Uganda - Financial sector review (Vol. 2 of 2) : Main report

Report No. 9099-UG Uganda Financial Sector Review (In Two Volumes) Volume II: Main Report May 7, 1991 Industry and Energy Operations Division Eastern Africa Department Africa Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ACRONYMS & ABBREVIATIONS ARP Agricultural Rehabilitation Project ASAC Agricultural Sector Adjustment Credit BAH Booz Allen & Hamilton BOU Bank of Uganda CMB Coffee Marketing Board COOP Cooperative Bank CPI Consumer Price Index C&L Coopers & Lybrand DFCU Development Finance Corporation of Uganda DFF Development Financing Fund DFG Development Finance Group (UCB) DFIs Development Finance Institutions EADB East Africa Development Bank ERC Economic Recovery Credit ERP Economic Recovery Program ESAF Enhanced Structural Adjustment Facility FY Fiscal Year GOU Government of Uganda HFC Housing Finance Corporation HFCU Housing Finance Corporation of Uganda IMF International Monetary Fund LAUB Libyan Arab Uganda Bank MDC Manpower Development Center MFS Mortgage Finance Scheme MOF Ministry of Finance NBFIs Non-Bank Finance Institutions NIC National Insurance Corporation OGL Open General Licensing PFP Policy Framework Paper RFS Rural Farmers' Scheme (UCB) SCC Swedish Cooperation Center SIP Special Imports Programme UCB Uganda Commercial Bank UDB Uganda Development Bank USh Uganda Shiflings CURRENCY EQUIVALENTS Currency Unit = Ugandan Shillings (USh) US$ 1.0 = USh 570 GOVERNMENT OF UGANDA FISCAL YEAR July 1 - June 30  FOR OFFICIAL USE ONLY PREFACE This report is the result of a collaborative effort between the Government (the Ministry of Finance and the Bank of Uganda) and the World Bank Group (the International Bank for Reconstruction and Development (IBRD) and the International Finance Corporation (IFC)' and is based on a mission that visited Uganda in March 1990. The members of the mission, led by Mr. Irfan Aleem, were Messrs. John Roberts (corporate and development finance issues), Roy Karaoglan (commercial banking specialist), Jacob Yaron (rural finance issues), Yaw Osafo-Maafo (housing finance specialist), Alan Roe (macroeconomiet), T. N. Iyer (central banking specialist), James Mallyon (central banking specialist), Harry Sasson (development finance issues) and Ms. Diane Coogan (researcher). Although there has been extensive collabora- tion with Government, the conclusions of this report are ultimately the responsibility of the mission. While Mr. Irfan Aleem is the principal author of this report, there are many people who greatly assisted in its preparation. In addition to the other members of the mission, they include staff of the various government agencies, parastatals, and the Bank of Uganda, and many individu- als from the private sector. It is not possible to name all of them here, but their assistance is gratefully acknowledged. The World Bank team would, however, specifically like to acknowledge the valuable advice and inputs provided by the Government team, including Dr. Suruma and Mr. Opio-Okello, from the Bank of Uganda, and Dr. Zake from the Ministry of Finance. From the IMF, the team received valuable advice from Mr. Niepoort (Central Banking Department) and Mr. El-Valeed Taha (African Operations Department). Within the World Bank, the contributions of Mr. Patrick Honohan (who acted as Lead Advisor), Mr. K. Loganathan (Senior Financial Analyst, who advised the team on crop financing issues), Mr. A. Chandarvakar (Consultant, Central Banking Specialist), Mr, Owaise Saadat (Principal Economist), and Mr. Carlos Montes (Consultant, who contributed to macroeconomic aspects of the report), are gratefully acknowledged, as is the excellent administrative and secretarial support, including report compilation, provided by Mr. William R. Wright. The report is made up of an executive summary (Volume 1), and the main report (Volume 2) consisting of eight chapters containing detailed descriptions and recommendations, -i agenda for action, and a series of annexes. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  UGANDA FINANCIAL SECTOR REVIEW VOLUME II: MAIN REPORT TABLE OF CONTENTS I. BACKGROUND TO, AND RATIONALE FOR, THE STUDY A. Purpose of the Study and Report Structure . . . . . . . . 1 B. Macroeconomic Context for a Review of Financial Sector Performance . . . . . . . . . . . . . 1 C. Current Situation in the Financial Sector and its Implications . . . . . . . . . . . . . . . . . 4 D. Issues Addressed in The Review . . . . . . . . . .. . 12 II. THE LINK BETIEEN THE FINANCIAL SECTOR AND THE MACROECONOHY A. Introduction and Nature of the Problem . . . . . . . . 13 B. Background: Recent Monetary Developments and Prospects . 14 C. The Vulnerability of the Economy Through Financial Sector Link . . . . . . . . . . . . . . . 18 D. Financial Policies to Facilitate Stabilization . . . . . 22 E. Recommendations . . . . . . . . . . . . . . . . . . . . 29 III. DISTRESS IN THE COMMERCIAL BANKING SYSTEM A. Introduction . . . . ... . . . . . . 31 B. Features and Growth of the Commercial Banking System . . 31 C. Performance of the Domestic Banks . . . . . . . . . . . . 37 D. The Foreign Banks ................. ..45 E. Long Term Issues ... . . . . 50 F. Recommendations . . . . . ... . .. .53 IV. THE BANK OF UGANDA AND ITS ROLE IN THE FINANCIAL SYSTEM A. Introduction . . . . . . . . . . .. . . . . . . . 57 B. Authority of the Bank of Uganda . . . . . . . 58 C. Autonomy of the Bank of Uganda . . . . . . . . . . . . . 60 D. Capacity of the Bank of Uganda to Fulfill Its Role . . . 62 E. Resources Available to the Bank of Uganda, Staffing, Training, and Technology . . . . . . . . . . . . . . . 67 F. Effectiveners of Monetary Policy . . . . . . . . . . . . 69 G. Recoammendations . . . . . . . . . .. . . . .. 74 V. REGULATION AND SUPERVISION OF FINANCIAL INSTITUTIONS A. Introduction . . . . . . . . . . . . . 77 B. Existing Regulatory and Supervisory Framework . . . . . . 77 C. Legal Framework . . . . . . . . . . ..78  D. Supervision and Examination . . . . . . . . . . . . . . . 82 S. Larc Accounting Principles and Practices 85 P. Reposit Insuratsce . . . . . . . . . . . . . . . . . . . . 86 G. Recoamendations ................... ,o os oo 86 VI. ADEQUACY OF WORKING CAPITAL AND OTHER FIP'x.CIAL SERVICES TO SUPPORT THE REAL ECONOMY A. Introduction . . . . . . . . . . . . . . . . . . . . . . 89 B. Credit Expansion Patterns . .... . . . . ... . . . 89 C. Factors Affecting the Supply of Working Capital . . . . 91 D. Characteristics of Credit Demand . . . . . . . . . . . . 94 E. Sample Survey Evidence . . .o. . . . . . . . . . . . . . 96 F. Payments Mechanisms and Other Financial Services . . . . 98 G. Recommendations . . . . . . . . . . . at n. . ..... . .. 99 VII. ISSUES IN BUSINESS FINANCE: TERM CREDIT AND SPECIAL CREDIT PROGRAMS A. Introduction . . . . . . . . . . . . . . . . . . . . . 101 B. Uganda's Development and Other Term-Lending Institutions 101 C. Leasing Finance . . . . . . . . . . . . . . .. .. . . 111 D. Agricultural Credit . . . . . . . . . . . . . . . . . . 111 E. Housing Finance . . . . . . . . . . . . . . . . . . . . 113 F. The Long Term: Capital Market Development . . . . . . 114 G. The Long Term: Institutional Change . . . . . . . . . 116 H. Recommendations . . . . . . . . . . . . . . . . . . . . 117 VIII. SEQUENCE OF REFORMS IN AN ACTION PROGRAM . . . . . . . . . . 120 ANNEXES 1.1: Macroeconomic Perspective and Monetary Targets 1.2: Flow of Funds 1.3: Association between budget deficit, monetary expansion, and parallel exchange rate 2.1: Money creation in Uganda 2.2: Crop financing prospects 2.3s Interest rates structure and policies 3.1: Statistics on commercial banks 3.2: Efficiency of the commercial banking system: Cost of intermediation  I. BACKGROUND TO. AND RATIONALE FOR, THE STUDY A. PURPOSE OF THE STUDY AND REPORT STRUCTURE 1.1 This report evaluates the main constraints facing the Ugandan financial sector and identifies the policies and institutional changes needed to support reform and efficient levelopment of the sector. A major motivation for carrying out the review is that questions have emerged recently about how problems in the financial sector are affecting the Government's Economic Recovery Program. Specifically, concerns have surfaced inside and outside Uganda, about the lack of discipline in the financial system, and the adverse impact this could have on the Government's stabiliza- tion objectives. At the same time there are questions about the efficiency and solvency of financial institutions, and the extent to which problems facing these institutions are inhibiting the flow of funds into the real economy. 1.2 This introduction looks at the background and rationale for the study. It outlines recent developments in the macroeconomy and the financial sector, and identifies the main issues facing the Government in formulating a strategy for the financial sector. Chapters II through VII address five main issuest (a) the two-way link between the financial sector and the macroeconomy, (b) the distress in the commercial banking system, (c) the role and functioning of the Bank of Uganda, (d) adequacy of working capital and other financial services to support real economic activity, and (e) the role and viability of development-finance institutions. Chapter VIII gives a summary of the recommendations in the form of an action program outlining the timing and sequence of reforms. B. MACROECONOMIC CONTEXT FOR A REVIEW OF FINANCIAL SECTOR PERFORMANCE Recent performance 1.3 The Economic Recovery Program, initiated in July 1987, faced the monumental task of rebuilding an economy devastated in both its productive and financial sectors by almost 20 years of severe political instability. The results of the ERP, now entering its fourth year, have been mixed. In relation to rehabilitation and restoration of economic growth, significant progress has been made in reviving economic activity and creating a climate for expansion. GDP growth rates of 5 percent or higher have been achieved in all years since FY88. However, progress toward stabilization objectives, including the restoration price stability and a sustainable balance of payments, has been more problematic, and achievements have yet to be fully consolidated. Despite recent improvements, the rate of inflation is still far too high and uncertain to encourage the long-term business and other initiatives needed for sustained economic development. The year-on-year rate declined to 29 percent in June 1990, as against 163 percent in December 1987, and has risen again over the past three months to about 35 percent. In addition, the external payments situation is more precarious now than it was three years ago. Exports in PY90 of $185 million were less than half the  -2- $383 million level of FY87, while the debt service ratio, before reschedul- ing, had almost doubled--rising from 54 percent in FY87 to 89 percent in FY90. 1.4 As part of the ERP, and with the support of the World Bank and the IMF and other bilateral programs, the Government of Uganda has implement- ed a wide range of structural and financial policy reforms designed to achieve sustained growth consistent with a viable medium-term balance of payments program. 1/ Policy measures have includedt several large exchange rate devaluations designed to maintain the alignment of domestic and international prices in the face of continued high inflation, a partial liberalization of the trade regime, and the virtual elimination of price controls. The greatly improved growth rate, to which these reforms have contributed, has supported significant progress in rehabilitating essential economic and social infrastructure. Much o, this progress occurred in the context of a comprehensive public-sector investment program and significant improvement in the security situation in the country in the past two years. 1.5 Difficulties in achieving stabilization objectives At the end of FY88, the first year of the Economic Recovery Program, the year-on-yaar rate of inflation stood at 240 percent. In FY89 this rate declined to 86 percent, against a target of 55 percent, and to 29 percent at the end of FY90, compared to the program target of 30 percent. Slow progress in controlling inflation, especially in the earlier years, has largely been associated with the difficulty the Government has faced in effecti ely controlling increases in its expenditures and managing with limited domestic revenues. Given the very limited pool of domestic savings available for government borrowing, assessed more fully later in this report, the ensuing deficits fed through to substantial monetary expansion. Growth in liquidity was further enhanced by the inability of the authorities to restrain the surge in private sector demand for credit, notably for crop finance. Pivotal to all this has been the inherent difficulty of balancing the interests of the productive sector enterprises - especially the coffee producers - from whom the supply response and improved export earnings must come, on the one hand and the expenditure needs of the Government, on the other. The Government's expenditures are essential for rehabilitating the economy, but the necessary financing is severely limited. The tensions between these two sets of interests explain many of the macroeconomic decisions and difficul- ties with the Economic Recovery Program in each of its three years (see Annex 1.1). In addition the slower-than-anticipated restoration of fiscal and monetary discipline has been partly due to external shocks - in particular the sharp decline in international coffee prices during 1989, which led to a major decline in foreign exchange earnings and tax revenues. 1/ Bank and IMF support for the Economic Recovery Program has been in place from an early stage. The Fund's Structural Adjustment Facility was provided from June 1987 and an Enhanced Structural Adjustment Facility was put in place in April 1989 followed by a second year ESAF in September 1990. The Bank's first Economic Recovery Credit was approved in September 1987 and a second similar credit was approved early in 1990.  -3- 1.6 Policy implementation during FY90. Policy implementation wag considerably better in FY90 than during the previous twc years of the Economic Recovery Program. The reduction in the rate of inflatLon over the past year, as planned, and the better-than-expected performance on the current account (which was 1.7 percent of GDP lower than targeted in PY90), despite the deteriorating external environment, reflect in part the Government's willingness to pursue stabilization with greater vigor. Since November 1989, the Government has implemented monthly adjustnents of the exchange rate to avoid any appreciation in real terms. On the fiscal side, the budget deficit (excluding grants) is estimated to have remained well within the revised target for the year. Monetary expansion was, however, larger than projected, with broad oney (M2) about :5 percent above target. In spite of this, inflation performance was on course, partly due to the effect of the bumper food harvest on prices and the increased preference to deposit money into banks (rather than spenu it) after the restoration of positive real interest rates. 1.7 While slow has been made in controlling inflation, the external imbalance has continued to expand. With a 40 percent deterioration in the terms of trade during FY90, in addition to the 46 percent cumulative decline since coffee prices peaked in (FY86), the balance of payments position has worsened substantially. This deterioration is predominantly due to the decline in the international price of coffee, which currently accounts for 90 percent of total export receipts. The world market price of robusta coffee averaged about $1.10 per kilogram in FY90, compared with $2 per kilogram in the second half of FY89. In the absence of an unexpected recovery in coffee prices, external sector viability is not envisaged in the next three years. 2/ Prospects 1.8 The problems and limited economic successes of the recent past both emphasize the fragility of Uganda's economy and the major problems that still need to be reiolved. Savings and investment are still far too low and this holds back both growth rates and the pace at which infrastructure can be rebuilt. While overall budgetary performance in the past two years has not been particularly expansionist the restraint has been achieved in part by imposing undesirably tight curbs on expendituires for critical economic and social services which, are already too low. Although Inflation has been brought down sharply, it is still too high to generate the long-term expecta- tions of low and stable inflation needed to encourage investment. Finally, the recent sharp decline in the coffee price has again highlighted Uganda's over-dependence on this crop and the critical need to encourage the emergence and growth of other productive-sector activities. 1.9 Against this broad background the Government seeks as its medium- term objective: to sustain a 5 percent growth rate to reduce inflation to 6 percent by FY93, to strengthen external payments to permit a build-up of foreign reserves of $15 million a year (the present stock is $23 million, 2/ External viability means that: (a) there are no arrears, (b) debt rescheduling is not required, and (c) imports are maintained at a level sufficient to maintain the economy's growth objectives.  which represent only 0.4 months of imports), and to reduce external arrears by $20 million per year. A detailed analysis of the prospects for achieving these and related targets is presented in Annex 1.1. But the main weakness lies in the balance-of-payments strategy. As indicated in the most recent Policy Framework Paper, to meet the Government's objective requires annual net capital inflows for the next three years of nearly $500 million - a formidable challenge for Uganda. The funding requirement is made all the more daunting because of the increased uncertainty about oil prices and because the projections assume non-traditional exports will grow from the present level of $8 million (5 percent of export earnings) to $80 million (30 percent of export earnings) by 1993, a 10-fold increase in three years. 1.10 In addition to questions about the balance of payments, there are also some fundamentals of policy, especially financial-sector policy, that need to be clarified to get a firmer grip on the stability of the economy in the future. It is relatively easy for an economy such as that of Uganda to achieve short-term gains in output even with an unstable macroeconomic environment and an impaired financial sector. The experience of the past three years is evidence of this. But these gains are likely to be based on existing capacity to rely little, if at all, on new investment and to emphasize traditional forms of economic activity rather than the diversifica- tion and modernization associated with a more robust economy. Thus these gains are unlikely to be easily sustained. It is also unlikely in the extreme that the long-term investment decisions needed to produce a more resilient economic structure (one that is less dependent on coffee) will occur while the financial sector is as shallow and impaired as it is now. This assessment is the main context in which a fundamental reform and strengthening of the financial sector needs to be considered. C. CURRENT SITUATION IN THE EINANCIAL SECTOR AND ITS IMPLICATIONS Structure of the existing financial system 1.11 At the end of April 1990, Uganda's financ'al system, consisted of a central bank -- the Bank of Uganda (BOU), nine commercial banks, eight non-bank credit institutions specializing iD hire/purchase finance, two development banks, an almost defunct post-office savings bank, 12 insurance companies, about 10 building societies, a `.ew pension funds, and two investment companies. The commercial banks dominate the sector, accounting for over 90 percent of the assets of the system, and thereby reflect the strong monetary basis of most financial transactions. The largest commercial bank government-owned Uganda Commercial Bank (UC.), which accounts for about half the assets and deposits, but a far smaller nihare of capital. The UCB also accounts for 184 of the country's 230 commercial bank-branches. The Cooperative Bank (COOP) is owned by the state-sponsored cooperative movement, and has the second largest number of commercial-bank branches after the UCB, namely 24. The Government also owns 49 percent shares in four other banks, in partnership with foreign banks Three banks are exclusively in  - 5 - private hands, including the Nile Bank established in 1988. 3/ One credit institutions is owned by the Government, and three are subsidiaries of commercial banks. The development banks, the savings bank, and the investment companies are also state-owned and more than two-thirds of insurance is in the hands of the state-owned Na:ional Insurance Corporation. The building societies are privately owned, and by existing law are under the surveillance of the Registrar of Building Societies. Thus, despite the diversity of institutions, government ownership in the sector is considerable. The total assets of the financial system, excluding the central bank, amounted to USh 57.3 billion in June 1989, or 6.4 percent of GDP. Total assets, including the central bank, totaled USh 146.8 billion, or 16.5 percent of GDP (see the flow of funds table in Annex 1.2). 1.12 There is also evidence of a large, private informal financial sector, the precise nature of which is poorly documented and understood. This informal mazket is extremely active in foreign currencies. Because such a large proportion of total inrports enter the country with the assistance of non-official foreign exchange, the exchange rate established in this parallel market is an important influence on the determination of price levels and inflation rates (see Annex 1.3). A considerable part of the total local currency issue is also probably held to facilitate tLansactions in the informal markets. Overall state of development of the financial system 1.13 The problems facing the Ugandan financial sector should be seen in the context of a system whose development has been set back and, in many ways, reversed as a result of the socio-political dislocations of the past two decades. There are no capital markets or merchant banks, and only a limited money market involving a small, outstanding stock of government bonds. The interbank market is also absent. The institutional system of payments (checks and invoices) is inefficient and ineffective, and there is heavy reliance on barter and informal cash market transactions (see Chapter VI). 1.14 The financial system is small, in terms of the value and the volume of transactions undertaken, and undiversified, in terms of the type of transactions that it undertakes. The majority of financial transactions in the economy have for some years, been conducted using a few monetary instruments (such as cash and demand deposits). Furthermore, both the size and the effective diversity 4/ of the sector appear to have declined during the 1970s and through most of the 1980. This decline clearly reflects the significant degree of disintermediation that the economy has experienced. One indication of this is the ratio of broad money (M2) outstanding to GDP, 3/ In 1990, two new commercial banks became operational: Centenary Bank and Teefe Trust. 4/ "Effective" means that some nonbank financial institutions continued to exist but did extremely small amounts of business and were generally demoralized. An example is the Housing Finance Company of Uganda.  -6- shown in Table 1.1, com.only used as a measure of the 'depth' of the financial system. Although the ratios need careful interpretation, the M2/GDP ratios 5/ shown in the table are among the lowest to be found anywhere in the developing world. The financial depth figures for PY89 (a M2/GDP ratio of 6.8 percent) put Uganda well below the average for sub- Saharan Africa (M2/GDP of 22.3 percent), as recently estimated by a World Bank study. Only two countries, Zaire and Guinea, had ratios of below 10 percent. The present Ugandan figure for M2/GDP also represents a major decline relative to the levels of financlal development that Uganda had achieved in the 1960s. 1.15 The evidence in Table 1.1 is too sparse to provide full conclu- sions, but it is consistent with the hypothesis that the high inflation rates of recent years, the correspondingly highly negative real return on money balances, and the political instability have causec . further decline in the use of monetary asGets in the system. The decline has been particularly marked in relation to quasi-money (mainly time and savings deposits), whose share in M2 has fallen from 23 percent in 1983 to only about 10 percent in early 1989. Thus the savings demand for money balances has been most severely affected by negative real interest rates. On the other hand, the transactions demand to hold money balances (as reflected by the size of currency and demand deposits) has held-up somewhat better. But within the overall total of the transactions demand, currency holdings have become somewhat more important, accounting for about 50 percent of M2 in FY89 compared with 40 percent for demand deposits. This reflects of the sustained importance of the parallel financial markets and inadequacy of the real returns on financial assets held in cenventional bank accounts. One of the significant consequences of the recent shift to positive real interest rates, as indicated above, is that dll deposits have increased significantly. In particuiar, time and savings deposits have doubled between June 1989 and March 1990. 5/ The main problem of computing these ratios in an environment of high inflation is that the value of the ratio is highly sensitive to the precise month chosen for comparing the stock of money balances with the flow of GDP. If, for example, the December values of M2 is used for 1987, the ratio would be 11.1 percent, compared with the 7.3 percent shown in Table 1.2: the money stock almost doubled between June and December.  TABLE 1.1: MONETARY AGGREGATES 19S2-19S9 (USh bXlilon to 1988 *nd now USh billion thereafter) FY83 FY84 FY86 FY86 FY87 FY63 FY89 Currency 16.8 28.0 0664 197.7 4.2 14.$ 29.2 Dmand deposits 19.6 88.1 90.6 194.7 8.6 9.6 25.1 Savings A time depos- 10.8 14.2 24.6 69.1 110 2.0 6.9 I to - - - - TOTAL = 12 47.2 75.9 181.9 461.6 6.6 26.6 60.1 Share In 42 (X) Currency 86.0 88_0 37.0 48.0 47.8 62.2 4S.6 Dma;ad deposits 41.5 48.6 49.9 48.1 41.1 38.5 41.7 Savings A time 22.9 18.7 8.5 18.0 11.5 9.7 0.8 d*posi toI ODP at market prices 410 752 11631 8.869 121 863 890 M2 to share of GDP (X) 11.6 10.1 11.1 11.7 7.8 7.6 6. ource BUu Problems confronting the sector 1.16 The problems confronting the financial sector are serious and call for urgent remedial measures. Unless an integrated strategy for addresaing these problems is defined and implemented soon, the costs to ':he economy due to inefficiencies in the sector will continue to increase and will undermine the Economic Recovery Program. This assessment stems from the nature of the problems facing the sector. First, the financial system has to cope with some deep-rocted structural difficulties, including: (a) a domestic savings rate that is low even by African standards, (b) a degree of financial-sector development, as measured by the ratio of broad money supply (M2) to GDP, that is one of the lowest in the world, (c) a central bank that lacks the authority and the capacity to adequately preserve the integrity of the financial system, (d) the insolvency, in all probability, of more than half the commercial banking system, and (e) a serious lack of confidence in the financial system. The situation has been further exacerbated by the failure of initial efforts at stabilization and a sharp drop in external earnings. The i;qplications of the above-mentioned problems are extremely serious both in terms of the ability of the sector to efficiently mobilLze and allocate financial resources within the economy, and for macroec- nomic stability and recovery. 1.17 Effect of low savings rate and lack of depth in the finsncial system. The low savings rate, currently estimated at 2-4 percent, means that any major boost to economic activity will quickly expose shortages of domestic finance in some form (for example, difficulties in finding local counterpart funds for longterm investments financed with foreign exchange).  The lack of depth in the financial system, as reflected in the low M2/GDP ratio and the reluctance to hold domestic monetary assets, implies for example, that even a relatively small domestic financing of fiscal deficits will have major impact on monetary expansion. Thus, financing a deficit equal to 4 percent of GDP--not an unusually high figure--when K2/GDP is only 6 percent, would result in a monetary expansion of almost 70 percent. 1.18 In such an environment, an anti-inflationary policy implies a tight fiscal policy and limited monetary financing of the Government as its pivotal component. Unfortunately, the Government's success in reducing the fiscal deficit and the monetary financing that it incurs (the USh 2 billion repayment of the Ways and Means account at the BOU in FY89 was the first since FY84 has been substantially overshadowed by a rapid expansion of credit elsewhere in the economy, especially in 1988 and the first half of 1989. The expansion in credit over this latter period was in large measure linked to the explosive effect of credit extended for coffee financing and the initiatives taken by the UCB and the Cooperative Bank to expand their loan portfolio without regard to sound commercial banking principles (discussed below). The resulting mixture of tight fiscal and loose monetary control, while allowing a welcome boost to real output and GDP growth of over 7 percent in both 1987 and 1988, led to the continuation of a damagingly high rate of inflation (about 100 percent) during the first two years of the ERP, and a significant deterioration in the health of the financial system. As indicated above, until recently, interest rates were strongly negative in real terms even though nominal regulated interest rates on most loans have been 40-50 percent since 1988. 1.19 Weaknesses in the authority and capacity of the central bank. The BOU has enacted a variety of measures to tighten monetary control kincluding tne currency conversion tax in FY87, which also had adverse effects on the public's desire to hold the currency, and more recently, the SIP II System for drawing liquidity from the system. But the BOU's ability to succeed in these measures, as well as in efforts to fultill other conventional functions of a central bank (sueTh as supervision and protec- tion of the soundness of the commercial banking system), is being under- mined by internal and external constraints. On the external side, BOU has for some time been under political pressure to finance crop production. Since 1989, it has also responded to the politically felt need to finance coffee purchases. These interventions have had a profound effect on the way credit is allocated in the economy. The most obvious evidence of this is that at the end of June 1989, no less than 47 percent of credit out- standing was owed directly to the BOU rather than to a commercial bank. This has raised questions about the need for a central bank to get involved in commercial banking on such a large scale, as well as questions about the efficiency of this form of credit allocation. Another constraint on the BOU takes the form of significant ambiguities in its legal authority to manage the financial system. As a result of one such anomaly, the BOU, as the supervisor of the banking system, was not even consulted in the decision made by the UCB, and approved by the Ministry of Finance, to expand the commercial-bank branch network at an imprudently rapid pace. 1.20 The authority of the BOU is also weakened by internal organiza- tional weaknesses, especially in the areas of prudential regulation, super-  -9- vision, and accounting. The bank's supervision department is poorly staffed and cannot cope with the task of supervising nine commercial banks and eight credit institutions. The last full on-site bank examination was carried out in May 1988 on the Cooperative Bank, and the largest bank the (UCB) has not had a full on-site examination in over 10 years. The lack of timely and accurate flow of information--while understandable given the dislocations that BOU and other institutions have gone through--is also a major constraint; The non-availability of annual audited accounts since 1986 (in the case of BOU) is highly unsatisfactory; not only is this in violation of the law, but it makes it difficult to assess the extent of central bank losses. This lack of information is worrying given the extent of the BOU's involvement in functions other than its normal role. Inade- quate information flows have also contributed to two other problems currently facing the BOU: allegations of fraud in the clearinghouse and discrepancies between BOU and Ministry of Finance figures regarding the true level of BOU's advances to the Government. The magnitude of these discrepancies is such as to make it at times difficult to assess whether the Government has achieved a surplus or incurred a deficit. 1.21 Distress in the commercial banking system. The commercial banking system is in a considerable state of distress, reflecting adverse economic conditions that have compounded managerial problems in two of the three largest banks, the UCB and COOP. These two banks, which together account for more than half the assets of the commercial banking system, are suffering from an acute shortage of liquidity. They are in all probability insolvent, or at least technically so, and will require restructuring operations with likely fiscal implications. Since early 1988, they have had to borrow heavily from the BOU and have failed to meet the cash reserve requirements (10 percent of their deposits). Their combined overdrawn position with the BOU deteriorated from USh 287 million at end-1987 to USh 6,034 million by the end of August 1989. The main reason for the shortfall in their reserves was excessive lending. Their combined ratio of advances to deposits increased from 83 percent at the end of 1987 (the upper end of BOU's guideline) to 99.1 percent at the end of August 1989. Other factors that have contributed to their liquidity problems include: (a) investment in fixed assets resulting from a rapid expansion of their branch network, especially UCB's expansion, and (b) an increase in the value of items in transit, wlhich could represent hidden undeclared losses. To place this problem in context, liquidity is not a systemic problem in the commercial- banking sector. The combined reserves of the seven remaining banks at the BOU amounted to USh 3488 million at the end of August 1989, equivalent to 25 percent of their deposits, reflecting reserves substantially in excess of requirements. Although the loans to deposits ratio of the two problem banks declined after August 1989, reflecting an easing of the liquidity crisis, the balances of the two problem banks at the BOU remained overdrawn during the latter part of 1989 and the early part of 1990. 1.22 The distress in the system is also related to the issue of bank insolvency. COOP, which accounted for about 13 percent of the financial systems assets in August 1989, is insolvent. Without the continuing support and subsidy of the BOU, COOP would have ceased to operate. Although UCB's financial position is less critical than that of COOP, the results of a recent diagnostic study (done by external auditors) indicate  - 10 - that if the recommended additional provlsions for bad and doubtful debts were to be taken, the UCB would become technically ins-lvent. The study also revealed that the revaluation of UCB's fixed assets could more than offset the losses that would be incurred in cleaning the loan portfolio. But the revaluation would not obviate the need to inject fresh capital to allow the UCB to meet their liquidity and capital adequacy requirements. 1.23 La^k of confidence in the financial sostem. Although imprudent management dF.-cisions have had a major part to play in the problems current- ly facing the UCB and COOP, adverse external factors in their environment have also made a significant contribution to their difficulties. Perhaps the most Important problem facing the commercial banks in their business environment is the lack of public confidence in the financial system, not all of which can be attributed to the commercial banks themselves. Lack of confidence is reflected in a variety of ways. The public has an unusually high reluctance to use checks as a system of domestic payments. People prefer to use cash despite the cost involved in carrying and using large bundles of low-denomination notes. A measure of the role of the general socioeconomic environment in contributing to lack of confidence is afforded by noting that the number of monthly checks cleared at the BOU dropped from 135,502 in December 1970 to 66,642 in December 1973, and to only 27,142 in December 1988. In June 1989 this figure stood at 12,305. This problem is also reflected in the unusually high ratio of East African currency in circulation to money supply M2--about 50 percent. Other features of the business environment that pose a problem for the banks include: (a) an increasing incidence of fraud, aggravated by the slowness and inefficien- cies of the check clearing system at the BOU and the high inflation that has eroded the real wages of bank staff; and (b) 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 credit-worthiness of their clients. 1.24 Impact of other problems: failure of initial efforts at stabil- ization. In addition to the above-mentioned structural problems facing the financial system in Uganda, the situation has been worsened by the slow progress in stabilization and deficiencies in the financial services provided by banks. In terms of stabilization efforts, the continuing high rate of inflation and the consequent need to practice repeated and massive devaluation have all but wiped out the share capital of the banks. The large changes in relative prices during the past few years, as part of the Economic Recovery Program, has also affected the portfolio of the banks. Many banks emphasized that relative price changes have adversely affected the collateral value of many loans given against machinery or buildings. 1.25 The gap between the recuirement and availability of financial servlces. The services offered by the financial sector have shortcomings in respect of all the main services needed to support the real economy. Some of the shortcomings may be attributable to the operations of the financial institutions themselves, while others seem to have been the consequences of the country's macroeconomic circumstances, including inflation and underlying monetary and credit policies.  - 11 - - There are obvious deficiencies in the range and quality of payment mechanisms, available to the business sector. The reluctance to use checks as a payments mechanism may be attrib- uted to a variety of factors including a pervasive distrust of the creditworthiness of many private-sector issuers of checks, the remoteness of bank branches in many parts of the country, the inability of the legal system to enforce financial contracts or to prosecute fraud successfully, the indifferent counter services in banks, and the slow clearing of checks. All these problems add to the costs of producers and traders who use the banking system. There are also restrictions on the availability of trade credit and finance for working capital, from formal and informal sourc- es of credit. For example traders (or wholesalers) are reluc- tant to extend trade or supplier's credit, a common feature of a credit and payments mechanisms in most developing countries, to their customers. In the case of formal or institutional sources of credit, while there are no formal guidelines on the shares of total lending to be devoted to each economic sector, there is pressure on the banks, especially those in the public sector, not to finance trade and commerce, and to make more lending available to agriculture and industry. While there are com- plaints about shortages of working capital from some businesses, it is not clear whether this is a supply-side problem (shortage of deposits and therefore loanable funds) or a demand-side constraint (including lack of credit worthiness). - Finally, financial services and resources, either in the form of term credit, equity, or investment banking services, for long- term investment in agriculture or industry are deficient. In the present environment, term loans are much more c'.vio-asly rationed than short-term facilities. At current interest rates, there appears to be many more projects that qualify for financ- ing based on existing criteria for project selection used by DFI's than there are bank-funds to finance them. The main reason is the low level of domestic financial savings by house- holds and the enterprise sector. As a result, there are few deposits in the financial institutions, apart from the BOU's Development Fund, suitable for conversion into term loans. The only term resources available in these circumstances are those from external sources and the Development Finance Institutions consequently operate mostly as the on-lenders of externally provided oevelopment assistance. As discussed in more detail in Chapter VII, there has been strong pressure from donors to lend and the DFI's have as a result relaxed their eligibility crite- ria and financed a number of projects whose v .ability is doubt- ful. 1.26 Creditworthiness problems. Finally many firms face creditworth- iness problems arising out of (a) lack of ownership titles, especially firms representing assets confiscated from deported Asians; (b) overindeb- tedness and insolvency, particularly in the public sector; and (c) absence  - 12 - or outdated nature of financial accounts kept by these enterprises. All these factors have serious adverse consequences for the creditworthiness of' the corporate customers of the banking system. D. ISSUES ADDRESSED IN THE REVIEW 1.27 Based on the above findings and the broad understanding reached with the Government during the reconnaissance mission, it was agreed that this Financial Sector Review would focus on the following five issues: 1.28 First, there is an important need to evaluate the manner and extent to which the financial sector is contributing to macroeconomic instability, and hence the timing and nature of financial sector reforms needed to facilitate the on-going adjustment process. This assessment needs to take account of the fact that this is a two-way link and the macroeconomic imbalances are also having an adverse effect on the liquidity and solvency of financial sector institutions by contributing to the instability of bank deposits and precipitating firm closures. 1.29 Second, the Government needs to assess the reforms needed to restore the solvency and viability of the two key domestic banks (the UCB and COOP) through such options as restructuring of loan portfolios, recapitalization, strengthening of technical and management skills, loan recovery procedures, and reorganization. For designing long-term reforms, it is also necessary to review both the potential for raising the efficien- cy of the commercial banking sector as a whole, and the factors inhibiting the growth of financial services needed by the economy. 1.30 Third, one of the areas in which the financial sector appears most vulnerable relates to the role and functioning of the central bank. The critical weaknesses in the authority and capacity of the BOU to supervise and maintain the financial system need urgent review and action. 1.31 Fourth, the Government is concerned that economic recovery is being restrained by the inadequacy of financial services, in particular credit. It is therefore important to review the adequacy of existing financial services and assess the extent to which credit is the key to increasing unused capacity and thus increasing output. 1.32 The last issue concerns the role and viability of specialized financial institutions (such as the Uganda Development Bank and the Housing Finance Company) whose services complement, and to some extent also compete with, those of the commercial banks. In reviewing their viability particu- lar emphasis needs to be put on options for reducing their dependence on subsidies and foreign loans, scope for improving their current pcor rates of loan recovery, possibilities for developing new product lines (such as leasing and joint venture capital companies), scope and timing for capital market development, and the Government's strategy for improving the access of small-scale enterprises to the financial services provided by these institutions.  CHAPTER II. THE LINK BETWEEN THE FINANCIAL SECTOR AND THE MACROECONOKY A. INTRODUCTION AND NATURE OF THE PROBLEM 2.1 A key short-term issue for the Ugandan economy is the link between the financial sector and the macroeconomy. First, problems in the financial sector are contributing to macroeconomic instability. The timing and nature of financial sector reforms to facilitate stabilization are reviewed in this chapter. The reforms include (a) strengthening the ability of the BOU to monitor and control credit expansion and coordinate fiscal, monetary, and balance of payments policy; (b) reforming the crop finance arrangements to curb their inflationary impact; (c) restructuring of insolvent institutions to remove any constraints to the flow of funds to economically viable activi- tiest (d) reforming of the structure and level of interest rates, as well as the mechanism for determining these rates, in order to enhance monetary discipline and raise the efficiency of financial intermediation; and (e) using other levers available to the Government, such as open-market operations by the BOU, to manage liquidity in the economy. The relevance of these measures is enhanced by the difficulty that the Government faces in using conventional instruments for stabilization in Uganda as noted in Chapter I.1/ 2.2 Second, the ability of financial markets and institutions to mobilize and allocate resources efficien.ly will depend heavily on the existence of a stable macroeconomic environment. The high inflation rate of recent years has engendered uncertainty regarding prices, interest rates, and exchange rates. This uncertainty has inhibited financial savings, reduced the demand for domestic financial assets, and stimulated capital flight. The adjustment process is also contributing to bank insolvency through the impact of firm closures on the loan portfolios of the banks. Dealing with the problem of bank insolvency must go beyond recapitalization. Addressing underlying causes of insolvency involves: achieving macroeconomic stability and restructuring or closing insolvent firms, otherwise the recapital'.zed banks that continue to lend to them will once again become insolvent. In exploring this link, it should, however, not be forgotten that financial discipline, enforcement of laws, and the effective supervision of banks are as essential to the development of confidence in the banking system as macroeconomic stability. These aspects are discussed later in the report. 2.3 The financial sector and the macroeconomy are struggling in a vicious circle. Negative real interest rates, high inflation, and expecta- tions of devaluation have undermined confidence in the financial sector, resulting in a low savings rate, and a lack of monetary depth. In turn, the lack of monet.iy depth and other inefficiencies in the financial system have contributed to macroeconomic instability. Monetary discipline has been difficult to enforce, and even relatively small fiscal deficits have generated large monetary and inflationary pressures because of the small I/ Crop financing reforms are also being addressed by ERC II and the Agricultural Sector Adjustment Credit (ASAC).  - 14 - monetary holdings in the economy. While the Government now appears to be coming to grips with stabilization, the damage done in earlier unstable periods, in terms of the effect of instability on the financial sector, continues to make fiscal deficits unusually dangerous. The question now is what is the best way to move from this vicious circle to a virtuous one. Some of the questions that need to be addressed ares (a) Does the interaction between the financial sector and fiscal deficits in Uganda pose a significant threat to the achievement of the Government's stabilization objectives? If so. what are the policy implications of this vulnerability? (b) What are the effective monetary, financial, and other instruments available to the Government now to manage liquidity in the economy and thereby influence the rate of inflation (for example, reforms of the system of crop financing)? How should the Government use these levers to maximum effect? (c) What are the macro-economic consequences of any financial restruc- turing of the problem commercial banks? (d) Can any sustainable reforms be effected in the financial sector while the present macroeconomic imbalances persist? 2.4 These are complex issues and this chapter attempts to provide some initial answers. As a background to this discussion, the chapter starts with an outline of the flow of funds in the economy and reviews recent monetary developments. Section C addresses the issue of the risks posed by the interaction between the financial sector and the fiscal deficit. Section D reviews some of the more potent financial policy tools available to the Government to achieve its stabilization objectives, including reforms of crop finance, enhanced discipline in the banking system, use of open-market operations, and interest-rate policy. The section also touches on the macro-economic consequences of financial restructuring of commercial banks and options for reducing their impact. The chapter concludes with recommenda- tions on the priorities for policy reform. B. BACKGROUND: RECENT MONETARY DEVELOPMENTS AND PROSPECTS Flow of funds within the economy 2.5 Uganda is currently characterized by a shallow financial sector and a low savings rate. A flow of fund analysis for the Ugandan economy for 1989 2/, shows that within the domestic economy, the Government and parastatals have been net borrowers. Only the private sector saves more than its own 2/ The flow of funds for Uganda has been constructed for the private, parastatal, financial, government, and foreign sectors. The financial sector is subdivided into the central bank, commercial banks, and non- bank financial institutions.  - 15 - expenditures on investment (see Table 2.1). The foreign sector provides the remaining credit to the economy. It provides funds for 44 percent of the total net lending in the economy, and the government absorbs 78 percent of it. Table 2.1: Net Financial Savina Balances by Sector. FY89 Sector USh billtons r-overnmnt -62 = 2. Perestatalr (Non-flnancial) -14.6 S. Private Sector 29.9 4. ForeIgn 81.2 S. Financial Institutions 6.2 Source: See Table 2 in Annox 1.2 of thiT report. 2.6 The savings surplus of the private sector has been predominantly allocated to holdings of currency and demand deposits in financial institu- tions. These resources have in turn been channelled by these institutions primarily to the Government and parastatals through loans. The parastatal and government sectors accounted for 67 percent of total outstanding loans from the economy. 2.7 The substantial part of the private sector's savings surplus nas been channelled to the public sector indirectly through the intermediation of the banking system. Such dominance of the banking sector is not unusual in developing countries, but public policy should diversify the range of financial instruments available to attract the savings of the household sector. Recent monetary developments 2.8 Inflation in Uganda is largely driven by monetary growth. Control over monetary growth should be attained through control over the expansion of reserve money.3/ The sources of reserve money growth are shown in Table 2.2, which outlines the aggregated balance sheet of the BOU for the past five years. As shown, money is a liability generated as a counterpart to the changes in the assets of the BOU. The main counterpart of reserve money expansion has varied considerably from year to year. Lending to the Government was a main source of money expansion in FY85 and FY87. The private sector became a bigger source of money expansion than the Government for the first time in FY89. This was due to loans extended by BOU for coffee financing. The foreign asset position of the banking system has also contributed to the growth of reserve money, though the row "Net foreign assets' in Table 2.2 overstates this effect because it includes valuation changes that are netted out in 'Other items net." 'Other items net, may also contain other elements that do contribute to reserve money growth, complicat- ing monetary targeting, which in recent years has focussed on limits on domestic credit expansion as a means of restricting monetary growth. 3/ Reserve money (or the monetary base) is currency issued and deposits held by banks at the BOU.  - 16 - Table 2.2 Balance Sheet of the BOU (USh millions) ----Changes In stock*---- Change In stocks a percont of change in reserve money Fiscal ysar e6 86 67 88 69 eS 86 87 88 s9 Asseits F11irelgn estaet I/ 114 788-11,338 9,540 4,074 29.8 42.0 -287.7 130.4 24.9 Domestic credit 680 670 8,140 680 17,980 1U8.6 80.5 79.7 8.6 109.5 Claims on govt. U80 570 8,090 660 4,160 188.6 80.6 78.4 7.7 26.8 Claim on prlv. sector 0 0 sO 70 18,780 0 0 1.2 1.0 64.1 Other Itme net -266 514 12,189 -2,655 -6,629 -65.9 27.6 806.0 -89.0 -84.4 Liabilities "rv money 2/ 868 1,870 8,941 7,815 18,876 100.0 100.0 100.0 100.0 100.0 Includes revalustion Currency and bank deposits at BOU. 2.9 The expansion of broad money, M2 4/, has been highly correlated with the expansion of reserve money. Control over reserve money by the BOU can therefore be used to influence M2, which in turn has a strong effect on the domestic price level. In practice, however, the BOU has not controlled reserve money, but has allowed banks to run down their deposits at the BOU well below the reserve requirement. Loss of BOU control has also come from the foreign-asset side of the balance sheet, as mentioned above. The money multiplier is low in Uganda, 1.8 on average for the period 1984-89 51. This is primarily because of the high currency to deposit ratio which was 0.94 in FY89 6/. This is in turn due to "-he reluctance of the public to hold deposits in banks, as discussed in Chapter One. Monetary obiectives 2.10 The reduction of inflation depends on continued monetary re- straint. This means tackling the two prime sources of recent credit expansion: the fiscal deficit (loans to the Government) and credit for crop financing. The credit requirements of the Government, will be modest if current fiscal targets are successfully achieved. Although the overall deficit is not anticipated to decline below 6 percent by FY93, it is expected that large external transfers will help the Government avoid net additional borrowings from the domestic banking system in FY91, and in fact 4/ Broad Money consists of currency and bank deposits held by the non-bank private sector. S/ Money multiplier is the ratio of broad money to money created by the Central Bank. It measures the ability of the banking system to create new money. The money multiplier is of the order of 10 in developed countries and above 3 in most developing countries. 6/ See annex 2.1.  - 17 - effect significant reductions in both FY92 and FY93. Similarly, the restructuring and reform program for the Coffee Marketing Board and other elements in the marketing chain are projected to result in a real decline in the volumes of credit required for crop finance relative to the excep- tionally high levels reached in December 1989 (see below). 2.11 Alternative estimates of credit availability for the private sector have been made by deducting credit targets for the government and crop finance, described above, from overall projections for monetary expansion based on the Government's targets for inflation, GDP growth, and alternative assumptions about the depth of the financial system (M2/GDP). The alternative monetary prospects are set out in detail in Annex 1.1. A summary of these projections is shown in Table 2.3 below. Targeting of credit to the public and private sectors is of doubtful effectiveness in the Ugandan financial context. As discussed in Chapters VI and VII below, the past few years have seen relatively high rates of growth of private credit, but its benefits are far from clear because of the poor quality of much of this lending. This situation has brought two banks to the state of bankruptcy. There is absolutely no point in squeezing government credit to allow an expansion of private credit if this will repeat past experiences. A precondition for a policy based on a rapid expansion of private credit has to be the reestablishment of sound management, especially of credit allocation procedures, in the problem banks. The Government faces a complicated social choice in deciding to expand the credit to the private or to the public sectors. Table 2.8 Monetary Projections of the Banking System (USh billions) FY90 FY98 Scenario 1 Scenario 2 Scenario 8 Foreign assets (net) -181.7 -119.7 -119.7 -119.7 Domestic credit 74.0 112.1 ls.8 2". 5 Govt. (not) 8.7 -86.0 -86.8 -86.8 Private 85.8 148.9 202.8 293.8 of which crop financing 19.2 29.9 29.9 29.9 Othor Items net 147.7 157.4 167.4 167.4 Money scipply (M2) 90 149.8 208.4 294.1 Memo: Financial depth 6.2 8.2 8.8 12.0 (M2/GDP) Sousces: BOU, IMF, and World Bank estimates.  - 18 - Monetary projictions and th-ir Implications 2.12 Although the numbers in the scenarios given in Table 2.3 are subject to the specific projections of "Foreign assets, and will change as these underlying projections change, they illustrate two basic points. First, they suggest that, consistent with the existing macroeconomic program, there ought to be scope for a large real expansion of credit for the use of the private sector during the period up to FY93. However the expansion will be greater if the financial depth of the system can be significantly increased. Scenario 1, used in the Policy Framework Paper, assumes no change in finFncial depth (M2/GDP), while Scenarios 2 and 3 assume that financial depth increases by 25 and 50 percent, respectively. The reforms would be unlikely to generate new savings directly, but could attract some nonfinancial or informal savings to the banking system -- thus increasing monetary depth from its recent low levels. The emergence of Scenario 2 would imply that the credit available to the economy to finance growth is Ush 50 billion higher than in Scenario 1. 2.13 Second, the additional growth in money supply, which an increase in M2/GDP allows, will not add to inflationary pressures and will give the Government more room for its own and private sector credit. 7/ These projections further emphasize the importance of taking measures to increase monetary depth. They also suggest that it would be unwise to focus excessively on money-supply targets without taking account of likely changes in the financial sector. C. THE VULNERABILITY OF THE ECONOMY THROUGH FINANCIAL SECTOR LINKAGES 2.14 An economy like that of Uganda, which is struggling within the environment outlined in the introduction, is vulnerable to inflationary pressures arising out of even small fiscal deficits as well as credit policy shocks. High inflation makes it extremely difficult to avoid budget deficits, but fiscal deficits in their turn feed rapidly through to generate further inflationary pressures because of the limited size of the financial sector. The evidence available in Uganda lends support to this view. 2.15 The deterioration of fiscal revenues in an inflationary context While inflation remains at high levels, the achievement of a sound fiscal position in Uganda will prove difficult. The evidence from recent years, during which serious efforts have been made to improve revenue performance illustrates this point (see Table 2.4). 7/ This flexibility will be reduced as the financial deepening causes an increase in the money multiplier.  - 19 - TABLE 2.4: BUDGETARY REVENUES AND INFLATION (USh billons) FY84 FY85 FY8 FY87 FY66 FY89 FY90 Budgetary rovenues 0.9 1.6 2.8 5.9 22.9 49.7 86.8 Inflatlon Index(1988/84=100) 100 166 892 1,B05 4,477 8,828 10,748 Revenues: In roal terms 0.9 1.08 0.71 0.45 0.51 0.60 0.80 Budgetary rev./CDP (X) 12.4 9.9 7.4 5.0 G6. 6.6 5.9 Sourc-: 2.16 Despite all the revenue efforts, including the currency conversion of 1987, the real resources available to the Government from conventional taxation are now as low as they were in FY84, and in relation to GDP they have declined from 12.4 to 5.9 percent. In part this is because of exogenous factors, such as the coffee price, and policy decisions. However, even with an efficient revenue collection system, which Uganda certainly does not have, high inflation tends to erode the revenues actually achieved by the government because of lags in collection. Thus, the Government has good financial management reasons to bring down inflation, but it must also strive to rebuild its shrunken tax base. 2.17 High inflation rates tend to reduce the conventional tax base, but the loss in revenues could be partly offset by the inflation tax: people who hold cash 'pay, the tax by losing purchasing power. In order to restore the real value of cash balances they have to accumulate more nominal cash balances, thereby providing resources to the issuer of currency (the BOU). 8/ In Uganda our calculations, as seen in Table 2.5, show that from 1985 to 1988 the inflation tax was equivalent to about 30 percent of conventional tax revenues, but it has been reduced to 20 and 8 percent of these revenues for the last two years. Since conventional revenues have not increased, this decline has contributed to put additional pressures on the deficit and to limit the expansion of critically needed expenditures in social services. 8/ However, high inflation rates bring higher inflation tax revenues only to a point, beyond which the tax base (money holdings) is reduiced as people start to economize on money holdings to avoid the tax. If that limit has not been reached, a reduction of inflation might cause a reduction in government revenues from the inflation tax, in a context when the conventional tax base has also shrunk.  - 20 - TABLE 2.6: REVENUES FROM INFLATION TAX el Inflation tax Inflation tax (USh billions) as a X of Covt. ravenue 19084/86 0.8 17.8 1986/88 0.9 28.0 1986/87 2.1 85.6 1987/88 6.6 28.6 198/89 10.1 20.8 1989/90 7.1 6.2 a/ The inflation tax is calculated as C x fi/(l+i)) where C is the average stock of currency during a given fiscal year, estimated by taking an average of the money stock at the beginning and end of the year, and i is the June to June inflation rate for that year. Source: BOU, MOF, and Staff estimates Shatlow finpvial sector and monetary consequences of deficits. 2.18 The private sector's desire to avoid the inflation tax (and the 30 percent currency conversion levy of May 1987) have contributed to the substantial shrinkage of the financial sector. Such a small monetary sector implies that a given expansion in currency to cover budgetary deficit will lead to a large monetary and inflation impact. The numbers for recent years illustrate this point. As shown in Table 2.6, the magnitude of this problem has been increasing. TABLE 2.8: FISCAL DEFICITS AND MONETARY EXPANSION FY84 FY85 FY88 FY8T FY88 FY89 FY9O Fiscal deficit (cash basIs, 4.1 4.4 4.9 4.7 6.6 6.8 8.4 as X of CDP) M2/GDP 10.1 11.1 11.7 7.8 7.6 6.7 6.2 Monetary expansion If deficit entir ty financed by bank 40.6 89.6 41.9 84.3 86.5 79.1 108.2 credit (%) Source: MOF and Staff estimates 2.19 The high inflation environment of the Ugandan economy has eroded conventional taxation revenues, some of which have been substituted by the collection of the inflation tax. In addition, the non-inflationary financing of even moderate fiscal deficits has been complicated by the contraction of the financial sector, also a consequence of the high inflationary environ- ment. In a vicious circle, inflation feeds back into itself. The reduction of inflation in the last two years has already reduced revenues from the inflatlin cax, but neither conventional tax revenues or the financial sector  21 - has expanded yet to compensate for this loes of revenues. In fact in :he last three years, the potential impact of moderate fiscal deficits on monetary expansion has increased considerably, to more than 100 percent in the last year. Government expenditure in indispensable social services and in credit to the private sector will be constrained until these perverse effects of high inflation can be reversed. For this, interest-rate policy could prove to be critical. Impact of recent credit policy shocks 2.20 An economy operating with such a small financial sector as that in Uganda is extremely vulnerable to shocks that impact on reserve money expansion. Two recent events illustrate this vulnerability. The first is the boost in credit associated with the rapid expansion of the loan portfolios of the two distressed commercial banks during 1989. The second is the credit explosion that came about because of the change in coffee financing regime in 1989. Both of these events had inflationary consequences that were substantial because of the extremely small size of the financial system. 2.21 The first shock was the collapse of discipline in the UC'B and COOP, especially in FY89. Specifically, by August 1989 the net overdraft position of these two banks showed that their deficiency of reserves relative to their statutory requirements was equivalent to more than 30 percent of their total deposits. This episode fully illustrates the fundamental trade-off between short-term output gains and long-term sustainable development, based on low inflation pointed out earlier. UCB and COOP's credit expansion certainly fuelled some output gains in FY89, but at the expense of a severe set-back to stabilization objectives. The monetary stimulus from this loss of control was far greater in that year than the stimulus coming from the fiscal deficit. Furthermore, the poor quality of the lending that was associated with their rapid growth is the main element in the present distress of these banks. Removal of this distress in the form of new capital injection will have fiscal consequences of significant magnitude as discussed in the next section. 2.22 The -ond shock that shows the vulnerability of the monetary sector is associated with the credit explosion that came about because of the changes introduced in crop financing. Specifically, crop-financing advances by the BOU accounted for no less than 84 percent of the expansion of reserve money in FY89, as shown in Table 2.3, and like the first shock surpassed the importance of credit provided by the financial system to the Government. 2.23 As a result of difficulties in the crop financing system, there was concern that adequate credit was not filtering down to enable full procure- ment coffee crops at the farm level. This included the inability of several of the 19 credit unions in the country to establish their credit worthiness for normal commercial-bank credit. To overcome this difficulty, BOU at the behest of Government took over the responsibility of coffee financing from the commercial banks. This responsibility included: (a) BOU acting as a banker to the Coffee Marketing Board and providing funds to (i) clear the board's outstanding liabilities to commercial banks, cooperative unions, primary societies, and private processors, to cover the board's financial  - 22 - position pending payment by the treasury for the large volumes of barter sales effected by the board on behest of the Government and its agencies, and to finance working capital needed by the board to pay for its inventories of coffee, (b) BOU providing guarantces to commercial banks for lending to unions considered uncreditworthy by the banks, (c) BOU lending to some primary societies through commercial banks. As a result of this involvement, BOU's outstanding loans for crop finance jumped from USh 2.3 billion in December 1988 to 18.7 billion in December 1989 (Tab!' 2.7). This has had extremely serious consequences for the control of aggregate credit. TABLE 2.7: CROP FINANCE CREDIT OUTSTANDING (1985-1989) USh billions 1986 1988 1987 1988 1989 1989 1909 Dec. Dec. Dec. Dec. Mar. Jun. Dec. Total Domestic Credit 267.2 646.3 11.8 27.0 66.6 67.4 76.8 Of which Crop Financing 48.6 169.9 8,7 4.6 14.2 19.6 26.0 Share of Crop Financing(#) 18.9 31.2 31.2 17.0 88.0 88.9 8B.0 BOU Loans for Crop Finance 6.1 0.0 0.8 2.8 9.6 13.9 18.7 Share: BOW (X) 12.6 0.0 20.a 60.0 Ul.9 71.8 74.8 Source: Data to 1988 from Bank of Ugaend, quarterly Economic Report, Dec 2988. Date for subsequent years from printouts supplied by th BOU. It should be noted th.%t there was a currency reoorm In Ma;j 1967 which explains the taparent inconsistency betwoen pre- and post-1987 data. 2.24 The policy message is quite clear. Given the fundamental inflationary pressures coming from the bank financing of fiscal deficits, strong BOU control of nongovernmentol credit is vital for successful stabilization. The accommodating sa.sce of monetary policy in FY89 contributed to short term growth, but in doing so has compromised prospects for successful stabilization. D. FINANCIAL POLICIES TO FACILITATE STABILIZATION 2.25 While a deeper financial system will make the Government's task of macro economic management easier, this respite is unlikely in the short term, especially in an environment of continuing high inflationary expecta- tions . But the Government have some levers to use to control inflation pressures. These include: (a) enhanced discipline in the banking system; (b) reforms of system of crop finance; (c) use or introduction of instru- ments such as open market operations to manage liquidity in the economy;  - 23 - (d) interest rate policy; and (e) restructuring of insolvent financial institutions. Banking discipline 2.26 In relation to banking discipline the strategy is clear and critical successful stabilization requires far stricter enforcement of the monetary policy controls on the banking system than in effect prior to September 1989. The BOU have authority in the economic policymaking process to give it a greater chance for resisting political pressures for short term, but ill-considered expansion. The modalities of implementing this recommen- dation are outlined in Chapters IV and V. 2.27 The importance of banking discipline is enhanced in the Ugandan context because of the extensive use of arrears not only of the Government itself but also of parastatal enterprises, including the Coffee Marketing Board. Whatever the cause of payments arrears--bad financial management, lack of adequate legal recourse, and so forth.--since they have come to be accepted as normal, attempts to tighten the monetary stance may merely lead to a further increase in arrears rather than to economic adjustment. For example. a tightening up on the Government's own finances may cause the basic shortages of savings in the economy to reveal themselves elsewhere. If. for example, the Government were to repudiate the responsibility for the debts and deficits of the parastatal enterprises, then the financial positions of those enterprises would deteriorate, and they would become directly dependent on credit from the banking system rather than indirectly through the Government. In short, extensive payments arrears as in Uganda are a basic reflection of an inadequate financial system in which many nonfinancial organizations are being forced to operate, in effect, as quasi-banks. The authorities acceptance of widespread domestic arrears is destructive to the functioning of the financial system. It must be tackled urgently. Reforms in the crop financing system 2.28 Coffee is Uganda's most important crop; credit to produce and market coffee invariably represents a large part of total credit outstanding. Crop financing in general, and coffee financing in particular, has always been problematic in Uganda, and previous approaches to allocating credit have been fraught with problems. Many, if not most, of the past and present problems in this area are associated with the presence of a parastatal that has simultaneously had monopoly powers over coffe. exports and monopsony powers in the purchase of coffee from local produce't. This has led to a credit pyramid with inefficiencies in different layet The main layers in the pyramid include the farmer, primary societies, cooperative unions, and the Coffee Marketing Board. Although commercial banks (and more recently the BOU) have been involved in providing credit directly to different layers of this pyramid, as well as to private processors of coffee, the main channel through which credit filtered through the system has been the board. 2.29 The problems of coffee financing essentially reflect fundamental weaknesses in both the financial arrangements for Coffee Marketing Board and its management more generally. These certainly need to be corrected if the  - 24 - specific problems encountered in FY89 are not to recur, and if the commercial banks are to return to crop financing on a substantial scale. To address this problem, the Government has recently agreed to a number of measures as part of Agricultural Sector Adjustuser,t Credit (ASAC) negotiations. First, BOU's role, starting in the FY91 crop season, is be restricted to the provision of refinancing facilities for commercial banks involved in crop financing (with risks to be borne by commercial banks). Second, the Government has agreed that it does not expect borrowers in the marketing chain to obtain all their financing requirements from institutional credit. Third, the Government has decided that effective from FY91, fresh equity is to be injected into the board to meet its minimum seasonal working-capital needs to lessen its strong dependence on institutional sources of credit. As part of this financial restructuring, the board's entire debt to BOU, estimated at approximately USh 17 billion, will be eliminated. This is to be accompanied by improved arrangements for financial management, inventory control, and management information systems. Parallel arrangements are also being put in place for the cooperative unions, especially for those earmarked to undertake export marketing on their own account (that is, without going through the board). This arrangements include medium-term loans to unions to finance their minimum seasonal working capital, pending the union's accumulating their own equity from future profits. Pricing and taxation arrangements for coffee also need to be reviewed in order to enable the marketing intermediaries to generate internal funds to supplement those obtained by borrowing.7/ 2.30 But, the reforms will not moderate credit requirements if the Coffee Marketing Board persists with the large quantities of barter sales of coffee and continues to experience substantial delays in achieving the payments for these from the Government. The continuation of this practice in FY,90 after strong commitments from the Government that it would cease, can only be explained by pressure from several sources to which the coffee board is subjected. From the viewpoint of certain ministries, the resources resulting from barter sales are valuable, as they are extra-budget "free' resources that the board rails to be paid. The consequences for the overall financing calculus of the economy cannot be avoided because the coffee board has to borrow on a one-for-one basis for every one dollar of barter sales not reimbursed by the Government. Thus barter sale represent yet another, albeit disguised, form of deficit finance. 2.31 As regards the credit arising from the direct intervention of the BOU in the provision of finance to the primary societies, the cooperative sector has agreed not to seek credit for the crop-financing needs of the primary societies. Farmers are expected to deliver coffee on credit, pending payment by district unions. This is an artificial restriction and its success remains to be seen. 2.32 More fundamental, however, are problems related to the modalities of the participation of commercial banks in crop financing. Although there is agreement in principle that commercial banks as a group should take over 7/ These and other reform arrangements are being discussed in more detail in the context of ASAC.  - 25 - crop financing, an issue to be resolved is the degree of participation by the UCB and COOP--the two illiquLd banks--and the sharing of arrangements. The other, mainly foreign, banks are liquid but most of the rural-branch network needed for crop financing is owned by the UCB and COOP. There are several other failings in the credit process, evident before December 1988 that may still cause problems even after the implementation of the proposed new reforms. The quality of management at branch-bank level of the UCB and COOP and their general disregard for sound banking principles is just one example. 2.33 Based on the likely structure of the reforms, broad indicators of the probable credit needs of crop finance can be assembled. Using the same assumptions as in the ASAC preparation mission and the Government's procurement and export targets, and benchmarks for credit turnover rates, three alternative price scenarios are presented in Table 2.8. The table indicates that the bank credit required under each price scenario is considerably lower than the amount outstanding against the banking system as of end-December 1989 (USh 25 billion). A large part of this decline is due to the equity finance that the Government plans to inject into the coffee board as part of its financial restructuring, thereby making it less dependant on commercial banks for working capital. Implicit in the projections, however, are also assumptions about a more efficient use of credit by the unions and primary societies, encouraged in part by structural changes in the marketing chain. These are outlined in Annex 2.2, with the mission's assessments regarding other financial assumptions underlying the estimates given in Table 2.8. These considerations suggest that taking account of uncertainties and delays in implementation, a pessimistic scenario can be painted involving bank credit of some USh 10 - 12 billion more than the figures shown in the table (at a coffee price of USh 75 per kilo). The revised total of USh 21-23 billion would still however represent a fall of 8-10 percent relative to the December 1989 figure. TABLE 2.8: THREE POSSiBLE SCENARIOS OF 1990/91 CROP FINANCING REQUIREMENTS (-ssuming reforms) Possible producor prices (USh KG) 60 76 90 Ftnancne re ulrements: (i.e. max 18.7 21.5 24.0 outstanding at sason peak, USh billion) inancing sources: 7.6 8.6 9.5 Windfall gain - 1.6 8.1 Bank borrowing 11.1 11.8 11.4 TOTAL 18.7 21.6 24.0 Coneg.ition of bank borrowino Comercial bankes (own rsources) 4.1 4.8 4.4 BOU refinance 7.0 7.0 7.0 TOTAL 11.1 11.8 11.4 Sources Staff estimtes In ASAC Documents 2.34 The above considerations suggest that the Government is moving in the right direction to put crop financing on an efficient basis. It should maintain these efforts, in particular the momentum toward a competitive and market based arrangements where the coffee board competes with other entities  - 26 - for ezports and procurement. At the same time, credit extension at all levels should be based on commercial creditworthiness criteria, rather than administratively imposed allocations or restrictions. Use of ogen-market operations 2.35 In the short run, the only open market operation that is suffi- ciently developed to be used for monetary control purposes is the market for foreign exchange. The link between monetary expansion and inflation involves a role for the foreign-currency market. Additional money injected into the economy from whatever basic source probably causes a rapid portfolio adjustment from excess money balances and into the parallel market for dollars. This is because alternative forms of asset holdings that offer equivalent prospects for profit such as equity securities, simply do not exist in Uganda. The higher initial demand for dollars raises its price and with it the prices of goods it is used to purchase. If this reasoning is accepted, then the authorities have another useful monetary control lever with which to manage inflation. Specifically, the Special Import Program II which involved the sale of foreign exchange in an effective open market operation at a rate higher than the official market rate, successfully demonstrated it can help to drain liquidity from the system and stabilize or lower the demand for parallel market foreign exchange. The potential here is quite considerable (provided foreign exchange was available) because of the small size of Uganda's monetary base. For example US$40 million sold at the official exchange rate in 1989 would have removed Ush 16 billion, or 25 percent of K2, from circulation. 2.36 In the medium term the BOU should consider the development of inter-bank and money markets for managing liquidity. The issues related to the development of these instruments are addressed in Chapter IV. Interest-rate policy 2.37 Interest-rate policies ought to play a central role in increasing the financial depth of the Ugandan economy. After 1981, the interest rate on time deposits (minimum of one year) edged up from 5 percent to a June 1987, level of 35 percent but was then lowered to 22 percent (18 percent for 3-6 month deposits) in mid-1987 on the basis of small, downward movements of 200 percent plus inflation. A similar pattern of change applied to lending interest rates, which hit a peak of 42 percent for unsecured loans (38 percent for agricultural loans) by June 1987, before being adjusted downwards to a range of 25-30 percent. Subsequent high rates of inflation have encouraged further upward movements of interest rates, but the rates still remain negative in real terms (for current schedule of rates, see Annex 2.3). 2.39 However, with the reduction of the inflation rate to below 30 percent for FY90, interest rates have become highly positive and thus were adjusted downwards. As of June 28 1990, the maximum deposit rate was reduced to 32 percent and the lending rate to 45 percent. Even more importantly, beginning October 1990, it is the Government's intention that interest rates will be adjusted each month on the basis of the average year-end inflation rate for the preceding three months, in order to maintain positive real deposit rates of at least 4 percent. This recent development reverses  - 27 - policies from the past, and should encourage the expansion of the financial sector. TABLE 2.9: BA( DEPOSITS AND ADVANCES. 1986-SO 196 196 19t7 19ow 1989 Demand deposite 0.76 1.55 8.04 9.22 21.07 Other depoelt. 0.20 0.60 1.29 2.18 4.20 Total depolIt 0.98 2.05 4.88 11.85 26.a8 Total loan. 0.87 1.00 8.1i 10.07 22.80 Loan/deolt X 88 49 78 69 56 Source: BOU 2.40 In the 1970s and certain periods during the 1980s when economic activity was severely depressed, the banks did not actively seek deposits because the deposits they did mobilize could not easily be lent out. In the more recent past, when credit demand has been high, the banks were hampered in their mobilization of deposits by the combination of high inflation rates and low nominal-interest rates. The result, shown in Table 2.9, was a system-wide breaching of the standard Ugandan prudential lendingt deposits ratio of 82.5 percent, which for the more aggressive banks such as the UCB has been even higher. For example at the end of August 1989, the UCB and COOP together had advances and discounts outstanding (excluding administered loans) equivalent to 99.7 percent of deposits. This compares with the ratio in the rest of the banking system of 72 percent. 2.41 It is a complex matter to devise a 'correctw interest rate policy in the difficult circumstenices faced by Uganda, and it would be naive to imagine that a simple formula-approach of adopting positive real-interest rates would produce only beneficial effects. However, the tight money needed to control the inflation rate will certainly need high real interest rates for a time. This policy ensures that there will be forces that restrict the demand for credit, matching the supply contraction associated with greater discipline by commercial banks and better supervision by BOU. In the specific area of coffee-financing, relatively high interest rates would be an important mechanism to help to achieve the improved adherence to Agricultural Policy Committee benchmarks and the reduction of waste on coffee-sector credits from the past. High interest rates also give unions and processors a strong incentive to use their own funds in coffee-financing, to the extent assumed in the projections of coffee financing (see Table 2.2). In addition, higher interest rates should dampen demand for holdings of private wealth in parallel foreign currency rather than in domestic financial assets. 2.42 The dangers of excessively high interest rates should not be ignored and these dangers relate mainly to the credibility of the anti-infla- tionary program of the Government. If real interest rates become highly positive, then given the low return on capital in many of Uganda's productive sectors (including coffee), the burden on enterprises and cooperatives would be unreasonable. The majority of credit used in these circumstances would be  - 28 - for speculative purposes or would be linked to distress borrowing. Many borrowers would have no intention or ability to repay their loans, and hence they could further worsened the banks already bad debt situation. For these reason lengthy periods of high and positive interest rates (above 10-15 percent real) should certainly be avoided, and the new interest rate policies seem to guarantee that. However, if the fundamentals of inflation determi- nants relating to the budget deficit and other sources of monetary expansion are progressively being brought under control, then short periods of highly positive interest rates would be a potent indicator that the government is committed to drive inflation from the system. In particular, high rates could be extremely significant in encouraging portfolio shifts into domestic financial assets. Once this has occurred, the vicious circle explained above could be turned around to greatly enhance the government's ability to manage the economy and finance reasonable levels of fiscal deficits. However, this strategy would imply a short period of genuinely tight money and slower growth. 2.43 Finally, if it is realistic to address the fundamentals of inflation causation, then high positive interest rates should not be invoked as a single policy instrument to do all the work, to control the fiscal deficits and monetary expansion. The economic costs of sustaining high positive interest rates for long periods, in an attempt to kill inflation, would be extremely high. Related to the policy issues concerning the level of interest rates, there are also a variety of issues that need to be addressed concerning the structure of rates. These are discussed in Section II in Volume 2. Fiscal consequences of bank restructuring 2.44 The necessary restructuring and recapitalization of the two distressed banks, the UCB and the COOP will have important fiscal implica- tions. The orders of magnitude involved are explained in greater detail in Chapter III. The containment measures effected by the BOU in the last few months of 1989 sharply reduced the overdrawn position of the two banks from the alarming levels of late August. But, the basic factors that caused the crisis have led to a major undermining of the two banks' equity and almost certainly to a state of insolvency. The estimates of the amount of new capital needed to be injected are still being calculated by Coopers and Lybrand. However, the requirements seem likely to be of the order of USh 10 billion which put into perspective the FY90 budget is the equivalent of more than 10 percent of total estimated revenues and sufficient to almost double the estimate of the domestic financing of the deficit (see Table 1.2 Chapter I A, Volume 2). 2.45 Fortunately, the massive disruption of the government's fiscal and monetary program that these numbers suggest is muted by the possibilities of phasing the cost to the government over time. This could be done by providing a large part of the new capital in the form of an issue of new government securities on which only the interest costs would represent an immediate claim or the public finances. In addition, the capital injection would need to include sufficient liquid resources to provide the banks the liquidity cushion that they presently lack. Subject to the detailed Coopers and Lybrand recommendations, this figure is likely to be sizeable in this  - 29 - particular case -- possibly as much as USh 3.4 billion. Finally, the liquidity injection is likely to require the back up of rediscounting facilities from the BOU, tnereby providing a new source of future monetary expansion. Overall, with careful design, even though commercial bank restructuring will complicate the government's task of achieving the fiscal and monetary program, it should not be a major disruptive force. E. RECOMMENDATIONS 2.46 A number of main recommendations follow from the analysis of this chapter. The first of these recommendations relates to inflation. Although the trend of the recent months has been encouraging, Uganda's record on inflation-management during the ERP period has been inadequate, and there is no guarantee that single digit annual inflation can be attained unless assisted by appropriate policies. For this reason, a short-term priority is to build on the successes of the recent past and maintain a concentrated effort to drive inflation down to the low levels targeted for the next few years. In addition to the continued use of tight credit restrictions overall and a refusal to monetize the fiscal deficit, the authorities should resist the temptation for a premature lowering of interest rates to recognize that a short period of modestly high real rates can be a powerful complement to institutional measures (such as stronger BOU supervision of the banks) to achieve greater financial discipline in the economy. The distress in the financial system, explained in Chapter III, has occurred during a period of extremely easy money and highly negative interest rates, and not because of high interest rates and tight money. Thus, while the warnings about the damage that can be brought by high interest rates must be taken seriously, they are not a reason for continuing with policies of loose money and low interest rates. 2.47 A useful by-product of a period of tight money is likely to be a recovery of public confidence in the institution of money, and financial assets more generally, and so in higher ratios of broad money balances to GDP. If lower inflation and reasonably high nominal interest rates can both persist for some time, it is realistic to hope for an increase in monetary depth. This conjuncture of events would assist the Government's financing operation in two ways. First, lower inflation would ensure an enhanced revenue collection at any level of collection-efficiency. Second, a greater depth would result in a smaller inflationary impulse for any budgetary deficit still needed to be financed using monetary means. 2.48 Success in the fight against inflation also brings the need for the Government to find alternative revenues to replace those from the inflation tax. A policy priority for the next 1-2 years will be to review and implement policy, made in contexts other than that of this present report, to improve the collection-efficiency of the existing tax system. In the recent past, inflation tax revenues have provided the equivalent of 30 percent of conventional tax revenues. These need to be replaced with an alternative revenue base to remove this potential source of inflationary pressures and still allow basic expenditures in social services.  - 30 - 2.49 Third, the government needs to refine and extend its use of instruments such as the SIP (for open-market operations) to gain greater control of the liquidity in the economy and of the parallel-market exchange rate and the inflation rate. The defined interest rate policy will be an important element and establish more attractive domestic financial assets to reduce parallel foreign currencies from portfolios. However, given the several limitations of SIP that arise from the country's chronic shortage of foreign exchange, alternative instruments of intervention which are more directly controllable by the authorities need to be developed. The treasury bill is an obvious candidate for this role; and reforms of the method of issue, the interest rate structure, and the eligibility to hold such bills are needed in order to extend its use. 2.50 Fourth, as a means of enhancing banking discipline the Government should give a high priority to the restoration of monetary control and elimination of payments arrears (both of the Government and parastatal enterprises). Financial discipline of the banking system, enforcement of laws, contracts and accounting rules, and the effective supervision by the BOU, which is discussed later, are as critical to the development of the Ugandan financial system as attaining macroeconomic stability. A financial system depends primarily on the confidence of the public: confidence not only in how the economic authorities handle the economy but on the reputation of the financial institutions. Give past performance of Ugandan financial institutions, this process of confidence building will be difficult. 2.51 Fifth, the Government should ensure the implementation of its decision to transfer coffee financing back to commercial banks in FY91. To bring this about, among other things, the Government should facilitate the restructuring of the UCB and COOP at an early date. 2.52 Finally, there is the issue of the volumes of credit that might realistically be available to meet particular needs during the next few years. The projections done by the mission indicate that in the absence of financial deepening, it may be difficult to meet program targets and provide a reasonable real rate of growth of credit for the private sector after FY91 without a severe credit restraint on the Government. This result is based on the enforcement of restricted levels of credit-use in relation to crop financing, which may be difficult to achieve in practice. The hope for some easing of the credit restraint on the Government, consistent with an adequate rate of expansion of private sector credit, depends on the achievement of some degree of financial deepening in the economy. It seems likely, for example, that in FY93 there would be USh 50 billion more credit available (consistent with growth and inflation targets) if financial depth can be increased by 25 percent compared to its present levels. The Government in this instance will have th* choice to decide how much of the credit available should be allocated to the private sector and how much to its own budgetary needs. But, this easing of credit restraints could only be achieved by a stable environment and the use of interest rates and other policies that would make the holding of domestic financial assets more attractive.  II. DISTRESS IN THE COMMERCIAL BANKING SYSTEK A. INTRODUCTION 3.1 The major impediments to the growth and development of the banking system, some of which have already been discussed in Chapter I, are: (a) a lack of confidence in the financial system and in particular in the propensity to hold financial assets in Ugandan shillings whether as currency or deposits; (b) the short maturity and instability of deposits reflecting in part the presence of interest rates that have until recently been highly negative in real terms; (c) the uncertain and irregular flow of foreign exchange to bank clients; (d) the lack of adherence to, and absence of, well- defined standards of accounting and auditing practices as reflected in the poor state of accounts kept by bank clients, and the consequent difficulty encountered by the banks in assessing the creditworthiness of their customers; te) increasing levels of fraud and internal misappropriations, exacerbated by inefficiencies in the check clearing system and an erosion, in an inflationary environment, of the real level of wages and salaries paid to bank staff; and (f) absence of an adequate pool of trained bank staff and the relatively slow growth in training programs, a problem faced in particular by banks who are expanding their branch networks and their operations in an environment characterized by poor transportation and communication systems and the slow development in computerized banking operations. 3.2 These problems have been further exacerbated by management deficiencies in the case of the two leading domestic banks--Uganda Commercial Bank (UCB) and Cooperative Bank (COOP)--which, as mentioned earlier, are experiencing acute liquidity and solvency problems. These problems have raised concerns both inside and outside Uganda about the stability of the financial system in the country. There is a pressing need firstly to resolve the problems facing the insolvent banks, and secondly to restore the health of the system by introducing reforms aimed at improving the efficiency and stability of the system. Most of this chapter focusses on an analysis and possible solutions to the immediate problem facing the commercial banking system in Uganda. However the mission has also looked at some of the longer term issues in the commercial banking sector, including options for making it more efficient (so as to reduce the cost of intermediation which at about 23 percent is estimated to be one of the highest in the world) and responsive to the needs of the economy as it moves towards sustained growth. B. FEATURES AND GROWTH OF THE COMMERCIAL BANKING SYSTEM 3.3 Foreign banks played a major role in the development of commercial banking in Uganda. The first banking institution, the National Bank of India (the predecessor of Grindlays Bank), opened its doors in Entebbe in November 1906. In due course, Standard Bank (1912), Barclays Bank (1927), and Bank of Baroda (1953) entered the Ugandan banking scene. By the time Uganda obtained its independence in October 1962, Barclays Bank (which had assumed the role of the leading bank in the country), Grindlays Bank, and Standard Bank 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., was established by the coopera- tive movement under the Cooperative Societi3s Act of 1963 to carry out  - 32 - commercial as well as development banking business. The following year, the Government made its first equity investment in the banking sector by setting- up, under a special act, the Uganda Commercial Bank. 3.4 By 1973, tiie Government acquired a 49 percent share in three out of the four existing foreign banks (only Standard Chartered Bank remained wholly foreign-owned) and in the then newly crected Libyan Arab Uganda Bank for Foreign Trade and Development. In addition, UCB and COOP acquired the bulk of the branch network of Barclays Bank and Grindlays Bank (allegedly as a forced acquisition), thereby making the Government the major player in the banking sector. And despite the fact that the last two commercial banks established in Uganda during the 1980s (Gold Trust Bank Ltd. in 1985 and the Kije Bank Ltd in 1988) are 100 percent privately owned by Ugandans, the Government's share in the combined shareholders' funds of the nine commercial banks currently operating in Uganda stood at the end of 1989 at about 37 percent, or 48 percent if COOP is excluded. Size of the system and recent growth 3.5 Despite the problems mentioned earlier, the commercial banking system in Uganda has grown in both nominal and real terms during the past two years, thereby contributing to a slight deepening of the financial system. Preliminary figures indicate that the aggregated assets of the commercial banking system increased from USh 13,906 million at the end of 1987 to USh 67,536 million at the end of 1989, an increase in real terms of around 23 percent. Concurrently, the ratio of average aggregated commercial bank assets to GDP increased from 3.43 percent to 4.0 percent. 1/ However, in the wake of the significant devaluations of the Ugandan shilling during the past two years (from USh 60 to USh 370 to the US$), the total assets of the commercial banking system shrank in foreign currency terms. Whereas at the end of 1987, the aggregated assets of the commercial banks were of the order of US$232 million, by the end of 1989 they had dwindled to less than US$183 million, a decrease of more than 21 percent in US dollar terms. Main features 3.7 An evaluation of the commercial banks during the past three years reveals the following main features of the systems (a) emergence and subsequent easing of the liquidity crisis (b) dependence on demand deposits (c) decreasing share of agricultral lending (d) inadequacy of the loan loss provisions Ce) inadequacy of the liquid capital base (f) market concentration (g) operations with positive recorded profits (h) high cost of intermediation 1/ The ratio of H2 to GDP is slightly different from the figures quoted in Chapter I as average, as opposed to mid-year, figures have been used here for H2.  - 33 - 3.8 Liquidity crisis and its subsequent easing. As a result of the rapid increase in the commercial bank assets, the most significant develop- ment in the commercial banking system during 1988 and 1989 was the large decrease in liquidity, which reached crisis proportions during the months of July and August 1989. Whereas at the end of 1987, the combined balances of the commercial banks at the BOU amounted to USh 2.9 billion (equivalent to 32.9 percent of their total deposits), by the end of 1988, they had decreased to USh 1.9 billion (equivalent to 10.1 percent of their total deposits), and by the end of August 1989, they stood at a negative figure (an overdrawn position) of USh -2.5 billion, in violation of the prudential statutory requirement that all commercial banks keep at least 10 percent of their deposits in the form of unremunerated balances at the Bank of Uganda. 3.9 This shortage of liquidity reflects problems facing the two leading domestic banks. In the wake of the containment measures adopted by the BOU, the position of these two banks at the BOU improved during the last four months of 1989, leading to a significant easing of the liquidity crisis. Thus at the end of 1989, the combined balances of the commercial banks at the BOU amounted to USh 1.4 billion, equivalent to 3.3 percent of their total deposits, but still short of prudencial requirements. The remaining banks had excess liquidity over this period. In fact, although the banking system as a whole still did not meet the 10 percent cash ratio at the end of 1989, the combined liquidity of the remaining banks was more than adequate (with reserves at the BOU equivalent to 20.1 percent of their deposits). 3.10 High dependance on demand deposits. Despite increases in the level of nominal interest rates during 1988 and the containment of the inflationary pressures toward the end of 1989, demand deposits still accounted for 76.1 percent of total deposits at the end of 1989, as compared to 83 percent at the end of 1988. This relatively high ratio, even by African standards, of demand to total deposits has had the adverse effect of severely limiting the banks' ability to expand their term lending operations, without the assistance of external sources of funding or the BOU. Public sector deposits are not significant in Uganda. At the end of 1989, the combined deposits of the Government and the public entities accounted for only 15 percent of the total deposits of the commercial banking system (see Table 3.1). Table 8.1: Breakdown of Deposlts of the Commerelal Banks in Ugands by Source of Deposit. 1987-1989 (percent, as of end-uecomber) Source 1987 1988 1989 Government 2.1 8.7 4.0 Public entities 18.8 14.9 11.0 Banks 2.2 1.6 2.2 Credit Institutions 1.7 0.8 2.0 Individuals, partnerships, and private companies 80.2 79.1 80.2 Tots I 100.0 100.0 100.0 MM 7 :sod on Information obtained from the Banks Supervision Department, Bank of Uganda, and the banks. For some banks, the 1989 figures are provisional and unsudltod. 3.11 Decline in the share of lending to agriculture. Over the past few years there has been a noticeable change in the sectoral composition of the  - 34 - commercial banks. The share of agriculture, includir.g crop finance, in total lending has decreased steadily from 57.5 percent at the end of 1987 to 42.8 percent at the end of 1988, and to only 27.3 percent at the end of 1989, as a result of the direct involvement of the BOU in crop financing (a policy initiated in December 1988). Commercial banks, which have traditionally shown a preference to lend to the trading and other services sectors of the economy, have compensated for the decline in agricultural lending by increasing the share of trading in their portfolios from 20 percent at the end of 1987 to 34.2 percent by the end of 1989. The other sectors that have benefited during the past two years are the transpor.ation and construction sectors, whose respective shares increased from 3.6 percent and 2.5 percent at the end of 1987 to 11 percent and 6.6 percent at the end of 1989. The share of the manufacturing sector has remained broadly unchanged and has fluctuated in the 11 to 15 percent range (Table 3.2). Table 3.2: Sectoral Breakdown of Loans and Overdrafts of the Commercial Banks In Usanda. 1987-1989 ( percnt as of end-December) Sector 1987 1988 :989 Government 0.2 0.1 1.0 Agriculture 67.6 42.8 27.8 Production (11.1) (16.6) (11.0) Processing (26.2) (16. 8) (13.1) Marketing (21.2) (10. 9) ( 8.2) Manufacturing 16.2 11.7 13.2 Trade, commerce and other services 20.0 29.8 84.2 Transportation 8.8 6.0 11.0 Building and construction 2.6 2.9 6.6 Other I/ 1.0 6.9 6.7 Total 100.0 100.0 100.0 yI Consisting mainly of administered loans, most of which have not been classifled by economic sector, the agricultural sector being the main benoficiary. SOURCE: Bsoed on information obtained from the Banks Supervision Department, Bank of Uganda, and the banks. For some banks, the 1989 figuros are provlsional and unaudited. 3.12 Inadequacy of loan loss provisions. Although the banks' provisions for bad and doubtful debts increased more than seven-fold during the past two years, they are insufficient to meet the potential loan portfolio losses. At the end of 1989, the aggregated provisions for had debts amounted to USh 778 million, equivalent to 2.5 percent of the banks' loan portfolios (excluding the administered loans whose risks are supposedly borne by the BOU). Such a level of provisioning is inadequate by any developing country, and especially by African, standards. This low level of provisioning is partly due to the restrictive policy adopted by the Ministry of Finance regarding tax deductibility, whereby only specific loan loss provisions (as opposed to general provisions) are tax deductible. However, the low level of provision- ing is also due to tha financial structure and performance of certain domestic banks--UCB and COOP--which have in the past created an incentive on their part not to make adequate loan loss provisions. 3.13 Inadequacy of capital. The aggregated shareholders' funds of the commercial banks increased from USh 799 million, or 5.7 percent of total assets at the end of 1987, to USh 6.4 billion, or 9.5 percent of total  - 35 - assets, at the end of 1989 (sLe Annex 3.1, Table 3). These ratios, if taken on face value, imply that the commercial banks in Uganda are adequately capitalized. However, the bulk of the banke shareholders' funds consist of revaluations of fixed assets. At the end of 1989, the banks' paid-in capital, liquid reserves, and retained earnings totalled USh 610 million, equivalent to only 9.5 percent of total shareholders' funds and a meager 0.9 percent of total assets. By international standards, 2/ this is an extremely low ratio. This undercapitalization is, to a large extent, the result of the long period of inflation that the country has experienced, which, as discussed below, has also induced some of the more profitable banks to adopt the policy of distributing substantial dividends and retaining only a fraction of their profits as reserves. 3.14 Market concentration. One of the most significant features of the commercial banking system in Uganda is the high degree of concentration, which adds an element of instability to the system. At the end of 1989, UCB, the largest bank in the country, accounted for 81 percent of the number of branches, 66 percent of the v.ork force, 47 percent of total assets, 50 percent of total loans, and 48 percent of total deposits. As such, the actions of UCB have important repercussions on the other banks. The market shares of each one of the nine commercial banks currently operating in Uganda are shown in Table 3.3. Table 3.3: Market Shares of the Commercial Banks in U*anda (percent, as of end 1989) Number Loans and Overdrafts of Total Including Excluding Shareholders' funds Bank staff assets adm. loans ad.. loans Deposits Liquid TO-iT Uganda Com. Bank 66.8 47.3 56.9 49.6 48.2 50.0 6.6 Cooperative Bank 13.0 7.8 8.0 6.9 4.6 -48.7 22.2 Nile 1.2 4.6 5.6 6.8 5.6 28.8 2.8 Cold Trust 1.6 1.6 1.2 1.4 1.8 4.1 0.4 Domestic banks 81.3 60.7 70.7 64.7 69.6 84.8 82.0 Barclays 7.6 16.3 13.6 16.B 19.3 28.2 29.8 Grindlays 3.0 7.4 4.6 6.6 5.6 5.4 9.9 Berods 2.6 5.6 4.9 6.8 6.9 8.1 1.0 LAUB 8.1 65. 2.8 8.8 8.B 12.8 22.8 Standard 2.6 4.6 8.6 4.4 6.8 10.7 6.0 Foreign banks 18.7 89.3 29.8 85.3 40.4 66.2 68.0 All banks 100.0 100.0 100.0 100.0 100.0 100.0 100.0 SOURCE: Based on information obtained from the Banks Supervision DOpertment, Bank of Uganda, and the banks. For certain banks, the 1989 figuroe are provisional and unaudited. 3.15 Positive recorded profits. The commercial banking sector as a whole has in recent years been recording a relatively high level of 2/ The Basle recommendations call for a minimum ratio of capital to risk aa ets of at least 8 percent, of which at least half should consist of primary capital.  - 36 - profitability, although these figures need to be considered in the context of inadequate loan loss provisions. Despite the rapid increase in operating costs, the commercial banks have generated substantial profits during the past three years (Annex 3.1, Table 7). Aggregate profits before tax, after decreasing from the level of USh 915 million in 1987 to USh 783 million in 1988, increased to an estimated USh 1.4 billion in 1989. Although the ratio of profits before tax to average total assets decreased from 3.69 percent in 1988 to 3.12 percent in 1989, it still remained high by international standards. 3.16 Given that tax rates are relatively high in Uganda, 31 the banks' profits after tax amounted to only USh 608 million in 1989. This implies a net profit of 1.3 percent on average total assets and 10.9 percent on average shareholders' funds (including the substantial revaluations of fixed assets) in 1989. 4/ But if one compares the aggregated net profit with the aggregated paid-in capital plus liquid reserves (that is, USh 453 million at the end of 1988), the net profits of 1989 exceeded the liquid component of the banks' shareholders' funds. This is a good performance, given the difficult economic environment that has prevailed in Uganda in recent years. However, as will be shown below, the performance of the individual banks has been very uneven, with the foreign-controlled banks performing much better than the domestic ones. 3.17 As noted earlier, the profitable commercial banks have tended to distribute most of their profits in the form of dividends. In fact, during 1987-1989, the aggregate dividends distributed by the banks totalled USh 925 million, equivalent to more than 81 percent of their aggregated net profits during the period (see Annex 3.1, Table 7). 3.18 Cost of intermediation. The cost of intermediation (also referred to as gross earning margin), consists of three components: operating costs, other costs (including depreciation and provisions for bad debts), and gross profits. It is computed as a percentage of total assets. As shown by the data in Table 3.4, the cost of intermediation for the commercial banking sector as a whole was 23.6 percent in 1989, an extremely high figure, even for a country that has had persistent inflation. Studies conducted in other developing countries indicate that the cost of intermediation seldom exceeds the level of 15 percent, except in Brazil, where the cost of intermediation of the 10 largest financial conglomerates was 25.6 percent in 1981. Even in countries with relatively inefficient banking systems, such as Liberia and Peru, the cost of intermediation (of 10 and 11 percent respectively) is considerably lower than in Uganda. 3/ The income tax liabilities of the commercial banks during 1987-1989 are estimated at USh 2 billion, equivalent to 63.6 percent of their gross profits. 4/ In view of the high inflation rates recorded in Uganda, the above ratios were computed by dividing the flow variables by the geometric (rather than the arithmetic) averages of the end-year stock values.  - 37 - Table 8.4: A Comp arison of the Cost of Intermediation between Foreon and Domest c Ban s n Uan a. 1988-1989 (percont of average total assets) 1988 19S9 Forqlgn banks Gros earnings margin 26.62 21.68 Operating costs (16.39) (X813) Other costs (not) ( 1.16) (1) Profits before tax ( 9.97) ( 6.89) Domestic banks dross earnings margin 20.70 26.14 Operating costs (24.07) (28.97) Other net income (costs) (-1.62) ( 0.76) Profits (losses) before tax (-1.86) ( 0.41) All commercial banks Gross earnings margin 28.41 28.64 Operating costs (19.97) (19.40) Other costs (net) (-0.26) ( 1.12) Profits before tax ( 8.69) ( 3.12) SOURCE: Based on Tables 3, 7, 9, 10, 11 and 12, Annex 8.1. The average total assets figures used in the computation of tho ratios are the geometric means of successive end-year figures. 3.19 Data in Table 3.4 indicate that even for the more efficient foreign banks in Uganda, the cost of intermediation was 21.6 percent in 1989. This cost is broken down into: operating costs (13.1 percent); other net costs, including depreciation costs and provisions for bad debts (1.6 percent); and gross profits (6.9 percent). On the other hand, the cost of intermediation of the less efficient domestic banks was about 25.2 percent in 1989. Operating costs averaged a staggering 24 percent (reflecting, to a large extent, the effects of branch banking), other net costs averaged about 0.8 percent, leaving a margin for gross profits of 0.4 percent only. The key measure of efficiency is the component relating to operating costs. 3.20 A comparison of the cost of intermediation (23.6 percent) and the operating cost ratio (19.4 percent) in Uganda with the averages prevailing in the OECD countries (3.9 percent and 2.3 percent, respectively, in the early 1980's) gives a rough estimate of the magnitude of the inefficiency of the commercial banking system in Uganda. Multiplying the difference in the operating cost ratio between Uganda and the OECD figures (a difference of 17.1 percent) by the ratio of total bank assets to GDP in Uganda (4 percent in 1989) yields a crude estimate of the excessive cost of intermediation as a percentage of GDP, or the loss in efficiency. Hence, it is estimated that in 1989, the loss from resource misallocation from inefficient intermediation in Uganda was of the order of 0.7 percent of GDP. The other implication of these figures is that if the Government wishes to protect the less efficient domestic banks, it must set interest rates to allow them a substantive margin (as has been the case to date). A detailed analysis of the cost of intermediation of the commercial banking system in Uganda is presented in Annex 3.1 C. PERFORMANCE OF THE DOMESTIC BANKS 3.21 The domestic banking sector has in recent years adopted a dynamic stance, including the establishment of much-needed programs for branch  - 38 - expansion in rural areas with an emphasis on deposit mobilization. This particularly applies to UCB and to a more limited extent to COOP. However, it is the mission's assessment that given their inadequate capital and deposit base, the shortage of professional and management staff, and the absence of adequate control and screening procedures for investment and portfolio decisions, these two banks should have followed more prudent policies toward new bank branches and expansion of their loan portfolios. Growth in both areas appears to have been too fast and has been achieved at the expense of reduced liquidity and likely insolvence. The situation in UCB, while it has apparently improved slightly since August 1989 as a result of temporary containment measures imposed by the BOU and Ministry of Finance including some changes in its top management, is still worrying because it dominates the financial system and poses a threat to its stability. The long-term viability of UCB is not in question. What is in question is the decision-making process, organizational structure, and inadequate procedures that allowed this situation to develop and that need to be altered to restore the bank to a solvent state and prevent a recurrence of these events. The situation at COOP bank is more serious as its viability is also in question. Rapid growth 3.22 The operations and assets of domestic banks increased substantially during the past two years. As a result of this rapid growth their assets grew from USh 7 billion at the end of 1987 to USh 41 billion at the end of 1989, a growth rate in real terms of 200 percent. Associated with the rapid growth in their portfolios (most of it due to UCB), the domestic banks at the end of 1989 accounted for 81 percent of the work force of the whole commercial banking system, 60.7 percent of aggregated assets, 64.6 percent of total loans (excluding administered loans), and 59.6 percent of total deposits (see Table 3.4). This rapid growth was achieved mainly because of the expansion of the branch network of UCB and, to a lesser extent, COOP. Whereas at the end of 1987 the domestic banks jointly operated 79 branches (out of a total of 93), by the end of March 1990, the number of their branches had risen to 212 branches, or 94 percent of the total number of commercial bank branches in the country (see Table 3.5).  - 39 - Table 8.5: Geoqraohical Distributlon of the Comerclal Danking Branch Network In Ugands (numb r ot branch"s) Reoion Domestic banks Foreion banks All banks Kampa l 67 a 66 Ubarara 81 81 MbalI 26 1 27 Jinja 21 a 24 Maska 19 2 21 Aruc 19 _ 19 Masindi 16 - 16 Fort Portal 16 16 Oulu 7 - 7 Total (end March 1990) 212 14 226 Total (and 1988) 158 14 172 Total (end 1987) 79 14 98 SOURCE: Bas-d on information obtained froe the banks. Liquidity crisis 3.23 The liquidity position of the domestic banks steadily deteriorated throughout 1988, and especially during the first half of 1989, to finally reach crisis proportions during the third quarter of 1989. The loans to deposit ratio (after excluding administered lending) of the domestic banks increased from 70.3 percent at the end of 1987 to 98.6 percent at the end of August 1989, well in excess of the 82.5 percent upper limit set by the BOU. As a result of this, the combined balance of the domestic banks at the BOU turned negative in January 1989 and reached the alarming level of USh 5.8 billion at the end of August 1989. Considering that banks are required to maintain a minimum 10 percent cash reserve ratio at the BOU, the shortfall in reserves of the domestic banks reachei the level of USh 7.9 billion at the end of August 1989, equivalent to 38 percent of their total deposits at the time. 3.24 Although the liquidity crisis eased considerably during the last four months of 1989, the domestic banks' combined position at the BOU remained negative due to the relatively large overdrawn position of COOP. At the end of 1989, the combined domestic banks' overdrawn position at the BOU stood at USh 2 billion. This implied an aggregate shortfall in cash reserves of the order of USh 4.6 billion, equivalent to 18 percent of their deposits. This reduction in the degree of illiquidity was achieved, as a result of the decrease in the loans to deposit ratio from 98.6 percent at the end of August to 79.1 percent by the end of 1989 (see Annex 3.1, Table 9). 3.25 The effects of the expansions of the branch networks of UCB and COOP are reflected in the data relating to fixed assets. The level of the fixed assets (net of depreciation) of the four domestic banks increased from USh 266 million at the end of 1987 to USh 3.9 billion at the end of 1989. A good part of this increase resulted from COOP's revaluation of its assets in 1988. However, even after excluding this revaluation, the net outlays on fixed assets are significant, especially when they are compared with the liquid portion of the banks' shareholders' funds. Thus at the end of 1989, the net fixed assets of the domestic banks (after excluding the revaluations)  - 40 - stood at USh 2.1 billion. This amount is almost equal to 10 times the domestic banks' shareholders' funds (also excluding the revaluations). In other words, the expansion of the branch networks was financed by customer deposits, rather than by shareholders' funds. In addition to being contrary to proper banking practices, such a policy had adverse effects on the banks' liquidity positions and profitability. Profitability 3.26 The profitability of the domestic banks decreased sharply during 1988, with operating costs increasing at a pace more than double that of operating income. As a result, the domestic banks collectively recorded in 1988 a loss of USh 208 million. In 1989, the domestic banks recorded a profit before tax of USh 109 million (see Table 3.6). However, it should be noted that the loan loss provisions being taken by the domestic banks, though increasing, remain inadequate in relation to the potential loan portfolio losses. At the end of 1989, loan loss provisions of the domestic banks vere equivalent to only 1.5 percent of the banks' outstanding loan portfolios. One reason why the domestic banks have such a low level of loan loss provisions is that they have not been able to generate sufficient profits and have chosen not to show losses. At the same time, the banks do not have adequate capital to asset ratios. With higher capital adequacy ratios, they would have been able to sustain some losses, without risking insolvency. This also raises the related and important issue of poor auditing and accounting standards: the bank's auditors should have ensured a more realistic provision for losses. Finially, another important factor that is likely to have had an adverse impact on the profitability of the domestic banks, and in particular UCB and COOP, is the cost of managing administered funds for the BOU. 5/ 5/ Administered Developmental Lending In their lending operations, UCO and the COOP discharge both a comercial and developmental rolo, the latter being financed either by external aid funds or the BOW. The proportion of the domestic banks' loans and overdrafts portfolios that in admInistered, increased substan- tially during 1989 to exceed 24 percent by year-end. Roughly 70 percent of adminittered lending is externally fundod, while the remaining 30 percent Is financed by the BO W. In the cose of UCB, administered funds are usod mainly to extend medium- and long-term loans, predominantly (almost 90 percont) to the agricultural sector (with the romaining 10 percent going to the manufacturing soctor). In the coae of tho COOP, adminisoterd funds are directed primarily at tho cooperative soctor. Roughly half of COOP's administered loans aro short- term (used for crop production and markoting), while the other half consist of modium- and long-term loans used predominantly for the rehabilitatlon of the cotton and coffee Infra- structure. Banks in Uganda do not have much floxibility In pricing their loans. The lending rate structure depends on the source of funding and tho purpose of tho loan, rather than on the maturity, the degree of rilk,or other relevant parameters. Interost rates on administered loan& are lower than thoso levied on normal commercial borrowors. In cortaln cases of externally funded loans, borrowors recolvo a considerable subsidy over commerclal rates. However, the interest spreads on these externally borrowed funds, S-6 percent, are not sufficIent to cover the relatIvoly hIgh loan processing costs (largoly due to tho smaIl ize of tho loans) and the provistons for bad debts. Judging by the relatively Iarge provistons for bad debts recently recommendod by external auditors, and, except for those administered funds that are presumably non-repayable grants used as revolving funds, the administerod lending activities of UCS and the COOP have probably boen, or will prove to be, loss-making operations.  Table 1.S6 Aggr2oated ProfLt and Logo Accounts of t~he Domestic Banks in Uganda. '187-19i" (USh millions) 1907 1998 1989 Interest recived 780 2,261 7,107 Interest paid 162 679 2 772 Interest Margin 687 Y1,t I1 Comission and forex Income 180 648 1,730 Other operating Income 46 107 740 Gross earnings "mrgin 618 TIM W Staff costs 209 824 2,341 Occupancy costs 144 948 1,988 Other operating costs 286 928 2.160 Operating costs 588 2,700 6,489 Net earnings margin 226 ( 878.) 818 Depreciation coots 9 60 185 Provisions for bad debts 12 62 329 Other Income 128 272 307 Other net income (Coots) 107 170 ( 207.) Profits (losses) before tax 332 ( 208.) 109 Taxes 172 s0 131 Profits (losses) after tax 160 ( 248.) ( 22.) SOURCE: Basod on published financial statements and Information obtained from banks. Data refer to calendar years, except for one bank whose financial years end on September 80. For some banks, results for 1989 are unaudited and provisional. Insolvency__problems 3.27 The profitability and capital adequacy figures for 1989 are based on the provisionsl and unaudited accounts of the two leading domestic banks. According to the draft diagnostic studies recently undertaken by Coopers and Lybrand, both UCB and COOP are technically insolvent, due to th2 significant impairment of their loan portfolios. On the basis of a sample of 220 debtor accounts at UCB, equivalent to 30.4 percent of UCB's outstanding loan portfolio as of December 29, 1989, Coopers and Lybrand estimated that provisions totalling USh 7.6 billion 6/ (or 32.5 percent of the total portfolio) would be required to clean up the portfolio. Given that actual provisions for 1Fad debts totalled only USh 184 million at the end of September 1989, additional loan loss provisions of the order of USh 7.5 billion are recommended. Since shareholders' funds stood at USh 425 million at the end of September 1989, it is obvious that UCB is insolvent. 7/ 6/ Calculated on the basis of the following provisioning ratios: 2 percent of performing loans, 10 percent for substandard loans, 50 percent for doubtful loans and 100 percent for bad loans. The definition of categories such as "substandard" is based on a number of criteria including age of debt. 7/ The financial audit of UCB by Coopers and Lybrand has also uncovered a number of errors in the draft accounts which, on the whole, tend to increase further the extent of UCB's insolvency. However, since the audited accounts have not yet been approved by UCB, the recommended adjustments have not been taken into account.  - 42 - Although according to Coopers and Lybrand, UCB's reserves could conceivably be increased by as much as USh 31 billion i.f its fixed assets were to be revalued at current market prices, such a move would not resolve UCB's liquidity and profitability problems. Its fixed assets cannot be easily liquified, especially at the assumed market prices, and UCB will not be able to generate enough income to cover its costs, unless its non-performing loan portfolio is replaced by performing assets. In other words, unless UCB is recapitalized, it cannot generate any profits. 3.28 The financial situation of COOP is considerably more critical than that of UCB. On the basis of the loan portfolio evaluation undertaken by Coopers and Lybrand, additional provisions totalling USh 1.7 billion would be needed to clean up the portfolio. A total of 193 debtor accounts (equivalent to 4.2 percent of the total number of debtor accounts but to 46.2 percent of the outstanding loan portfolio. which amounted to USh 2,868 million at the end of 1989) were reviewed. The recommended provisions are equivalent to 62.8 percent of the outstanding portfolio at the end of 1989. Because of the relatively poor performance of the agricultural and cooperative borrowers, a higher provision was recommended with respect on the one hand, to agricultur- al loans (as compared to loans extended to the manufacturing, trading and transportation sectors) and, on the other hand, to loans to cooperatives (as compared to loans extended to non-cooperative companies and individuals). The loan loss provision of USh 1,697 million, even after allowing for the revaluation of fixed assets would more than wipe out the entire share capital of the bank. ManaRement deficiencies at UCB and COOP 3.29 The diagnostic studies of UCB and COOP and the findings of the financial sector review mission clearly indicate that the problems of these two institutions were partly the result of management deficiencies. Although the major internal and external shocks that the Ugandan economy has suffered during the past two decades have undoubtedly adversely affected the banks' loan portfolios, the deterioration in the quality of UCB's portfolio--and even more so, COOP's loan portfolio--can be attributed largely to weaknesses in the lending operations. 3.30 In the case of COOP, weaknesses were observed in all phases of the lending process. The loan application procedures are inefficient; the loan appraisal, credit analysis, and sanctioning techniques are either non- existent or deficient; the level of effective loan supervision is very low, especially in the case of administered loans and overdrafts, resulting in low loan recovery rates; and finally, the credit control and portfolio monitoring systems used are rudimentary. In the case of UCB, major deficiencies were found in the loan supervision practices as evidenced by the low frequency of field supervisory visits and reflected in the low loan recovery rates; however, the weakest area in UCB's lending operations was found to be credit control and management information systems, with multiplicity of controls and reporting lines and the lack of standardized information relating to portfolio performance. The latter implies lack of coordination between lending groups so that it has been possible for a customer to get a loan from one group, despite having been refused by another. 3.31 In addition to the weaknesses in their lending systems and controls, both banks have been facing lending pressures in relation to, but  - 43 - not limited to, their administered lending operations. Both banks have been induced by the Government and donor agencies, not only to adminiater projects that had already been designed and the beneficiaries identified, but also to assume the risk for bad and doubtful debts. Both banks, UCB in particular, claim to have been subjected to political interference by the Government, and used to implement government policies which may be socially desirable, but are inconsistent with sound commercial banking practices. The banks' financial performance would certainly have been better had their senior management resisted these pressures. 3.32 Management deficiencies of UCB and COOP are probably best illustrated by the way their branch expansion programs were implemented, and the effects of programs not only on the banks' liquidity position, but also on the banks' loss of internal control and profitability. Despite claims to the contrary, feasibility studies on branch expansions were not carried out. The banks' overall branch expansion strategy was to provide banking services to all parts of the country, without taking sufficient account of the viability of the rural branches and of the capability of the head office to effectively monitor and control such widespread and fast-growing networks. The result was a breakdown in the internal audit and inspection functions of the banks. Management's lack of control over the operations of the branches rendered the banks more vulnerable to acts of fraud, embezzlement, and misappropriation of funds. 3.33 In terms of management structure, some recent changes have been made at UCB, including the replacement of the managing director/chairman by his deputy on an acting basis. While this change is a step in the right direction, it would be a serious mistake on the part of the Government to assume that all or most of UCB's difficulties have been resolved by this change. More fundamental changes are required in the decision-making process at the senior management levels. In this context the Government should carefully considert (a) the proposal to separate the roles of chairman and managing director, with the chairman handling government and public relations while the post of managing director would be filled by an experienced banker; (b) changes to make the board more active than it has been in the past by increasing the frequency of meetings and altering the areas in which the managing director could make decisions without consulting the board; and (c) further regroupings of responsibilities below the level of managing director to allow stronger management control. Future prospects and options for restructuring UCB and COOP 3.34 Restructuring of UCB. The above discussion suggests that UCB's financial problems have been caused by two major sets of management and operational deficiencies. On the lending side, significant potential loan losses have been incurred due to poor loan extension, monitoring, supervi- sion, and control coupled with the unprofitable terms of its administered lending; while on the expenditure side, costs have been excessive due to the lack of strict control over cash management and branch operations, the high level of capital expenditures on the fast expanding aned loss making new branch network, and the excessive expansion of its head office staff. Consequently, if UCB is to improve its performance and generate profits in the future, it would have to improve the overall efficiency of its lending operations, better control its branch network, and reduce its operating  - 44 - costs. To accomplish this a number of urgent steps need to be taken, including: (a) strengthening of the top management structure; (b) separation of the development lending operations from the commer- cial lending operations, in terms of management teams and accounts; (c) completion of the task of reviewing and classifying the whole loan portfolio, concurrent with the launching of an intensive effort to recover loans in arrears coordinated by a special loan recovery unit reporting to the managing director; (d) tightening of lending procedures for new loans, increasing the frequency of field supervision, and improving the system of credit control and management information (including the adoption of internationally accepted accounting practices and procedures in consultation with the BOU (see Chapter V); (e) reaching an agreement with the Government and the donor agencies on an upward adjustment of the pricing of its administered lending operations, to ensure that the interest spread at least covers the operating costs plus allocations for loan loss provisions; (f) operating with a lower loans to deposit ratio than in the past few years; (g) strengthening its inspection and internal audit team; 3.35 Rationalization of UCB's branch network and head office. UCB's excessive expansion of its branch network, and staffing of its head office have had adverse effects on its profitability. During the last two financial years, 60.9 percent of UCB's capital expenditures was accounted for by expenditures on new branches. Of the 117 new branches opened by end- September 1989, 85 had deposits of less than USh 10 million each, and it is estimated that the losses of the new branches amount,d to USh 268 million in 1969. Host of the 77 branches that were loss making at the end of 1989 were new and some of these may never attract enough deposits to become profitable. Consequently, a rationalization of UCB's branch network could lead to cost reductions. A downgrading of some of these branches to the status of an agency (i.e., an office offering banking services during certain weekdays) may render them more viable. This technique could result in staff cost reduction, since the staff at regional branches could be moved around to man these agencies on a weekly rotation basis. 3.36 However, the overstaffing problem is more acute in the head office in Kampala than in the branches. During the last two financial years, UCB's staff increased by 40 percent (from 2,588 in September 1987 to 3,620 at the of September 1989). The staff in the branches and the regional offices that monitor the branches increased by 36 percent during the interval, as compared to a 48 percent increase in the Head Office staff. Currently, head office costs represent 59 percent of UCB's total operating costs, which is a relatively high figure. Consequently, although some cost reductions could be  - 45 - achieved from a rationalization of the branch network, a reorganization of the head office could result in even more significant savings. 3.37 Restructuring COOP. The problems of COOP are different from those of UCB, since COOP is endowed with less experienced staff than that of UCB, and has less potential for income generation. COOP's draft financial statements indicate a loss of USh 128 million in 1989. The losses would have been considerably larger had the BOU applied its official interest charges (i.e., 55 percent per annum) on COOP's overdraft. Instead, the draft accounts imply that COOP paid an estimated rate of interest of 20 percent on its overdraft at the BOU. Therefore, despite the assistance received from the BOU, COOP's insolvency problems are deepening. Furthormore, the obvious inability of the present shareholders--the unions--to raise the amount of funds needed for recapitalization renders its situation extremely precarious. COOP thus faces two additional problems. First, there appear to be serious questions about its viability at least based on the principles or vision on which it is currently organized. Second, assuming a convincing restructuring plan can be devised, the source of funds needed for recapitalization is not clear. 3.38 COOP options; There are only two feasible options available for COOP. The first is liquidation. The second is an arrangement whereby the management of COOP is handed over to the Swedish Cooperation Center (SCC) which is already giving the bank significant management and technical assistance. The arrangement would involve asking the SCC to reorganize the bank and design a strategy in order to make it viable, and manage it through a transition phase. The difficulty in this option is to find sufficient equity funds to resolve COOP's capital adequacy problems. Since it is highly unlikely that any investors (private or public) would be willing at this juncture to acquire COOP, the only way out would appear to be for the Government to acquire provisionally a majority participation in COOP, thereby canceling COOP's indebtedness to the BOU. The present shareholders could be given the option to repurchase in the future all or part of the Government's share at a predetermined price. In addition, COOP should be able to generate substantial windfalls from the projects currently being funded by the USAID PL 480 Programme and the SCC. Once, and if, the capital adequacy problem is resolved, the remaining issue becomes one of ensuring that COOP gets a competent senior management team. Given SCC's interest in assisting and promoting the cooperative movement in Uganda, the best course of action would be for the Government to request the SCC to assume the management of COOP for a specified period of time (say three to five years), after which the institution, if revitalized and rendered viable, could be privatized. Otherwise, the institution would have to be liquidated. D. THE FOREIGN BANKS 3.39 The foreign controlled banks in Uganda have consistently outper- formed their domestic counterparts, in terms of return on assets and shareholders' funds. This is only partly explained by the fact that they have shunned away from the riskier agricultural and term lending activities, and concentrated on the more lucrative short-term financing of trade. The main explanation lies in the fact that the foreign banks are better managed institutions and are in a position to resist pressures from the Government to extend their operations to projects or areas that are not viable on  - 46 - commercial grounds (such as branching out into rural a=eas, which invariably leads to higher operating costs). Out of a total of 226 branches in the country, the five foreign-controlled banks between them operated only 14 branches in the major cities and towns (i.e. Kampala, Jinja, Masaka and Mbale) at the end of March 1990. This divergence is partly attributable to the allegedly forced acquisition of a significant portion of the branch network of Grindlays Bank and Barclay's Bank in the early 1970's. Growth and composition of assets and liabilities 3.40 The aggregated assets of the foreign banks increased by 108.6 percent in 1988 and by 85.3 percent in 1989 to reach the level of USh 26.5 billion at the end of 1989. Given that these rates of growth were lower than those recorded by the domestic banks, the share of the foreign banks in the total assets of the commercial banking system decreased steadily from 49.4 percent at the end of 1987 to 39.3 percent at the end of 1989. 3.41 High liquidity. Foreign banks in Uganda are traditionally more liquid than their domestic counterparts, as reflected by the lower loans to deposits ratio. At the end of 1987, the loans to deposits ratio of the foreign banks averaged 51.9 percent, as compared to 68.5 percent for the domestic banks. And although the average ratio increased appreciably after 1987, it remained at 65 percent at the end of 1988 and 63.8 percent at the end of 1989 (see Annex 3.1, Table 11) well below the ceiling set by the BOU (82.5 percent). 3.42 The composition of the deposits held by the foreign banks is similar to that of the domestic banks, with demand deposits accounting for the bulk of their total deposits. However, in the wake of the decrease in the rate of inflation during the latter part of 1989, savings and time deposits increased faster than demand deposits. As a result, the ratio of savings and time deposits to total deposits of foreign banks increased from 18.1 percent at the end of 1988 to 23.4 percent at the end of 1989. The corresponding ratios for the domestic banks were 17.2 percent for end 1988 and 24.2 percent for end 1989 (see Annex 3.1, Table 9). 3.43 Foreign banks differ markedly from domestic banks with respect to the sectoral breakdown of their loans and overdrafts. Whereas the agricul- tural sector is the largest recipient of loans and overdrafts extended by domestic banks, lending by foreign banks is concentrated in the trade and other services sectors and the manufacturing sector. As can be seen from Table 3.7, at the end of 1989, 65.9 percent of the outstanding loan portfolios of the foreign banks went to trade and other services and manufacturing, as compared to 39.7 percent for domestic banks. On the other hand, although lending to the agricultural sector decreased in relative terms during 1989 to some extent due to the entry of the BOU into the field of direct commercial lending, agriculture, nevertheless, accounted for more than 31.2 percent 8/ of the outstanding loan portfolios of the domestic banks at the end of 1989, as compared to only 18 percent for the foreign banks. 8/ This ratio will in fact approach the 38 percent mark, if account is taken of the portion of the portfolio which has not been classified by sector (i.e., 8.5 percent), the bulk of which consists of loans to the agricultural sector (see Annex 3.1, Table 13).  - 47 - Table 8.7: Sectoral Br-eakdo-wn of Loans and Overdrafts. Of so bic and Forel n anks in Ugcnd a l98- l9 (percent) 1987 19s8 1989 Do etlc Bonk* - lNo en _ nt 0.2 0.2 1.2 Agricultur* 68.8 47.5 C1.2 Manufacturlio 11.0 7.4 7.0 Tead and Servicoe 19.4 25.6 82.7 Transportation 4.7 7.6 12.6 Bullding and Construction 1.2 2.7 6.8 Other Soctors 0.2 3.9 8.6 All Sectors 0 0 . 100 .0 Foregn Banks GovernMOnt - - 0.6 Agriculture 48.6 82.? 18.0 Mnufaecturlng 28.2 20.9 28.2 rad and Srvice. 21.8 87.9 87.7 Transportation 1.5 2.7 7.2 Building and Construction 6.0 8.8 6.1 Other Sectors 2.6 2.6 2.8 All Sectors 100.0 10..0 All ommercial Banks Government 0.2 0.1 1.0 Agriculture 67.6 42.8 27.8 Manufacturing 16.2 11.7 18.2 Trad and Service 20.0 29.8 84.2 Transportation 8.6 6.0 11.0 Building and Construction 2.5 2.9 6.6 Other Sectors 1.0 6.9 6.7 All Sectre 100.0 100.0 !00.0 SOURCE: Based on Information obtained from the Banks Supervision Department, Bank of Uganda. Capital inadequacy 3.44 The balance sheet data imply that the foreign banks operating in Uganda are more than adequately capitalized, with the ratio of aggregated shareholders' funds to aggregated total assets standing at 16.5 percent at the end of 1989. However, a closer scrutiny of the data shows that the bulk of the shareholders' funds of the foreign banks consists of revaluations of their premises. In fact, four of the five foreign banks (one in 1987, two in 1988, and one in 1989) have revalued their fixed assets, the four revalua- tions amounting to USh 3,981 million (see Table 11, Annex 3). Therefore, if one excludes these revaluations, the aggregated shareholders' funds of the foreign banks would stand at USh 398 million at the end of 1989, equivalent to only 9.1 percent of their reported figures. If the revaluations are excluded from the balance sheet data altogether, the ratio of the aggregated shareholders' funds to aggregated total assets of the foreign banks would stand at less than 1.8 percent (i.e., USh 398 million as compared to USh 22.6 billion). Indeed, as the foreign banks have been distributing the bulk of their profits (i.e., 75 percent during the three-year period 1987-1989) as dividends rather than ploughing them back as retained earnings, the ratio of the liquid shareholders' fund to total assets has been decreasing, thereby reaching unacceptably low levels.  - 48 - Hi&h profitability 3.45 As mentioned earlier, foreign banks have been considerably more profitable than their domestic counterparts. Despite the fact that operating costs increased at a faster rate than operating income in both 1988 and 1989, the combined profits before tax of the foreign banks, which amounted to USh 582 million in 1987, increased to USh 990 million in 1988 and to USh 1.4 billion in 1989 (see Annex 3.1, Table 12). In terms of the return on average total assets, however, the trend was downwards profits before tax decreased from 9.97 percent in 1988 to 6.89 percent in 1989, while profits after tax decreased from 3.87 percent in 1988 to 3.23 percent in 1989 (see Table 3.5). Despite this noticeable decrease in the profitability ratios, they remain quite high by international standards, since a ratio of profits after tax to average assets in excess of 1.5 percent is considered more than satisfactory. However, when the profits of the foreign banks are measured in foreign currency terms (rather than in Ugandan shillings) the rate of return on the original investment becomes much less attractive, given the recent steep devaluations of the Ugandan shilling and provides one explanation for distributing large dividends to their shareholders overseas. 3.46 The difference in profitability between the foreign and the domestic banks is explained, especially in 1989, by the difference in operating costs (reflecting in part urban concentration of the foreign banks), rather than in operating income or gross earnings margin. In fact, whereas in 1988, the ratio of gross earnings margin to average total assets was higher for foreign banks than for domestic banks (i.e., 26.5 percent as compared to 20.7 percent), the reverse was true in 1989, when the ratio was higher for domestic banks (i.e., about 25.2 percent as compared to 21.6 percent for foreign banks). This reversal was due to the change in the breakdown of operating income. As shown in Table 3.8, foreign banks derive a higher percentage of their income from commissions and foreign exchange (reflecting the lucrative aspect of trade financing), while domestic banks rely more heavily on interest and other income. The entry of the BOU into the field of coffee financing in December 1988 changed the breakdown of operating income for both foreign and domestic banks. In the wake of a noticeable decrease in the opening of letters of credit, the ratio of conuission and foreign exchange income to total operating income of foreign banks decreased from 64.0 percent in 1988 to 45.2 percent in 1989.  - 49 - Table 8.8: Components of Oross Earning. Mlraln In Domestic and For.lan Banksin Unanda. 1987-1989 (percent) 1987 l988 1989 1987-1989 Domestic Bank. lnWrooEt MargIn 72.2 67.7 68.7 06.8 Commisslon A Forcx Income 22.1 27.7 25.4 25.7 Other Operating Income 6.7 4.6 10.9 9.0 Grove Earnings Margin 100. 0 100.0 I00.0 is O Forein Bank Interest Morgin 82.1 86.0 64.8 46.7 Cor.Aialson A Forox rncome 67.9 64.0 46.2 54.8 Other Operating Income 0.0 0.0 0.0 0.0 Cross Earnings Morgin 1F-o 100 00100. 0 All Commerclal Banks Interest Margin 60.8 60.8 00.8 66.7 Commission A For-x Income 48.6 47.0 88.0 88.2 Other Operating Income 2.6 2.2 0.7 6.1 Gross Earnings Margin 100.0 ro-0.0 To-" COO SOURCE: Based on Tables 7, 10 and 12 of Annex 8.1. 3.47 Lower operating costs. The difference in the ratio of operating costs to average total assets between foreign and domestic banks widened in 1989. Whereas the ratio for foreign banks declined substantially from 15.4 percent in 1988 to 13.1 percent in 1989, that for domestic banks moved fractionally downward from 24.1 percent to 24 percent. Hence the difference between the two groups in terms of the operating costs ratio increased from 8.7 percent in 1988 to 10.9 percent in 1989. Although salaries paid by foreign banks are much higher than those paid by domestic banks, yet the ratio of staff costs to average total assets was lower in 1989 for foreign banks than for domestic banks (i.e., 7.3 percent as compared to 8.7 percent). This reflects the oves zaffing of the two leading domestic banks (i.e., UCB and COOP). More impoLeantly, the effect of branch banking is reflected in the higher ratios of occupancy and other operating costs to average total assets in dowestic banks as compared to foreign banks (ie., 15.3 percent as compared to 5.9 percent in 1989 (see Annex 3.1, Table 15).  - 50 - Table 8.9: Comaonents of Oseratina Exuens In Domestic and Forelan Banks In Uoanda. 1987-1989 (percont) 1987 1988 1989 1987-1989 Domeetic Banks Staff Costs 85.6 80.6 88.1 84.6 Occupancy Costs 2656 86.1 80.6 81.6 Other Operating Costs 89.0 84.4 ab.8 84.0 Operating Costs 100. 0 100.0 100.0 010.5 Fore 7n Banks Staff Costs 68.0 60.9 55.8 67.1 Occupancy Costs 18.4 12.0 9.6 10.8 Other Operating Costs 88.6 27.1 85.2 82.3 Operating Costs 100.0 1o0.o0 o0.o0 oo.o All Commercial Banks Staff Costs 41.9 41.5 41.6 41.6 Occupancy Costs 20.5 2B8. 24.6 26.0 Other Operating Costs 87.6 81.7 88.9 88.5 Operating Costs 100.0 100. 0 100.0 00. 0 SOURCE: Based on Tables 7, 10 and 12 of Annex 8.1. E. LONG-TERM ISSUES The Business Environment 3.48 The extent of the future growth of the system will depend on such factors as the maintenance of political stability, the growth of the economy in general, the reduction in the macroeconomic imbalances, and the level of real interest rates. As already mentioned, in recent years an environment of chronic inflation with interest rates held well below the rate of inflation has been one of the main factors inhibiting the growth of the commercial banking system in TTganda. This is reflected in the ratio of average total commercial bank assets to GDP of 4 percent in 1989, as compared to 15 percent in neighboring Rwanda. The size of the financial system should expand to more normal higher levels once the macroeconomic situation has stabilized and improvements in the security situation consoliiated. 3.49 In particular, after a long period of persistently negative real interest rates, which have adversely affected deposit mobilization, if the present downward trend in inflation, is maintained, it would have a major beneficial impact on the banking system, provided the recent emergence of positive real interest rates can be maintained. Such an environment would help to significantly increase the share of savings and time deposits in total deposits of the commercial banking system above its June 1989 level of 24 percent, which is considerably lower than the ratios prevailing in neighboring countries such as Kenya (54 percent) or even Rwanda (46 percent). Also without an appropriate structure of interest rates which are not only positive in real terms but provide adequate incentives for providing long term loans (as discussed in Chapter II), one would not expect the commercial banks to increase the level of their term lending operations which are currently relatively insignificant.  - 51 - Raising efficiency and competition 3.50 With the recent licensing of two new domestic banks, Centenery Bank and Teefe Bank, the number of commercial banks has risen to 11. This is more than sufficient to provide competition within the system now and in the foreseeable future. However, the mere increase in the number of banks will not by itself increase the competition and efficiency of the system. The inefficiency in the banking system as a whole is highlighted by the high ratio of operating costs to average total assets, 19.4 percent in 1989. This is in part due to the current low level of financial intermediation: with fixed costs to be covered by a limited number of loan assets, unit costs are bound to be pushed higher. As a corollary, net operating costs should decline as the economy recovers. However, the fact that the figure for the most efficient bank (9 percent) was roughly one-third that of the least efficient bank (26.1 percent), implies that there is still considerable room for reducing the cost of intermediation in Uganda; although some differences will remain due to structural factors, in particular the different size of rural branch networks. 3.51 To improve the efficiency of the system, and reduce intermediation costs, a first step is the restoration of the solvency and liquidity of the distressed banks or their liquidation. The prevailing interest rate structure implies that the average commercial lending rate of the commercial banks is of the order of 45 percent compounded monthly (equivalent to more than 55 percent on an annual basis), while the average cost of deposits is of the order of 20 percent compounded semi-annually 9/ (equivalent to more than 21 percent on an annual basis). Taking into account the 10 percent cash reserve requirement pushes up the effective average cost of deposits to more than 23 percent, implying an interest spread of about 32 percent. However, in the absence of an interbank market, the need to maintain excess unremuner- ated liquidity pushes down the actual interest spread which, nevertheless, remains in the neighborhood of 28 percent. It is quite likely that the present administratively set margins have in part been motivated by the desire to keep the two problem banks afloat, a situation which allows other banks to accrue rents and reduces their incentives to provide improved and expanded services to their clients. 3.52 Over the long run, the development of efficient inter-bank and money markets will help to reduce the costs of intermediation. These markets, together with the restoration of siuspended discounting facilities at the BOU, will provide more efficient instruments for managing liquidity. Reduction in excess unremunerated liquidity will automatically cut the costs of intermediation. At the same time, the presence of money markets will provide a more efficient and less arbitrary basis for setting of margins and spreads. Competition for funds should help to reduce the interest spread between deposits and loans and thus add to the incentive to reduce the cost of intermediation. 9/ Computed on the basis of the following assumptions: 60 percent of demand deposits are remunerated at the rate of 20 percent per annum, savings accounts earn 33 percent per annum and time deposits earn 35 percent per annum.  - 52 - 3.53 However, the development of money markets should not be seen as a panacea for removing the inefficiencies in the banking sector. Effective competition requires complementary and perhaps more fundamental changes. The vision of a genuinely competitive banking sector requires the acceptance on the part of the Government of the removal of exit and entry constraints not only to and from the subsector, but also within the subsector itself. Removal of exit barriers requires that an insolvent and non-viable bank should be liquidated even if it is part of the public sector. This vision may not be feasible in the short to medium term as the economy recovers from the upheavals of recent years but nevertheless this should be a long term goal for the Government to aim for. 3.54 The Government should also review the conditions for entry into the sector as well as the freedom available to existing institutions to move into areas of business in the financial sector from which they are currently restricted. In terms of the former, the Government should review the option of allowing merger with failing bank as a mode of entry into the market, should the entrant so request. In terms of the degree of specialization, the Government should remove existing restrictions on the type of financial services offered to customers. Commercial banks should be allowed, if they so choose, to become multipurpose financial institutions offering a range of financial services including insurance, hire-purchase venture capital, etc. This would also curtail the present practice of commercial banks passing on such business opportunities to subsidiaries that are non-bank financial intermediaries, and set up explicitly to circumvent these restrictions (e.g., leasing). At the same time, DFIs should be allowed to get into deposit mobilization. 3.55 Future strategy and policies of the Government and the BOU geared toward encouraging genuine competition between the banks (i.e., a level "playing field, approach) should also ensure that, as far as possible, one group of banks is not favored over another. The vision of a genuinely competitive subsector requires, in addition to the removal of restrictions on entry and exit, that ti) foreign banks should be allowed to compete on an equal footing in any profitable ventures such as crop financing or expansion of operations in rural areas, and (ii) Government should give early consideration to the earlier recommendation, that foreign banks be allowed to maintain part of any new capital infusion denominated in foreign currencies. In the long run this is the only way to ensure that banks compete among each other for clients and thereby improve the quality of financial services provided. Manpower development 3.56 Although aggregate data on the banks' outlays on manpower development are lacking, there is evidence that banks have recently increased their staff trairing budgets. Generally speaking, the staff of foreign banks get better training opportunities than the staff of domestic banks, because of the assistance the banks get from their head or regional offices. However, in recent years, domestic banks have put special emphasis on manpower development. For example, in 1989, UCB's staff training budget amounted to USh 235 million, equivalent to about 11.8 percent of its total staff costs and 4.4 percent of its total operating costs. Although the training programs of UCB's Manpower Development Center (MDC), which was established in Kampala in 1973, are tailored to meet UCB's specific training  - 53 - needs, MDC has provided training services tc other domestic banks and government organizations. However, this is not sufficient to meet the requirements of the whole banking sector. Considering the shortage of banking skills in the country and the importance of human capital in the development process, a case can be made for the setting up of a training center in Uganda to provide all banks and financial institutions, including the Bank of Uganda, with general banking skills training for their staff. F. RECOMMENDATIONS 3.57 The commercial banking system in Uganda is in a state of crisis. Urgent measures are needed to restore its financial health and subsequently, improve its stability and efficiency. Two sets of recommendations are presented by the mission: the first addresses the future of the two insolvent banks. while the second outlines measures needed to promote efficiency and increase competition in the system. Actions relating to UCB and COOP 3.58 The analysis in this chapter reveals that incremental changes will not be enough to turn the situation around at UCB and COOP. A sustained improvement can only be brought about by implementing a plan of action that signals a clear break from the past. For UCB, the mission recommends that: (a) Senior management be changed or strengthened and structural changes be implemented at the top layer of management and decision making. In particular, the roles of chairman and managing director should be separated; the chairman should handle government and public relations, whilst the post of managing director should be filled by an experienced banker to concentrate on the management and direction of the business. Other changes should be implemented in .he structure and composition of the Board of Directors so as to make it more active. These changes will require modifications to the UCB Act. Below the managing director level, additional regroupings of responsibilities are needed to enforce stronger management control particularly in the areas of credit control, internal audit, and management information systems. (b) The expansion of the branch network be frozen and the operations of loss-making branches be closed or their status reduced to that of agencies (operating on a limited schedule to reduce costs). (c) New lending be severely restricted, in order to improve the liquidity position of the bank and allow it to meet its reserve requirements at the BOU. (d) Given the fragmented nature of the loan portfolio, a special loan recovery unit, reporting to the managing director, be immediately formed. The primary task of the unit, which should include experienced banking officers to be recruited from outside the bank, would be first to classify the whole loan portfolio, and subse- quently, launch an intensive loan recovery campaign of outstanding loans in arrears. The option of creating an independent asset recovery agency outside the commercial banks should be left open  - 54 - for the time being and at least until the performance of the loan recovery unit has been evaluated. (e) The replacement of the non-performing loans with performing assets be delayed until the bulk of the loan portfolio is reviewed and classified. The rationale behind this recommendation is that the motivation for loan recovery diminishes once the non-performing loans are carved out. On the other hand, the level of the earning assets of the bank should be restored as quickly as possible, to enable it to generate profits. Consequently, the share capital should be increased as soon as possible, taking into account the Basle Committee's recommendations for capital adequacy. This will have an immediate positive effect on the bank's liquidity position. However, to maintain the motivation and momentum for reforms it is essential that such a recapitalization form part of a detailed plan for implementing reforms. The latter should be drawn up by management within six months. (f) Developmental lending operations be separated from those of commercial lending as a separate profit center with its own accounts and management teams; subsequently, the pricing of administered loans be reviewed with the Government and donor agencies to ensure that the interest rate spread adequately covers costs and risks. (g) The operations of the bank be streamlined, with a view to reducing costs both at head office and in the branches and improving new lending procedures, as well as monitoring and supervision methods. As part of streamlining, management will need to reduce overstaf- fing particularly at the head office. (h) The Government should allow UCB management greater autonomy and refrain from using the bank directly or indirectly, as an arm of Government to implement policies which are inconsistent with sound commercial banking principles. 3.59 COOP reforms Even though COOP's potential is less promising than that of UCB, and hence, its future is uncertain, the mission recommends that a final effort be made to determine whether such a bank can play a signifi- cant role in the development of the cooperative movement and the rural economy, and be at the same time profitable. At this juncture, the only alternative to liquidation is that an institution such as the Swedish Cooperation Centre (SCC) takes over the management of COOP and attempts to transform it into a viable institution. Therefore, the mission recommends that: (a) the SCC be approached by the Government with the view of requesting it to assume the management of the bank for a specified period of time (i.e., three to five years), after which the future of the bank can be more objectively assessed; (b) provided the SCC is willing to assist in the rebuilding of COOP including any equity funds which SCC may wish to inject on behalf of the unions, the overdraft at the BOU be converted into equity,  - 55 - thereby resolving the insolvency problem and easing, but not altogether solving, the liquidity problem; (c) the new management should be called upon to fundamentally review the bank's role and strategy for converting this institution into a viable enterprise and present it to its shareholders for approval; (d) the loan recovery drive launched in 1989 be intensified. This would require a full review of all outstanding debtor accounts, and effective follow-up action on delinquent accounts. In the meantime, new lending should be restricted to prime customers, the volume of which would have to depend on the success of the deposit mobilization drive, especially in the rural areas; (e) the unions be given the opportunity to raise funds and repurchase their shareholding from the Government, in full or partially; (f) efforts to rehabilitate the bank be intensified with a special emphasis on the strengthening of the accounting and internal audit systems; and (g) if within a specified time limit (at most five years) COOP cannot be restored into a viable institution, it should be liquidated. Measures to improve the long-term efficiency and stability of the system 3.60 The mission also recommends that a number of measures designed to improve the efficiency and stability of the whole banking system, and to avoid the recurrence of the existing crisis in the banking system, be taken by the BOU and the Ministry of Finance. These measures relate to bank supervision, capital adequacy requirements and other matters relating to capital structure, tax treatment of general loan loss provisions, the development of money and interbank markets and rediscounting facilities at the BOU to facilitate liquidity management, enhance competition and lower intermediation costs. More specifically, the mission recommends the following. (a) Beyond immediate measures, a long-term comprehensive strengthening of the Bank Supervision Department at the BOU should be implemented including the development of more prudent standards for loan classification (see Chapter V). (b) The Basle Committee's recommendations of linking bank capital to risk assets (including off-balance sheet items) and of splitting capital into two components (i.e., the primary or core capital and the secondary capital) should be adopted in Uganda. Also, BOU could adopt a more flexible policy of allowing the banks to revalue their fixed assets (the revaluations being included in secondary capital) provided the secondary capital component does not exceed 50 percent of the capital adequacy requirements. (c) The BOU should assess the advantages of allowing the foreign- controlled banks operating in Uganda to maintain part of their capital in foreign currencies, as a hedge against further deprecia-  - 56 - tion of the Ugandan shilling. This measure, which should be implemented in the context of the overall policy for foreign investment in Uganda, could conceivably lead to an increase in the capital of the foreign-controlled banks and a consequent expansion in the role they play in the development of the Ugandan financial system and economy. (d) Banks should be encouraged to take general loan loss provisions, within specified limits (i.e., say up to 2 percent of total loan portfolio per annum) by treating these provisions as expenses, and therefore, not subjecting them to taxation. (e) To effect improvements in efficiency, changes are needed to help banks manage their liquidity more effectively. These include allowing the banks to hold treasury bills, the development of an interbank market and the resumption of discounting by the BOU. A phased deregulation of interest rates and the development of an active interbank markets will ensure that intermediation margins, which are currently about 23 percent (in gross terms) and extremely high by international standards, are determined by market condi- tions rather than by the Government or BOU as at present. (f) Future strategy and policies of the Government and BOU towards the banking system should be geared towards encouraging genuine competition between the banks (i.e., a level 'playing field" approach) and should not favor one group over another. The vision of a genuinely competitive subsectur requires the removal of restrictions on entry and exit, interpreted in their broader sense: non-viable banks should be closed even if they are part of the public sector; all banks should be permitted to become multi- purpose institutions offering a range of services to their clients. Implementation of the level playing field idea also requires that foreign ban',:s should be allowed to compete on an equal footing in any profitable ventures such as crop financing or expansion of operations in rural areas.  - 57 - CEAPTR IV: THE DAN OF UGANDA AND ITS ROLE IN TUM FINANCIAL SYSTEM A. INTRODUCTION 4.1 A central bank should play a substantial role in the formulation of economic policy generally, and monetary and supervision policy in particular. At present, in Uganda this is not the case. There appears to be a number of critical weaknesses in both the authority and capacity of the central bank. For a country so heavily dependent on overseas financial assistance for development, perceptions of the strength and performance of the central bank are extremely important. 4.2 The BOU appears to have less authority than is usually the case for a central bank. For it to be an effective organization, the role of the BOU in formulating economic policy--its inputs in this process are at present largely informal--should be strengthened. The BOU should have prime responsibility in the implementation of monetary policy, prudential regulation, and supervision, as well as other policies directed at financial institutions. The BOU's capacity to effectively influence the operations of financial institutions is weakened substantially by both uncertainty about its role (for example in the determination of interest rates), ambiguities about the assignment of responsibilities between the bank and the minister of finance (for example in the approval of new bank branches), and anomalies in the legislation that seriously undermine the authority of the bank governor in his internal management of the bank. The capacity of the BOU has also been weakened by being involved in activities on behalf of the Government (such as crop financing) that are inconsistent with monetary and supervisory policy being implemented by the BOU. 4.3 At the same time, there are major weaknesses in the capacity of the BOU to fulfill its role. Although the bank has been making strenuous efforts to improve the situation more recently, there have been long delays in the publication of the accounts and annual reports of the BOU--the last set of audited and published accounts were for 1986. The present distress in the banking system also reflects in large part the ineffectiveness of the BOU's regulation and supervision function. There are also significant weaknesses in the areas of policy formulation, implementation of monetary and foreign exchange policy, clearinghouse operations, and coordination between departments, which erode the BOU's credibility. 4.4 This chapter covers the major shortcomings in the areas discussed above, (except prudential regulation and supervision, which are discussed in the next chapter) and suggests appropriate remedial measures. The chapter takes account of the recently concluded diagnostic review study of the internal operations of the BOU carried out by Booz Allen & Hamilton Interna- tional as part of an IDA-funded project. In the areas it covered, the BAH study was necessarily more detailed than was possible, or appropriate, for the World Bank mission, particularly in the analysis of accounting systems, organizational and management structure, coordination between departments, and staff training. The conclusions drawn by the two exercises in these areas are essentially consistent, although there are some differences in  - 58 - points of detail (for example, in the suggested allocation work of executive directors). 4.5 The chapter is organized as follows. The Authority of the bank is reviewed in Section B in terms of its legislative basis and working practices as they affect the status of the Governor and the Board. This section also reviews, the erosion in the authority of the Bank over the years, and the case for effective autonomy. The case for divesting the BOU of its non- traditional activities in conmercial and development finance and the agrlculture secretariat is argued in Section C. This is followed in Section D by an appraisal of the capacity of the BOU to fulfill its role with reference both to its financial position and its organizational capability. The resources available to the BOU in terms of staff, technology, and external technical assistance are discussed in Section E. The effectiveness of monetary policy is reviewed in Section F in the light of the constraints imposed by the environment on the available range of monetary policy instruments, particularly by the financial distress in the system and the lack of adequate financial markets. The need for an efficient system of check clearing and payments and the modalities of developing financial, interbank, and treasury bill markets are also discussed. The chapter concludes with a summary of recommendations. B. AUTHORITY OF THE BANK OF UGANDA 4.6 The powers end functions of the BOU as a traditional central bank (responsible for the issue of currency, banker and financial advisor to the Government, lender of last resort, supervisor of banks, and controller of foreign exchange) derive from the following acts of legislation; * The Bank of Uganda Act, 1966, as amended by Act 16/68 * The Bank of Uganda (Amendment) Act, 1982 * The Bank of Uganda (Amendment) Decree, 1986 * The Banking Act, 1969 * The Banking (Amendment) Act, 1969 The nontraditional functions of the BOU as a development finance agency derive from two separate statutory instruments: * The Development Finance Fund (Establishment) Instrument, 1986 * The Credit Guarantee Scheme (Establishment) Instrument, 1986 4.7 The legal authority of the BOU to function as a central bank appears to be generally adequate. However, there are anomalies in the law as well as in practice that erode the authority and influence of the BOU and create ambiguities in the relationship between the central bank and the Ministry of Finance. This is evident from the following review of the status and powers of the governor, the board, and the working relationships of the BOU with the Ministry of Finance.  - 59 - Governor 4.8 Currently, the status and powers of the Governor are not commensu- rate with that of a chief executive with full responsibility for administra- tion of the bank (with reference, as necessary, to the board). For instance, the appointments of heads of departments in the BOU are by law subject to approval by the minister of finance. This approval system represents a serious dilution in the authority of the governor as chief executive of the bank. Similarly, the minister can determine, without consulting the Governor, who will represent the Bank in various forums--such as discussing matters relevant to the bank's responsibilities with other banks and international organizations. It is imperative to confer the full powers of a chief executive on the governor of the BOU with necessary legislative changes. The Board 4.9 In recent years, the Board has not been as active as required by law. The number of directors of the board and the frequency of board meetings have been less than is specified in the Bank of Uganda Act. The number of external directors is less than the minimum four required by the act and the number of meetings has also been less than the minimum specified in a financial year (10). Currently, the quorum for meetings is specified as consisting of four members, including either the governor or the deputy governor. The meetings of the board should be subject to a majority quorum, which would include the secretary to the ministry of finance, the governor or the deputy governor, and at least one external director. Concomitantly, it would be helpful to provide for the presence of the economic advisor or head of the research department at board meetings together with other heads of departments (depending on the agenda), but without the right to vote, so as to ensure the necessary professional inputs at board level. However, the current practice of the board to meet only in sub-committees, which detracts from the authority and efficiency of the board, should be discontinued. This is an unusual procedure for a central bank board. The quorum for the board meetings, as also the right of participation of departmental heads, could be provided for by suitable changes in the by-laws and rules of business of the board. This would avoid the need for any special amendment of the act. Relations with Government 4.10 Although the Bank of Uganda Act (Section 25 (1) lays down that the "bank shall act as financial adviser to' the Government, there is no requirement to formally advise the Government of the board's views after regular meetings. It would therefore be beneficial if the act (or the by- laws) specifically required the bank to inform the Government of its views on, and approach, to monetary policy after each regular meetings of the board required in the act. This should be supplemented by regular discussions between the governor and the minister of finance (and between bank officers and their Ministry counterparts). If a consensus cannot be reached on policy issues on any significant or sensitive issue, the Government should be empowered to direct the bank. But in order to preserve the autonomy of the bank and the integrity of the Government, there should be legislative provision to the effect that in such a situation the relevant differences and  - 60 - the need for their resolution should be made known in an appropriate public forum--in some countries this is done through the medium of an annual report. It is, however, equally important to stress that productive working relationsbips between the BOU and the minister of finance and the Government depend ultimately more on personalities and healthy conventions and traditions than on mere legislation. However, the latter must be consistent with legislation and should avoid any implication that the BOU is lacking in authority. Erosion of the Authority of the Bank of Uganda 4.11 The authority and role of the BOU in respect of its primary responsibility for the formulation and implementation of monetary, regulatory and supervising policy scenes has been considerably eroded in recent years. At present the BOU's input through the governor's participa- tion in key organs of decision making, like the Presidential Economic Council, is largely informal and ad hoc and monetary policy therefore tends to be formulated in the council in some detail but at the political level. Similarly, the minimal participation of the BOU in negotiations with the IMF in recent years has revealed its inappropriately limited role in macro- economic policy. There should be standing provision for the participation of the Governor (or his nominee in his absence) in the council to formalize BOU's role in economic policy formulation. At the same time, the BOU should be an active participant in negotiations with international organizations that involve monetary, financial, and foreign exchange matters. 4.12 There is also a serious fragmentation of regulatory authority between the BOU and the minister of finance, and the resultant ambiguity and uncertainty has been exploited by banks leading to inefficiencies and distress in the financial system. Some matters are decided by the minister (licensing of banks and branches, hours of business) others by the BOU (minimum holdings of assets), and still others by either (inspection of banks). All such powers should be within the BOU with provision for consultation and clearance with the minister on such politically sensitive matters as licensing of banks. C. AUTONOMY AND ROLE OF THE Bank of Uganda 4.13 The BOU must, if it is to be an effective central bank and contribute to sustained growth and development, be a strong, autonomous, and well-respected organization. International financial institutions (and other donors) view of the continuing creditworthiness of a country can be greatly influenced by the strength of the central bank and its capacity to maintain financial stability. It would therefore be advantageous to the Government for the BOU to have substantial autonomy and independence from the Govern- ment, because decisions relating to such matters as inflation and the financial strength of individual financial institutions are frequently best taken in a non-political professional environment. It is also difficult for a central bank to regulate and supervise banks, and other financial institutions, if it does not have full autonomy and a clear mandate from the Government.  - 61 - 4.14 For the bank to have maximum autonomy, it must also be seen as accountable to both the Government and the community as a whole. Monetary and supervisory policy is more likely to be effective when their techniques and objectives are fully understood by the Government and financial community. By far the most effective vehicle for this is the timely publication of its audited Annual Accounts and Anrual Report, which should clearly explain the rationale, technique, and any constraints--including the requirements of Government--on all central-banking policies. In addition, the BOU should provide both periodic and occasional analyses anA commentary on current economic and financial issues and conditions through quarterly bulletin, press releases, and discussion papers. The nontraditional activities of the Bank of Uganda 4.15 The overriding issue here is whether the BOU has assumed over the yeare an unjustifiably wide range of nontraditional activities of supplemen- tal commercial and statistical activities--such as crop financing, commodity (particularly coffee) trading, compilation of a consumer price index, and the work of the Agricultural Secretariat. The BOU undertakes quite a wide range of functions and activities, traditional and nontraditional, which have steadily expanded from two departments in 1966, to seven in 1970, and 15 in 1990 (see Chart 4.1). The expansion of its nontraditional activities reflects responses to situational needs and a general confidence-- not always justified--in its operational capabilities. The BOU, like central banks in many developing countries, is heavily involved in such activities because both human and financial resources are even scarcer in other areas of the Government. But whatever the original catalytic and promotional role of the BOU in developmental and commercial finance it raises basic issues of policy and practice. 4.16 The strongest objection to the continuance of such activities is that they involve a conflict of interest between the bank's basic monetary and supervisory policy functions and its participation in commercial and developmental lending. To begin with, it is questionable whether the BOU's involvement in commercial and developmental finance is consistent with the Bank of Uganda Act, which debars it from engaging min trade or otherwise have a direct interest in any commercial agricultural, industrial or any other undertaking...." I/ In fact, the same clause requires the BOU to dispose of any interest it may acquire in satisfaction of debts as soon as may be reasonably practicable. The coffee financing of the BOU, on behalf of the Government, has been a substantial source of monetary expansion and has also exposed the BOU to commercial risks and losses. BeFides, commercial lending requires credit assessment skills that are not commonly available and hard to nurture in a central-bank staff. The mission therefore welcomes the acceptance, in principle, by the Ugandan authorities to transfer coffee financing from the BOU to commercial sources, effective September 1990. But for adequate funding to be available from commercial sources, the present distress in the financial system will need to be removed. In addition, the 1/ Part III, Clause 3 of the Bank of Uganda Act.  CHART 4.1: BANK OF UGANDA ORGANIZATON BOU ORG AIONAL EVOLUTION 1989 ORGANIZATION Dpty C~ - I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ ExtemalOt |~~~~~og ID I , p I | ,, EREElC.ElNxihw . 1989 ORGANIZATION 'Non-trdanlonl Functions of a Centnal Bawk Sace: Adapted from Booz Alen and Hamlton. Diagnotic Review Study Executive Sumnmary. April 11. 1990.  - 62 - Coffee Marketing Board and any other processors involved in the handling of cof fee will need to be made credit worthy in the eyes of banks and other commercial lenders or replaced by others. Pending this, a Government guarantee to the Coffee Marketing Board may be necessary, but the associated quasi-fiscal deficit (arising from any financial support that may be provided as a result of this guarantee) must be recognized. D. CAPACITY OF THE BOU TO FULFILL IT'S ROLE 4.17 For the Government to delegate the requisite authority and autonomy to the BOU and for the financial community (domestic and overseas) to recognize it, the BOU must be an effective central bank fully capable of discharging all its functions. The capacity of the BOU depends on the adequacy and strength of its financial position, and the efficiency and motivation of its institutional and human resources. Financial position of the Bank of Uganda 4.18 The BOU should have a strong balance sheet position, and its capital and reserves should reflect the economic position and responsibil- ities of a central bank. It should not depend on allocations in any year from the Government's Budget, and its reserves should be available with certainty to meet actual and contingent liabilities. However, it is not possible to make any definitive analysis of the BOU's balance sheet because the latest available unaudited accounts to the mission are as of June 30, 1988 (Table 4.1). But the available bslance sheets and the profit and loss account clearly show that the BOU's need for reserves is considerably greater than usual for a central bank. The BOU's capital and reserves are less than 1 percent of total liabilities and are, in fact, considerably less than the bank's investment in premises. No reserve provision has been made for any possible losses on the substantial amount of lending, particularly for coffee finance undertaken without formal guarantees, on behalf of the Government, on the assumption that any losses will be borne eventually by the Government. But given the risks involved in such lending, it is imperative to create specific reserves to provide for any delays by the Government in meeting its commitments and the possible risks and liabilities given the high incidence of fraud in the Ugandan financial system. These aspects of reserve policy should be reviewed afresh when coffee financing by the BOU is transferred to commercial agencies. The BOU's finances should be independent of the exigencies of the Government budget, which should eventually assume all the losses arising from crop financing. 4.19 The recorded net profits of the BOU (FY87) have been sizeable (4.5 percent of the total balance sheet), but almost 80 percent cf profits came from foreign exchange gains. Some of this may have come from revaluation of the IMF quota in terms of Ugandan shillings. Gross profits from sources other than foreign exchange gains did not cover expenditures, which amounted to 44 percent of total recorded gross profits. Foreign exchange gains depend on the level of foreign exchange available for sale and the extent of any depreciation of the local currency since it was acquired. Given the extremely low levels of current reserves, the extent of future income flows  - 63 - from this source must remain uncertain. A more serious concern in the short term is that no account appears to have been taken of possible portfolio losses, arising out of doubtful loans. These were estimated at about USh 10 billion by BAH. In sum, the overall adequacy of capital and reserves of the BOU merits an early expert review. Meanwhile, it is imperative to keep the audited accounts of the BOU on schedule in accordance with the requirements of the Bank of Uganda Act. Tablo 4.1: BANK OF UCANDA Balanco Sheot(of Juno 30. 1988, unsudited. in USh) EXTERNAL ASSETS FY88 FY87 Foroign Exchange 11,104,688 4,949,674 Special drawing rights holld. - 16,774 Ites in Transit 2,152,584 1,224,269 IMF Quota 7 851 747 7 638 824 21,-13z8,8 13:92B,031 INVESTMENTS Government Securities 18,725 61,874 Other securities 698 095 14,418 62,0B7 LOANS, ADVANCES A DISCOUNTS Uganda Government 28,088,042 10,464,177 Banks 2,016,046 18,816 1 628 016 62.882 29,727,103 10,640,T25 FIXED ASSETS Cost Depreciation Net book value Bank Prmises Land and building 88,980 1,003,799 80,180 Bank of Uganda extensions 846,493 - 845,498 Office furniture A equipment 89,302 14,867 24,485 Motor vehicles 97,287 31,806 65,482 Staff houses 89,294 2,860 86,444 Staff houses furn A 21,738 9,867 12,879 equipment 4 877 2.787 2.090 l,131,698 $5,465 IL, OM, W4 Fixed Assets are depreciated on a straight line basis so as to write off ovor their useful lives. The rates are as follows: Land Nil Buildings 2X per year Staff housing furniture A equip. 26X per year Office furniture A equip. 2OX per yrr Motor vehicles 25X per year  - 64 - SHARE CAPITAL AND RESERVES Pald up capital 6,000 6,000 General roservo fund 400 400 Capital resorvo 67,819 67,816 Other resrves 2 420864 66,281 PI 4,688 117,m CURRENCY IN CIRCULATION Not" 14,925,490 4,051,887 Coins 157,976 11,165 16,063,406 4,062,602 DEPOSITS Uganda Government 16,648,484 0,059,198 1,160,982 1,964,287 4.80 071 118 267 24,1354N 7 8,141,747 FOREIGN LIABILITIES Banks 420,796 269,084 IMF Accounts 1,880,801 (2,882,891) IMF Securitis 6,187.178 4,928,260 OTHER LIABILITIES Allocation of Special Drawing Rights 221,728 221,724 Current Liabilties 6,022,698 8.264.627 6,244,419 8,476,35i The organizational capability of the Bank of Uganda 4.20 The autonomy, creditability, md effectiveness of the BOU depend critically on its institutional and staff capabilities, which are well below par for a central bank. This is most noticeable in the decline of work performance shown by the bank's failure to provide its annual accounts on time (the last published accounts were for FY86). In addition to improvement of performance, it is equally important to expand and upgrade operations in a number of areas, particularly the contribution to policy analysis and decisions from such departments as research and foreign exchange, as well of bank supervision to cope with the abnormal volume of non-performing assets in the system. The improvement of organizational capability will involve appro- priate reorganization of departments, more effective inter-departmental coordination, upgrading of staff and managerial skills through training, better information flows, and management tasks. Structure of the organization 4.21 The problems in this area are three-fold. First, within depart- ments the number of organizational layers is excessive and diffuses  - 65 - accountability for results. The detailed suggestions of the Booz-Allen & Hamilton Study in this regard merit attention. Second, the multiple depart- mental involvement in transaction flows (such as foreign exchange) also diminishes accountability for results. Third, the grafting of additional functions on departments detracts from their efficiency, as for instance the operational and control functions of the Research Department, which affect the efficiency of its primary functions as an intelligence, analysis, and advisory unit. The functions of individual departments owe more to history, personalities, and ad hoc decisions than to any rational Organization and Management structure (from the Agricultural Secretariat). Quite often transferred officers have taken specific responsibilities with them. In practice, all departments (which at the last count numbered 18, instead of the 15 shown in Chart 4.1) report to the governor, giving him an extremely heavy involvement in detailed operations even though the deputy governor and, to a limited degree, some of the advisors are involved in the decision process. 4.22 A department structure that would be helpful to both present operations and future development of the bank and its performance could be based on six major areas of activity: i. Policy formulation ii. Implementation of monetary End foreign exchange policy. iii. Supervision and examination iv. Banking and financial services to the government and community v. Bank's own services: Secretariat vi. Bank's own services: Human Resources The line between the formulation and implementation of policy is not always clear cut. However, departments involved in policy usually analyze the broad economic situation and give advice on the appropriate thrust of policies. On the basis of this advice specific actions are taken by the implementing department, such as variation of cash and liquidity ratios, interest rates, and so forth. 4.23 A policy fomulation department would comprise the present Research department and the Agricultural Secretariat (pending its transfer) and to a degree the Supervision Department. The Research department should play a more active role in the formulat'. of monetary and other policies affecting financial conditions and the