the dependence on foreign savings need to be reduced, but in the future an increasing portion of foreign financing should come from direct foreign investment. With the growth of non-traditional exports, the proportion of import-support in donor flows should be significantly reduced in the medium to long term. Also, the use of import- support must be managed carefully to avoid undermining the incentives provided through the exchange rate and reversing the trend towards a lower import content of production and consumption. 1.25. Investing in People. Shortage of skills is a major constraint on development in Uganda. Although the problem is serious in many fields, managerial, accounting and administrative capacities are particularly important deficiencies and need immediate attention. Improvements in basic education should receive high priority, along with technical and vocational training. This wil help to increase the general level of literacy, numeracy and technical skills, which are vital to sustained development. As managers of the government's recovery and reform process, the public sector needs to attract the best qualified professional and administrative people. To enable this to occur, the Government needs to complete the civil service reform program and begin paying civil servants a competitive wage as quickly as possible. 1.26. Gender Responsive Growth In addition to being heavily involved in economic production, women are responsible for household management and care of the sick and elderly in Ugandan society. They work longer hours, with fewer resources, fewer opportmities and lower rewards than men. They account for 80 percent of food production and supply 70 percent of agricultural labor. They are mostly confined to the subsistence sector and have access to little in the way of technology. Their responsibility for managing the household includes child-rearing, food preparation and family health and welfare, all without benefit of modern labor saving devices. They have much less access to education than men and, because of their heavy workload anid high fertility rate, have more health problems. Consequently, any strategy to reduce poverty and foster sustainable economic growth needs to take explicit account of the gender dimension. 1.27. The priority areas requiring attention to enable women to contribute more fully to economic and social development are: a) legislative reform efforts to establish legal rights and protection, enabling women to benefit from their own labor and have greater access and control of economically productive resources; b) investments in literacy and education aimed at overcoming social, financial and cultural barriers to full female participation in economic activities; c) investments in health care responsive to the wide range of women's health needs; d) investments in targeted programs aimed at raising women's access to credit, extension services, technology and inputs; e) programs that take specific account of female user's needs for labor saving technologies, e.g., transport, feeder roads, markets, etc.; and f) the  -9 - provision of political and financial support to efforts to reduce the AIDS risk among young girls and to protect the rights of children. 1.28. Protecing the Environment. Uganda Is endowed with great diversity of animal and plant species, with a diversity of habitats that ranges from grasslands to mountain forests. Use of these resources was for decades of no serious concem and the country even today is relatively well-placed in terms of environmental status compared with other African countries. On the other hand, the economic development that has taken place has largely ignored enviromnental considerations and there are now serious environmental concerns comiing to the fore. One of the most important of these concerns is the very high rate of population growth. The rapidly expanding population will put heavy pressure on the nation's natural resources and even further overstretch the public sector's ability to provide the minimal services in health and education. Rapid increases in population are beginning to strain the balance of food production and in some areas have increased sharply pressures on the country's natural resources, particularly the land. Extensive encroachment into forest and game habitats has already occurred, with serious harm to ecosystems. If the present rate of destruction continues, the damage to ecosystems would reach major proportions by the turn of the century. In addition, ecological damage to Lake Victoria has increased in recent decades. The extensive period of armed conflict caused considerable damage to ecosystems and the current unrest in neighboring Rwanda is threatening wildlife habitat in border areas with Uganda. 1.29. In 1986 the Ministry of Environmental Planning was created as a first step in centralizing responsibility for environmental issues and ensuring the design and implementation of a national environmental strategy. Performance to date has been disappointing, however, mainly because of resource constraints, shortages of qualified staff and budgets, and a lack of a legislative framework for its operations. Uganda, therefore, still lacks the policy, insdtutional and legislative framework to protect and manage the environment. Among the priority issues that need to be addressed are: a) rapid population growth; b) land management, to ensure sustainable agricultural development and protect against nisuse and destruction of natural resources; c) protection of wetlands, especially to engender a better understandg among the population and politicians of the benefits of these areas; d) conservation of forests and wildlife, to preserve diversity, prevent deforestation and permit ecologically sound use of these resources; e) surface water management, including controlling pollution from human, industrial and mining activities. The actions required include strengthening of the institutional framework for protecting the environment and development of a national environmental strategy and action plan. The necessary legislation needs to be adopted to make environmental management effective. D. Median-Tenn Prospects And External Capitl Requirments 1.30. Prospects for Growth Uganda's growth prospects are quite favorable. Agriculture has good potential and is expected to contribute a solid base of futre growth. Within the sector the emphasis is expected to shift from food production for the domestic market, which fueled recent growth, to production of raw materials for processing or for direct export. The domestic demand for food is now largely met, so future growth in demand will be driven by population and per capita income growth. On the other hand, with the trade and exchange reforms in place, production for export and further processing should grow rapidly. Regional markets will be increasingly important and Uganda will be looking to those markets. Periodic drought can be a problem as was evident in the past couple of years and esonal labor shortages could be exacerbated by the AIDS epidemic. Uganda still has some room for expansion of area cultivated, but increasingly growth will have to come from higher yields. Land  - 10 - temnre reform and improved research and extension services will be important if sector output is to expand. 1.31. Industry grew more rapidly tban any other sector over the past five years, with man uri, especially basic consumer goods and the processing of agricultural raw materials, leading the way. While these growth rates are probably not sustainable, growth in the sector is expected to remain strong as manufacturers substitute for imports and agroprocessing expands. The key to growth in the sector is private investment. Establishment of the Uganda Investment Authority (UIA) as a 'one stop shop' for foreign and domestic investors should help break through the bureaucracy and speed approvals of investments. With removal of the investment licensing requirement, resolution of the expropriated properties matter and reduction of government's direct role in the sector through the privatization program, investment is expected to increase significantly. While industry itself constitutes only about 10 percent of GDP, and thus will have a limited impact on overal growth, it wil encourage similar growth in the utilities and service industries. Real GDP growth of 5 percent is expected for the next five years, with per capita growth of 1.5-2.0 percent. 1.32. External Capital Req enIs. The sustainability of the targeted growth rates and the country's reform agenda will depend critcally on adequate exernal financing, since the country faces an extremely difficult balance of payments situation, at least undl the turn of the centy. Interational price prospects for coffee remain bleak, with the price of Ugandan coffee projected to remain in the US cents 80-90 per klo range for the next few years, implying prices which will be less than fifty percent of what they were in 1986-87. While the volume of coffee exports should receive a boost from the contined increase in domesdc producer prices, the production response could only marginally compensate for the large decline in world market prices. Non-coffee exports should contime to benefit from the elimination of marketing monopolies and the policy of 100 percent retention of foreign exchange earnings. However, given the extremely small base of these exports, a significant impact on the balance of payments can only be expected over the medium term. At the same time, the country needs a minimum level of imports to meet its growth and stabilizadon targets. 1.33. The targeted 5 percent growth rate would necessitate broadly that non-project imports including raw materials, semi-finished goods and petroleum products, grow at roughly the same rate in volume. This implies non-project import requiremen of about US$313 million in current fiscal year, rising to US$ 377 million by FY94/95. The current account deficit (excluding official transfers) for the next three fiscal years (FY93-95) is expected to total US$1.3 billion (Annex m and Annex IV). During the same period, scheduled princi repayments on external debt (excluding the IMF) are expected to total around US$231 million. External reserves are targeted to rise by US$45 million during the same period and a cash payment of US$77 million is exected against the stock of arrears. These factors, together with scheduled IMF repurchases of US$53 million, are expected to result in a total financing requirement for the three-year period of US$2.3 billion (Annex IV). 1.34. Ugana received approximately US$400 million in official development assistance during FY89 - FY90, represendng US$25 of aid per capita, approximately 55 percent of which came from multilateral sources. While IMP ESAF resources would be available in the short run, over the medium-term, such resources would net out to zero as a result of the associated debt service obligations. Over the next three years durng FY93-95, disburements from existing commitmenare estimated at US$913 million. Disbusement from new commitents are projected to be around US$637 million, of which approximately US$373 million would be quick-disbursing with US$150 million coming from IDA, including FSAC. Disbursements from existing pipeline and new commiments would thus bring the total available resources over the projection period to around US$1.6 billion, leaving a f gap of  - 11 - approximately US$750 million. This gap is expected to be filled from (unforseen) new commitments of US$110 million (the reddual finacng gap) and exceptional assistance of US$640 million, including debt-forgiveness and debt rescheduing. E. Country Assistance Strategy Objectves 1.35. The main objectives of the Bank's assistance strategy for Uganda have not changed significantly since the strategy was last discussed with the Executive Directors in December 1991. These are first and foremost to stabilize the economy, and then to alleviate poverty by bringing about an acceleration of economic growth and by improving the delivery of p-ublic services to the people, particularly the most vulnerable groups. Stability is to be achieved through firm control over the budget deficit and monetary growth, reinforced by a strengthened financial system, while an acceleration in growth is to be accomplished by removing the remaining regulatory impediments in the way of the private sector. IDA will continue to assist with the rehabilitation of essential infrastructure, focussing primarily on feeder roads, and to help the Government provide basic economic and social services, e.g., health, education, research and extension. To underpin these efforts and ensure their sustainabiity, IDA will support civil service reform and capacity building, together with a reduction in the direct involvement of government in commercial activities. For the next couple of years the emphasis will be on implementation of existing reforms, e.g., civil service reform, privatization and parastal reform, financial sector reform, etc., as opposed to introducing major new initiatives. 1.36. Although the main objectives of Bank assistance to Uganda will not change, there will be some significant changes in emphasis. Pirst, the emphasis on donor import-support is expected to begin to decline in the medium term. Given the increased flexibility provided by recent changes in the trade and payments system, the rapid increase in non-traditional exports, the further expected decline in the country's import dependence (ImportslGDP), and implementation of the country's debt strategy which wil lower the need for debt service payments, donor quick-disbursing import-support is expected to finance a progressively smaller proportion of total imports over the medium term. Once the markets are unified, the country should have sufficient foreign exchange to pay debt service (not now being paid because of the lack of free foreign exchange available to BOU) and finance the increased imports required by accelerated economic growth. While IDA lending for import support is expected to remain at the present level in the short term, over the medium term IDA is expected to shift increasingly from import support to in estment projects. 1.37. Second, there will be a greater focus to IDA's investment lending and sector work, with a view to increasing the effectiveness of those programs. The focus will be on those activities that have a major impact on poverty alleviation; a return to the basics of health and education, infrastructure rehabilitation (including feeder roads, clean water and sanitation facilities) and essential productive services such as agricultural research and extension. Recently completed sector work in agriculture, transportation and the social sectors will provide the basis for this more focussed approach. Also, IDA is currently working with the Government to rationalize the public investment program, including the existing portfolio. At present, the number of ongoing projects is unsustainable. Government is not able to provide the counterpart resources needed for these projects and most of them have been languishing for years, with little or no progress being made. Moreover, insufficient attention is being paid to the fuiture recurrent costs of development projects. The current PIP work is expected to reduce the size of the investment  -12 - program to a high priority core program that is within the country's projected resource availabilities. IDA will support this effort by rationalizing its own investment portfolio in Uganda. 1.38. A third shift in emphasis will be towards Sector Investment and Maintenance (SIM) programs, in which the Association will finance a time slice of sector investment programs and mobilize donor support behind sound sector policies and investments. This will depend upon the extent to which implementation capacity improves. By spreading itself less thinly and focussing on fewer sectors, IDA hopes to increase significantly the effectiveness of its support to Uganda. Also, by improving aid coordination on sector programs, this approach is expected to avoid duplication of effort which now exists in donor programs. 1.39. Fourth, a much stronger emphasis will be placed on implementation, starting from the time of project identification and design to final completion. Overall disbursements on the 29 investment projects in the Uganda portfolio are satisfactory as compared to the disbursement profile estimated at appraisal, though there has been a decline in disbursement performance due to the increasingly young age structure of the portfolio, a relatively weak institutional capacity, and insufficient counterpart funds. On some of the older projects, the civil war and subsequent turmoil and lack of security delayed the start of implementation by about two years. Poor design with overly complicated projects has been an important cause of implementation delays and eventual low rates of return on these investments. Projects will be simplified and supervision stepped up to enhance implementation. At a Country Implementation Review, jointly organized in May 1992 by Government and the Bank, the main recommendations for improved Implementation performance focussed on measures to ensure: adequate and timely release of counterpart funds; timely procurement of goods and services; adequate use of Special Account funds and prompt disbursement processing; improved financial management, budgetary controls, and compliance with audit covenants; expeditious credit effectiveness; and effective project management and coordination. At a follow-up CIR held in Febmary 1993, further measures were adopted to reinforce progress already being achieved in implementing the above recommendations. Projects that do not perform will be shut down and unexpended balances canceled to avoid tying up valuable domestic and foreign exchange resources. This approach will complement the rationalizadon of the public investment program that is presently underway in Uganda. 1.40. IDA's assistance to Uganda will also have three other major thrusts during the next three years. All projects, to the extent possible, will promote benefits to women participants. The agricultural research and extension project will seek out women farmers and address the problems inherent in their special circumstances. Road maintenance and feeder road projects will, to the extent possible, impact on areas with high concentrations of women farmers. Health and education projects will stress the needs of women and children, with particular emphasis on maternal and child care, and vulnerable groups, e.g., orphans from wars and AIDS. The education of girls will be an important objective of IDA's efforts in that sector. All IDA projects will pay due regard to the environment; the objective being to leave the environment better than if the project hadn't taken place. In addition, IDA is assisting the Government to develop an environmental action plan and proposes to assist with the implementation of that plan once it is ready. To complement this, IDA is cooperating with the Government through the Global Environmental Fund (GEF) on a study of pollution in Lake Victoria and a project to protect the mountain gorillas in Western Uganda. In addition, IDA intends to underscore much more the benefits of family planning, both as a women's issue (health, etc.) and as a population issue (so that Uganda does not join the ranks of couties that cannot feed themselves).  - 13- 1.41. In summary, the Bank's assistance strategy aims to assist Uganda: to maintain macroeconomic stability, by improving revenue collection and control of public expenditure, by reordering public expenditure priorities, by enhancing monetary management and control, and by achieving a unified foreign exchange market; to improve the climate for private investment, production and exports, by eliminating the remaining barriers to competition and efficiency, by removing the remaining market rigidities and imperfections, by privatizing public enterprises; by overhauling the financial sector to enhance the mobilizaton of domestic resources and their efficient allocation, and by rehabilitating infrastructure and strengthening the provision of essential government services; - to enhance human resource development, especially of women, by increasing the allocation of resources to education and health, by placing greater emphasis on basic needs in these sectors, and by slowing the rate of population growth; - to stem environmental degradation and promote conservation, and; - to mobilize and coordinate external assistance. Economic and Sector Work (ESW) and Lending Program 1.42. The Bank's lending and economic and sector work (ESW) programs will support the framework outlined above. IDA lending operations will be based on the substantial ESW carried out over the past three years. The sector work completed during this period included major reviews of agriculture, industry, transport, finance and the social sectors. Also, the situation of women and the impact of AIDS has been analyzed. There was also an assessment of the constraints on the private sector as well as a review of the export potential for a number of crops in which Uganda has comparative advantage. The economic work has helped identify the macroeconomic measures needed for laying the basis for sustainable long term development. Of particular importance are two Public Expenditure Reviews (PERs). The first one focused on the size and composition of public expenditure across sectors as well as within sectors, while the second one emphasized the process of public expenditure management. A Country Economic Memorandum (CEM) whose theme is poverty alleviation through accelerated growth and improved human resource development will be issued later this fiscal year. 1.43. In the near term, the Association will work with Government on a Public Investment Program and a Poverty Action Program, with the latter based on the recent Country Economic Memorandum on poverty and the Social Sector Study. In addition, the National Environmental Action Plan should be completed during this period. A CEM is planned in FY95 focussing on civil service reform and parastatal efficiency. Sector work will concentate on four priority areas, roads (formulating a district roads strategy), industry (conmpetitiveness and investment constraints), agriculture (land tenure and other issues) and water supply (needs assessment). 1.44. IDA lending during FY93-95 aims at a balance between investment projects and quick-disbursing import-support, with the latter declining as a proportion of total lending, especially in the latter years. As regards investment lending, IDA is supporting an Agriculural Extension Program and an Agricultural Research and Traimnig project, which were approved by the Board on September 29 and December 15, 1992, respectively. These projects are based on recently completed agriculture sector work and have as  -14- their objeetives increases in yields and the incomes of small farmers, especially women. These projects will have strong povertyr lleviation and women in development impacts. The Board has also approved (August 4, 1992) an Economic and Financial Management project to provide technical assistance in economic and financial management to the Ministry of Finance and Economic Planning, and to Bank of Uganda. This project will improve fiscal and monetary perfomace, and raise human resource capacity in the main economic ministries and agencies (e.g., URA, budget office). IDA's first Financial Sector Adjustment Credit, which is before you today, is designed to strengthen the banking system and BOU, and thus has a strong capacity building focus. The recently-negotiated Fifth Education project, which will focus on improving primary education, will have longer term poverty alleviation and capacity building implications. In FY94, IDA expects to support a Transport Rehabilitation Project to rehabilitate feeder roads and improve road maintenance, a Small Towns Water Project to bring potable water to small towns and ural villages, and a Health and AIDS Project focused on rural clinics and designed to assist Uganda shift from curative care to community and preventive health. The latter project is expected to have a significant AIDS component aimed at stepping up the fight against a disease which is ravaging the population, while the former two have growth, poverty alleviation and WID aspects. Subsequent investment lending is expected to include Export Development and Cotton Development (FY95), followed by Institutional Development and Rural Roads projects (FY96). These projects will have an important bearing on poverty alleviation, especially those in agriculture which provides a livelihood for 80 percent or more of the population. 1.45. IDA's proposed adjustment lending includes a quick-disbursing import support operation each year. The objective is to keep supporting the policy and institutional reforms needed to ensure that the economy returns to the path of self-sustained growth. After the Financial Sector Adjustment Credit, IDA is expecting to provide Second Structural Adjustment Credit (SAC II) to consolidate and deepen the reforms initiated under SAC I. While emphasizing stabilization, it will further the reforms designed to strengthen private sector development, e.g., privatzation, investment promotion, tax and tariff reform, etc., and to rationalize public expendiur, particularly public investment. It will also aim to enhance progams to alleviate poverty, e.g., health and education, and encourage human resource development. This Credit would then be followed by a Second Financial Sector Adjustment Credit to firther strengthen the financial system. 1.46. The "base" lending program described above, which is conditional on the Goverment keeping its stabilization and structural adjustment program on track, would provide IDA financing at the level of about US$225 million per year, or US$900 million for 16 operations over the period 1993-96. In nominal terms, this is slightly less than the US$250 million per year included in the previous lending program and reflects the phase-down of adjustment lending. This level of lending (which at US$13.2 per capita is comparable to the Africa Region average for countries under adjustment included in the SPA) seems justified on the basis of Uganda's deteminaton to persevere with the economic reforms, the need to restore basic infrastructure and social services neglected during the decade when the country was engulfed in chaos, and the limited prospects for substantally increased assistance from other donors. Odier donor aid, which had been very low, has been on the increase in the past couple of years, but is unlikely to replace IDA resources in the short or medium tenn. 1.47. Progress on Uganda'- recovery and adjustment program, and the impact of IDA's country assistance strategy on that program, will be monitored closely. Criteria for assessing country progress includes measures relating to both the economic performance and policy implementation, as well as to the effectiveness of IDA's Country Assistance in helping the Government to bring about real advances in its program. In the short term, a reduction in the budget deficit through improved expenditure management and revenue performance will be an important measure, as will continued lowering of the  - 15- inflation rate in line with the PFP targets. Adequate and timely budgetary releases to the priority sectors wit also be an important meare of te provisionof services the poorer segments of Ugandan society. The impact of these services and interventions in the health and education sectors on poverty alleviation will be monitored to confirm the effectveness of these programs. Over the longer term, reduced dependence on adjuen lending (import support) will indicate progress in unifying the exchange system, reducing dependence on coffee and stimulati non-traditional exports. Fther improvements in health and education status will be monitored to ensure contined inroads on the poverty problem. Ongoing and Proposed Bank AJustment Opas0- 1.48. Since 1987, Uganda has been the beneficiary of four adjustment operations. A first Economic Recovery Credit (ERC 1) was approved by the Board on September 15, 1987. This was followed by the Second Economic Recovery Credit (ERC II) in January 1990. There is also a sector adjustment operation, the Agricultural Sector Adjustment Credit (ASAC), which was approved by the Board on December 13, 1990. More recenly, the first Structural Adjustment Credit (SAC) was approved by the Board in December 1991. The current and proposed adjustmen credits, other than the proposed FSAC, are reviewed briefly below. 1.49. FPst Economic Recovery Credit (ERC 1). The ERC I supported the first phase of the Economic Recovery Program initiated by the NRM Government. Specifically, a limited Open General Licensing system was introduced to improve the allocation of foreign exchange; a Public Sector Investment Program was prepared, consistent with the priority needs of the economy and resource availabilities; and, an action program for the restrucuring and divestiture of public enterprises was agreed with IDA and the program was inidated. 1.50. Second Econaomc Recovery Credit (ERC M). The basic thrust of ERC II was to deepen and extend the reforms aimed primarily at stabilizaion and rehabilitation initiated under ERC I. The highest priority was given to reducing the severe imbalc in the economy and lowering the rate of inflation. The credit therefore supported the following demand management policies: improvements in revenue generation; improvements in budget formulation and expenditure control; and adoption of tighter monetary and credit policies. With regard to the incentive and regulatory system, the credit supported a more active exchange rate policy, the simplification of export procedures, further liberaliztion of the exchange policy and further price decontrol. In the area of public sector management, ERC II laid the groundwork for major civil service reform by establishing a permanent information system and initiating the functional rationalization of ministries. 1.51. Under the ERC I, the Government took the stabilization objective more seriously than it did under the ERC I. The most striking result of this has been a sharp decline in the rate of inflation since the beginning of 1990. The Govnment has also demonstrated a strong commitnent to the attainment of a market-detemined exchange rate. There have, however, been slippages in the implementation of some of the meures supported by ERC 11, including delays in increasing coffee producer prices in line with exchange rate adjustments; failure to addrms the problem of poor tax administrton in a fimdamental way; and somewhat slow progress towards civil service and parastatal reform. The studies which would pave the way for actions in a number of these areas have, however, been completed. In particular, the Public Service Review and Reorgzation Commission (PSRRC) has made extensive reommendations regarding the reorganizationof the civil service. Studies on parastatal reform have also been completed, and action on parastatal reform has been initiated under the Enterprise Development Project, which was approved by the Board in December 1991.  - 16 - 1.52. Agricultural Sector Adjustment Credit (ASAC). A hybrid operation with an adjustment component and a smanl investment component, ASAC reflects the key role that the agricultural sector will continue to play in the Ugandan economy. The actions being supported under the adjustment component include the following: (i) restructuring of the Coffee Marketing Board (CMB) into a commercial organization within a more liberalized and competitive market structure; (ii) creation of a separate body to regulate the coffee trade; rehabilitation of the cooperative unions; (iii) broadening of private sector participation in the coffee domestic and export trade; reform of the coffee export taxation; (iv) transfer of the responsibility for crop financing from the central bank to the commercial banks; and (v) establishment of a semi-autonomous national agricultural research organization. The implementation of the measures supported by ASAC has proceeded well. All of the major objectives have been achieved. First, a new commercially-oriented marketing agency, Coffee Marketing Agency Limited (CML) has been incorporated under the Companies Act. Second, several private entities are now participating in coffee exports. Third, the balance sheet audit has provided the basis for dividing the CMB's assets and liabilities between CML and the Coffee Marketing Authority and division of these has been completed. Fourth, responsibility for crop finance has been shifted back to the commercial banks. Fifth, the National Agricultural Research Organization has been established. 1.53. First Structural Adjustment Credit (SAC I). The first Structural Adjustment Credit continues to support the ERP with two main themes: First, the removal of remaining constraints on the private sector and the creation of an environment in which private initiative can flourish and Uganda's comparative advantage can be realized. Second, the improvement in the efficiency and the effectiveness of the public sector. The credit has six sets of instruments to achieve the above objectives: (i) it is improving the trade regime by further easing restrictions on exports and imports, and removing the implicit exchange rate subsidies enjoyed by some importers; (ii) it is promoting private investment through the establishment of an Investment Authority which will, among other things, administer the incentives provided under the Investment Code; (iii) it continues to address the resolution of claims on Custodian Board properties; this will provide an important signal to private foreign investors that Uganda is no longer hostile towards foreign investment; (iv) it is improving the Government's revenue collection through the establishment of an independent revenue authority; (v) it is reorienting public expenditure allocations so as to protect a set of high priority programs in primary health, primary and secondary education, water supply, road maintenance, and agricultural research and extension; and lastly (vi) the credit is supporting a major program to transform the civil service into a small, a more efficient and effective service. 1.54. Second Structural Adjustment Credit (SAC II). A second Structural Adjustment Credit is scheduled for FY94. The SAC II will aim at consolidating and deepening the reforms implemented under SAC I. The proposed credit will support further development of the private sector including the development of private investments and exports. It will also support actions aimed at enhancing the contribution of the public sector to growth, poverty alleviation and human resource development. 1.55. Second Financial Sector Adjustment Credit (FSAC ED. The (proposed) first FSAC has been designed to address the urgent and fundamental problems facing the financial sector. The second FSAC will consolidate the achievements under the PSAC I, and move towards the second phase of sector adjustment with an enhanced program of policy and institutional reforms aimed at further deepening, diversifying and strengthening the financial sector. The FSAC II would (a) further strengthen competition and efficiency within the banking sector through divestiture of public ownership in aU banks and through elimination of all remainng barriers to competition, (b) contuie to improve the capacity and the effectiveness of Bank of Uganda as the Monetary and Supervisory authority. (c) pursue the recovery of non-performing assets taken over from the UCB by an independent agency, (d) liberalize interest rates,  . 17- sequenced to fit with stabilization measures, particularly the reduction of the fiscal deficit and inflation. (e) promote the development of interbank and money markets (f) prepare the BOU for a shift from direct monetary controls to indirect instruments of monetary policy, and (g) further stimulate the development of capital markets. Aid Coordination 1.56. An important part of the Bank's activities over the next 3-4 years will be to help strengthen and coordinate donor support for Uganua's reform efforts. The reform agenda is large and will tax the capacity of the Govemment to the fullest. At the same time, the scope for confusion and contradictory activities by donors is also large, with real potential for undermining the reform program. Aid coordination remains ineffective mainly because the duties and responsibilities of each of the major players (the Prime Minister' Office, Miaistry of Finance and Economic Planning and Bank of Uganda) are ill-defined. Largely as a result of this the public investnent program remains very much donor- driven. This in turn means that the country's public investment portfolio is not focused adequately on the national priorities and is far too large for the Government to support out of its limited domestic resources. 1.57. The main responsibility for aid coordination rests with the Government which has taken a number of steps to improve its performance in this area. The most important measure taken was the merger of the old Finance and Planning ministries. While the merger has yet to be fully consummated, it is expected, inter alia, to result in improved aid coordination in due course. The Bank will continue to play an important role in mobilizing donor resources and fostenng donor coordination by: (a) assisting the Government to increase its capacity in this area; (b) making its own views on the reform program, implementation, and financing requirements known to donors; (c) informing donors of its own proposed activities in support of the reform program; (d) encouraging donors to support areas of the reform program where they have specific expertise; and (e) identifying systemic issues which may affect the effectiveness of donor support. Aid coordination takes place within the SPA framework and through the Consultative Group process (with CGs every 12 to 18 months). Effective donor coordination also requires day-to-day contacts with donor representatives and the assurance of a regular flow of information on policy developments and project activities. To facilitate this exchange, the role of the Resident Mission has been expanded. IFC Operations 1.58. IPC has a total investment of US$10 million in four companies: Sugar Corporation of Uganda, Uganda Tea Corporation, Toro and Mityana Tea Company and the Development Finance Company of Uganda. In the mid-1980s, due to the extreme shortage of foreign exchange, IFC experienced difficulties with loan service payments from Uganda and, as a result, was unable to consider new invesunents in the country. However, the Government made the necessary foreign exchange available in 1990 and IFC was paid. It undertook a promotion mission to Uganda in December 1990 with the aim of identifying new investment opportunities. IPC is currently considering projects with foreign exchange earning potential in the tourism and textile industries. In the context of the reform program, IFC also hopes to play a role in fostering the development of small-scale businesses through its African Enterprise Fund. It could also be active in assisting with the divestiture of public enterprises (through its advisory services) and with the rehabilitation of such enterprises, once privatized.  i8s - F. Relations with the DMU and Other Donors 1.59. The Bank and Fund have cooperated closely in assisting the Government with the design and monitoring of Uganda's stabilization and adjustment program since the Economic Recovery Program was launched in May 1987. In particular, the Bank and the Fund have worked together, and with the Goverment, to prepare :he Policy Framework Papers (PFP), the sixth of which was circulated to the Board on November 4, 1992. This PFP, covering the period FY93-95, was discused by the Fund's Board on November 25, 1992, along with Uganda's request for a fourth annual arrangement under the Enhanced Structural Adjustment Facility (ESAF) in the amount of SDR 40 million. The fourth ESAF arrangemenm was approved. 1.60. The Bank has also worked closely with other multilateral and bilateral donors. Such cooperation has taken the form of cofinancing of investment and adjustment operations, and collaborative financing of Uganda's technical assistance requirements. A number of donors took part in the appraisal of SAC I. Others have contributed to PERs through the direct participation of their staff or the funding of consultants. G. SmmY Am 1.61. Uganda is making good progress in implementing a comprehensive recovery and adjustment program. As a result, the economy is growing and real per capita incomes are rising. The objective is poverty alleviation through accelerated economic growth, with the private sector as the engine of growth. The means are liberalization and simplification of procedures, together with an sharp improvement in economic and social services provided by govermnent. Improvements in health and education are essential for both growth and poverty alleviation. Good progress has been made on price decontrol, liberalizing the trade and payments system, resolving the expropriated properties issue, dereguladng private sector activity and encouraging non-traditional exports. Saving and investment are increasing only slowly, however, and some of the more difficult reforms, e.g., privatization, civil service, and marketing boards (except for coffee) are getting off to a slow start. Govermment's first priority, however, is stabilization and here Uganda's record is not all positive. A serious slippage in fiscal and monetary control in FY92 resulted in serious inflationary problems. Although the slippage was corrected subsequendy, it came at a heavy cost to basic public services and the development program. The inflation sitation remains delicate and requires close monitoring. The Government has also introduced a comprehensive debt-workout strategy designed to reduce the country's excessive debt burden. 1.62. The economy has good potential for growth. Real GDP growth of 5 percent per ann, 1.5-2.0 percent in per capita terms, is expected over the medium term. To achieve this, the Government will need to stay-the-course on stabilization, while pressing ahead with the adjustment program. The issue is more one of implementation now, rather than new reform initiatives. Raising saving and private isvestment is the key to accelerated growth. Stimulatng private sector activity requires reform of the financial sector to increase the availability of low cost credit and acceleration of the privatization and other reforms to establish a supportive business climate. Improved infastructure, especially in nual areas, is also essential. Within this growth framework, attention needs to be paid to capacity building and to gender and envirmental issues to ensure maxim productivity. 1.63. IDA's strategy is direcdy supportive to that of the Government. It continues to stress poverty alleion through accelerated growth and improved public services, especially health and education. It also stresses gender issues, enviomental protection and capacity building. As in the recent past,  -19 - agricultural services, infrastructure rehabilitation and the social sectors are the main priorities in IDA's lending activities, supported by a large amount of recenly completed economic and sector work. Import support will comprise a large, but gradually declining share of IDA's lending as the foreign exchange constraint lessens in Uganda. IDA expects to continue working with the Government (and the IMP) in designing and implementing the macroecononuc program. PART II. TE FINANCIAL SECTOR: KEY ISSS AND PERFORMANCE A. Sector Stucture 2.1 The financial system is crucial to economic development because of its key role in mobilizing and allocating financial resources as well as stabilizing the economy. Uganda's formal financial system is one of the least developed in Sub-Saharan Africa. It is small in terms of the value and the volume of transactions undertaken, as well as undiversified in terms of the type of transactions which it undertakes. The system consists of a central bank - the Bank of Uganda (BOU), twelve commercia banks, two development banks, and an almost defunct post-office savings bank. There are also a number of non-bank financial institutions. These include, eleven credit institutions, four active building societies, fifteen insurance companies and one significant pension fund. In July 1990, as a part of its liberalization program, the Government began to license foreign exchange bureasw, to buy and sell foreign currencies for a range of current account transactions. There are currently 42 bureaus operating in Uganda. 2.2 Commercial banks dominate the financial sector accounting for about 90 percent of the assets of the system. The largest is the government-owned Uganda Commercial Bank (UCB) which accounts for half of all the business in terms of both assets and deposits but for a far smaller share in terms of capital. The UCB also accounts for 189 of the country's 223 commercial bank branches and has been undergoing rapid, albeit loss-making branch expansion in the recent past. The Cooperative Bank (COOP Bank) is owned by the state sponsored cooperative movement, and has the second largest number of commercial bank branches (24). The Govemment also owns shares in four other private banks. The building societies are privately-owned, and fall under the surveillance of the Registrar of Building Societies. The development finance institutions primarily onlend external donor funds and both institutions, the Uganda Development Bank and the East African Development Bank, have experienced severe problems in recent years as a result of political and economic disruptions. The majority of the remaining institutions are extremely small and several are effectively non-operational. 2.3 Money and capital markets are underdeveloped. There is no formal interbank market, with interbank lending only being conducted on an infrequent bilateral basis. A lack of confidence in a significant proportion of the bankdng system and the unavailability of a means to collateralize loans, has acted as a major constraint to the development of this market. Until May 1991 commercial banis were not permitted to purchase Treury Bills as it was thought that this would reduce the incetive to provide loans. However, this restriction was llfted and replaced with the ruiremnet that holdings of government paper should not exceed 10 percent of the deposit base. As of September 1991 approximately USh 7 billion of Treasury Bills were outstanding, the majority of which were held by non-bank institutions. The scale of Treasury Bill sales has until reety made them unimportant as a source of government financing. A small quantity of govermment stocks are also outstanding (USh 16 million as of September 1991). The only other financial instruments relate to trade finance. Re-discount facilities at the Bank of Uganda are used on a case-by-case basis mainly for crop finance bills.  -20- B- Key Isues 2.4 Govenmment Ownership and Interference. Most financial institutions are govermnent-owned. The system initially had a large foreign presence as a result of the country's historical ties with the UK. In 1962, Barclays, Grindlays and Standard Banks operated extensive branch networks throughout the country. Altogether, in 1963 there were 65 bank offices operating in Uganda. By 1964, the first indigenous bank, the Cooperative Bank Ltd. (COOP), was established by the cooperative movement. In the same year, the Government made its first equity investment in the banking sector by setting-up, under a special Act, the Uganda Commercial B&k (UCB). During the decade, the Government acquired a 49 percent share in three out of the four existing foreign banks , including the Libyan Arab Uganda Bank. In addition, UCB and the COOP banks acquired the bulk of the branch network of Barclays and Grindlays, thereby making the Government the major player in the banking sector. The UCB and the COOP Bank have been subject to extensive government intervention, particularly regarding their lending priorities. The most dramatic example of this was the rapid expansion in the branch network of the UCB that occurred over the latter half of the 1980's, which was heavily influenced by the Government's desire to ensure improved access to the new crop financing scheme. In addition, all government-owned banks have been involved in administered developmental lending, under which the Banks' managers have been under pressure to lay aside strict commercial criteria in order to pursue developmental or social objectives. The majority of these loans are extemally financed and in the case of the UCB most are allocated to the agricultural sector, while in the case of the COOP they are onlent to the cooperative societies. Restricted management fees paid have in the past caused these to be loss making activities for the banks. 2.5 Lack of Compeion and Efficiency. There is a high degree of market concentration in the commercial banking system. The fonnal financial sector is dominated by the Uganda Commercial Bank and the COOP bank. Lack of conpetition has reduced incentives for the managers of the banks to reduce costs and improve efficiency and remains a major factor in contributing to the high cost of financial intermediation. 2.6 Weaknesse in the Authority and the Capacity of Central Bank, Existing banking legislation fragments responsibility for the formulation and implementation of monetary and supervisory policies and limits the power of the BOU to enforce directives issued. Moreover, there are weaknesses in the capacity of BOU, particularly in the formulation and implementation of monetary and supervision policy. Furthermore, the BOU's internal accounting system is weak, as is its balance sheet. 2.7 The legal authority is vested in the Bank of Uganda by the Bank of Uganda Act of 1966. The Act gives the Minister of Finance the power to issue directives relating to the monetary and financial policies. This places limits on the independence of the Central Bank with respect to the Ministry of Finance and undermines the proper functioning of BOU as the monetary authority. At present, the BOU does not have the prime responsibility for the implementation of monetary policy, supervisory policy and other policies directed at banks and other financial institutions. The Minister of Finance and Economic Planning (MFEP) approves changes in interest rates. The Minister also approves the opening (and closing) of individual bank branches and shares with the BOU the supervisory responsibility over banks and credit institutions. On monetary management, the original Act followed a prudent approach and placed strict limits on the extent of temporary government financing from the Central Bank. However, the events of the 1970's and 1980's led to a serious erosion of the Bank of Uganda's authority and considerable divergences between actual practice and the provisions of the Act.  -21 - 2.8 The BOU's efforts to fulfill conventional functions of a central bank have been affected also by internal organizational and technical weaknesses especially in the areas of prudential regulation, supervision, and accounting. The Bank is understaffed at the senior level, particularly in key departments like Bank Supervision and Accounts. On-site inspections of banks, have until recently, been exceptional and the information for adequate off-site monitoring is lacking or not up-to-date. The Bank's own accounts have not been audited or published during 1985-91. Furthermore, its departmental and organizational structures are not conducive to efficiernt flows of information and management. Inadequate information flows have also contributed to two other problems currently facing the BOU, namely, allegations of major malpractices in the clearinghouse and discrepancies between BOU and MFEP figures regarding the true level of BOU's advances to the Government. Apart from weaknesses in its independence and legal authority, the BOU's weak internal capacity to influence effectively the operations of financial institutions has in practice led to confusion and inadequate supervision. Banks clearly have exploited the uncertaint in recent years to an extent which in part contributed to the financial distress in commercial banks. 2.9 Defciencies in the Payments Mechanism. There are legitimate complaints in the business community in Uganda about poor communications within the banking system, the difficulties in the use of checks and the inconvenience of cash transactions using large volumes of low denomination notes. Because of poor communications within the networks of the main banks with rural branches, checks drawn on rural branches may take up to 4-6 weeks to clear. The banks with branch networks have also given poor cash withdrawal service. Depositors are commonly unable to withdraw their deposits, after giving the required reasonable notice, because of defective cash management by the banks and because the banks centralize their operations in Kampala instead of regional centers. Long delays have been common in transferring accounts between branches and even in cashing drafts in one branch drawn on another branch. These features have been a deterrent to the use of the banking systemn and to the use of credit instruments instead of cash. As a result primarily of the inefficiencies in the payments system, the public in Uganda has an unusually high reluctance to use checks as a system of domestic payments. This is reflected in the unusually high ratio of currency in circulation to money supply. Other features of the business environment that pose a problem for the financial system include: an increasing incidence of fraud aggravated by the slowness and inefficiencies of the check clearing system at the BOU, and lack of adherence to, and absence of, well-defined standards of accounting and auditing practices in Uganda and the consequent difficulty encountered by the banks in assessing the creditworthiness of their clients. 2.10 Weakmesses In Prudential Regulation and Supervision. Inadequate prudential regulation and supervision has been a major constraint on the efficiency and the depth of Uganda's financial system. The legal framework for prudential regulation of the financial system is provided by the Banking Act of 1969. The Act covers commercial banks and credit institutions but excludes building societies and insurance companies. Prudential supervision is confined to that undertaken by the BOU in relation to commercial banks and eleven credit institutions. Development Banks are not supervised. There are also significant shortcomings in the current supervision and examination processes. On-site examination is currently highly unsatisfactory. The BOU's Bank Supervision Department has until recently been seriously understaffed and has not been able to examine banks at sufficiently frequent intervals. Also, there is often inadequate follow-up to see that required corrective actions are carried out satisfactorily by the banks. The BOU's off-site surveillance capability is also equally weak. 2.11 Finandal Distrs in Commercl Banks. Banking activities in general have been severely undermined by the political and military upheavals of the 1970s and the 1980s. More recently, the currency reform of May 1987 (a 30 percent levy was imposed on liquid asset-holdings associated with the 100=1 conversion of the old for the new Ugandan shillings), and the subsequent exchange rate  - 22. adjustments together with substantial operating losses incurred, have rendered the capital base of the commercial banks extremely deficient. The problems that the commercial banking system as a whole has faced, and is still facing, are numerous. The most important impediments to a healthy financial performance and growth include: (a) the lack of public confidence and lack of debt in the financial system; (b) the short maturity and instability of deposits, due to a large extent, to the negative real interest rates in the past. The share of demand deposits to total deposits exceeds 80%, well above the ratios prevailing m neighboring East African countries; (c) the lack of adherence to, and absence of, well defined standards of accounting and auditing practices. This is reflected in the lack of proper accounts kept by even the biggest bank customers, and the consequent difficulty encountered by the banks in assessing the creditworthiness of their customers. (d) the general problem of malpractices and internal misappropriations aggravated by the slowness and inadequacy of the clearing system, and by the highly inflationary environment, which has eroded the real level of wages and salaries of bank staff and; (e) lack of properly trained staff, aggravated by the problems arising from the poor transportation and communuication systems and the lack or slow development in the computerization of banidng operations. These problems have been further exacerbated by management deficiencies in the case of two leading domestic banks, Uganda Commercial Bank (UCB) and Cooperative Bank (COOP), which have experienced acute liquidity and insolvency problems. C. Sector Performance 2.12 Because of these systemic deficiencies in the financial sector and the weaknesses in money and credit policies in general, the formal financial system in Uganda has not been an effective vehicle for mobilizing domestic resources. The M2/GDP ratio at 8 pent is among the lowest in the world, after Zaire and Guinea, and indicates the low level of savings and financial intermediation. Incentives for fimancial savings by the private sector have been undermined in the past by substantially negative real interest rates. Despite these disincentives however, the flow of funds analysis indicates that the private sector in the domestic economy generates net (although small) positive savings. The central Government is the largest "dissaver" ( i.e., overall net borrower). 2.13 The most important macroeconomic consequence of the low domestic savings and low monetary assets ratio is that it severely complicates the task of financing government deficits. In the absence of bill, bond and other securities markets, the Ugandan Government has financed almost all of its deficits in recent years from extemal sources or through ways and means advances from the Central Bank. This proved to be highly inflationary, which in turn has eroded the deposit base of the banking system, reducing the basis for extending credit to the private sector. Its impact on private sector credit has therefore been negative but indirect. 2.14 With a low deposit base, the level of credit relative to output is low in all sectors with the exception of trade and commerce. Trade and commerce, including crop finance, accounted for over 60 percent of total commercial bank lending to the private sector as of June 1992. The high level of crop finance reflects both the importance of coffee financing and the inefficient use of credit. The only positive feature is that the Government exercises relatively little control over the sectoral allocation of commercial bank credit in Uganda. There are no formal sectoral credit targets, although the Government has on occasion used moral suasion to encourage the extension of credit to the productive sectors and through the BOU, some bank guarantees have been provided for 'developmental' lending. Agriculture contains a large non-monetary sector (accounting for about half the total value added) and peasant agriculture usually makes little use of formal credit. Low ratios of credit to value added in both manufactring (14 percent) and construction (6 percent) iply that credit is not widely used for either working capital or  -23 - investment purposes. It is clear that the formal credit markets are insufficient to fulfill all credit needs and that a substantial infonnal market is operational, especialy in the rural areas. PART Il. PROPOE INACL SECTOR ADJUSTENT ]PROGRAM A. Objectives and Strateg 3.1 An efficient financial sector, with an effective banldng system at its core is essential to support and foster Uganda's stabilization and structural adjustment program. The proposed credit will support both policy and institutional reforms in Uganda's financial system as described in the Government's letter of Financial Sector Policy (Annex VI). The overall and longer-term objective of the Government's reform program is to deepen the financial system and to establish, over the medium term, an efficient system of resource mobilization and allocation which would become increasingly more liberal and market- oriented and offer greater variety of instumes to both borrowers and savers. "Efficiency" requires sound financial institutions operating in a competitive market structure and in a policy environment that enables proper assessment of risks against returns. An "effective" financial system fosters longer-term growth and development and requires that savers and borrowers are adequately served throughout the country. However, the reforms required to achieve these longer-term goals will need to be phased over a number of years because of the serious weaknesses that exist in key financial institutions in Uganda, and the limited implementation capacity of the country. Furthermore, some of these reforms are prerequisites for the others: Financial sector deenig and diversification can take place cohesively and with success only if enabling enviroment is in place and key financial institutons are sound and fuctioning. The viability of the financial system also depends heavily on the viability of the real sectors. The types of financial services/products needed by the real sectors, and the availability of bankable opportunities in the economy as a whole will determine largely the growth of financial services in the fumre. 3.2 In the short-term, the priority objective is the achievement of macro-financial stability which is an unconditional and essential prerequisite for savings mobilization and as well as the development of Uganda's financial system. A significant surge in inflationary pressures in FY92 derived from excessive monetization of the government deficit has underlined the fragility of macroeconomic management and the progress achieved to date. Financial sector reforms can not succeed if macro-management is not prudent. Conversely, successfil financial sector reform makes the task of macro-management easier. Given the fundamental inflaonary pressures coming from the central bank financing of government deficits, strong BOU control of money and liquidity in the economy and non-inflatonary ways of deficit financing are vital for successful stabilization. This also argues for the BOU to be posidoned as a more forceful element in economic policy-making with an enhanced ability to resist at least some of the political pressures for monetary expansion. Another priority goal is the development of an appropriate policy and regulatory enviroment conducive to increased competition and efficiency, and greater private sector participation in the financial system. It is also vitally important to enhance the soundness of the banking system as a whole; to restore public confidence in financal institutions and to make sure that public confidence is sustained through effective enforcement of prudential regulation and supervision. 3.3 The Government's reform program for the period of FY93-95 to be supported by the proposed PSAC focusses on these urgent and fundamental needs. Specifically, the Government's reform program covers actions in three key areas. On the poli fho, the Govemment will take steps to improve the  I24- effectiveness of monetary policy and support the ongoing stabilization efforts; increase deposit mobilization and the efficiency of credit allocation through rationalizing the interest rate structure and maintaining positive real interest rates with a view to liberalizing these once economic stability is restored on a sustainable basis; encourage banking competition and efficiency and greater private sector participation in the financial system by eliminating all existing entry and exit barriers, reducing Government's equity participation in private banks and eventually privatizing fully-government owned financial institutions. On the legal and the regulatory front, actions will be taken to enact new financial legislation and improve the legal and regulatory framework for banks and other financial institutions. On the Institonal front, the Government will take actions to strengthen the role of the Central Bank as the monetary authority, improve its supervisory capabilities, and develop specific Restructuring Plans for the insolvent Uganda Commercial Bank (UCB) and the Cooperative Bank (COOP Bank). These restructuring plans will be implemented as part of the proposed FSAC. The Technical Assistance Component of the Credit (Annex V) will provide technical support to the reform program as a whole. B. Policy Reforus Fiscal Poicy 3.4 Badkground. The Govemment recognizes that sound macroeconomic policies are essential if financial sector policies are to be effective. The ability of financial markets and institutions to mobilize and allocate resources efficiently will depend heavily on the existence of a stable macroeconomic environment. The Government has therefore reaffirmed its intention to continue its medium-term program of stabilization and structural adjustment by sustaining and deepening reforms in key areas of fiscal, monetary and financial policies and leading real sectors. The source of much instability in the Ugandan economy over the past few years has been the fiscal policy. Restructuring/recapitalization of insolvent banks will increase the need for public funding thus, adding to the already severe fiscal problem. The success of the reforms in the financial sector will continue to be dependent on a responsible fiscal policy, that minimizes the need to monetize the govemnment deficit and prevents the build-up of domestic arrears. 3.5 FSAC Supported Acdons. Under the reform program, the Government will continue to reduce both the size of the fiscal deficit as well as its financing through the domestic banking system. Because of the importance of fiscal reforms and macroeconomic stability to the success of financial sector reforms, the proposed FSAC links the first and second tranche release to satisfactory macroeconomic and fiscal performance, as judged by 1DA, as well as sector spedfic conditions outlined In Part IV. 3.6 The Government will also undertake a thorough review of the mechanisms in place in both the Ministry of Finance and Economic Planning and the Bank of Uganda to monitor the Government's finan- cial position, with a view to upgrading these mechanisms to establish formal information flows and a regular and comprehensive reconciliation process. Shortcomings in this area frequently lead to a failure by the Ministry to recognize the severity of the deficit financing problem in sufficient time to instigate adjustment measures. 3.7 In addition, the Government will establish a more effective market for government debt instrumens. This will potentially address four important issues; the need for non-inflationary financing of the government deficit; the Bank of Uganda's requirement for a flexible means of liquidity management; the need to provide the financial system with new investment outlets; and the requirement  -25 - for a reference market rate of interest. The Government is committed to broadening the use of the treasury bills for these purposes. Fortnightly treasury bill auctions of 91-day bills have been introduced under the reform program in FY92. Since then, the BOU has moved to weekly auctions, including also 35 and 63-day bills. Under the FSAC, technical assistance will be provided for more active use of treasury bill auctions. The technical assistance will also cover the necessary treasury management functions to ensure that full account is taken of the impact on the debt service burden of the Government. Managemenlt of Monetary Polcy 3.8 Palcground. The need for a more active management of monetary policy in Uganda has grown substantially with economic liberalization. Auction sales of foreign exchange have a direct impact on domestic liquidity. The liberalization of foreign exchange controls would soon necessitate the Bank of Uganda engaging in open market operations in foreign exchange. As a dominant participant in the market, the BOU's involvement will have implications for both exchange rate management and domestic liquidity. Moreover, the development of the financial system itself will increase the potential for financial instability in the absence of effective monetary management. As confidence in the banlkng system increases and financial asset holdings become more attractive, the ratio of currency to M2 will decline. In addition, the ratio of commercial bank reserves to deposits is likely to fall as the efficiency of the clearing system improves. As both the currency and the bank reserve ratios fall, the money multiplier will rise. Thus for any initial injection of reserve money the growth in M2 will be higher, with implications on the domestic price level. 3.9 FSAC Supported Actions. Within the broad aim of improving the management of monetary policy, there are several key issues that will be addressed by the reform program. These are: monetary policy formulation and implementation, liquidity management and control, development of new monetary instruments and development of money markets. 3.10 The Government recognizes that monetar policy formaon and Implemetation is one of the most important functions of a Central Bank. Under the reform program this responsibility will be transferred from the Ministry of Finance and Economic Planning to the Cental Bank. Consonant with this, the Bank of Uganda will ensure that both the technical staff and the senior decision-making resources devoted to this function reflect this priority. 3.11 At present the range of monetary pocy hIstruments available to the Bank of Uganda is limited. The Bank is effectively only able to influence the level of reserve money through changes in the cash reserve ratio and changes in the quantity of reserves exteneed to the banks. The Government recognizes that the cash reserve ratio is an instrument of little flexibility. As the economy condnues to grow, the adjustment process takes hold and the financial system strengthens and diversifies, management of money and liquidity will require a broader range of chanels and instuments. However in the short tetm the cash reserve ratio will beccwne a key instrument to effect stuctural changes in liquidity and the Bank of Uganda will enforce strict compliance with the ratio. To avoid excessive costs to the commercial banks, the Bank of Uganda after careful consideration of its own financial position, wiUl begin to pay a rate of reurn on cash reserves held at the Bank of Uganda. A strategy for improved monetary control, through reserve money p and manag nt, has already been developed with technical assistance from the IMF. Under the reform program reserve money programming will be established as a regular management tool. Successl intoducion of Reserve Money Programming and Mana t at the BOU Is a condition for the release of the Second Tranche.  g26- 3.12 Effective monetary policy and management will require timely and accurae balance sheet iformation from the commria bank and within the Bank of Uganda. The Research Deparment will work in close collaboration with the Supevion Department of the BOU to upgrade commercial bank reporting and, all commcial banks wil be reminded of their legal responsibWit to report to the Bank of Ugnda in a tidy and accuae faio. Eforceme of compance by the commeil banks i is area wffl be a Second Trcbe reease condonal which will be monitored by the Moneay Polcy I Unit, to be established In the Research Departmet, and through the BOU's legal enfoemt powel. 3.13 In the past open-ended lending to the commercial banks by the Bank of Uganda has been a significant source of inflationary pressure. The Bank in future wIll use its ledig facilities for two purposes; as a source of reserve management and as temporary financing for liquidity shortflls, in its role of lender of last resort. The amounts to be made available for purposes of reserve management will be determined by the monetary programmng exercise and market interest rates will be charged on this type of lending. The lender of last resort facility will supply temporary credit only, at punitive rates of interest. 3.14 Under the reform program, the Bank of Uganda will take the lead in facilitating the development of an tebank market. Currently, there are some informal, mostly overnight transactions undertaken by banks on a bilateral basis. There is a need for the establishment of a more extensive and more structured interk market. A lack of appropriate infastructure and wide differences in the financial health of the commercl banks are the major obstacles to the development of an effective interbank market. In principle, the interbank markets are free markets where rules and rions are set by the participating commcial banks. In the case of Uganda however the BOU will funetion as a clearing home debiting and crediting comnJercial bank accounts on a same day basis. The Bank of Uganda will also act as a broker bringing parties together and holding coLateral when banks require them to guarantee their loans. Once the market is established, an idependent broker or a Discount House will take over the Central Bank's functions other than clearing arrangements. Inteest Rate Poicy 3.15 Bd. The Govermnent is committed to moving towards a more market deermined interest rate structure. However, the full liberalization of interest rates in an environment where inflation has not yet stabilized, would add to macroeconomic instability. 3.16 FSAC Supprtd Actions. The reform of interest rates will therefore take place in a phased ma.r. In the first phase, key rates will be aligned to the average preceding month's treasury bill rate which is deternined in an auction market. The existing strutre of rates wil be reguarly reviewed by the Research Department in association with the Bank Suprvision Deparuntm, to ensure that the spread between the deposit and lending rates does not act as a disincentive to financil itemdiauon. At the same time the Govenmt wil continue to ensure that positive real rates of interest are mainmined on saving and time deposits. In the second phse, as inflation declines and stabilizes, the functioning of credit market is improved and a larger set of financial instuments is available in the market, greater flexibility will be permitted in the determination of interest rates.In the third ad final phae, the Bank of Uganda will fiy lble intet rates and manage these rates through indirect monetary instruments with a key interest rate for anchor.  -27 - Rediscouto Poicy 3.17 At present, the Central Bank provides 24 hour credit at zero interest rate to commercial banks on their clearing/borrowing accounts. Beyond this facility all other credit to commercial banks is pro- vided at highly punitive rates. The lowest non-punitive rate, the rediscount rate was 43 percent (or 1 percentage point below the maxhmum lending rate) in August 1992. The BOU's lending rate to commer- cial banks when these are allowed to borrow for a period of five days in order to complement their insufficient reserve requiremnts was 51 percent. 3.18 Under the reform program, the BOU will adopt a more flexible rediscount policy and use the rediscount facility increasingly as an instrument of monetary policy: It will impose punitive rates when monetary policy needs to be tightened and lower the discount rates substantially when monetary policy needs to be relaxed. Consistent with this policy and the prevailing domestic imflation rate, the rediscount rate has recently been reduced to 30 percent and the BOU's lending rate on short term advances, to 35 percent. Dircted Credit Policy 3.19 The Government will continue to pursue its current policy of allowing market forces to determine credit allocation. Where targeted credit is provided through the banking system, using external sources of finance, the cost of credit to the end-user will reflect the full cost of funds, inclusive of the administtive costs of the banks involved. Policies to Encourage Competition, Efficiency and Private Sector Paridcpation in the Financial System 3.20 To raise the efficiency of the financial system as a whole, as reflected in performance indicators such as productivity, intiation costs and profitability, the Government will take actions to encourage effective and genuine competition among banks and reduce its own participation in the financial system. With the recent licensing of three new domestic private banks, the number of commercial banks has risen to 13. However, the market remains oligopolistic, dominated by the UCB and the COOP Bank. To firther improve the competitive environment in the banking system, the new Financial Institutions Act (paras. 3.25-3.26) will liberalize barriers to entry and exit in the sector. In order to avoid an excessive proliferation of small banks, the Government will increase the minimum capital requirements for new and existng banks. Furthermore, the Government will also scrutinize, through the BOU, applications to establish new banks more rigorously with emphasis on the qualfications of promoters and their short-and medium-term operating plans. 3.21 Diversified ownersbip in government-owned or dommnated bans is another important element of the reform program. Although it is too soon to tell how much interest there is in private purchase of banking institutions in Uganda, some eptriate firms have expressed interest in existing banks or parts thereof and domestic groups are discssing creation of new institutions. The Government has annunced In its FY1992/93 Budget Speech (July 1992) its intention to reduce the Government's equity pariipin in private banis and open up the Uganda Commercia Bank (UCB) to private particiption In December 1992, the Governmet offered its equity sbares in two private banks for sale to private Investors.  - 28 - 3.22 Before the release of the Second Tranche, the Government will offer its equity shares, in part or in whole, in (a) remaining privately owned banks and (b) in UCB, for sale to potental private investors. C. Legal and Reguatory Reforms 3.23 Under the reform program financial legislation will be substantially revised and redrafted, and other legislation will be prepared for the first time. Revisions of the BOU Act and the Banking Act have been given high priority. Major objectives of the revisions are to ensure that primary responsibility for the formulation and implementation of monetary policy rests with the BOU and that the BOU has adequate powers to fulfil its regulatory and supervisory functions in relation to banks, other depository institutions and all other financial institutions. Later in the reform process legislation relating to Building Societies and Insurance Companies will also be updated. Legislation relating to Leasing Finance will be prepared. The new Bank of Uganda Act and the new Finadcial Institutions Act have become operational in FY93. The New Bank of Uganda Act 3.24 The new BOU Act has just been enacted. The objectives of the changes in the new Act are to (i) clarify and strengthen the BOU's role as the monetary and supervisory authority; (ii) specify clear legal limits on BOU lending to Government, particularly by ways and means advances; (iii) ensure BOU control over its lending to banks; (iv) enact exchange rate provisions consistent with present foreign exchange operations of the BOU; (v) provide the BOU with more flexible powers for the investment of foreign exchange reserves; (vi) give the BOU authority to ensure that all clearing and payment arrangements are effective and operate on a sound basis; (vii) provide for an increase in the BOU's capital and establish mechanisms to maintain adequate capital in the future; and (viii) provide for BOU independence with regard to its internal administration including on such issues as appointment of Department Heads. The New Fnanl Institutions Act 3.25 The new Financial Institutions Act, which replaces the old Banking Act, has become operational in March 1993. The new Financial Institutions Act provides for a sound basis for prudential supervision of banks and other depository institutions. The new Act ensures that authority for supervision of banks and other deposit taking institutions is clearly vested in the BOU and that the BOU has unquestionable powers to: (i) license banks and other financial institutions; (ii) specify minimum and on-going capital adequacy requirements; (iii) specify prudential liquidity requirements; (iv) establish minim requirements with regard to non-performing assets, credit concentrations and lending to insiders; (v) undertake inspections as necessary; (vi) require banks to redress difficulties that emerge or if necessary the BOU to take over the management, require banks to cease operations or be placed in liquidation in a manner consistent with the best interest of depositors. 3.26 The new Act covers satisfactorily most of these issues. Purthermore, the Act has a sound provision for ongoing capital requirements related to risk weighted assets. The minimum capid requirements as specified by the new Act also provide a sustainable balance between prudential requirements and the social objective of eliminating entry barriers to locally owned banks. These minimnum capital requirements will be indexed to inflation in order to prevent establishment of banks below the mininum operationally effective size, in the future.  -29- The Building Sodeties Act 3.27 The Building Societies Act was enacted in 1955. It is largely concerned with establishing the legal basis for building societies. It specifies the necessary content of rules, management arrangements and requirements for reporting to members and to a Registrar appointed under the Act, and borrowing and lending powers of the societies. The Registrar, appointed by the MFEP, is given powers to require production of books, inspect books, inspect and report on the affairs of a society, suspend borrowing or lending and suspend or cancel registration. Under the reform program, the Government has agreed to give supervision responsibilities of the building societies to the BOU. As a result, relevant prudential requirements emerging from the new Financial Institutions Act will also apply to the Building Societies. Under the reform program, the Building Societies Act has been revised and upgraded as appropriate. The Insurance Industy Act 3.28 The insurance industry was liberalized about a year ago, with the insurance field open to competition amongst private and publicly owned companies. As a result, the industry is beginning to grow and diversify while the economy and business begin to benefit from insurance services. Liberalization of the insurance industry was a remarkably bold policy step whose positive results are already apparent. This development has however brought to light two important needs which will be addressed under the reform program. First, there is an urgent need for the enactment of a new Insurance Industry Act to provide an appropriate legal and regulatory framework for the sector. Second, there is an equally urgent need to strengthen the supervision of the insurance industry. This will be done initially by the Supervision Department of BOU with a view to transferring this function to an independent body or to MFEP as the supervision capacity of a new entity is created and strengthened over time. Before the release of the Second Tranche, a new I1surance Ind_ty Act will be prepared and submitted to the Legsatum The Leasing Finance Act 3.29 It has been observed in other developing countries, and in particular in Sub-Saharan Africa, that leasing finance is a potent activity that develops fast, provided that it benefits from a supportive legal and regulatory framework. In contrast with commercial bank lending, leasing finance does not require collateral, since the lessor remains the owner of the leased equipment. It enables the financing of equipment for micro enterprises and artisans, an important advantage in the African context. It also fosters the development of medium term instruments, since leasing offers to the market instruments with maturities matching those of their assets. Under the reform program, a brief survey will be conducted on the potential and prospects for and constraints to the development of leasing finance in Uganda. On the basi of this survey and as a condition of the Second Trxnche release, a new LAasing Financing Act will be prepared and submied to the Leg1slatum D. Institional Refonns 3.30 The institutional reforms initiated under the FSAC are well advanced. The reform process is overseen by the Government's FSAC Review Committee and the Bank Restructing Committee, both established under the proposed credit. The key institutions covered under the reform program have prepared Restructuring Plans. Some elements of these plans are already being implemented.  30- Central Bank (BOU) Reforms 3.31 IMF/IDA/Government Collaboration. There has been an extraordinarily good and productive collaboration between the IMF, IDA, and the Government on the design and preparation of the Central Bank reforms. First, through its Monetary and Exchange Affairs (MEA) Department, the IMP provided guidance and technical support to the Research Deparment. Second, the Monetary Policy Advisors for the Research Department fianced under FSAC have been identified by the IMP in consultation with IDA and Government. Third, through its African, MEA and Legal Departments, the IMP commented extensively on new financial legisladon and assisted the Government with the drafting of the Bank of Uganda Act. Finally, the ESAF missions led by the African Department overlapped with IDA FSAC teams and coordinated their work throughout the credit preparation. The IDA's main are of concentration has been the Bank Supervision Departmem and other areas of reform in the Central Bank. The IMF/IDA/Government collaboration based on their relative strengths will continue during the credit execution. 3.32 Trxnsfonrmng the BOU into a Monetary Authority. Under the reform program, the BOU has been steadily upgrading its operations. Nevertheless, it is recognized by both the BOU and the Goverment that further substial improvements in the BOU's authority, status and performance remains to be achieved if it is to properly fulfil its pivotal role as Uganda's Central Bank. Improved performance will require changes in BOU's legal authori, organizational structure, management culture and operaional procedures. The BOU will continue its efforts to strengthen its capacity to perform as a Monetary and Supervisory authority. In part this will be facilitated by legislative changes. At the same time, the capacity of the Research and Svision Deparments will be substantially bolstered so that these can play an increasingly important and leading role in policy fornmulation, implementation and prudential supervision. Critical tasks for the Research Department include: (i) regular assessment of economic developments and their policy implications; (ii) development of relevant data bases, including rgular monty surveys, balance of payments aggregates and analysis on financial flows. This will require the Department to take a leading role in coordinating data from a number of departments within the BOU, the MPEP and commercial banb; (iii) development of a quarterly Reserve Money Management program, as discussed above; (iv) strengthening existing policy instruments and continuously upgrding/developing new financial iumen; (v) facilitadng the development of an interbank market in Uganda; and (vi) preparation of BOU Annual Reports, Quarterly Bulletins, and occasional papers on key policy issues. 3.33 Changing its Orgnzatonal Sucture and Culture: To improve its technical efficiency, the BOU's organizational strucue will be changed, and its current management culture will substantially be modified. These changes will occur through: (i) consolidating the present cumbersome 15 department structure into a more effective organiztion comprising about six departments; (ii) clarifying curent delegation and committee arrangements to ensure that all areas of the BOU can operate effectively and be less dependent on the day to day availability of the Governor, Deputy Governor and other key staff; (iin) instuing arrangements to make sure that computeizaon of the BOU progresses speedily; (iv) makdng present work plan arrgemens perma and regularly monitoring performa against performance targets; and (v) recognizing that the BOU coninmes to have both excess staff in less- skilled categories and a critical shortage of skilled and experienced staff in areas such as accounts, computrization, research and supervision. The BOU will seek to fil the most urgent gaps in the near future. For the longer term the BOU will contime to develop manpower, salary, promotion, recruitment and retechment policies that enable the Bank to establish and maintain quality staff and managers.  -31. 3.34 BOU's Supervision Function. The BOU's capacity to fulfil its supervisory role has been increasing steadily under the reform program through intensive training and recruitment. The need for the Central Bank to be particularly strong in prudential supervision is well understood by both the BOU and the Government. The legislative changes about to be enacted will substantialy stngte the role and the powers of the Centra Bank in this area: (i) the new BOU Act expands the BOU's role as the Supervisory authority to all deposit taking insdtutions, building societies, non-bank financial institutions and the insurance industry. While supervision of development banks ansurance companies and pension funds are comonly undertaken by separate bodies because of the diverse nature of their operations, the immediate issue in Uganda is that there be sound and consistent supervision across all financial institutions as soon as possible. At present faster progress in achieving that can be expected by extending the operations of BOU's Supervision Department than by seeking to develop multiple supervisors in the country. Supervision of insurance industry and pension funds would be undertaken by a separate unit in the BOU Supervision Deparment, which over time, would become a fully independent body; and (ii) the new Financial Institutions Act gives unquestionable powers to the BOU with regard to prudential oversight and supervision to enforce strict guidelines with regard to such matters as minimum and ongoing capital adequacy requirements, loan/loss provisions, insider lending principles etc. Within the BOU an effective program for on-site examations has already been established. At the same time, off-site surveillance is being upgraded. It is expected that arrangements will be completed for more timely reporting from commercial banks. Off-site surveillance work will fuier be facilitated with use of more advanced office technologies. The BOU has been giving recruitment and training of supervision staff high priority. Nevertheless, funher recruitment and training will be needed for the Department to fulfill its role. A critical task for BOU's supervision deparment, in the months ahead will be the close monitoring and oversight of progress under the restucturng programs of both the UCB and the COOP Banks. The Department will continue to receive substantial Technical Assistance under the reform program. 3.35 Improving Acountng and Check Clarng sysem and Coordination Between the BOU and NOP: The existence of a well developed accoundng framework and a check clearing system are preconditions for the development of a modem financial system. The BOU has begun to address these problems. Daily statements of commercial bank accounts are now provided within 24 hours. The BOU has also initiated discussions with commercial banks aimed at reducing cleaing times in Kampala from 4 to 2 days before the end of current fiscal year. Banking for Government remains an area where current operations are indequate to the point of damaging the BOU's image. The BOU will upgrade its banking and account keeping arrangements so that balances of accounts are made available to the MFEP within 24 hours. It is also expected to initiate regular meetings with the MFEP to assist in identifying differences between BOU and MFEP balances. The BOU wfll also play a key role in assisting the newly established Institute of Chartered Accountn (ICA) with the preparation of generally accepted accountng and auditing standards for Uganda. Sasisctory sent of accounting and check cleari system is one of the conditins for the Rael of the Second Tranche. 3.36 Repit the Central Bank. The fial stading of the BOU has not been favorable. This perception was fielled by the contimned failure of the BOU to publish audited accounts beyond June 1986. To this was added a belief that the BOU had almost certaiy been involved over this period in foreign exchange and lending operations that could well haie produced substantial losses. 3.37 Under the reform program, the BOU's audited accounts for the five years from June 1986 to June 1991 have been prepared and published. They disclosed a weak financial performance but not to the exent anticipated. The accounts show total assets of the BOU to be 677 billion shillings with loans and advances (mainly to Government) 506 billion shilngs and external assets Qargely IMP Quota and to a lesser extent foreign currency deposits) 132 billion shillings. Capital and reserves amount to 16 billion  -32 - shillings, which is the amount of operating profits over the five year period. The accounts (and auditors report) disclose that a foreign currency suspense balance of 18 billion shillings is included in other assets pending verification of the authenticity of the transactions involved. It is understood that subsequent work in the BOU has already established the validity of virtually all of these transactions. In the future, the BOU intends to publish its annual accounts within three months after the end of a fmancial year and to supplement this with quarterly accounts which are already being published for FY92. 3.38 An examination of BOU's capital needs based on 1991 accounts indicated that its capital and reserves should prudently be about 30 billion fUganda shillings. After allowing for some provisions, it has been estimated that the BOU's current business requirement would warrant a capital injection of 15 billion Uganda shillings. The BOU is expected to close the 1992 accounts with a profit of around USh 14 billion. If this materilizes, BOU may not require immediate capital injection. When the ongoing discussions regarding the treatment of IMF charges is completed, the BOU will specify its capital requirements to the MFEP and the Association. On this basis, the MPEP will provide capital injection in the form of interest bearing Government securities. Also, before the release of the Second Tranche, the MFEP will make the necessary budgetary alocations to meet the second year financing reqirements of BOU recapitalization 3.39 The financial position of a Central Bank depends not only on its balance sheet but also on its cash flow position. A central bank must be able to fund its operations, and particularly its monetary and exchange policy operations, including any capital losses independently of the Government's annual budgetary process. In the Ugandan context, there is a strong case for the BOU to pay some interest on required reserves. Earnings from capital should be an important source of income. Beyond that the BOU has limited sources of income other than earnings on foreign exchange. The BOU receives no fees for its substantial banking operations on behalf of the government and little income from loans to Government because of the low (and substantially negative real) interest rates charged. Under the reforn progm, the IOU will give greater emphasis to generating income through recovering its net costs on baniing services for the Government from interest or other charges. UCB Restrucuring 3.40 Background. The UCB is the largest commercial bank in Uganda with 189 branches providing commercial banking services to much of the country. The prolonged civil wars that extended through nuch of the 1970s made the UCB's operations difficult particularly outside the Kampala area. As the security situation improved in the late 1980s, the bank undertook a rather quixotic effort to stimulate development of the national economy by implementing a massive branch network expansion plan. The lack of trained managers, inadequate communication facilities and lack of bankable economic opportunities in the rural areas has had predictable negative results on the bank's financial performance. In addition, the UCB's strong market dominance and political power shielded the bank from normal market discipline and regulatory oversight. As a result, the bank has been insolvent for sometime. The bank's accumulated operating losses totaled some USh 37.6 billion as of September 30, 1991. At present, the non-performing loans account for about one-third of the UCBs portfolio. 3.41 The Restructuring Strate. The restructuring strategy under the FSAC requires a substantial reduction in the relative size of the UCB through the segregation of its bad assets and the rationalization of its staff and branch network. In addition, as privatization proceeds, careful attention will be given to breaking up UCB in order to reduce its preponderant role in the market. Under the reform program, the UCB will transfer its non-performing loans to the Non-Performing Loans Recovery Trust (NPLRT), charged with the recoverv or liquidation of these assets. This action will be accompanied by a  -33 - substantial down-sizing of the bank with the much reduced but good part of its portfolio. In addition, the Government will give greater authority and accountability to the UCB Management and minimize its own interference with the UCB through a "performance contract" to be signed between the Government and the UCB. The "performance contract" will set clear performance targets for the UCB and its management for 24 months, with a probation period for the management of one year. Before the release of the Second Trance, the Govermnent will offer UCB to private investors, preferably after packaging the restruchre UCB in such a way as to ensure competition in the market. 3.42 Recent Developments and Measures Ahready Introduced. After the inauguration of the reform program about a year ago, the UCB's liquidity position has improved steadily with continued increase in deposits in response to positive real interest rates, coupled with increased emphasis on loan recovery. As a result, UCB has managed, until recently, not only to wipe out its overdraft at the Bank of Uganda (BOU) but also to generaly maintain the 10 percent cash reserve requirement at the BOU. Since October 1992, however, the UCB's liquidity position has deteriorated once again. Moreover, its operating costs have remained excessive over the past two years. Under the reform program, the Management prepared a comprehensive Restructuring Plan to be implemented during FY93-95. The primary objective set forth in this plan is to reduce costs and improve operating efficiency and profitability. The UCB has also identified the technical assistance needed to successfully implement this restructuring program. With funds made available under the Project Preparation Facility (PPF) they hired an outside consultant to assist with the selection of an internationally reputable firn to assist with the restructuring exercise. At present, the UCB has completed the selection process through ICB. 3.43 Key Elements of the Restu g Plan. The primary objective is to transform the UCB from a loss-makilg to a profitable entity within a reasonable time frame (two years). This core task will be achieved through institutional and financial restructuring; strengthening the organization and management policies; internal procedures; and recapitalization. 3.44 Under the Restructuring Plan the UCB aims at: i) redefining the mission and the role of the UCB. This will require the modification of the traditional role from that of a semi-developmental to that of a commercial banking institution operating accordin1, to normal commercial principles. At present the UCB derives its mission from the UCB Act. Under the reform program, the UCB Act will be repealed with the UCB placed under the new Financial Institutions Act. ii) restructuring its organiza, ni chart along functional lines, creating a number of business units that address specific market segments. This is anticipated to result in a rationalization of operations and corresponding reduction in staffing of at least 23 percent. iii) rationalizing the branch network to insure that each operating unit is independently profitable. The restructuring plan identifies 48 out of 125 new branches as not meeting this criterion and proposes their closure. The plan also aims at merging overlapping branches. iv) strengthening the credit management processes, in particular in properly matching loans to client needs and repayment capacity, identifying problem loans at an early stage and acting aggressively to protect the bank and depositor funds as soon as a loan becomes past due.  -34. v) substantially revamping the Bank's accounting policies and procedures. vi) segregaing "good" from "bad" portfolio and transferring the bad assets to a separate entity responsible for the recovery and collection of these assets. vii) introducing an effective planning and budgeting process. viii) strengthening the inspection and audit functions. ix) improving the employee motivation and training process to emphasize performance and professionalism. x) completing the automation project and developing mangfUl management information systems. 3.45 UCB RapitalizatiOn The limited-scope on-site examination of UC0, conducted recently under the reform program by the BOU Supervision Department, confirmed the earlier findings on UCB's asset quality and revealed alarming facts about UCB's financial position. The exam of UCB found the bank, as of the 30 June, 1992 exam date, to be insolvent to the extent of USh 32 billion. This was due to massive levels of bad and doubtful debts, far greaer than has been previously disclosed. In order to put the bank on a solvent basis, a minimum recapitalization level of USh 36.5 billion was called for in this exam. Using provisioning percentages of 20 percent for substandard, 50 percent for doubtful, and 100 percent for loss, the exam concluded that the UCB's exisdng portfolio of USh 71.7 billion (August 1992) required a provision of USh 34.1 billion. This compared with the UCB's exisfing loan-loss provision of only USh 12.7 billion. The exam also disclosed that the UCB's "core" capital was in a deficit position of USh 10.7 billion due to retained profits (losses) fromn prior years. When the required adjustment to the loan-loss provisions of around USh 21.4 billion was added to this total, the UCB's core capital was at a deficit of USh 32.1 billion. This meant that the UCB would need an injection of at least USh 32.1 billion to remove the current level of insolvency as disclosed in the exam. In addition, the 4 percent reqirement for core capital (of risk-weighted assets), esmaed at around USh 4.3 billion would raise the UCB's capital requirement to about USh 36.5 billion. 3.46 FSAC Supported Actiens. Under the reform program, the UCB will complement its Restucturing Plan with a Finnial R Plan, which is already underway with assistance from external consultants. The UCB's Financal RP D?lan, will ensure that UCB achieves satisfactory levels of profitability within a reasonable time frame ( i.e, no more than two years) and that the financial funds to be invested through recapitalization would be effective to return the bank to profitability and financial soundness. Specifically, the F1_al Retrctuing Plan will re-assess UCB's goals and objectives as set out in the Restucturing Plan in light of most recent financial realides; specify clear financial performance targets such as (a) ratio of operating costs to average total assets; (b) return on shareholder's equity; (c) return on average total assets; (d) percentage of non-performing portfolio in relation to total outstanding portfolio; (e) ratio of loan collectiorm as a percentage of scheduled collections; establish clear benchmarks and timetables to put greater discipl.& into UCB's recovery and performance; recommend specific strategies and specify actions required to achieve the set financial objectives; recommend improvements on the current budgeting and fancial management systems; help to achieve improvements in asset and liability management; and develop a medium term capitalization plan taking into account factors such as planned growth, planned staff rationalization, plnned branch network closure, earnings retention, the nature of future operations and nature of capitalztion instrums.  -35 - 3.47 The actal injection of capital will wait until after the completion of the Facal R Plan. Given the extremely tight fiscal situation, the Government will provide longtenu bonds rather thn direct cash injection for recapitaatlon purpos. Even with this fonm of financing, the cost of servicing USh 36.5 billion in long-term recapitalization bonds (with adjustable interest equal to the average cost of mobilizing deposits - currenly around 18 percent) would place the first year budgetary impact at around USh 7 billion with a total budgetary impact of around USh 15 billion during the life of the Credit. This amount does not include the expenses involved in obtaining the long-term Technical Assistance (TA) discussed above, and in rationalizing the staffing of the UCB, estimated at around USh 3 billion, which will need to be covered in cash to match the timing of the expenses. UCB's recapitalization will be accompanied by the implementation of the total reform package, as outlined above. (a) Sadsfactory progress towards meeting the fi-year performance tagets Is a condition for Second Trache Release. Also, (b) before the release of the Second Trance, the MFEP will make necesary budgetary allocations to meet the second year finanig rerements of UCB recap ita liz atlion . Non-Performig Loans Recovery Trust NPLRT) 3.48 The UCB has over the years accumlated an unmanageable amount of non-performing loans as against the relatively inadequate amount of loan loss provisions. As UCB is being restrctured into a more viable and dynamic insttution, it will segregate its non-performmg assets and transfer these to the proposed NPLRT, which will be established by the Government by July 1993, as a new entity charged with the recovery or liquidation of these assets. This will enable the UCB's management to focus on its future operations. The Technical assistance Program will provide funding for a management contract with a private consultant firm which would be in a position to field staff of various expertise necessary for the purpose viz. liquidation lawyers, financial and industrial management specialists, etc. The resident personnel of the consultant firm will report to the Governor, Bank of Uganda, through the Project Coordinator of the FSAC Implementation Secretariat. COOP Bank Restuduring 3.49 Background and Measmres Alrea Introduced The COOP Bank had serious management problems in the late 1980s. Its financial performance has been impaired by a severe liquidity squeeze resulting from the failure of the bank to adequately ensure recovery of loans and some excesses in its lending. Cogniznt of the financial difficulties, the Swedish Cooperatve Center in 1990 refined its support to the COOP Bank by funding a technical assistance team as part of a comprehensive restruring program. Given the enormity of the rehabilitation task required and the small size of the technical assistance team and the paucity of financial resources available to the bank, dramatic changes could not have been expected. Rather, the team has focussed on developing a sounder management infrastucture so that the process of changing the insution can be effectively managed. The initial stage led to a revision of the COOP Bank's organization chart during the last quarter of 1990 with substantial alignment of organization with function and with rationalized spans of control. These changes were implemented in February, 1991. One branch has been closed, and five branch managers have been replaced. In one case, deposit levels have incsed significantly since the replacement. More recently, focus has shifted to tightening the credit process, particularly recovenes and developing a clearer picture of the recoverable value of the loan portfolio. The next major step is to complete the financial restuctuing already underway so as to ensure a sound financial base and allow management to focus on strengtening the managemnt t and operations of the bank.  - 36 - 3.50 FSAC Supported Actions. The financial analysis shows that placing the COOP Bank on a sound financial footing will require some USh 7.5 billion in new capital, most of which will come from conversion of deposits from the Cooperative system that have come out of the PL 480 program to capital. Recapitalization will have the immediate effect of reducing the COOP Bank's interest expense, which would do much to help the institution pass through the restructuring process. In the interim, the COOP Bank will adopt an ultra-conservative approach to lending until credit policy and procedures are significantly tightened through technical advise and assistance. 3.51 Despite the proposed recapitalization, the COOP Bank will remain a troubled bank until its loan portfolio and the financial performance standards are improved. Assuming that the financial restructuring is completed as planned, then the COOP Bank will be given a new lease on life. With the use of funds generated by the PIA80 program for capitalization purposes, the next step for the Goverunent will be to place the COOP Bank on the same level playing field as other financial institutions by subjecting it fully to the new Financial Institutions Act and repealing any conflicting legislation such as applicable provisions of the Cooperative Act. 3.52 Continued survival of the COOP Bank will depend on its ability to position itself properly in the market and manage itself well enough to be commercially viable. The uldmate success of the recapitalization and restructuring will depend on two key issues: (i) Recovery of the bank's loans so that the new capital is not immediately wasted, recreating the insolvency. (ii) A sharp reduction in operating expenses through staff rationalization. The capital Injection required as well as substantal Technical Assstance support to the COOP Bank will be provided by the USAID. Satisfactory progress towards meetng the first-year performance targets Is a conditon for Second Tranche Release. Financiai Markets Development 3.53 Background. The dynamics of financial markets development is essentially private sector driven. However, the Government can take a number of measures to organize and foster this development. The reform program under the FSAC will focus primarily on improving/establishing the legal and regulatory framework for governing and guiding the development of non-bank financial institutions, the insurance industry, the national pension fund, leasing and hire purchase finance, and eventually the stock exchange. 3.54 FSAC Supported Actions. The Government currently has a major program of increasing public participation in a wide range of non-financial public enterprises. To achieve appropriate development in this area, the Government believes that it must set the legal and regulatory framework for mobilizing domestic resources in addition to those being tapped through the banking system, and enable dispersion of ownership through equity shareholdings by a large number of Ugandans. To ensure that the steps taken are soundly based, a brief review, exploring the potential for securities market in Uganda is currently being financed by the PPF fuids. In light of that review, a specific action progran for the development of securities market in Uganda will be designed, jointly with Government, IFC and IDA. This program will be implemented as part of the proposed FSAC. PART IV. FEATURES OF THE PROPOSED CREDIT Credit Objectives and Rationale 4.1 The proposed FSAC is one of a series of adjustment operations in Uganda designed to support the Government's overall program of stabilization and structural reforms. The proposed FSAC will  -37- complement the policy reforms begun under the two ERCs, ASAC, and the SAC, and support the implementation of Uganda's Financial Sector Adjustment Program (FSAP) during FY93-95. At present, the formal financial sector in Uganda is unable to contribute effectively to economic growth and stabilization. The existing system suffers f.om both lack of monetary depth and monetary restraint. Two major conunercial banks face severe fincial difficulties which, if left unaddressed, will impede the future progress and constrain seriously the supply response to the economic incentives being introduced by Government. There is also a high degree of govemment ownership and interference in the financial system. The reform program proposed under the PSAC will help to restore monetary management and control; create an appropriate policy and regulatory framework conducive to increased competition and efficiency and greater private sector participation in the financial system; strengthen the role and the capacity of the Central Bank (Bank of Uganda) as the monetary and supervisory authority, and; enhance the soundness of the banldng system through improved prudential regulation, supervision and restructuring of problem banks. Credit Amount and Description 4.2 The borrower is the RepLblic of Uganda and the credit amount is SDR 72.8 million (US$100 million equivalent). The credit would consist of two major components: (i) a quick-disbursing sector adjustment component for balance of payments support (US$90 million equivalent) linked to the conditionality specified for first and second tranche releases; and (ii) a technical assistance component (US$10 million equivalent). The quick disbursing component, which is equal to about 15 percent of total imports of goods, or about 30 percent of non-project imports required in FY93, is necessary to maintain the momentum of the stabilization and adjustment programs and, along with other donor assistance, to help close the financing gap of the balance of payments (Amnexes m and IV). The Technical Assistance Component, outlined in Annex V, would help to strengthen the capacity of BOU, UCB and the UDB, and support the reform process as a whole. Uganda's key bilateral and multilateral donors, including USAID, Sweden, Netherlands and African Development Bank have expressed interest in providing cofinancing or parallel financing for the proposed FSAC. Procurement and Disburm 4.3 Sector Adjustment Component. The adjustment component of the credit would be disbursed in 24 months in two tranches. The first tranche (US$45 million equivalent) would become available upon credit effectiveness, expected in April 1993, and the second (US$45 million equivalent) upon fulfillment of specific conditions for second tranche release. The proceeds of this component would be used exclusively for financing the foreign exchange costs (c.i.f. Kampala) of Uganda's general imports, except for a small negative list of ineligible goods (military or paramilitary equipment, luxury goods, precious stones, gold, etc.) agreed between the Government and IDA. Also, items costing less than $5,000 and goods financed by other donors would be ineligible for financing under the credit. The Govermnent would furnish to IDA docments and other evidence showing that payments have been made exclusively for eligible expenditures; however payment for contracts under $250,000 would be submitted on the basis of Statements of Expenditure (SOE). The SOB supportive documents, such as invoices, evidence of shipment and payment, will be retained by the Bank of Uganda for random review by Bank staff and by the auditors. The Bank of Uganda would be responsible for the coordination and collection of relevant docments from the commercial banks and the foreign exchange bureaus, as well as the preparation and submission of withdrawal applications and supporting documents to IDA under the Special Account. The Special Account would be audited periodically by an idependent auditor. The Uganda Shillings generated by the sale of foreign exchange provided by the Credit would not be eannarked for specific purposes, but rather would be available for use in the Government's budget. However, the Government  -38 - intends to allocate the equivalent of US$10 million in Uganda Shillings in each of the FY94 and FY95 budgets for the Institutional Reform component of the proposed FSAC. These funds would be used for equity contributions to BOU ar4 UCB, in line with progress achieved in the implementation of the reform/restructuring programs for'each institution as agreed with IDA. 4.4 Procurement procedures for the Sector Adjustment component of the Credit would be patterned after those applied under the Uganda SAC. Contracts for the procurement of goods estimated to cost the equivalent of US$1 million or more each shall be awarded through International Competitive Bidding (ICB). For such contracts, the international community will be notified in a timely mamer of the opportunity to bid and the contracts will be submitted to IDA in advance for no objection. For contracts estLnated to cost less than $1 million, purchasers required to follow the Borrower's public sector procurement procedures when importing goods, would obtain price quotations from at least three eligible suppliers with the exception of proprietary equipment, spare parts and standardized equipment where compatibility with existing equipment is required. These procrement procedures have been reviewed by IDA and are considered acceptable. Private sector procurement under contracts valued below $1 million will follow established commercial practices. Discussions with the Uganda Chamber of Commerce, Bank of Uganda and a number of importers indicate that the private sector does follow established commercial practices, including wherever possible competitive bidding or comparative assessment of costs. All imports over $10,000 will be subject to pre-shipment inspection, except for price verification on IDA-financed goods procured by ICB where such verification is not pennitted. The pre- shipment inspection will be carried out by the Government appointed agency, which is currently the Societe Generale de Surveillance S.A. 4.5 Up to SDR 16.3 million (US$20 million equivalent) of the proceeds from this component may be used to purchase petroleum products. These products axe currenly procured by the six oil companies operatng in Uganda under service and supply agreements with the parent enterprises in accordance with a pricing formula agreed with the Government. Since few of the parameters in the formula are market determined, this system does not necessarily result in the least-cost prouemet of these products. However, given the country's landlocked status, lack of its own storage facilities at Mombasa and the Government's chronic shortage of free foreign exchange, Uganda has continued this methodology so as not to disrupt the supply of oil ahd precipitate a crisis. The Government now wishes to move to international competitive bidding in the procurement of petroleum products on the basis of c.i.f. Mombasa and has commissioned a feasibility study to assess the benefits and costs of doing so. The consultant's draft report, which recommrnds that ICB be adopted, is cely being discussed by the Government. The consultant's proposal will be submitted to the Bank for review prior to a final decision being taken. If the feasibility of introducing ICB is established, all petroleum products will be procured using that method. However, if the feasibility is not established, the Credit will revert back to the standard ICB clause which requires ICB for conracts in excess of $1 million. To facilitate disbursement and procurement, a special account of 15 million would be established in US dollars at BOU or commercial banks, on terms and conditions acceptable to IDA. 4.6 Technical Asstace Component. The overall cost of the Technical Assistance Program (TAP) is US$10.9 million, of which 90 percent is in foreign costs and 10 percent in local costs (Annex V). IDA's contribution is US$10.0 million, covering 100 percent of foreign costs, including USh expenditures related to foreign contracts. The Government/financial institutions will contribute equivalent of US$900,000 (USh of around 1.0 billion) from their own resources for the local costs. The cost breakdown for each sub-component is presented in Annex V, Table 1. Consultancy services for the various technical assistance sub-components (estimated at around US$7.5 million) will be obtained in accordance witli the Bank Guidelines for the Employment and Use of Consutants. The cost of  -39 - staff/management training in BOU, UCB and the Institute of Banker is estimated at US$1.1 million and would be carried out in consultation with IDA. Most of the conacs for hardware and software (esdmated at US$1.1 million for UCB, US$110,000 for BOU and US$110,000 for the Institute of Bankers) will be awarded on the basis of interational competitive bidding (ICB), in accordance with the Bank's guidelines. Minor items below the ICB threshold of US$50,000 per contract up to an aggregate of US$100,000 will be procurod through prudent shopping on the basis of comparison of price quotations from at least three qualified suppliers eligible under the Bank's gwudelines. Disbursement under the teebnical assistance component will not be subject to the tranche release conditions, and the technical assistance component is expected to be disbursed in 36 months. Accordingly, the closing date for the program is June 30, 1996. Statement of Expenditures (SOE) would be used for contrc not exceeding US$100,000. A special account of US$900,000 representing about three month's expenditures would be established in a commercial bank to expedite disbursements. Management, Reporting, and Auditig 4.7 FSAC Smplemetatior 9 . Presently, BOU has established a small project management office to handle the processing and ainisttion of the PPF (US$750,000) approved by IDA to enable the Government to initiate some of the activities under the reform program. To ensure effective inplementation of the varous programs and activities, there is a need to institutionalize and strengthen the implementation arrangements. A FSAC Implementation Secretariat will be set up in BOU to replace the small project office. It will be headed by an expatriate Project Coordinator (who will be a highly experienced commercial banker); he will be assisted by a TA Coordinator. The Secreiat will also include representative(s) of the private management group responsible for recommending disposal of the non-performiung loans which will be transferred to the Non-Performing Loans Recovery Trust (NPLRT). BOU will have the overall management responsibility for the program, while the component for assistance to banks will be implemented by the managers of the respective banls. The Project Coordinator will report implementtion progress to the Governor and submit quarterly reports to IDA, within one month of the quarter's close. 4.8 The operation has been prepared in close collaboration with the IMP, and is fully integrated in its program. Reforms to be carried out under the proposed operation have also been discussed with IFC, particularly regading the returing of UCB and the COOP Bank and the development of financial markets. The Bank staff will conue to coordinate with ID teams in monitoring key macro economic indicators and policies. IDA is making available part of the technical assistance for implementing the BOU restructning program through the Economic and Financial Management Project which was approved by the Board in August 1992. 4.9 The BOU will maintain records of all transactions under the Credit in accordance with sound accounting practices. No later than six months after the end of each fiscal year, aU accounts will be audted by idepenet auditors acceptable to IDA and submitted to the Association. Audit reports will include a separate opinion with regard to the claims submitted to IDA on the basis of withdrawal applications and would state whetier such claims have been affected in accordance with the Credit Agreement. The Government will document local cost contributions within the Credit's financial control procedures for appropriate auditing. Mouitorable Actions and Tranche Rldease Conditin 4.10 Conditions of Board Presentaton. The reform progam is front-loaded in the sense that a sizeable number of actions have been completed prior to Board Preseation. The most important actions  -40- in this category included the legislative reforms and the Government's policy announcements/actions regarding its intention to encourage competition and efficiency and greater private sector participation in the financial systm. The new Bank of Uganda Act as well as the new Financial Institutions Act, prepared under the reform program, have been enacted and put into effect in February 1993. 4.11 The conditions for Board Presentation, which have been fully met, are listed below: Polcy Reorms (a) Achievement of satisfactory macroeconomic and fiscal performance, with minimal domestic bank financing of the fiscal deficit in FY93. (b) Assignment of primary responsibility for formulation and implementation of monetary policy to Bank of Uganda (Central Bank). (c) Establishent of a Monetary Policy Management Unit in the Research Department of BOU, for effective monetary policy formulation and management. (d) Removal of restrictions imposed on commercial banks to hold Treasury Bills. (e) Removal of interest rate subsidies granted to public sector. (f) Announcement of the Government's policy statement regarding its intention to reduce its equity share in pdvate banks and open up the UCB for private participation. (g) Actual offering of the Government's equity shares in two private banks for sale to poentia private investors. Legiative Reforms (h) Revision of the old Bank of Uganda Act and the Banking Act so as to enhance the role of BOU as the monetary and the supervisory authority. (i) Provision of adequate legal powers to BOU to implement and enforce its supervisory responsibilities on banks, other depository and non-bank financial institutions, and the insurance industry. j) Enactment of new Bank of Uganda Act and the new Financial Institutions Act to replace the old BOU Act and the old Bankdng Act. (k) Preparation of new prudential guidelines to be followed by banks regarding such matters as licensing, capital requirnts, loan classification, general and specific loan loss provisions. (1) Establishmnent of oversight over "unreguated" Insurance Industry.  -41 - kulttonlReforms (m) Changing of the Cental Bank's organiztonal strue, satisfactory to 1IDA, including the appointment of key senior staff. (n) Preparation of Restructuring Plans for UCB and the COOP Bank. (o) Completion of a background study on the establishment of a potential Securities Market in Uganda. 4.12 Conditions for Secod Tranche Rdease. Disbursemet of the second tranche (US$45 million equivalent) anticipated for April 1994, would be contingent on a review, satisfactory to IDA, of (a) Uganda's implementation of the overall adjustment program, with emphasis on macroeconomic and fiscal performance and (b) filfillment of the sector-specific Second Tranche conditions listed below. Some of these conditions have been spelled out in detail in side letters to the legal documents. Poliy Reforms (a) BOU to (i) inroduce Reserve Money Progrmming and Management to improve monetary management and control; and (ii) enforce timely and accurate financial reporting by commercial banlks to strengten bank supervision. (b) Goverment to offer its equity shares, in part or in whole, in privately owned banks for sale to potential private investors. Legislative Reforms (c) Govermment to submit to the Legislature new legislation on Insurance Indutry and on Leasing Finance. Reform of the Central Bank (d) BOU (i) to establih a standard accountng system in all its Departments; and (i) to substantially improve the check clearing system in and outside the Kampala area. (e) The Ministry of Finance and Economic Plaming to make the necessary budgetary aRocations to meet the second year financing requiremes of BOU recapitalization. UCB R (t) UCB to make progress towards meeting the first-year performance targets set forth in the Financial Restucturing Plan. (g) The Ministry of Finance and Economic Planning to make necessary budgetary allocations to meet the second year financing requiements of UCB recapitalization. (h) Govermment to offer its equity shares in UCB, in part or in whole, to potental private investors.  -42- COOP Bank (i) COOP Bank to make progress towards meeting first-year performance targets set forth in the Financial Restucturing Plan, satisfactory to IDA. PART V. BENEFITS AND RISKS Economic Impact 5.1 The formal financial system in Uganda is at an early stage of development and has been handicapped by significant institutional and policy weaknesses. In the proposed FSAC, emphasis is being placed on priority policy and institutional refonns to increase efficiency, profitability, and financial resiliency of the banks, leading to more efficient provision of fiancial services and a greater flow of financial resources for production and investment. Increased efficiency of the financial system should therefore enhance growth, both by increasing savings antl by channeling them to higher yielding economic activities and investments. A more dynanic Central FTank and an efficient financial sector should also increase the Goverment's ability to manage the ece omy and further the successes of the stabilization and adjustment programs. Moreover, the enhance soundness of the banking system which will be pursued through its restrucing together with the proposed reform of the financial legislation and iproved bank supervision should increase confidence in the financial instions, thus inducing their further growth. The credit will also address the development of the money and capital markets which s6ould contribute to a broadening of the financial system and help to stimulate private investment, both domestic and foreign. Socal Impa 5.2 The reduction in staff in UCB, BOU and the COOP Bank will adversely affect mainly low-level civil servants who will be displaced. Their prospects for obtaining formal employment in the private sector are not promising, especially in the short run. Assistance will be necessary to enable them to enter into self-employment activities. The Govermment has pred a redundancy scheme for civil servants under the auspices of its Program for the Alleviation of Poverty and the Social Costs of Adjusmnt (PAPSCA). It will start laying off workers In financial institutions with compensation packages similar to the redundancy scheme under PAPSCA. 5.3 Staff retrnchment aside, on balance, the recovery and adjustment programs are improving the overall economic well-being of Ugandans by reversing the damage brought by 15 years of mismanagemnt sand civil wast. Agicultural producers are reaping the benefits of trade and price liberalizion and exchange rate adjustments. At the same time, employment opportunities would expand in reflection of increased industa capacity utilization and new investment. The process of economic rejuvenation would be reinforced by increased budgetary allocations for social services such as primary health cre, primary and secondary education, and sanition and water supply. With an improved economic climate and adequate flows of external mssistance, real per capita income and consumption is exected to grow by about 2 percent per annum over the next two or three years. Sfill, the Government is addressing the specidal needs of these disadvantaged groups. Recognzing its own limited implemntation capacity, the Government decided to make the maximum use of the expertise that local communities and non-govenmental organizations (NGOs) can bring to bear on the delivery of services  - 43- and the creation of assets, and has begun this process under PAPSCA. The impact of the adjustment program on the poor is being monitored through the Social Dimensions of Adjustment (SDA) initiative. Risks 5.4 The credit faces three major risks. The fhrst is that the Government may not be able to achieve one of its critical macroeconomic objectives which is to control and stabilize inflation at an acceptable level. High and sustained budget deficits may continue to threaten macro/financial stability, drive up interest rates and crowd out the private sector. If inflation is not reduced, the lowering of and eventual liberalization of interest rates would be difficult. The persistence of inflation at a high level would also make it difficult for banks to provide medium and long term credit for investment. Therefore, both the reduction of fiscal deficits and their financimg through non-inflationary sources are critcal elements to the success of the program. The second risk relates to the complexity of undertaking a massive restructuring of the banking system which requires not only the strong commitment of the Government but also the full cooperation of the banks' management. Finally, the restructuring of UCB and the COOP Bank may proceed more slowly than anticipated, if the bank restructuring component encounters political resistance. 5.5 These risks, however, would be mitigated largely by the Government's strong commitment to the stabilizaton objectives under the PFP and Fund supported programs, and its willingness to receive technical assistance for insttutional reforms. The Government is in the process of appointng new and highiy qualified managers, with greater authority and accountability, to the UCB and BOU. Moreover, the ongoing Economic and Financial Magement capacity-building project will help to alleviate implementation weaknesses in key ministries and institutions. Finally, proposed improvement of the regulatory framework and strengthering of Cental Bank supervisory funcdons are expected to ensure the competitiveness, efficiency, and soundness of the banking system in the future. PART VI. RECOMMENDATION 6.1 I am satisfied that the proposed Credit would compiy with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed Credit. Lewis T. Preston President Washington D.C. March 5, 1993  - 44 - USAt A - FINAICIAL SECTOR ADJUSIIIIT CREIT (FSAC) SUNX#RR OF GOEUET REFORN PROGRO INSTWANtUS AnD FSAC RUNITORABLE OBJECTIVES NEASIRES ALREADY ACTION PROGRAN TINIUG ACTIONS I1TM A. POLICY REFCRS 1. Sqpprt onging Fiscal Policy - Achieve satisfactory macroeconomic 3193* Macro Prog. stabitization efforts and fiscal performance, including Currently on track domestic bank financing of fiscal deficit in FY93. - Achieve satisfactory macroeconomic 3/94 Second Tranche and fiscal performance in FY94. Release - Broaden the use of Treasury bills. Continuous fonetary Policy - Assign primary responsibility for 3/93* Done formulation and implementation of monetary policy to 80U. - Establish a Monetary Policy 3/93* Done Management Unit in the Research Department of BOU. - introduce reserve money programming 3/94 Second Tranche and management at the BOU to Release improve monetary control. Enforce timely and accurate 3/94 Second Tranche financial reporting to BOU by the Release commercial banks. II. Iqrowe the Interest Rate Policy - Maintain positive real interest Continuous efficienrcy of rates on time deposits of one year resource or more and on lending instruments. mtlization md altocation - Remove restrictions imposed on 3/93* Done cormercial banks to hold T-bllts. Directed Credit - Prepare a plan to phase out 7/93 Done Policy interest rate subsidies (granted currently) to public sector. Discount Policy - Introduce a properly functioning 7/93 Central Bank discount policy, which provides funds to meet temporary liquidity needs of banks and provides incentives to banks to seek and mobilize additional deposits before coming to the 80W. Retail Savings - Carry out a study of the potential 7/93 Nobilization and prospects for developing retail savings networks, particularly in the rural areas. - Introduce the retail savings 3/94 network scheme, as feasible. Candtfta of bawd Presettiao  - 45 - - - - FSIIC ' ' I'NT ''B -UC OUNITUADLE OB IECT IES ALREADY ASCT POuW TINING ACTIaNS: I-. Create a Goverrent has -inistry of Finance end Plannin 7/92* Done ceBtitive and established an Ad publish in the official Gazette the efficient banking Hoc Advisory Government s intention to reduce sector by Committee for Bank its equity share in private banks elitinating entry Restructuring to and prepare the UCB for public MaO exit barriers oversee the (private) participation once its encouragine Joint formilation and financial viability is restored. venRures and implementation of privatiitin fulty the entire Bank Ministry of Finance and Planning 12/92* Done verWnment-omned Restructuring offer the Goverrnent's equity babs and exercise. shares in at least two private restructuring banks for sale to potential private prablen bInks. investors. - Ministry of Finance and Planning to 3/94 Second Tranche offer the Goverrment's equity Release shares, in part or in whole, in privately owned banks for sale to potential private investors B. LEGISLATIVE REFIS IV. Strengthen Government has - Agree with IDA on a revised Banking 12/92* Done Prudential established various Act (Financial Institutions Act) to Regulatien legislative ensure that it provides for a sound cnamnttees to basis for prudential oversight of revise/draft banks and other depository legislation to institutions. Improve financial discipline - Enact the new Financial 3/93* Done establish prudent Institutions Act, satisfactory to lending practices IDA. and suwport financial sector - Agree with IDA on a revised BOS Act 12/92* Done development. to establish BOU as the monetary authority and the supervisor of all depository and other financial institutions. - Enact the new BOU Act, satisfactory 3/93* Done to IDA. - Revise the Building Societies Act 7/92 Done so as to give oversight responsibilities to the BOU. - Prepare a Leasing Finance Act (and 3/94 Second Tranche submit to Legislature) to support Release private investment and develop medium-tena financial instruments. * Substantially revise the Insurance 3/94 Second Tranche Industry Act (and submit to Release Legislature) to provide an appropriate legal and regulatory framework for the insurance industry. - SOW to take steps to establish 3/93 * Done oversight over the Insurance Industry.  - 46 - IUUUS0 - 'FNO' -MiT* i ltBLE QB=CTIVES UraS *L1 ACTION PROE TINIES CIUS: V. Enane the AutbuIty ud the Capacity of Oenl 'u-* a. Enhance its letga Revfse the BOU Act and the Banking 3/93' Done authority Act so as to enhance the role of BOU as the monetary and the supervisory authority. b. Strengthen poticy - Chnge BOU's organizational 12/92 Done formulation and structure and complete the research capability appointment of key senior staff. Of Ku - Strengthen the technical capacity 3/93* Done of the Research Department for policy formulation and implementation. - Institute a monthly Policy Analysis 7/93 Report, to be prepared by the Research Departmnt for regular submission to the BOU's & NOF's Senior Hanagements. c. Strengthen MU's - Provide WU adequate legal powers 3/93* Done prudentfal to implement and enforce its supervision supervisory resposibilities on function banks and all other depository institutions. l Iprove existing enforement 3/93' Done procedres to be followed by KU. - Prepare new prudential guidelines 3/93* Done to be followed by banks regarding such matters as licensng, capital requirments, loan classification, generaL and specific loan loss provisions. - Substantially ifprove WU's off- Continuous site and on-site exmfination capabilities. d. Iwrove KOU's - Pubtish Ku's accounts for Fy87, 7/92 Don internal accounting 8B, 89, 90, 91 and 92. practice * Begin to publish Ku's financiaL 7/92 Done statements on a quarterly basis. - Prepre a mwt specifying 3/94 Second Tranche accounting polieies and proedues ReLease to be used throuahout the KU. Improv the check clearing system and etend clearfig operations in and outside the Kamla area by shotenfng the return days and estabifshing clearing houes in Ku's eRegiona currency centers.  - 47 - INST'T'' PSAC U -|ITOML E CBEOU"BCTIK Maiw Acla PHOSM . TIMING ACTIUBS: VI. nestructue Prdbim Soft a. Restructuring of UWCB arnagement has - Convey to IDA, Governnmnt's final 12/92 Done UcB prepared a strategic decision on the amount, modalities buSinesS plen with and timing of recapitalization monitorabae which should: (a) minimize burden performance targets on the budget; (b) maximize the use and a financist ptan of external grants from varlous for the next 3 sources; and (c) take into account years. the eventual downsizing/divestiture of the UCS. UC8 management is in - Institute the TA arrangement. 12/92 Done the process of agreeing on a TA - Complete the Financial 3/93 arrangement with on Restructuring Plan and reach internotional ffrm agrement with IDA on clear to asist with Ucs performance targets to inprove restructuring. operating efficiency. - Government give greater autonomy 5/93 and acountability to UCB angement. Agree on a "performance contract" with clear finansial performance targets for UCS and its manaemant, satisfactory to IDA. - Establish the Hon-Performing Loans 6/93 Recovery Trust tNPLUT) - Transfer UCB s non-performing assets 7/93 to the WPLRT. - U4CS chieve performance targets for 3/94 Second Tranche the first year. Release - Government to open UC8 to 3/94 Second Tranche private participation. Release b. Restructuring of The COOP Wanent - Reach agreement with USAID 3/93 COOP Bnk ha prepared a satisfactory to IDA on a timetable business end for the implementation of the financafl ptan business/financiat plan and including a clear performance targets to ioprove timetable and efficiency. monitorabte prram targets. sum a br nch network - Convey to IDA, USAID/Governmant's 12/92 Done rationalization, finat decision on the reductions in recapitatization of the COOP Bank. redunant staff, usradfng of staff 8i11 to computerization and other mesures necessary to iprove operating The COOOP gnt - Encourage continuing support from 12V92 Done Is sxleoring the USA1D/SIDA/SCC and ensure a po=ssbilitt of quatiffed management team is in otning ne equfty ptlae. funds from various donors ond - COOP chieve performnc targets 3/94 Second Tranche shareholders. for the first year. Retease  - 48 - INSTMITRENTS AND FSAC NOITMLE JECTIVES Ml _ES ALMEA ACTION PROGAMI TIRIN ACTIONS: IN c. Assistance to - Improve collection rate 3/93 UD8 significantly in the short term (i.e., facilitate the completion of viable projects, take legal actions against willful defaults, write off uncollectible debts, improve the balance sheet and strengthen the loan appraisal and collection techniques). - Review loan/Loss provisioning policy 3/93 including the "realizable value" of securities as part of the capital assessment process. - Revise the Corporate Plan in light 3/93 of resource availabilities and the UD8's new mandate for the future. VIl. Encourage the Money markets - Encourage the growth of the 7/93 dmLquent af interbank market through the 8OU finamital markets providing settlement facilities and if necessary a mechanism for a. Set the foundations collaterization. for the development and functioning of - Encourage the development of money Continuous money and capital market beginning with treasury mrkets bitIs. - Update the existing studies to 7/93 determine an appropriate mechanism and instrument for non-inflationary crop financing; and implement the recomnendations as appropriate. Capital markets - Encourage the development of 7/93 primary and secondary markets in mediun-term debt obligations. - Carry out a study of the insurance 7/93 industry and the Social Security Fund in order to make recomnendations about appropriate legal and regulatoty framework for the Industry and for public provident furds. - Prepare a background study on the 1/93 Done the establishment of a potential securities market in Uganda. - Finalize a time-bound Action Program 4/93 for the establishment of the regulatory and legal framework for the operation of the securities market. - Begin to implement the Action 5/93 Program. March 1, 1992  - 49 - ANNEX 1 UCGANOA: EY MACROECONONIC INDICATORS, 1987/88-1994/95 Prelim Est eo*** Pro.ection ***e ttem 1987/88 1988/89 1989/90 1990/91 1991/92 1992/93 1993/94 194/95 ... .................... ................................................................... ............... .................................. Growth Rates: GOP CFactor Cost) 7.2 7.5 5.8 4.2 4.2 5.0 5.0 5.0 Gross Domestic tncome 8.1 7.1 7.3 4.2 3.6 5.3 5.9 5.9 GOy per capita 5.5 4.5 4.6 1.6 0.9 2.6 3.1 3.1 Private Crsumption per capita 5.7 5.7 2.9 -0.3 -1.6 1.5 0.0 0.8 Debt Service 1/: Debt Service CUSS mitlVon) 193.0 239.5 197.0 185.0 246.0 176.0 176.9 187.0 o/w Interest tUSS milAion) 57.0 66.0 77.0 62.0 87.0 79.0 87.0 90.0 Debt Service/XMS 2/ 43.5 57.3 60.9 66.0 76.4 50.6 44.2 41.6 Debt Service/GOP 2.8 4.6 4.6 5.3 8.6 5.2 4.8 4.7 Ratios to GOP, Constant Prices: Gross Investment 8.6 7.7 8.4 10.6 9.0 12.1 13.1 13.8 Pub(ic Investment 5.1 4.0 4.4 5.3 3.7 3.9 4.2 4.3 Private Investment 3.5 3.7 4.0 5.3 5.3 8.2 8.9 9.5 Ratios to GOP, Constant Prices: Domestic Savings 3.5 2.5 3.7 6.4 6.4 9.0 10.2 11.2 National Savings 4.4 3.1 3.7 6.6 6.2 8.9 10.2 11.1 Public Savings -0.5 -1.3 -0.7 0.3 -4.4 -1.8 -0.6 0.2 Private Savings 4.9 4.4 4.4 6.3 10.6 10.7 10.8 11.0 Ratios to GOP, Current Prices: GovernDsnt Revenues 5.4 5.4 6.8 7.1 6.6 7.3 9.8 11.6 Government ExpendItures 10.5 9.9 12.3 14.1 20.6 19.4 20.6 21.5 overall Deficit 3/ -5.2 -4.5 *5.S -6.9 -14.0 -12.1 -10.8 -9.9 Miscellaneous: cpt (1987/88 a 100) 100.0 202.2 299.4 410.1 583.3 787.5 883.2 948.2 Real Exchange Rate C1987/88 = 100) 100.0 84.9 73.6 46.3 37.7 Export Growth Rate -22.2 -7.0 -14.2 -2.9 -5.1 7.4 14.9 13.9 Exports/GOP 4/ 4.6 4.0 3.2 3.0 2.7 2.8 3.0 3.2 Imports Growth Rate 4.7 1.1 -7.4 -6.2 -22.4 17.7 5.1 5.0 Imports/GDOP 4/ 9.7 9.2 7.9 7.1 5.3 5.9 5.9 5.8 Current Account, CUSS miLlion) -295.1 -361.0 -429.1 -443.8 -34.4 -425.2 -445.S -467.8 Current Account/GOP 4/ -4.2 -4.6 -4.7 -4.0 -2.8 -3.2 -2.9 -2.6 Gross Reserves Cmonths of imports) S/ 0.9 0.6 0.4 0.6 1 5 1.6 1.7 2.0