Uganda - Financial sector review (Vol. 1 of 2) : Summary and recommendations

Report No. 9099-UG Uganda Financial Sector Review (In Two Volumes) Volume l: Summary and Recommendations May 7, 1991 Industry and Energy Operations Division Eastern Africa Department Africa Region FOR OFFICIAL USE ONLY U Documnt of the World Bank This document ha,-a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be discloted without World Bank authorization. a  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 Shillings CURRENCY EQUIVALENTS Currency Unit = Ugandan Shillings (USh) US$ 1.0 = USh 570 GOVERNMENT OF UGANDA FISCAL YEAR July 1 - June 30  FOR OFFICIAL USE ONLY PREFACE This report is the result of a collaborative effort between 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 (macroeconomist), 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 thenm 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-Waleed 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, an ager . 'or 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.  U G A N D A FINANCIAL SECTOR REVIEW VOLUME I: SUMMARY AND RECOMMENDATIONS TABLE OF CONTENTS I. Context for a review of financial sector performance . . . . . 1 II. Credit Management Policies: Implications for Stabilization and Growth .5.. . . . . . . . . . . . . . . . S III. Institutional Issues . . . . .18 IV. Sequence of Reforms in an Action Program . .30 ANNEX: Action Plan for Financial Sector Reforms  WUMMARY AND RECOMMENDAMIONS I. Context for a review of financial sector pr Xormance 1.1 The objective of this report is to review the key issues to be addressed in formulating a strategy for reform and development of the financial sector in Uganda consistent with the Government's Economic Recovery Program (ERP). In terms of the ERP, in addition to broader and longer term questions about allocative efficiency and the range and quality of financial services, the need for carrying out a financial sector review has been motivated by more immediate concerns. At the macro level these concerns are related to the contribution that financial sector inefficiencies are making to macroeconomic instability. At the same time, at the micro level, there are questions about the extent to which the sector is facilitating the supply response from the growth sectors in the economy. Very little work, if any, has been done to-date on these issues. 1.2 The Economic Recovery Program (ERP) initiated in July 1987 faced the monumental task of re-building 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 miade in reviving economic activity and creating a climate for expansion: GDP growth rates of 5 percent or better have been achieved in all years since FY88. However, progress towards stabilization objectives of restoring 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 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, but 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, largely due to a decline in coffee prices. Export earnings in FY90 of $185 million were less than half the $383 million level achieved in FY87, while the debt service ratio, before rescheduling, had almost doubled -- rising from 54 percent in FY87 to 89 percent in FY90. 1.3 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 resolved. 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 expansiornist, the restraint has been achieved in part by imposing undesirably tight cur-bs on expenditures for critical economic and social services, while defense expenditures continued to rise. Although inflation has been brought down sharply, it is still too high to generate the long-term expectations of low and stable inflation needed to encourage investment. Finally, the recent sharp decline in the coffee price has again highlighted Uganda's overdependence on this crop and the critical need to encourage the emergence and growth of other productive-sector activities.  - 2 - 1.4 Against this broad background, the Government seeks as its medium- term objective: to sustain a 5 percent growth rate, to reduce inflation to 6 percent by FY93, to strengthen external payments to permit a build-up of foreign reserves of $15 million a year, and to reduce external arrears by $20 million per year. 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. Th- 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), a ten-fold increase in three years. 1.5 In addition to questions about the balance of payments, there are also some fundamentals of policy, and especially financial sector policy, which need to be clarified as the basis for getting a firmer grip on the macroeconomic 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 a seriously impaired financial sector. The experience of the past three years is evidence of this. However, those 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 diversification 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 (i.e. which is less dependent on coffee) will occur while the financial sector is shallow and impaired as now. This assessment is the main context in which a fundamental reform and strengthening of the financial sector needs to be considered. Problems facing the financial sector 1.6 The problems facing the sector should be seen in the context of a system whose development has been setback and in many ways reversed as a result of the socio-political dislocations of the past two decades. While there is a wide range of institutions (commercial banks, development banks, building societies, etc.) there are only a limited number of financial instruments for the mob::lization of savings, diversification of risks, and management of liquidity. There are also 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 conspicuous by its absence. The institutional system of payments (involving checks, invoices, etc.) is inetficient and ineffective and there is a heavy reliance on barter as well as on informal market transactions involving cash. Finally, an important point to note is that Government involvement is the sector is considerable. The significance of this involvement through substantial shareholdings in the key banks was given an additional boost when BOU took over crop fineacing responsibilities from the commercial banks (CBs) in December 1988. This action, which has recently been reversed, led to the situation in 1989 where over 40 percent of institutional credit in the economy was owed to the Government and thus outside the allocative n.echanism of the market. 1.7 The sector review mission found the financial sector in a deep state of crisis and which, despite some recent improvements, continues to face  serious problems. The basic problems confronting the sector are deep rooted and include; (a) Lack of confidence in the financial system: This is reflected in an unusually high reluctance to use checks as a system of domestic payments or to hold financial assets denominated in Ugandan shillings. The number of checks cleared at the Bank of Uganda has been on a downward trend since 1970 and the low ratio of M2 to GDP of 6 percent, represents lack of financial depth and one of the lowest propensities to hold financial assets in the world. A variety of factors have contributed to the lack of confidence in the institutions and assets of the financial sector including civil strife, weaknesses in laws governing financial transactions, and (until recently) highly negative real interest rates. The lack of financial depth implies that even relatively small domestic financing of fiscal deficits will have a major impact on monetary expansion. (b) Lack of control on credit expansion: Growth in recent years has been accompanied by rapid credit expansion. In 1989 this growth in credit can in large measure be traced to the explosive effect of credit extended for coffee financing by the Bank of Uganda (BOU) and the inadequate banking discipline at the Uganda Commercial Bank (UCB) and the Cooperative Bank (COOP). This has contributed to the high rate of inflation and the difficulty in achieving stabilization. Against this background the Government is reviewing its credit policies which in the past have yielded some short-term gains but have left behind inflationary pressures, insolvent or near-insolvent financial institutions and wasted resources (as revealed by the large number of Uganda Development Bank (UDB) projects which are lying dormant or working at extremely low levels of capacity). Without a shift in credit policies, so that there is more stress on monetary restraint, and on the quality rather than quantity of credit extended, economic growth is unlikely to be sustainable. (c) Internal and external constraints facing the Bank of Uganda (BOU): The ability of the BOU to assume its proper role at the apex of the financial system has been seriously compromised by (i) uncertainty about its role, (ii) anomalies in the law which erode its authority and influence, (iii) ambiguities about the assignment of responsibilities between the Ministry of Finance and the Bank, (iv) involvement in activities, at the behest of Government, that are seen as inconsistent with both monetary and supervisory policy, and (v) weaknesses in its internal organization especially in the areas of bank supervision, accounting, and internal coordination. These problems have undermined BOU's ability to supervise and protect the soundness of the financial system. Unless its authority is strengthened and its capacity to carry out its functions effectively is augmented, BOU cannot effectively carry out the role and functions of a central bank. (d) The high risk of financial system instability arising out of solvency problems at the two largest banks. The two largest banks, UCB and COOP, which between them account for more than half the assets of the financial system, are insolvent or on the verge of insolvency and need  - 4 - to be restructured and their management strengthened. Restructuring these institutions to place them on a sound financial footing is likely to have significant budgetary implications. The Government needs to explore options to reduce this impact. The Government also faces a dilemma regarding the timing for restructuring these banks: If these banks, which represent such a large proportion of the commercial tanking system, are not restructured at an early date their precarious position could destabilize the whole financial system (witt an attendant impact on the real economy) through a further erosion in public confidence in the financial system and in the use of financial assets as a payments mechanism. On the other hand, unless the economy stabilizes, there is a danger that rcHapitalized banks will once again become insolvent by lending to firms that risk becoming insolvent as a result of the on-going adjustment process. The solvency issue of the banks illustrates the complexity of the problems facing the economy through a two-way link to the financial sector. Thus, while the financial sector has added to macroeconomic instability through lack of monetary control, point (b) above, the on- going macroeconomic adjustment process has in turn made a major contribution to the problems facing the commerciil banks through the impact of corporate distress and closures on the loan portfolios of the banks. Dealing with the problem of bank insolvency must go beyond recapitalization. The underlying causes of insolvency must be addressed including (i) the need to achieve macroeconomic stability, and (ii) restructuring or closing insolvent firms. The financial sector mission also found that many of the losses in the public sector institutions are interlinked and that the financial costs of restructuring the banks could be reduced if account is taken of these interlinkages in drawing up a restructuring plan. These considerations suggest that the timing and nature of restructuring plans need to be carefully considered by the Government. (e) Unsustainability of DFI operations The portfolios of the DFI's are in serious trouble given the low rerovery rates (20 to 30 percent) being faced by these institutions. The low recovery rates combined with interest rates which have been highly negative in real terms implies that the resources available to the banks in real terms (for recycling to other projects) has been declining with disastrous consequences for their liquidity and solvency. As a consequence the DFI's have become little more than agencies for extending loans made by external donors and are not functioning as effective intermediaries. Radical changes to the management and the mode of operations of DFI's are needed to restore them to a sustainable basis. The number of such institutions and their role needs also to be rcviewed. Issues addressed in the review 1.8 Based on the above findings, and the understandings reached with the Government, the Financial Sector Review mission focussed its efforts on the following five issues: (a) the link between the financial sector and the  - 5 - 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 developmental finance institutions. These issues are addressed comprehensively in the main report (Volume II). For ease of presentation, and reflecting the Government's priorities, the mission's findings on these issues have been grouped in this summary report (Volume I) into three categories: (a) Credit management policies and their implications for macroeconomic stabilization and growth; (b) Institutional strengthening and restructuring; and (c) Sequencing of reforms in an action program. The next three sections cover these topics and are followed by a detailed action plan for the sector in the form of a policy matrix. II. CREDIT MANAGEMENT POLICIES: IMPLICATIONS FOR OTABILIZATION AND GROWTH 2.1 The erosion of confidence in the financial system and the associated lack of monetary depth, as reflected in the low ratio of M2 to GDP, has a direct impact on credit management policies both at the macro and the micro levels. 2.2 The mission's diagnosis of the present dilemma facing the Government at the macro level is that the financial sector and the macroeconomy are struggling in a vicious circle. Negative real interest rates, high inflation, and expectations 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 monetary 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 inflationar- pressures because of the small monetary holdings in the economy; for example financing a deficit equal to 4 percent of GDP -- not an unusually figure -- when M2 to GDP is only 6 percent would result in a monetary expansion of almost 70 percent. Although 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. While a deeper financial system will make the Government's task of macro management immeasurably easier, this respite is unlikely in the short term especially in an environment of continuing high inflationary expectations. In such a situation the question is: what are the financial levers or instruments available to the Government currently to manage liquidity in the economy and thereby influence the rate of inflation? 2.3 The need to curb monetary growth in an environment where the degree of monetization of the economy is limited and a relatively largi share of the money supply is held as cash outside the banks, in turn leads to policy questions about the allocation of available credit between the public and private sectors and specifically, at the micro level, about the adequacy of available credit to support growth in key sectors. The mission was made aware of the government's concern that economic growth is being restrained by the inadequacy of credit and that growth would have been lower if IMF credit expansion targets, agreed in the context of the Enhanced Structural Adjustment Facility (ESAF), had  -6- been adhered to. The Government argues that capacity utilization remains low in much industrial and agricultural activity and that more credit is the key to putting capacity back to use and thus to increasing output. 2.4 As a background to discussing these policy questions, it is useful to review recent patterns of credit use in Uganda as well as alternative scenarios for future credit expansion. Recent credit expansion patterns and monetary developments 2.5 Patterns of credit expansion With its low deposit base, the Ugandan economy is undersupplied with bank credit. While there are no reliable objective standards of credit adequacy, the ratio of sectoral credit to sectoral value added gives some indication of how different sectors of the economy are treated relative to each other and relative to the situation in other countries. Bank credit-to-sectoral-value-added ratios in Uganda show that most sectors operate with little bank credit. Trade, including crop marketing, however, is a major exception. The trade sector uses of bank credit amounted to 13 percent of sectoral value added in recent years (Table 2.1). Crop marketing, mainly coffee, has for a long time been the largest user of bank finance in Uganda. It is the biggest business activity in the country and credit to the Coffee Marketing Board, secured on coffee export bills which the banks negotiated, was regarded as relatively risk free and profitable. Its heavy use of credit is also a reflection of inefficient operations (see Chapter II in Volume 2). Agriculture contains a large non-monetary sector (accounting for about half the total value added) and peasant agriculture usually makes little use of formal credit. In manufacturing, if turnover is on average twice value added, credit use appears to have been a mere 2.5-3.5 percent of turnover. This is low compared with desired credit use, as revealed in a recent sample survey (see below) of 1-2 months' turnover. Use of credit in the construc.ion industry, where there are typically delays of 12-18 months between outlays and receipts from sales, is also surprisingly low. Table 2.1: Ratios of Bank Credit to CDP (in USh billion) fY 1980 FY 1989 Value Value Credit Added Ratio Crodit Added Ratio Marketing and trade 6.85 40.9 18.1X 15.14 120.2 12.65 Agriculture 0.84 242.8 0.8X 2.81 610.8 0.4X Manufacturing 1.08 14.9 7.8X 2.06 42.2 4.95 Transport 0.B7 9.1 4.05 1.62 28.0 7.0X Construction 0.22 14.8 1.4X 0.67 86.2 1.05 Source: Bank of Uganda. Figures Include Bank of Uganda londing. 2.6 The shares of economic sectors in net bank advances have fluctuated over the last three years. The share of manufacturing has been fairly constant; that of agriculture (excluding crop finance), after rising in FY88, has subsequently dropped; while the shares of transport and construction have risen.  -7- Trade has taken the largest share if bank lending, but not to the exclusion of healthy increases in advances to oLher sectors (see Table 2.2). Table 2.2s Net Bank Advence, to Economlc Sctore (X Sher"s) 1037 1030ff 1989 June Jne Doc Juno Doc Agriculturo 9.2 22.6 20.2 16.1 14.2 Trado 69.4 89.1 48.7 41.6 44.2 Manutacturlng .,7.6 21.6 17.1 16.7 17.1 Trensport 6.8 7.6 9.8 17.1 14.2 Constructlon 5.8 4.9 4.8 6.8 8.6 Other 2.4 4.8 4.9 2.6 1.9 TOTAL _l 10. Ulu AMR ag Source: Bank of Uganda. Figures Includo Bank of Uganda lending. 2.7 Credit expansion to the economy-- excluding Government and crop financing--has risen very fast in nominal terms and, in real terms, faster than the growth of GDP (see Table 2.3). The volume of outstandinig bank credit to the economy has risen faster, as inflation has abated, and its rate of expansion, in real terms, reached an estimated 45 percent in calendar year 1989 and 58 percent in the 12 months to June 1990. In the twelve months to December 1989, manufa- cturing and trade received real inc.eases in bank credit of approximately 45 percent. Credit to the transport and construction sectors rose by 110 percent and 190 percent respectively. However, real credit to agriculture (other than crop financing), having expanded fast in 1988, stagnated in 1989. Table 2.8: Credit Expansion to Economy (oxcluding Government and crop financing) Period Nominal growth (S) Roal growth(U)'1 Juno 1987-June 1988 287 e.8 Juno 1988-June 1989 191 6 .0 Doc 1988-Dec. 1989 163 46.1 June 1989-Juno 1990 104 58.1 s/ Deflated by the middle-income consumer prico index. 2.8 A rapid real expansion of credit to the economy has been consistent with the Government's macroeconomic targets. These envisaged a 50 percent real inc ease in lending to the non-governmental sectors, including crop financing, d' ring June 1988-June 1989 and a further 20 percent expansion in the fiscal year ending June 1990. Actual real increases in credit have been equal to, or highevr, than indicated in macroeconomic targets (84 percent in FY89 and 20 percent in FY90), and until recently, there has been little evidence that lending to the business sectors has been systematically crowded-out by higher than intended credit to the Government. The Government has not made use of some of the instruments of monetary control available to it to restrain bank lending. The structure of interest rates was until recently highly negative in real terms.  Now that inf'lation has declined to about 35 percent, and with the prices of some goods actually falling, interest rates (which allow for lending rates up to 45 percent) have turned positive in real terms and become a more effective tool for managing credit demand. 2.9 An instrument that the Government has consciously used to mop-up liquidity outside the banks is the sale of donor-provided foreign exchange through the Government's Special Import P-ogrammes (SIP). These periodic sales have reduced banks' liquidity, as firms have scrambled to draw down their accounts to purchase foreign exchange during the brief periods when it has been available. With a low 42/GDP ratio, the volume of liquid financial assets in the hands of the public is low, and periodic SIP foreign exchanie sales have temporarily aggravated the pervasive, inflation-related, shortage of liquidity. The central issue is whether the low level of liquidity has translated itself into an insufficiency of working capital and whether economic grcwth has beer. seriously harmed thereby. The mission has attempted to address this question using the results of a ccmmissioned credit needs survey of some 60 public and private enterprises carried out in March 1990. These results are discussed below. 2.10 Monetary projections and their implications In addition the mission has examined alternative scenarios for future credit expansion to FY93. A summary of these projections is given in Table 2.4 below and discussed in more detail in Chapter II in Volume 2. These projections help to throw some light on the issue of the volumes of credit that might realistically be available to meet particular needs during the next few years. Scenario 1, used in the Policy Framework Paper (PFP), assumes no change in financial depth (M2/GDP) while Scenario's 2 and 3 a';sume that financial depth increases by 25 percent and 50 percent respectively. 2.11 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. Furthermore, even this result is based on the enforcsment 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. In the projections this increase has all been allocated to the private sector. However, in practice, the Government will have the 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. 2.12 In the mission's view the targeting of credit to the public and private sectors is of doubtful effectiveness in the Ugandan financial context. As discussed in para's 2.7 and 2.8 above and in more detail 'n Chapters VI and VII of Volume 2, 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--a situation which has brought two banks to the state of bankruptcy. There is absolutely no point in squeezing government credit to allow Table 2.4 Monetary ProJections of the Bankina System (USh bilions) FY90 FY98 Sconario 1 Scenario 2 Sconario 8 Foreign assets (net) -181.7 -119.7 -119.7 -119.7 Domestic credit 74.0 112.1 165.8 266.6 Govt. (not) 8.7 -88.8 -86.8 -86.8 Privnt. 66.8 148.9 202.6 298.8 of which crop financing 19.2 29.9 29.9 29.9 Other Itom net 147.7 167.4 157.4 167.4 Money supply (M2) 90 149.8 208.4 294.1 Mmo: Financial depth 6.2 6.2 8.8 12.0 (M2/ODP) Sources: BOU, IMF, and World Bank estimate. 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. In these circumstances, in choosing between the allocation of available credit between the public and private sectors, the Government faces a complicated social choice. Adequacy of financial services to support the real economy 2.13 The question of whether credit shortages are the dominant cause of low capacity use in industry and agriculture or whether there are other more important factors has been examined by a small survey. This survey yielded illustrative, though not statistically significant, answers. A sample of 60 enterprises was drawn: 30, mostly small, were in the private sector; 15 were public sector firms in manufacturing, transport, trade, construction, and services; and 15 were agro-industrial enterprises, mostly medium-large in size and in the public or joint-venture sectors. The survey also covered 9 companies with entitlement to foreign exchange under the Open General License (OGL) scheme; S of these firms were in the public, and 4 in the private sectors. 2.14 In summary, the survey provides evidence that the cash shortages in the economy arise, to an extent, from deliberate and logical business decisions  - 10 - in an inflationary environment where physical security has been poor. It corroborates the view that there are multiple restraints on higher production and that expanding credit would not automatically engender a supply response. Most of the firms that complain of working capital shortages appear to be uncreditworthy, either because of insolvency or because their collateral has been exhausted as a result of a history of output problems, losses, and past borrowing. The survey results also suggest that a lower inflation and lower interest rate environment would be more conducive to growth because firms would be less reluctant to hold cash and to commit themselves to long-term business decisions. 2.15 The only well-attested area where credit per se inhibits activity is in importing goods using LCs. (Another area, which the Government felt strongly was a bottleneck in the past, has been credit for crop financing which led to BOU's involvement in this area.) The slow procedures tie up large volumes of working capital, and foreign exchange releases through the SIP are episodic and hence lumpy. Judicious credit expansion should accompany SIP releases to accommodate the needs of beneficiaries--provided that the increase is subsequently absorbed when the imports are received and the goods manufactured with them are sold. The Government has devised a Special Credit Facility with this aim in mind. Better still, the release of foreign exchange should be smoothed and made more regular and predictable. 2.16 Other financial services. There are legitimate complaints in the business community in Uganda about poor communications within the barLking system, the difficulties in the use of checks and the inconvenience of cash transactions using large volumes of low denomination notes. Because of poor communications within the networks of the main banks with rural branches, checks drawn on rural branches may take up to 4-6 weeks to clear. The banks with branch networks have also given poor cash withdrawal service. Depositors are commonly unable to withdraw their deposits, after giving the required reasonable notice, because of defective cash management by the banks and because the banks centralize their operations in Kampala instead of regional centers. Long delays have been common in transferring accounts between branches and even in cashing drafts in one branch drawn on another branch. These features have been a deterrent to the use of the banking system and to the use of credit instruments instead of cash. These delays cause uncertainty and are expensive in an inflationary environment. They could be reduced by better internal communications and greater sensitivity to customer requirements. Improved computer links, currently being installed by some of the major banks, should lead to some improvements. For the rural areas, the revival of the network of the Post Office Savings Bank should be reviewed as a major option in the medium to longer term for improving money transmission and savings facilities especially in areas facing a paucity of commercial bank branches. 2.17 Another problem that adds to the costs of business--and to insecurity in money transmission--is the fact that checks are not trusted in business transactions. Many transactions are consequently carried out in cash. This arises because of the prevalence of fraud and the legal difficulties, under present legislation, in prosecuting perpetrators. The problem is compounded by the low denomination of the bank notes currently in circulation, the highest being USh 100, or US$ 0.26. Few firms and banks have armored vans, so simple operations, such as the payment of weekly wages, require the conveyance and  - 11 - storage of large volumes of currency in insecure conditions. The low denomination of bank notes discourages business from depositirg cash because of the time taken to count it v,hen it is deposited and when it is subsequently withdrawn. It is an important factor in the poor quality of counter services. Legislation is now under preparation to repress check fraud more severely. If enforced this should eventually help restore confidence in the use of checks, which will reduce the cost and risk associated with financial transactions and contribute to the revival of the banking habit. Full confidence in the use of checks, however, will only revive when the process of check clearing has been drastically accelerated. 2.18 Transactions involving letters of credit. There are also complaints from the business community about the slowness and high cost of import trans- actions involving letters of credit (LC). Commercial banks seek LC because they bring in high margins which compensate the banks for their low deposit base and low real margins on lending. However, only certain banks have extensive networks of overseas correspondents, which restricts competition in this field. At the same time, with its tight controls on foreign exchange allocation, the BOU has to process all LC applications, which adds to the time and cost of transactions. Importers have claimed that LC procedures lock up expensive working capital for long periods of time (up to nine months for long delivery items), with the ever present risk that they will have to increase their local cover if the Ugandan shilling is devalued. 2.19 Overall assessment and recommendations Use of credit in most sectors of business is low. Because of the recent history of high inflation, high nominal interest rates, and other structural factors undermining creditwor- thiness, bankable effective demand for credit in Uganda is now below normal levels. The economy has accommodated itself to operating at low levels of working capital and has nevertheless achieved strong growth over the past three years. 2.20 There are many factors other than credit that inhibit production. Sample survey results indicate that these factors predominate. Businesses that state that their main problem is a lack of working capital have often had a history of production problems leading to a current loss of creditworthiness. At the same time the release of foreign exchange for lmports should be smoothed and made more regular and predictable. 2.21 Business decisions under inflation, with high nominal interest rates are based on short term considerations. In the interest of long term growth and of the more productive use of credit to facilitate expansion, inflation must be controlled, and inflationary expectations must be reduced. This requires monetary restraint even though this may lead some firms to feel a temporary liquidity squeeze. Subject to the overriding need to reduce inflation permanently, however, the current policy of allowing credit expansion to the productive and commercial sectors to expand faster than to the economy as a whole is to be endorsed. 2.22 Some firms that supply the Government experience serious delays in payment and problems in clearing Government checks, which cause them severe working capital shortages. The banks have given them some accommodation, but this has impaired the firms' profitability and ability to carry on business. To  - 12 - avoid damaging domestic industry, the Government should take active steps to reduce delays in payments and problems in clearing Government checks by improving its expenditure authorization procedures and financial controls. 2.23 While giving priority to productive and private sectors, as mentioned above, the Government should continue to avoid directing credit on a sectoral basis. Credit is fungible. Many businesses are in trade as well as manufactur- ing. While giving credit to monopoly traders can finance speculation and profiteering based on artificial supply shortages, this can just as easily happen by granting credit to monopoly domestic manufacturers. Increasing competition, rather than the direction of credit, is the answer to these problems. As counterinflationary policy takes effWct, there will be less incentive for businesses to seek short-run speculative profits. Lower nominal interest rates which should follow the fall in inflation will make longer maturing business opportunities seem relatively safer and more profitable. 2.24 The Government should particularly avoid, in present circumstances, and in the light of the overriding policy to create a soundly-based and better controlled banking system with a less impaired loan portfolio, to direct the banks to lend to non-bankable borrowers, such as overindebted public enterprises and firms without adequate property titles. In the present circumstances, the emphasis should be to exercise stern discipline on delinquent borrowers so that credit can revolve and be used more efficiently, and so that the credit needs of efficient borrowers be better and more promptly satisfied. 2.25 With regard to other financial services, Government action is required to facilitate the legal repression of check fraud and to accelerate the clearance of checks through the BOU. The Government should also quickly introduce higher value bank notes--which would not only reduce business costs, but would also cut the cost of note printing for the monetary authorities. 2.26 The Government, as an important shareholder in the commercial banks. should also press bank managements to improve the quality and speed of their services to customers, particularly in respect of money transmission and check cashing facilities. 2.27 In the long term, the Government should seek revival of the network of Post Office Savings Banks. Apart from contributing to the remonetization of the economy, which will assist the conduct of macroeconiomic policy, these banks would provide small savings and money transmission services to complement those of the commercial banks. They might also offer outreach facilities, on an agency basis, to the banks, which could thereby extend their operations without increasing their overheads. Financial policies to facilitate stabilization 2.28 At the macro level, as indicated above, a deeper financial system will make the Government's task of macro economic management easier. However, this respite is unlikely in the short term. In the interim the Government has some levers to use to control inflationary pressures. These includet (a) enhanced discipline in the banking system; (b) reforms of system of crop finance; (c) use or introduction of instruments such as open market operations  - 13 - to manage liquidity in the economy; (d) interest rate policy; (e) controls on bank lending; (f) restructuring of insolvent financial institutions. 2.29 Banking discipline In relation to banking discipline the policy message is clear: successful stabilization will require far stricter enforcement of the monetary policy controls on the banking system than in effect prior to September 1989. This argues for the BOU to be positioned with greater authority in the economic policy making process to give it a better chance for resisting political pressures for short term, but ill-considered expansion. The modalities of implementing this recommendation are outlined in the next section. Enforcement of banking discipline should aim to avoid the rapid boost in credit that occurred in 1989 when UCB and COOP expanded their loan portfolios by overdrawing on their accounts at the BOU; by August 1989 the net overdraft position of these banks revealed that their deficiency of reserves relative to their statutory requirements was equivalent to more than 30 percent of their total deposits. The resulting monetary stimulus was greater than that arising from the fiscal deficit in taat year. 2.30 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 and defeat the objective of stabilization. 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. Thus, if 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. 2.31 Reforms in the crop financing system The credit explosion that came about because of the change in coffee financing regime in 1989 again illustrates the vulnerability of an economy with a small financial sector and the potential for improved monetary control through reforms in the crop financing system. In 1989, as a result of difficulties in the crop financing system, there was concern within Government that adequate credit was not filtering down to enable full procurement 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 BOU: (a) acting as a bdnker to the Coffee Marketing Board (CMB), (b) providing guarantees to commercial banks for lending to unions considered uncreditworthy by the banks, and (c) 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. As was the case with the collapse in lending discipline at in the UCB and COr , the resulting monetary  - 14 - stimulus from this expansion was far greater in that year than the stimulus coming from the budget deficit (see Chapter II in Volume 2). The explosion in crop finance in FY89 may thus have contributed co short term growth, but in doing so compromised prospects for successful stabilization by adding significantly to inflationary pressures. 2.32 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 coffee exports and monopsony powers in the purchase of coffee from local producers. The more immediate problems of coffee financing also reflected fundamental weaknesses in both the financial arrangements for Coffee Marketing Board (CMB) and its management more generally. To address these weaknesses the Government has recently enacted a number of measures as part of Agricultural Sector Adjustment Credit (ASAC) operations. These include the transfer of crop financing facilities, including financing of CMB, to the commercial banks from FY91 with BOU's role restricted to the provision of refinancing facilities for commercial banks involved in crop financing (with risks to be borne by commercial banks). The package of measures also involves a financial restructuring of CMB, including substantive new equity injection, to reduce its need for borrowing and to place it on a firmer financial footing. At the same time CMB's monopoly on coffee exports is being terminated, and measures are being put in place for the cooperative unions to undertake export marketing on their account. 2.33 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 for exports 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. In the short term, however there are two problems that need to be addressed to avoid difficulties in the resumption of crop finance by the commercial banks and to keep crop financing requirements in line with those agreed as part of ASAC discussions. First, 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 central Government budget. 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 result in yet another, albeit disguised, form of potential credit expansion. 2.34 Second, the mission has concerns about 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 crop financing, the degree of participation by the UCB and COOP--the two illiquid banks--is not clear. The other, mainly foreign, banks are liquid but most of the rural-branch network needed for crop financing is currently owned by the UCB and COOP. There are also 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.  - 15 - These and other factors suggest that, while some reduction in crop financing requirements relative to the December 1989 figure (USh 25 billion) are likely, there is potential for further reductions, but t.his will depend upon the effectiveness with which the Government resolves some of the remaining institutional and policy uncertainties. 2.35 Use of open-market operations In the short run, the only open market operation that is sufficiently 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: money balances in excess of the needs for financial transactions within Uganda are converted into dollars in the parallel market. 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 resulting higher demand for dollars raises its market price and with it the prices of goods it is used to purchase. The authorities have thus another useful monetary control lever at their disposal 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 then 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 M2, from circulation. In the medium term the BOU should actively promote the development of inter-bank and money markets for managing liquidity. The issues related to the development of these instruments are addressed in Section III. 2.36 Interest-rate policy Interest-rate policies have a much greater role to play in Uganda's fight against inflation than they have so far been accorded. Until recently all key interest rates have been highly negative in real terms. However, with the reduction of the inflation rate to below 30 percent for FY90, interest rates had become highly positive and were adjusted downwards in June 1990. The maximum deposit rate was reduced to 32 percent and the lending rate to 45 percent. Even more importantly, the Government had indicated its intention that, beginning October 1990, interest rates will be adjusted each month on the basis of the average twelve-month inflation rate for the preceding three months, in order to maintain positive real deposit rates of at least 4 percent. This recent development reverses policies from the past, and should encourage domestic savings as well as the deepening of the financial sector. This appears to be a sensible approach and the question is whether there is any room for building further on this policy. 2.37 It is a complex matter to devise a "correct" interest rate policy in the highly inflationary circumstances faced by Uganda. However, to encourage savings in financial assets, interest rates will need to be positive in real terms so that depositors can earn real positive returns on their financial investments. At the same time this policy, by increasing the real cost of borrowing, will restrict the demand for credit to match 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  - 16 - 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 ASAC projections (see Chapter II, Volume 2). In addition, higher interest rates should add to financial depth by dampening demand for holdings of private wealth in parallel foreign currency rather than in domestic financial assets. 2.38 The dangers of excessively high nominal and real interest rates should, however, not be ignored. If real interest rates become highly positive, then given the low return on capital in many of Uganda's productive sectors (including coffee), the burden on enterprises and cooperatives would be unreasonable. The majority of credit used in these circumstances would be for speculative purposes or would be linked to distress borrowing. Many borrowers would have no intention or ability to repay their loans, and hence this could further worsen the bad debt situation facing the banks. For these reasons, lengthy periods of high and positive interest rates (above 10-15 percent real) should certainly be avoided. The danger of excessively high interest rates for prolonged periods is best avoided by ensuring that interest rates are not invoked as a single policy instrument to do all the work to control the fiscal deficit and monetary expansion. However, if the fundamentals of inflation determinants 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. 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 more detail in Volume 2. 2.39 Limits on commercial bank lending Many of the conventional Instruments to control the money supply will not work, at least until the current distress in the commercial banking system has been resolved. Thus reserve and liquidity ratios cannot be an effective policy instrument if the main banks, UCB and COOP, continue to avoid compliance. Similarly, discounting and rediscounting facilities at the BOU have limited use in a situation where some banks are relatively flush with funds, while others totally illiquid. Mopping up liquidity through open market operations involving the sale of foreign exchange (as in the SIP operations), is possible but cannot be relied upon due to uncertainties about the availability of foreign exchange. Finally, our earlier discussion, while recommending the use of interest rates, has cautioned against the over-vigorous use of this instrument. So, what should be done? One alternative, at the least for the time being, would be to extend the arrangement that the BOU already has for reigning in the UCB and COOP. This provides for strict limits on commercial bank lending. 'Corset" type limits on bank lending are inefficient and distorting if allowed to persist for any length of time. In the interim, however, physical controls on bank lending seem to be the most appropriate instrument. 2.40 Fiscal consequences of bank restructuring The restructuring and recapitalization of insolvent financial institutions will have important fiscal implications. Recent estimated of the new capital needed to be injected from public sources in the two commercial banks (UCB and COOP) are of the order of USh 10 billion; the cost of recapitalizing UDB could eventually also turn out to  - 17- be high. To avoid a massive disruption of the Governments fiscal and monetary program it is recommended that the injection be carefully designed and include such options as private sector participation, and the provision of new Government securities in which only interest costs would represent an immediate claim on public finances. 2.41 Recommendations A number of main recommendations follow from the the above analysis. The first of these recommendations relates to inflation. Altiiough 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 Volume 2, 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. 2.42 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 lowrC 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 enhanced revenue collection at any level of collec- tion-efficiency. Second, a greater depth would result in a smaller inflationary impulse for any budgetary deficit still needed to be financed using domestic bank credit. 2.43 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. 2.44 Fourth, as a means of enhancing banking discipline the Government should give a high priority to the restoration of monetary control, elimination of payments arrears (both of the Government and parastatal enterprises), and strengthening prudential supervision by the BOU. Financial discipline of the  - 18 - 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. Given the past performance of Ugandan financial institutions, this process of confidence building will take time to develop. 2.45 Fifth, the Government should ensure the implementation of its decision to transfer coffee financing back to commercial oanks in FY91. To bring this about, among other things, the Government should facilitate the restructuring of the UCB and COOP at an early date. 2.46 There is little to be gained by squeezing Government credit to allow an expansion of private credit if, as in the past, the quality of such lending remains poor. A precondition for a policy based on a rapid expansion of private credit has to be the re-establishment of sound management, especially of credit allocation procedures, in the problem banks and DFI's. III. Institutional issues Overview 3.1 In terms of institutional issues while there has been some improvement in the financial system since the time of the reconnaissance mission in October 1989, the basic problems remain unresolved. Since last October BOU has enforced a number of containment measures to stabilize the situation at both Cooperative Bank (COOP) and UCB. These measures include restrictions on new lending and opening of new bank branches. As a result of these measures the liquidity crisis at these banks also eased significantly and they were able to reduce their overdrawn position at the BOU by Ush 4787 million (i.e. Ush 4297 million by UCB and Ush 490 million by COOP) during the last four months of 1989. At the end of 1989 the combined balances of the two banks stood at an overdrawn position of Ush 1247 million, equivalent to only 5Z of their combined deposits. Indeed, at the end of 1989, UCB had a positive balance of Ush 866 million. However this was still well below the minimum cash reserve requirements (i.e. 101 of deposit liabilities). At the same time BOU has enacted a number of measures to improve its internal operations including the backlog of accounts. 3.2 While the above measures are a step in the right direction, it needs to be stressed tnat most of the basic problems remain including (a) critical weaknesses in the authority and capacity of the BOU to supervise and maintain the financial system, (b) the insolvency, in all probability, of more than half of the commercial banking system, (c) the apparent non-sustainability of the present mode of operations of the DFI's, and (d) lack of confidence in financial institutions. The implications of these problems, which are discussed below and have also been touched on in the previous section, are extremely serious and call for urgent remedial measures by the Government.  - 19 - The Bank of Uganda and its role in the financial sector ' 3.3 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 to facilitate necessary development, perceptions of the strength and performance of the Central Bank are extremely important. 3.4 (A). AUTHORITY OF THE BANK OF UGANDA The Bank of Uganda (BOU) appears to have less authority than is usua:ly 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 :;nformal - should be strengthened. The BOU should have prime responsibility in the implementation cf 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 (e.g., in determination of interest rates), reinforced by ambiguities about the assignment of responsibilities between the Bank and the Minister of Finance (e.g. approval of new branches). This has been a situation that banks exploit. The capacity of the BOU has in the past also been weakened by being involved in activities on behalf of the Government (e.g. crop financing) that are seen as being inconsistent with both monetary and supervisory policy being implemented by the Bank of Uganda. Finally, the present position where appointments to the position of heads of department are subject to the approval of the Minister of Finance represents a serious dilution in the authority of the Governor. 3.5 To overcome these deficiencies it is suggested that legislative and other changes be incorporated such that (a) all matters pertaining to areas where BOU has prime responsibility, as mentioned above, should be the decided by the BOU with clearance by the Minister in the case of predefined politically sensitive matters including licensing and closure of banks and interest rate policy, (b) BOU's role in economic policy formulation should be strengthened and formalized, (c) in circumstances where consensus cannot be reached between the Governor and the Minister of Finance on policy issues, the Government should have the power to direct the Bank but BOU should have the option to have the facts pertaining to the differences revealed in an appropriate public forum, such as the annual report of the BOU, (d) BOU be required to inform Government of its views on, and approach to, monetary policy after each regular meeting of the BOU board, and (e) the Governor's status and powers should be fully commensurate with that of a chief executive with full responsibility for administration (with reference, as necessary, to the Board) 3.6 (B) CAPACITY OF THE BANK OF UGANDA TO FULFILL ITS ROLE For a Governmert to delegate substantial authority to a central bank and for financ'al institutions (both domestic and overseas) to recognize the central bank as having I This section takes account of the results of the diagnostic study of the BOU carried out by the consultants, Booz-Allen and Hamilton. K .,  - 20 - authority, the latter must be clearly seen to be fulfilling its tasks effectively. THe Bank has made some significant improvements in a wide range of areas including accounting and research but more are necessary. Examples of poor operational performance detracting from the status of the Bank include its failure to produce annual accounts in a timely manner and the long delays in posting to the bank accounts of both Government and banks. BOU should clear its backlog of accounts as soon as possible and strengthen its accounting control procedures; BOU must be able to balance its books daily and promptly provide up to date bank statements to its clients (banks and the Government). At the same time BOU should improve its clearing house operations. This would also help to reduce the delays in posting transactions to bank exchange settlement accounts. In consultation with Government, it should also consider introducing higher value bank notes at an early date. 3.7 In addition to improving performance, there is a clear need for work in a number of areas of the Bank to be expanded and, or, rationalized. The analytical/ monitoring work in the research and the foreign exchange departments should be expanded to provide a strong basis for policy discussions. This expansion should include a unit to be set up in the research department to monitor monetary and credit developments. The research department should also be in a position to conduct credit market su.veys to augment the excellent information on sectoral distribution of credit contained in the Quarterly Bulletin, a document with which the mission was impressed. In parallel with these changes, the research department should consider phasing out the work it is currently doing on compiling of the consumer price index and the monitoring of export proceeds as and when other [Government] departments are in a position to take over this work. Other areas where capacity needs to be upgraded or rationalized include (i) bank supervision (see below), (ii) work of the Agricultural Secretariat, (iii) coordination of functions between departments, and (iv) staff training and the associated introduction of new technologies. 3.8 Additionally, organizational changes are needed; for example grouping departmental responsibilities under Executive Directors to streamline operations and reduce the number of staff reporting to the Governor; enhancing the status of the budgets and accounts department by giving the Chief Accountant the status of an Executive Director; avd the appointment of two non-executive advisors to the Governor - one could help upgrade policy work in the Bank, while the other could inject urgency and cohesion into the many changes that are being proposed in the work of the BOU - as well as a number of other experts. The above changes should be implemented in the context of a reorganization of the Bank. A possible restructuring of the BOU, showing a clearer division between t!Ie economic, technical, and administrative functions of the Bank than Lhe illustrative structure set out in the Booze-Hamilton study, is shown in Chart 4.2 on page 66 of the main report. 3.9 (C) MONETARY POLICY The overall economic environment in which monetary policy has been conducted has been quite difficult. Two important reasons for this are: (a) the need for BOU, on behalf of the Government, to provide finance for the FY89 and FY90 coffee crops, and (b) the need for BOU to provide finance because of the distress in the commercial banking system. The situation has been still further aggravated by the low repayment rates on loans being experienced by many financial institutions. Consequently, credit growth has been higher than would otherwise have been the case. A first priority for the future is to e-pand  _ 21 - substantially the analytical work underlying policy discussions and decisions, as already outlined above. If this can be done, then several of the policy Instruments available to the BOU could be used far more actively than in the past to provide strong control on economic developments. In the short term, as discussed earlier, the most effective Cool is likely to be controls on bank lending in conjunction with changes in interest rates as well as the use of open market interventions along the lines of the SIP II program when feasible. Restoration of monetary control also calls for the enforcement of reserve requirements, in particular the early elimination of BOV overdrafts to COOP and UCB. 3.10 In the medium to longer term, as the distress in the commercial banking system is alleviated, BOU should begin to make more active use of conventional instruments including (a) liquidity and reserve requirements, (b) fostering of an inter-bank market to provide overnight and short notice funds, (c) removal of restrictions on commercial banks on the holding of Treasury Bills and increasing the upper limit on the value of Treasury Bills that can be issued (currently USh 2 billion), (d) promoting development of money markets and instruments including securities issued by BOU on its own account, (e) introduction by the BOU of rediscount facilities to impLove the quality of commercial paper and the range of possible holders of it. To enhance the role of reserve requirements as a tool of monetary policy the Government should give considerntion to renamerating commercial banks for reserves held at the BOU; this would also help to improve the efficiency of intermediation by reducing what is effectively a tax on the banks. 3.11 BOU should also review the controls and targets it uses to implement monetary policy consistent with the evolution of financial markets in Uganda (for example in the medium to longer term, it should consider the use of more indirect controls, such as open market operations, and possibly use elements of its balance sheet, rather than say M2, as an intermediate objective of monetary policy). 3.12 (D) PRUDENTIAL REGULATION AND SUPERVISION OF FINANCIAL INSTITUTIONS Prudential regulation and supervision of banks and other financial institutions is essentially directed at maintaining stability in the financial system. Given the present distress in the Ugandan banking system, prudential supervision clearly has not been working. In the mission's assessment, the main factors contributing to this state of affairs in the past would seem to have included: (1) perceived lack of status of the Bank of Uganda, (2) difficulties in early identification of emerging weaknesses in the system, and (3, inability or unwillingness on the part of BOU to use its existing enforcement powers effectively. The step3 needed in the immediate future to correct the situation include the followings (a) BOU should be more ag