Uganda - Second Structural Adjustment Credit

Document of The World Bank FOR OFFICIAL USE ONLY Repwt No. P-6221-UG REPORT AND RECOMMENDATION OF THE PRISlDENT OF THE INTERNATIONAL DEVELOPKENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED IDA CREDIT IN THE AMOUNT OF SDR 57.8 MILLION TO THE REPUBLIC OF UGANDA IN SUPPORT OF THE SECOND STRUCTURAL ADJUSTMENT CREDIT APRIL 18, 1994 MICROGRAPHICS Report No: P- 6221 UG Type: PR This document has a resticted distribution and may be used by recipients only in the perfomanmce of their ofricial duties. Its contents may not otherwise be disclosed without World Ban;k authorization.  CURRENCY EQUIVALENTS Currency Unit = Ugandan Shillin (U Sh) US$1 U Sh 1047.22 (February 1994) U Sh 1 US$0.000954 US$1 = SDR 0.7213 SDR1 = US$1.3865 GOVERNMENT FISCAL YEAR July I - June 30 ABBREVIATIONS AND ACRONYMS ASAC - Agricultural Sector Adjustment Credit CAS - Country Assistance Strategy CEM - Country Economic Memoradum CMB - Coffee Marketing Board CMBL - Coffee Marketing Board Limited DAPCB - Departed Asians Property Custodian Board DFI - Direct Foreign Investment EDMO - External Debt Management Office EEC - European Economic Community ERC I - First Economic Recovery Credit ERC 1I - Second Economic Recovery Credit ESW - Economic and Sector Work FSAC - Financial Sector Adjustment Credit GDP - Gross Domestic Product ICB - International Competitive Bidding IDA - International Development Association IMP - International Monetary Fund LMB - Lint Marketing Board MPEP - Ministry of Finance and Economic Planning MPS - Ministry of Public Service NEAP - National Environmental Action Plan NRM - National Resistance Movement ODA (UK) - Overseas Development Administration (United Kingdom) SAC I - First Structural Adjustment Credit TIN - Taxpayer Identification Number UCDA - Uganda Coffee Development Authority UIA - Uganda Investment Authority URA - Uganda Revenue Authority URC - Uganda Railways Cororation USAID - United States Agency for Iternational Development VAT - Value Added Tax  FOR OFFICIAL USE ONLY REPUBLIC OF UGANDA SECOND STRUCTURAL ADJUMMENT CREDfT PRESIDENT'S REPORT CONTENTS Page CREDIT SUMMARY ...............; i PART I: COUNTRY POLICIES AND BANK GROUP ASSISllANCE SIRATEGY ........ .................... 1 A. Historical Perspective on Economic and Political Developments ....1.. B. Recent Economic and Social Performance .................... 3 C. Uganda's Development Objectives and Policies .... ............ 8 D. Bank Group Assistance Strategy ....... .................. 11 PART II. THE SECOND STRUCTURAL ADJUSTMIENT CREDIT .... ..... 19 A. The Regulatory and Business Climate .......... ............ 19 B. Divestiture of the Custodian Board Properties ....... .......... 23 C. Domestic Revenue Mobilzation ........... .............. 25 D. Public Expenditure Prioritization ............ 27 E. Civil Service Reform ............... ................. 29 PARTII. THE PROPOSED CREDT. 32 A. Credit Amount and Expected Cofinancing .32 B. Tranching .32 C. Disbursement .32 D. Procurement .32 E. Management, Monitoring and Accounts .33 F. Conditionality .33 PART IV. BE3ESANDRISKS .35 A. Benefits .35 B. Poverty Category of the Proposed Operation .35 C. Risks .35 PART V. RECOMMENDATION .36 lbis document has a restricted distribution and mlay be used by recipients only in the perfonnance of their official duties. Its contents may not otherwise be disclosed without World Bank authotization.  ANNEXES 1. Leter of Development Policy II. Policy Matrix 11. I Balance of Payments 111.2 External Financing Requirements IV. CAS Tables Table 1: Selected Indicators of Portfolio Performance and Management Table 2: Bank Group Fact Sheet Table 3: Poverty and Social Development Indicators Table 4: Key Economic Indicators Table 5: Key Exposure Indicators Table 6: Status of Bank Group Operations in Uganda Table 7: Statement of IFC Investments V. Statemnent of Bank Loans and IDA Credits VI. Uganda: Disbursement Issues  UGANDA SECOND STRUCTURAL ADJUSTMENT CREDIr CREDlT StMMY Borrower: Republic of Uganda Executing Agency: Ministry of Finance and Economic Planning Credit Amount: IDA: SDR 57.8 million (US$80 million) Terms: Standard IDA terms with a maturity of 40 years Description: The proposed credit has as its theme poverty reduction through accelerated economic growth and rapid human resource development. Accordingly, it will assist the Government to achieve a mumber of key objectives. First, it will support firiher deregulation of the economy involving the removal of the remaining barriers to trade and investment in the coffee subsector and liberalization of the cotton industry. Second, the credit will support actions aimed at completing the divestiture of the Custodian Board properties. Third, it will assist the Government to step up domestic revenue generation which is still only around 8 percent of GDP. Fourth, the credit will help to deepen the Government's efforts aimed at prioritizing both recurrent expenditure and development expenditure. Fifth, it will support further measures directed at downsizing the civil service and raising its efficiency. Benefits: The specific actions to be supported by the credit will benefit Uganda in a number of ways. Improvements in the regulatory and business climate will help unleash the full potential of the private sector as the engine of growth. The final phase of divestiture of the Custodian Board properties is expected to spark increased rehabilitation investment and reinforce Uganda's pro-business image. Civil service reform is aimed at building a competent, results-oriented service without which the present ineffectiveness of government programs will persist. Sharp increases in domestic revenue are needed to underwrite not only civil service reform (salaries in particular) but also much higher levels of expenditure in the social and economic sectors, especially health, education and roads. Public expenditure rationalization will lead to more productive use of the Government's own limited resources and the resources provided by donors. Risks: There are both extemal and intenal risks to the program to be supported by the credit. Coffee prices on the world market have firmed over the past few months but the risk of a further slide in prices cannot be ruled out. The best way Uganda can protect itself against such an eventuality is to promote noncoffee exports vigorously. Uganda has no control over international developments but it has demonstrated a readiness to respond to external shocks. On the domestic front, the main risks are a return to fiscal laxity in the run-up to presidential and parliamentary elections in 1994 and a weakening of resolve in implementing structural reforms, especially those involving retrenchment and revenue  -ii- generaton. On the posilve side, the i a much greater commitment to fiscal prudence than beo, and the centra bank has become more vigilant in managing the Government's accounts. Moreover, the merger of finance and planning has resulted in a more cohesive budget management structure. To reduce the risk of lost momentum on stuctura reform SAC II supports many up- front acdons. Povety Category The proposed credit has a strong poverty focus. Economil Rate of Return: Not applicable. Estmated Disbursements: The credt will be disbursed in two tranches of approximaely equal amowts, with the first tranche released upon credit effectiveness and th second tranche be)ming available about nine months later once the relevant conditions have been filfilled.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF TIHE INTERNATIONAL DEVELOPhMT ASSOCIATION TO THE EXECTIE DIECTORS ON A PROPOSED SECOND SRUCTURAL ADJUSTMNENT CREDIT TO THE REPUBLIC OF UGANDA 1. I submit the following report and recommendation for a proposed Second Structural Adjustment Credit (SAC U) in the amount of SDR 57.8 million (US$80 million) to the Republic of Uganda on standard IDA terms, with a maturity of 40 years. 2. DA has supported Uganda's stabilization and adjustment program, launched in May 1987, with two Economic Recovery Credits (ERC I and ERC 11), an Agricultural Sector Adjustment Credit (ASAC), a Structural Adjustment Credit (SAC I) and a Financial Sector Adjustment Credit (FSAC) as well as several investment operations which have attracted substantial amounts of cofinancing or parallel financing from other donors. The program has also benefitted from significant resource flows from the IMP. The proposed credit will support the deepening of some of the important policy reforms and institutional measures that have been implemented over the past six years. 3. Part I of this report presents Uganda's macroeconomic and structural policies and the Bank Group's assistance strategy. The reforms to be supported by the proposed credit are discussed in Part H. Part m descnbes the specific features of the credit. The benefits and risks of the program to be supported by the credit are discussed in Part IV. Part V Is the President's recommendation. Part I: Country Policies and Bank Group Assnce Strategy 1.1 This part of the report serves three purposes. First, it provides a brief !, ;torical background on the economy and politics. Secondly, it discusses receitt economic developments, focusing on progress towards stabilization and adjustment and the key development issues facing the country. Thirdly, it reviews the Bank's assistance strategy in Uganda. A. Historical Perspective on Economdc and Political Developments Historical Perspective 1.2 With a per capita income of only around US$180 in FY93, Uganda ranks among the poorest countries in the world. Poverty in Uganda is largely the consequence of civil war, political instability and economic mismanagement. The country has good growth potential, however. It is blessed with fertle soils and a good climate. Agriculture is the mainstay of the economy: it accounts for more than 50 percent of GDP, about 75 percent of export earnings and around 80 percent of employment; and it provides inputs for a number of manurig and  processing industries. Smallholders are the backbone of Ugandan agriculture; over 80 percent of the farmers cultivate less than 2 hectares. The country is predominanly rural, with only 11 percent of the population living in towns and cities. Industry has grown rapidly in the past six years but its contribution to GDP is only around 12 percent. Manufacturing accounts for about half of industrial output. 1.3 The years immediately following independence in October 1962 were marked by reasonably strong economic performance. The annual average rate of real GDP growth was 6 percent between 1963 and 1973. The balance of payments was in surplus during much of this period and inflation was low and stable. The advent of the repressive Amin regime in January 1971 changed things drastically. Amin expelled large numbers of Ugandan Asians and eypropriated their properties. His regime mounted a systematic attack on key institutions such as the judiciary, the civil service, the churches, the press and the banks. Accountability and financial discipline broke down. Economic activity was driven largely underground and the country became internationally isolated. This turn of events resulted in a 20 percent decline in GDP during the 1970s. After the overthrow of Amin in 1979, attempts were made to implement an economic recovery program, with the support of the Bank, th6 Fund and other donors. After some initial successes, these efforts were overtaken by a renewed civil war which lasted from 1981 to 1985. 1.4 The National Resistance Movement (NRM) waich assumed power in January 1986 inherited an economy which was in ruins. The war had disrupted crop production and marketing. Manufacturing activity had virtually ground to a halt. Foreign exchange reserves were depleted. lTe roads were in an acute state of disrepair and there was a severe shortage of trucks and other transport equipment. Telecommunications, water and power supplies were at best erratic. Moreover, large parts of the north and east of the country continued to be plagued by insecurity. In responding to these challenges the Government initially adopted an interventionist stance and introduced expansionary fiscal and monetary policies. Notwithstanding tentative signs of economic recovery, the results of these policies proved disastrous, as evidenced by the sharp acceleration of inflation from 130 percent in January 1986 to 361 percent in May 1987. Over the same period the parallel market exchange rate of the Ugandan shilling depreciated rapidly, from U Sh 30 to U Sh 144 per US dollar compared to an official rate of U Sh 60 per US dollar. In May 1987 the Government adopted new economic policies with the basic objective of creating a free market economy. Govemnance 1.5 Uganda has a government of national unity. There is a parliament whose members were elected on an individual basis rather than on the basis of party affiliation. There is an independent judiciary, respect for individual liberties and freedom of the press. At the height of the insurgency in the north and east there were incidents of abuse of human rights but, with the ending of rebel activities, these have virtually ceased. A draft new national Constitution is due to be adopted by the Constituent Assembly which was elected in March 1994. Presidential and parliamentary elections are planned for late 1994. The great unresolved question is whether there should be a return to multiparty democracy in 1994 or at a later date.  - 3 - B. Recent Economic and Social 1erformance 1.6 The Government of Uganda embarked upon an Economic Recovery Program (ERP) in May 1987. The basic objective of the program was to bring about rapid and sustained Improvements in the standard of living of the average Ugandan. This objective was to be achieved through policy and structural reforms aimed at: (i) restoring internal and external financial stability and lowering inflation through prudent flscal and monetary management; (ii} creating the conditions for rapid and sustained growth of GDP through deregulation of the incentive and regulatory framework; and (iii) developing human capital through investments in education, health and other social services. 1.7 Summary Assessment of Progress on Stabilization and Structural Adjustment. The Government has scored a number of successes in reforming the economy. First, it has achieved price stability. Year-on-year inflation, as measured by the consumer price index for Kampala, dropped to minus 0.5 percent in June 1993 compared to 63 percent a year earlier, before edging up to 12.5 percent in March 1994. The attainment of price stability took too long, as the Government was slow to bring public expenditure and monetary growth under control. Price stability has been accompanied by exchange rate stability, although between November 1993 and February 1994 the Ugandan shilling appreciated against the US dollar. Secondly, the Government has deregulated the incentive and regulatory framework to the point where Uganda can boast of a free market economy. Thirdly, it has begun to reform public sector institutions: the size of the civil service and the military has been reduced; there is better control over the civil service payroll; and a few public enterprises have been sold and many more put on the market. The sui,ply response to the reforms has been encouraging: the downward slide in the production of coffee, the main export, has been halted; nontraditional exports havs been growing rapidly but from a very low base; between FY88 and FY93 real GDP grew at an average annual rate of 5.7 percent, or 2.8 percent in per capita terms. 1.8 In spite of these achievements Uganda faces formidable hurdles that must be overcome before there can be any assurance of rapid and sustained economic growth and poverty reduction. First, a civil service competent enough to guide social and economic development is absent. Secondly, agriculture remains technologically backward. Thirdly, the human capital base is very deficient. Fourthly, a strong financial system capable of mobilizing and allocating savings is lacking. Fiftlily, external payments viability remains a distant prospect. The challenge for the Government, the Bank and other donors is to systematically remedy these deficiencies. 1.9 Key Policy and Institutional Reforms. Uganda launched its Economic Recovery Program at a time of high and volatile inflation. The immediate goal of economic policy, therefore, was to achieve macroeconomic stabiliy. To this end the Government sought to tighten fiscal and monetary policies. Up until the final quarter of FY92 these attempts were largely unsuccessful as the Government repeatedly exceeded its expenditure targets and resorted to larger- than-programmed borrowings from the central bank. The overall deficit (excluding grants) as a percentage of GDP rose from 5.6 percent in FY88 to 14.5 percent in FY92. The rise in the deficit was caused not only by inappropriate fiscal policies but also by the collapse of international coffee prices which virtually eliminated income from the coffee export tax, hitherto the mainstay of government revenue. In FY93 the overall deficit/GDP ratio declined markedly  to 11.2 percent. This was achieved largely by tightening expenditure control and adhering to strict limits on bank financing. The tighter fiscal stance, together with increased supplies of food following good rainfall, brought about a sharp deceleration in inflation, as noted in paragraph 1.7 above. 1.10 Uganda was fortunate in that at the time it embarked upon its stabilization and adjustment program it did not suffer from pervasive price controls and did not therefore have to undergo what is often a politically difficult and socially disruptive process of pris &Meglation. Still, in the product markets a number of important prices were subject to direct or indirect control. Among these were the prices of major locally-manufactured products, producer prices of the major export crops (coffee, cotton, tea and tobacco) and the prices of certain imported commodities of which petroleum was the most important. The Government first removed the price controls on industrial products. Ibis was followed by the removal of controls on crop producer prices in FY92. Finally, the price controls on petroleum products were removed in January 1994. 1.11 Price deregulation was accompanied by the removal of entry barriers to markets. First, the monopoly of the Produce Marketing Board over exports of foodstuffs was terminated. This action opened the way for private traders to compete for supplies of nontraditional exports such as beans, maize and simsim. This was followed by the abolition of the export monopoly of the Coffee Marketing Board (CMB) in 1990. With the abolition of the CMB's export monopoly, private traders lost no time in entering the coffee export business and now handle about 60 percent of Uganda's coffee exports. As a result of this and other measures taken to deregulate the subsector, coffee production has recovered somewhat, from 122,154 metric tons in FY91 to 130,000 metric tons in FY93, despite very low world prices for coffee. The Cotton Development Statute, which came into force in February 1994, did away with the two remaining monopolies namely, the cooperative unions' monopoly over cotton ginning and the Lint Marketing Board's monopoly over cotton exports. 1.12 Uganda has also carried out a far-reaching deregulation of the foreign exchange market. This proceeded in stages. The first stage lasted until the end of FY90. Its main characteristic was reliance on periodic devaluation of the currency to maintain (unsuccessfully) a competitive exchange rate. In this period foreign exchange allocation involved a combination of a limited Open General License (OGL) system and administrative allocations. To improve the administrative allocations the Government introduced in December 1988 a Special Import Program (SIP) which provided access to import support funds that were surplus to the requirements of the OGL, on a first-ome first-served basis. The second stage of liberalizing the foreign exchange market dates to July 1990 when the Government permitted the setting up of foreign exchange bureaus, a move which effectively legalized the parallel exchange market. The third stage began in January 1992 when the Government replaced the OGL and SIP with a weeldy foreign exchange auction involving the sale of donor import support funds to the commercial banks. At the start foreign exchange channelled through the auction sold at a discount of over 20 percent to the bureau rate. Over time the gap narrowed. However, owing to the segmentation of the two markets and differences in documentation requirements, full convergence of the rates on the two markets proved difficult to achieve. The other problem was that some foreign exchange transactions were still subject to administrative procedures. In particular, coffee exporters still had to surrender export proceeds to the central bank (albeit at the market rate with effect from April 1992) and foreign exchange for petroleum imports was administratively allocated by the central bank. In the latest stage of liberalization the Government abolished,  v - effective November 1, 1993, the auction and introduced a unified foreign exchange system in which the market-makers are the commercial banks and the bureaus. In the new setting the central bank would intervene from time to time to achieve certain monetary or balance of payments objectives. With the introduction of this foreign exchnge system Uganda now has a unified, market-determined exchange rate. The foreign currency market is free of controls on virtually all current account transactions. As a result of these actions, public confidence in the shilling has been restored and funds held abroad have been flowing back into the conntry. During FY94 the market bas been so well supplied with foreign exchange in the form of export earnings, private capital and transfers and donor import support that the Ugandan shilling appreciited strongly against all the major foreign currencies. From December 1993 the central bank resorted to market intervention to stem the appreciation of the currency. 1.13 In the financial sector reform has focused on interest rate policy and prudential uervision of banks. With regard to interest rates substantial progress has been made towards deregulation. Interest rates are now market-determined except for the rates on agricultural loans, term loans and one-year deposits which are linked to a moving average yield on treasury bills; treasury bills are auctioned weekly. Interest rates have come down over the past year but not by as much as inflation. The interest rate paid on savings deposits dropped from 21 percent in December 1992 to 11 percent in December 1993 while loan rates generally declined from 33 percent to 23 percent. The banks have maintained a constant spread of 12 percentage points between lending and deposit rates. The banks have clearly been slow to reduce interest rates, with the result that. for a time, borrowers faced real interest rates of 10 percent or higher. Four reasons may be adduced for the banks' reluctance to lower interest rates. First, their loan portfolios and balance sheets are very weak. Secondly, their operating costs are high. Thirdly, there is litde or no competition among them. Finally, they still harbor fears of high and volatle inflation. With respect to prudential supervision, the newly-enacted Bank of Uganda Act and the FinancW Institutions Act have, among other things, increased capital requirements and granted the central bank greater supervisory powers over the financW system; however, implementation has as yet been inadequate. 1.14 Intitutional dvelMent has also been an important component of the adjustment program. The notable actions taken in firtherance of this goal include: the merger of the finance and planning ministries in April 1992 which has resulted in a more coherent fiscal and economic management structure; the reorganization of the Bank of Uganda which has set the stage for improving the central bank's operations and accounting; the strengthening of the Office of the Auditor General in an effort to improve accountability for the use of public fuids; tie establishment of the Uganda Revenue Authority (URA) with the primary objective of revampiug tax administration; the creation of the Uganda Investment Authority (UIA) as the focal point for assisting investors in obtaining the necessary approvals; the downsizing of the civil service to 169,000 in 1994 from 320,00 in 1990; and the implementation of a veterans assistance program which made it possible to cut the size of the military by 23,000 in just one year. 1.15 The Environment. Uganda had earned the distinction of being referred to as 'the Pearl of Africa' because of the richness of its natural endowment of forests, mountains, waterways, wildlife, fertle soils and agreeable climate. Until the early 1970s the country had a well- managed system of natural areas which served as the basis for an expanding tourist Industry. This progress was interrupted and indeed reversed during fifteen years of political and military  -6- turmoil which took a heavy toll on the people, the natural resources wad the economy. The period of turmoil was marked by extensive encroachment on forest and wildlife habitats. Moreover, ecological damage to Lake Victoria has been on the rise. The Government has taken a number of actions which have set the stage for addressing the environimr-ntal problems facing the country, including the assignment of respon.ibility for environmental matters to a particular ministry. It is about to complete a National Env.ronmental Action Plan. A number of projects are already supporting improvements in the management of forests and other natural resources. 1.16 An Evaluation of Overall Economic Performance. The reforms have had a positive outcome on a number of counts. First, macroeconomic stability has been achieved; it needs to be sustained, however. Secondly, the supply response has been strong. GDP at factor cost grew by an average of 6.6 percent per annum during FY88-FY90, reflecting the impact of the reforms and the spurt in activity following the restoration of peace and security to most parts of the country. The next two years (FY91-FY92) saw the annual average GDP growth rate decline to about 3.5 percent, owing largely to the effects of poor rainfall on crop production. Provisional data, however, show that, in spite of the sharp disinflation, the economy cebounded strongly in FY93; GDP grew by 7.2 percent as agricultural production recovered from the near-drought conditions of the previous year. Thirdly, the reforms have stimulated the production of nontraditional exports but, in the aggregate, these are still very small. Overall export performance has, however, remained poor mainly because of the collapse of coffee prices following the July 1989 suspension of the quota arrangements under the International Coffee Agreement. The external current account deficit (excluding grants) remains large (11.0 percent of GDP in FY93) but has started to decline. Also gross investment is very low (15.3 percent of GDP in FY93 compared to an average of 27 percent for low-income countries). 1.17 There are no longer any major distortions in the incentive structure. Product prices, the exchange rate and interest rates are all determined by market forces. The labor market is practically free of regulations. Moreover, state monopolies have been abolished. The inefficiencies of public sector bureaucracies and of the financial system, however, continue to Impose unnecessary costs on the economy. 1.18 Sustainability of Recent Progress. It is too early to suggest that the macroeconomic stability that Uganda has achieved is sustainable. For one thing, there is as yet only a very narrow constituency in favor of tight fiscal and monetary policies. Moreover, a much stronger domestic revenue effort and more rapid and diversified export growth are needed to underpin macroeconomic stability. The revenue/GDP ratio is well below the Sub-Saharan African average of 20 percent. Overall exports have still not recovered from the slump induced by the collapse of world coffee prices in July 1989. The upshot of this is that the sustainability of macroeconomic stability is closely tied to the availability of import support funds provided by the donors. Import support per se is not as critical to the economy as it was a few years ago. However, the government budget is just as dependent upon the local cturrency generated from import support as, if not more so than, it was in the earlier stages of the Economic Recovery Program. 1.19 Although the risk of policy reversal can never be ruled out, there is a fair chance that structural reforms involving improvements in the incentive and regulatory framework as well as in the institutional setup would be sustained. The main reason for being sanguine about tle  - 7 - sustainability of the structural reforms is that there is no organized opposition to the reforms. Moreover, many of the reforms have been enshrined in law so that they are not ad hoc measures which can be easily overturned. But even if the structural reforms are sustainable, the average rates of economic growth recorded over the past six years may not be. The main reason why growth may falter is that savings and investment rates in Uganda are too low. The ratios of savings and investment to GDP were 3.4 percent and 15.3 percent, respectively, in FY93. The inefficiency and ineffectiveness of the banking system retard the mobilization and allocation of domestic savings. Two other factors militate against the sustainability of recent rates of economic growth. One is widespread illiteracy. The other is the combination of inadequate physical infrastructure and weak public institutions which serve to raise the costs of doing business In Uganda. Finally, there is the question of political stability. Given Uganda's history of political and social turmoil, both local and foreign investors still need to be convinced that political stability is here to stay. The parliamentary and presidential elections due at the end of 1994 will provide a test of that. 1.20 Progress in Poverty Reduction and Improvement of Social Indicators. One of the findings of the 1992 Bank CEM entitled Growing Out of Poverty is that on average the welfare of the rural and urban poor improved in real terms by 16 and 14 percent, respectively, between FY88 and FY92. Although difficult to disaggregate, the improvement in welfare appears at least partly attributable to the adjustment program. Other factors at work were the restoration of peace and security to the entire country and inflows of significant amounts of external resources from multilateral and bilateral donors. Another finding of the CEM is tht, even though US dollar prices have declined, producers of cash crops have seen a rise in their terms of trade owing to reforms in the exchange, trade, tax and marketing systems. The poor benefitted from this development as the main cash crops are produced by smallholders. The terms of trade for marketed foodstuffs declined as supplies increased. The incomes of foodstuff producers nevertheless lose because the impact of production increases more than offset the effect of price declines. 1.21 The social sectors were not immune from the general collapse that Uganda suffered during the 1970s and the first half of the 1980s. The poor health status of Uganda's 17 million people attests to this. Life expectancy at birth is 46 years compared to 59 years for low-income countries as a group (see Annex TV, CAS Table 3). With an infant mortality rate of 118 per 1,000 live births and a maternal mortality rate of 550 per 100,000 live births, Uganda also ranks well behind other low-income countries with regard to these health indicators. Preventable diseases such as malaria, tuberculosis and diarrhea continue to be leading causes of death. Lack of access to safe drinling water is a major contributory factor to the health problems facing the country. Only 21 percent of the population have access to safe drinking water. The fertility rate (7.3 in 1990) in Uganda is high; this is an indication of the lack of an effective population policy. The education indicators are equally poor. Primary school enrollment is about 71 percent but this is somewhat deceptive as completion rates are esdmated to be as low as 32 percent. Moreover, owing to lack of instructional materials, shortage of trained teachers and low pay, the quality of the education is very poor. Over the past six years the Government has taken important steps towards laying the groundwork for improvements in the social indicators. It has embarked upon the physical rehabilitation of the infrastructure in the social sectors while increasing budgetary allocations for operations and mainenance, especially instructional materials. It has carried out a review of social sector policies. An important outcome of this  - 8 - review Is that the Government will concentrate its limited resources on basic social services which have the broadest impact on the population. In FY94 the Government singled out the teachers for special treatment; it doubled the salary of the lowest-paid teacher while civil servants of similar rank received a salary Increment of only 19 percent. The Government recognizes that these efforts can only bear fruit In the long term. 1.22 The Extemal Environment. Uganda's accomplishments to date with regard to stabilization, adjustment and growth have been in spite of a number of setbacks on the external firont. To start with, Uganda is a landlocked country, dependent upon its neighbors for outlets to the sea. On occasion Kenya has closed its borders with Uganda, causing disruption to the flow of imports and exports. Fortunately, these episodes have been few and short-lived. The real extal shock has been the massive deterioration in Uganda's terms of trade. In FY90 alone the merchandise terms of trade declined by 72 percent as a result of the collapse of international coffee prices. There were further declines of 6 percent and 14 percent, respectively, in FY91 and FY92. The coffee price decline wreaked havoc on Uganda's balance of payments. Coffee export earnings declined from US$286 million in FY88 to US$104 million in FY93, with resultant severe limitations on the capacity to import and service extemal debt. One outcome of this is that Uganda accumulated sizable arrears to its external creditors (see Table I). The government budget was also adversely affected by the sharp fall in world coffee prices which destroyed the tax base for coffee revenue which accounted for almost half of government revenue at the start of the ERP. The Government responded to the world price decline by liberalizing coffee exports, freeing the producer prices of coffee, abolishing the export tax and allowing coffee export proceeds to be convered into local currency at the market exchange rate. 1.23 Uganda's dependence on a single commodity, that is, coffee, for merchandise export earnings is still high (about 66 percent in FY93) but is nowhere near as high as it was (around 95 percent) four years ago. The share of official development assistance in total public expenditure is very high. Aid accounts for up to 90 percent of annual development expenditure. Apart from project aid, exter assistce provides about a third of budgetary resources in the form of local currency generated from sales of import support fimds. Uganda's total stock of trnal debt was US$2.6 billion as of the end of June 1993 (see Table 1). The debt-service burden has been coming down but remains onerous; in FY93 the debt service ratio before rescheduling was 83 percent. About two thirds of the debt is owed to the multlateral development institutions. This reduces Uganda's options for seeking debt relief. C. Uganda's Development Objectives and Policies 1.24 Sources of Growth. Uganda is an agricultural country and will remain so for a long time to come. The transformation of agriculture is therefore key to any successfil development strategy. The sector has great potential: it can feed a growing population; supply the regional market with food; generate new exports as well produce more of the traditional export crops; and be a source of industrial raw materias. The key to realizing this potential is by increasing crop yields. For a wide variety of crops yields can be doubled, or even tripled. The prerequisites to increasing yields include improved security of land tenure, enhanced availability of basic social services and increased but more focused public expenditure on research and extension, control of plant and animal disease and feeder roads. Ihe industrial sector also offers scope for increased production, with obvious linkages to the agricultural sector. At present, the emphasis is on import-replacing investments. But as the experience of countries such as the Republic of Korea, Malaysia and China has demonstrated, import substitution is likely to be efficient only if it is part  .9 - of an outward-oriented development strategy. Given the dearth of lonterm fiace, the absenco of modern tecnology and the lack of knowledge of foreign markets and modern management practices, foreigp investment can play a crucial role in promoting Industrial development. Agricultural and industrial growth would be enhanced by the development of key services such as banking and finance, insurance, accounting and auditing. Table I: EtRna Debt by Creditor (as of June 30, 1993) (USS million) Arars Creditor Debt Outaig inluding APncpal ntert Total DOD lPicpal Arrar Multiateral 1,835 12 9 1,843 IDA/IBRD 1,174 0 0 1,174 IMP 344 0 0 344 Other 317 12 9 326 BilateWals 621 148 41 663 Non-OOECD 365 120 16 381 Pais Club, PreCutoff 152 4 19 171 Pais Club, Post-Cutoff 104 24 7 110 Psivate 108 59 29 137 Commerci Non-Baub 55 30 6 61 Commei Bank 11 11 3 14 Otder Lan Category 42 17 20 62 Total 2,564 218 79 2,643 Sour: EDMO, Bank of Uada 1.25 Key Constanh on Growth and Developmnt. Political iostability in the 1971-1985 period was a major hindrane to development In Uganda. This Is no longer the case. Since January 1986 the cunry has been politically stable. Moreover, the quality of governa has improved a great deal, as shown by the Governmne's commimnto accountability ad te rule of law. The present indications are that polidcal stability in a democratic frmework will condne to prevail in UgVda. his should boer Investor confidence and thus induce increased long-term investment. Until recentiy, macroeconomic instablity, c principally by high and volatle inflation, was a key constraint on economic gowth. On this score too there has been a draumatic turnaround over the past two years, with inflaon beIg virtually eldmna by the end of FY93. However, the fight against inflation is far from over. Uganda needs to demonsrate its commitment to the mainace of low and stble inflation in the long term and thus give people the condce to save and make long-term invstmen. The key remain constraints on growth and development are low saving and investment rates, low rates of literacy and numeracy, indequate physical ifastucture and ineffective and inefficient public sector Insiuions. As elabord below, the basic goal of goverme policy is to fmd ways and mns of overcomi ese consain.  - 10- 1.26 Development Objectives and Polides. The Government's development objectives and policies are set out in the Policy Framework Paper, 1992193-1994/95. The primary development objective is to rapidly improve the living standards of the population through accelerated economic growth and human resource development. To bring this about the Government will maintain prudent macroeconomic policies, improve public sector management, promote private sector development and protect the environment. 1.27 Sustained macroecononmiQ. hiily is the first prerequisite to accelerated economic growth and poverty reduction. The Government therefore intends to pursue prudent fiscal, monetary and exchange rate policies aimed at managing aggregate demand, mobilizing domestic resources and promoting external competitiveness. The Government's objective is to keep inflation below 10 percent. Attaining this goal will take a firmer fiscal stance which in turn calls for increasing public revenues sharply and maintaining firm control over public expenditure while implementing a sound set of spending priorities. In this regard, the Government continues to implement an IMF-supported program in the context of the fourth annual arrangement under the ESAF which has been extended to June 30, 1994. 1.28 The public sector will focus on its basic functions of maintaining macroeconomic stability, providing adequate infrastructure and developing human resources. Further reform of ukllc sector management will build upon the progress that has been made in three interrelated areas namely, civil service and parastatal reform, domestic revenue generation and public expenditure prioritization. In the case of the civil service substantial progress has already been made in reducing staff numbers and instituting controls on hiring and the payroll; between July 1993 and January 1994 over 25,000 ghosts were eliminated. The size of the military has also been reduced by over a quarter. The Government will continue to work towards the creation of a smaller, better-paid and more competent civil service. As the civil service is slimmed down further, the ministries will be appropriately reorganized and restructured so that they can focus on those critical functions and activities that, in whole or in part, should be undertaken by the public sector. The Government has also embarked upon decentralization. It will place increasing emphasis on decentralization over the next few years as it considers initiatives in this area to be essential to improving the delivery of public services. In order to maximize the peace dividend from the cessation of rebel activity, the Government plans to complete the implementation of the veterans assistance program before the end of FY96. Parastatat reform, including divestiture, is underway, with 3 public enterprises already sold and another 23 put up for sale. In addition, 8 parastatals have been liquidated. Divestiture of government interests in commercial activities will be accelerated and broadened, where necessary. Revenue generation is another important public sector management issue which has serious implications for the maint-mnance of macroeconomic stability and the Government's ability to pay a living wage, maintain and expand the economic and social infrastructure and develop human resources. Uganda's revenue/GDP ratio has only risen by about 2 percentage points from the start of the adjustment program to 7.2 percent in FY93 compared to an average of 20 percent for Sub-Saharan African countries. In view of this the Government will intensify recent efforts to improve tax administration and broaden the tax base. The other public expenditure management issue is expenditure prioritization. A start was made by designating, since FY91, a set of basic recurrent expenditure programs (primary education, primary health, agricultural research and extension, rural water supply and road maintence) as candidates for increased budgetary allocations. This was followed in FY94 by the classification of the development budget into core and noncore projects.  - l - The Government intends to tighten expenditure priorities. In this regard, it wili, given the paucity of domestic revenue and the limitations on implementation capacity, concentrate available resources on the essential tasks of improving the incentive structure for civil servants, making adequate provision for the operation and maintenance of basic economic and social infrastructre and expanding the stock of infrastructure that is likely to have the broadest impact on the population. 1.29 The private sector holds the key to increased production for the local market and for export. The Government will therefore continue to foster rivate setor develomn. Its approach is to rely on market forces. The most recent actions in this regard include the deregulation of the cotton industry and the removal of the remaining regulatory restrictions on the coffee trade. The utility companies excepted, these actions more or less complete the removal of sectoral impediments to private investment. The establishment of free markets is, however, not enough. Petty bureaucracy is still a major impediment to investment and production. This is a problem that the Government will increasingly turn its attention to. Even more important, the Government needs to create the conditions necessay for rapid increases in domestic savings which are now equivalent to only 3.4 percent (GNS-to-GDP ratio) of GDP. An efficient and effective banking system is indispensable to any effort to step up the mobilization of domestic savings. The Government will strive for the emergence of such a banking system. The Government's other major goal is to make Uganda an attractive destination for direct foreign investment (DFI), as it is crucial to supplement domestic savings with private foreign savings. 1.30 In the field of environment Nrotection the fundamental issue that the Government faces is that poverty, population and the environment feed on each other in a destructive way: poverty encourages rapid population growth; rapid population growth in turn increases pressure on the environment; a degraded environment breeds further poverty and so on. To arrest this spiral of destruction the Government will use the NEAP as a basis to improve environment and natural resource management. This will involve establishment of an environmental database and monitoring system; research and land management to ensure sustainable agriculturd development; protection of wedands; conservation of forests and wildlife; and improvement of surface water manlagement. D. Bank Group Assisance Strtegy 1.31 The primary objective of Bank Group assistance to Uganda is to help the country lay the foundations for rapid, sustained and equitable growth as an instrument for poverty reduction. To that end the Bank Group's assistance strategy aims to support the Government's efforts to sustain macroeconomic stability, raise the standard of public administration, create the conditions necessary for the emergence of a strong private sector and protect the environment. The implementation of this strategy will require a combination of the usual Bank instruments, that is, policy dialogue with the Government, economic and sector work, lending operations and portfolio management and supervision. The discussion of these instruments is preceded by a brief review of the prospects for accelerated economic growth. 1.32 Econondc Prospects. Uganda's economic prospects depend upon how quickly the fndamentals of development can be put into place. The first fundamental is macroeconomic stability. The Government has now achieved macroeconomic stability but must work assiduously  - 12 - to sustain it. To assure continued macroeconomic stability the Government will have to step up domestic revenue generation and enlarge the constituency which supports sound fiscal and monetary policies. The Ugandan economy has also changed in another fundamental way: it is now free of major distortions in the incentive and regulatory framework. However, other fundamentals are not so sound. Specifically, Uganda is deficient in human capital, lacks a strong financial system, is saddled with low productivity in agriculture and is devoid of strong and effective public institutions. Remedying the deficiencies in these four areas while consolidating macroeconomic stability is the key to accelerated growth and poverty reduction in Uganda. The base case scenario presented in Table U below assumes the continuation of present trends. In this case economic growth would remain level at 5 percent through the year 2000. Table II also presents a high case scenario. This scenario assumes that the Government moves quicldy to develop human capital, create a strong financial system, raise agricultural productivity and build strong institutions. The projections in Table II indicate that if these efforts are successful the annual growth rate would rise to around 8 percent by the year 2000. With population growing at 2.7 percent per annum, economic growth at 8 percent a year would make it possible to double GDP per capita in 14 years, instead of 31 years which would be the case under a 5 percent growth scenario. 1.33 Assessment of the Government's Development Strategy. Tne Government's development strategy focusing on poverty reduction through growth and spending on social sector programs is sound. The Bank has no differences with the Government, or with the IMP and other donors, on this strategy. However, there have been differences with the Government with regard to the speed and sequencing of a number of policies (exchange rate unification, for example) needed to implement the strategy. Similarly, there have been differences with the Government regarding the delineation of a core of recurrent and development expenditures which are better geared to overcoming the deficiencies in human capital formation, agricultura development and other areas. The basic principles underlying the core/noncore disdnction have been agreed with the Government. Obtaining the agreement of the other donors to put these principles into practice is, however, proving more difficult. 1.34 Bank Intruments for Implementing the Country Assistance Strategy. The Bank Group has had a constructive Qliy dialogue with the Government over the past six years. The issues that are usually the source of controversy (the exchange rate, interest rates, pricing, etc.) have already been successfully dealt with. Still there is a need for continuing dialogue with the Government in a number of areas. In the area of macroeconomic management the dialogue will focus on tax and expenditure policy, with the aim of building upon the recent gains In domestic revenue collection and expenditure control and establishing and adhering to a set of spending priorities which address the fundmentals of development. In the area of public sector management the dialogue will concentrate on further shifts in the role of the state (pruning of the civil service, privatization and liquidation of parastatals) and improved performance and accountability. Dialogue on private sector development will aim at improving the legal and regulatory climate for business at the micro level. 1.35 The Bank has produced a considerable body of eonQmic and sector work (ESW) on Uganda. The most recent includes an Agricultural Sector Memorandum, a Country Economic Memorandum entitied Growing Out of Povert and a Social Sector Strategy Report, aU issued between March and April 1993. A study of Non-Governmental Organizations (NGOs) has also  Table II: Projections - Key In,dicators for CAS Growth Rates - In Percent Exports of GNFS, constant 16.5 18.5 11.7 7.8 8.0 8.1 16.5 18.5 14.3 12.3 12.1 13.1 Exports of GNFS, nominal 23.2 28.7 18.4 12.6 11.0 9.5 23.2 28.7 21.2 17.0 15.0 14.8 Imports of GNFS, constant 19.2 8.9 4.7 4.5 4.0 3.8 19.2 8.9 6.5 6.3 7.3 7.2 ImportsofGNFS, nominal 21.1 11.5 7.2 7.1 6.6 6.1 21.1 11.5 9.0 9.0 10.0 9.6 GDP at FC 6.1 5.0 5.0 5.0 5.0 5.0 6.1 6. 6.6 7.1 8.2 8.2 GDP at MP 6.5 5.6 5.5 5.6 5.0 5.0 6.5 6.7 7.1 7.7 8.2 8.2 Ratios to GDP -in Percent CurTent Acct, incl. Grants -2.9 -3.1 -3.1 -3.1 -3.0 -3.0 -2.9 -3.0 -3.5 -3.6 -3.7 -3.5 Current Acct, excl. Grants -9.0 -7.8 -7.3 -7.0 -5.9 -5.5 -9.0 -7.7 -7.3 -6.9 -5.7 -5.1 Fiscal Deficit(-)/Surplus(+) -10.5 -9.5 -8.6 -7.9 -1.3 0.1 -10.5 -9.5 -8.0 -6.8 1.8 3.0 Other Rados - In Percent Debt Service/Exports GNFS 63.8 47.2 44.1 40.8 36.6 38.5 63.8 47.2 43.5 39.8 34.8 31.6 ConsumptionlGDY 101.6 100.0 98.7 97.5 94.4 93.1 101.6 99.3 97.8 96.5 92.5 91.3 Gross National SavingslGNY 5.0 7.3 8.1 9.1 11.4 12.3 5.0 7.9 8.8 9.7 12.3 13.0 Levels - In US$ milons Current Account - US$m -348.4 -334.7 -344.4 -355.9 -402.7 -435.6 48.4 -334.6 -353.4 -369.5 -463.2 -513.0 Direct Foreign Investment - US$m 5.0 6.0 7.0 8.0 27.4 36.2 5.0 7.0 10.0 25.0 75.0 117.2 Sources: Government of Uganda, IMF and Bank staff esfimates.  - 14 - been completed. These various pieces of work provide the underpinning for the Bank's dialogue with the Govermnent on macroeconomic and sector policies and the lending program. More ESW is in progress or is plarmed for the next few years. The National Environmental Action Plan (NEAP) is nearing completion. This year's Public Expenditure Review has involved working with the Government and other donors to bring about further improvements in the allocation of public resources. The CEM planned for FY95 will explore in greater depth the key policies and programs needed to achieve rapid, sustained and labor-absorbing growth. Sector work will concentrate on issues of competitiveness and investment constraints in industry, land tenure in agriculture and resources assessment in the water sector. An assessment of the energy situation is under preparation. 1.36 The "base" IDA lending program proposed for Uganda would provide about US$200 million per year, or US$1,000 million for 16 operations over the period 1993-97. This level of IDA financing is conditional upon the Government keeping its stabilization and structural adjustment program on track. Tae proposed lending program is somewhat smaller than the US$250 million per year committed in the FY90-92 period; this reflects the expected tailing-off of adjustment lending and the constraint on new investment lending due mainly to lack of budget resources. Investment lending is likeih to be particularly constrained in the next year or two, as Uganda tries to bring its development budget more in line with its capacity to inplement projects and fund the requirements for operations and maintenance. Uganda's stabilization and adjustment effort is not expected to slacken, but should it do so for some reason, the proposed lending program would be scaled down. In the event of a major reversal in disciplined macroeconomic management or a slackening of the pace of structural reform (with some of the critical reform conditions incorporated in the SAC not being met) IDA would retreat to a core program of not more than US$80 million a year focussed on direct poverty-reducing activities such as basic education and health. 1.37 The lending program seeks to achieve a balance between investment projects and quick- disbursing import support. The focus of investment lending is on growth (agriculture and infrastructure development) and improvement of the social indicators (human resource development). To this end, IDA is supporting agricultural extension and agricultural research and training through projects approved in FY93. These projects have a strong focus on reducing poverty and improving the economic status of women. The Fifth Education Project, also approved in FY93, is aimed mainly at improving primary education. Also approved in FY93 is the Economic and Financial Management Project which supports further strengthening of the core economic agencies. FSAC, approved in FY93, is designed to improve the legal and regulatory framework for financial intermediaries and strengthen the financial system. Projects already approved in FY94 include the Transport Project to rehabilitate feeder roads and strengthen road maintenance capacity, the Suall Towns Water Project and the Sexually Transmitted Infections Project designed to reduce the incidence and impact of sexually transmitted infections including HIV/AIDS. The other FY94 project is the Cotton Development Project. Other investment projects in the pipeline include District Health, Institutional Development and Environmental Management in FY95, followed by Agriculture Sector Investment and Private Sector Development in FY96. In one way or other, these projects will benefit the agricultural sector which provides a livelihood for 80 percent or more of the population and where over 90 percent of the poor eke out a living.  - 15 - 1.38 Since 1987 Uganda has received five adjustment credits. The first two credits, ERC I and ERC II, have been fully disbursed. The first sector adjustment operation, the Agricultural Sector Adjustment Credit, was approved by the Board on December 13, 1990. This is a hybrid operation with an adjustment component and a small investment component. All the major objectives of this credit have been largely achieved. The second tranche of ASAC was releas Ad in December 1992. ASAC was followed by the first Structural Adjustment Credit. The twin objectives of SAC I namely, enhancing private sector development and Improving public sector management, have been achieved in many important respects. The second tranche of SAC I was released in March 1993. The Financial Sector Adjustment Credit was approved by the Board in May 1993 and became effective on August26, 1993; some delay in release of the second tranche, scheduled for August 1994, is likely. The current lending program includes one further adjustment operation in FY96. 1.39 An important instrument for getting results on the ground is portfollo Mana.gagn and ugrision. The status of the existing portfolio is presented in Annex IV, CAS Table 6. There are twenty-seven projects under implementation. Most projects are rated as satisfactory. However, the implementation of investment projects has generally been slow. There are three principal reasons for this. First, In the past project start-up was often delayed because of the failure to put in place the requisite project management team or to meet the conditions of effectiveueiis in a timely manner. Secondly, the availability of counterpart funis nas been a major problem. Thirdly, there are weaknesses in procurement which cause delays in project implementation. 1.40 A number of steps have been taken to meet both these generic and project specific problems. Starting in mid-1993, IDA has worked to help the Government identify a core list of highest priority on-going projects which are to receive full counterpart funding. While there have been some problems in its application, this approach has helped improve Implementation of IDA- fimanced and other donor-financed projects included in the core program On the basis of this effort by the Government to rationalize its development budget, restructring of IDA-financed projects has been initiated, and the remaining problem projects are currently under intensive review and discussion with the Government, aimed at their restructuring or cancellation. A number of other generic issues have been addressed through the Country Portfolio Performance Reviews. IDA has assisted the Government to improve its procurement procedures and practices both through the CPPRs and a procurement assessment. The operation and accounting for special accounts has been improved, in part by shifting them from the Bank of Uganda to commercial banks, and the timeliness and accuracy of audits has been increased by Government's agreeing to appoint private auditors to do this task. While problems remain in the portfolio, progress has been made and implementation is improving. Main Features of the Bank1s Assistance Strategy 1.41 Sustained Macroeconomic Stability. Uganda has been very successful In reducing inflation over the past two years. Fears had been expressed that the sharp disinflation that occurred in FY93 would trigger an economic downturn. This has not happened. On the contrary, the economy grew by 7.2 percent in FY93, reinforcing the twin messages that squeezing inflation out of the economy is not inimical to growth and that macroeconomic stability is needed to give both Ugandans and foreigners confidence to invest and produce.  - 16 - Macroeconomic stability is basic to the success of the entire adjustment program. The Bank's assistance strategy will therefore give special emphasis to helping the Government to maintin price stability and a competitive exchange rate and overcome debt servicing difficulties. 1.42 Human Capital Formation. Uganda needs to invest more in human capital formation, especially primary education and primary health. This will benefit the poor directly. It would also prepare them to participate more fully in the growth of the economy. The Bank's assistance strategy aims to: support the Govermnent's efforts to expand basic education and health services to the entire population; reflect the emphasis on development of human capital in the Bank's own lending program; and build consensus among the donors on the need for redirecing resource towaras basic education and health. 1.43 Agricultural Development. Poverty in Uganda is largely a rural phenomenon. the attack on poverty must therefore focus on agricultural development. Ugandan agriculture is technologically very backward. High-yielding varieties, even when they are available, are practically unknown outside of the research stations. Fertilizer is used on a very limited s:ale. The extension services are ineffective. The challenge for the Bank is to assist the Government to raise the productivity of the farmers through improved research and extension and an expanded feeder road network. 1.44 Strengthening the Financial System. The financial sector has a key role to play in the mobilization and allocation of resources. In Uganda the financial system barely extends beyond the capital, Kampala. Worse still, the operations of the banks are clouded by insolvency, weak mnanagement controls and inadequate prudential supervision. Given the critical role the financ system must play in raising savings and investment rates, the Bank's assistance stratea wiU emphasize the speedy reorganization (including privatization) of the problem banks and beefed-up supervision by the central bank. 1.45 Improving Public Sector Management. Much progress has been made in getting the Government out of a host of activities which more properly belong to the private sector. This process has to continue. But even with the diminished state involvement in the economy, the Government is in many respects incapable of discharging its remnaining functions satisfactorily. This means that the performance of the public service requires significant improvement. Wholesale improvement will be difficult and will take considerable time. The Bank's assistance strategy to institution building will therefore include innovative approaches to creatg a core of public servants capable of managing the economy from policy formulation to program monitoring. External Flnandng Requirenents 1.46 While meeting an increasing percentage of foreign exchange requirements from its own resources, Uganda will, over the medium term, continue to rely on foreign assistance on a significant scale. Annex m.2 presents the estimated financing requirements for the period 1993/94-1995/96. The balance of payments is presented in Annex M. 1. This table shows that the balance of payments is improving but remains fragile. Coffee export earnings declined further, from US$117 million in the previous year to US$104 million in FY93. International coffee prices have picked up recendy to around US$1.20/kg, with beneficial effects on Uga sda's  - 17 - balance of payments, but whether or not these prices would be sustained remains to be seen. With regard to noncoffee exports, the recorded data, which are far from comprehensive, present a picture of stagnation but there is strong anecdotal evidence that noncoffee exports have been growing rapidly. 1.47 Imports have been rather volatile over the past few years, declining in FY92 before picking up again in FY93. The projected financing requirements assume that GDP would grow by about 5 percent per annum over the next few years. On the assumption that a sizeable amount of arrears would be carried forward, Annex m.2 shows that Uganda's FY94 external financing requirements will be fully met. Uganda's FY95 external financing requirements are estimated at US$1,159 million. Available financing consists of US$593 million in export earnings plus private transfers and US$383 million in drawings on existing donor commitments, leaving a financing gap of US$183 million, to which must be added arrears of US$232 million, bringing the overall gap to US$415 million. New commitments of project aid needed to fill this gap would have to be tailored more closely to Uganda's expenditure priorities, especialy in the social sectors, and its ability to adequately fund operations and maintenance expenditures and counterpart fund requirements. With regard to balance of payments support, much greater flexibility is needed to meet Uganda's requirements which are now not so narrowly focused on foreign exchange with which to pay for merchandise imports and related services. The Consultative Group for Uganda is expected to meet again in July 1994 to consider the country's external financing requirements. 1.48 A key issue in addressing Uganda's external financing requirements is the overhang of debt. The total stock of external debt is estimated at US$2.6 billion. Servicing this debt in the face of depressed international coffee prices has posed a serious challenge for the Government. The debt-service ratio remains high for three reasons. First, nearly two thirds of the debt is multilateral debt which cannot be rescheduled. Secondly, the Paris Club cut-off date is June 1981 which severely limits the amount of debt that is eligible for relief. Thirdly, It is only recently that Uganda implemented the decision to borrow only on the most concessional terms. The Government's objective is to normalize relations with its creditors. To this end it has been implementing a six-pronged strategy, with the following elements: year-by-year rescheduling of eligible Paris Club debt; maximum anmnal deferral of post-cut-off debt on a bilateral basis; write- off or long-term rescheduling of arrears and debt owed to non-OECD bilateral creditors; extension of bilateral balance of payments support to multilateral debt service; buy-back of uninsured commercial debt; and cessation of government or government-guaranteed external borrowing on all but the most concessional terms. Implementation of the debt strategy has met with some success. In June 1992 the Paris Club granted Uganda enhanced Toronto terms which it has extended to June 1994. A similar treatment is expected in FY95. Using the Debt Reduction Facility for IDA-Only Countries, Uganda bought back in FY93 US$152 million of uninsured commercial debt (representing 6 percent of the total debt and 63 percent of the commercial debt) at 12 cents on the dollar. IFC and MIGA 1.49 IFC has investments in agro-business (sugar and tea) and in financial services (development banking and insurance). Through the African Enterprise Fund, IFC has supported  - 18- four smaller projects. It has also completed for the Government three advisory assignments covering cotton, telecommunications and the stock market. IFC's priorities are to render further assistance in relation to the privatization process and institution building in the financial sector while continuing its traditional investment role when suitable project opportunities arise. MIGA has also been active in Uganda. It has issued guarantees against the risks of expropriation and war and civil disturbance for a cobalt extraction project and a fish processing project. In addition, MIGA organized a workshop in June 1992 which brought together policy implementors and their private sector counterparts to discuss regulatory rules and procedures which discourage direct foreign investment. Relations with the IMF and other Donors 1.50 The Bank and the IMF have worked closely to monitor the adjustment program and to help the C0vernment design the next phase of reform, particularly with regard to the integration of the foreign exchange markets, improvement of the tax system and the restructuring of the financial system. There is also increased coordination with other donors through the regular local donor representatives meetings. Donor coordination is especially important for the purpose of liberalizing and harmonizing import support disbursement procedures further and prioritizing public expenditure. Representatives of a number of donors participated in the preparation of the credit. Key Issues for Consideration 1.51 Summary Assessment. Uganda has implemented a wide range of macroeconomic and structural adjustment policies since it launched its economic recovery program in May 1987. Most of the important issues relating to the macroeconomic frontier have been successfully dealt with. Also measures have been introduced to address the most important structural impediments to growti and human resource development. Owing mainly to capacity constraints, the implementation of structural reforms in certain key areas (financial sector restructuring, public expenditure prioritization, etc) has been slow. From every indication the Government's commitment to the maintenance of macroeconomic stability is firm. The only caveat Is that the forthcoming parliamentary and presidential elections could test its resolve to pursue prudent macroeconomic policies. On the other hand, its ability to actually implement structural measures in a number of areas will remain limited for some time to come. 1.52 Issues for Board Consideration. The Board may wish to focus on the following issues which are critical to assessing economic and social progress in Uganda: o The maintenance of macroeconomic stability. * Public expenditure prioritization. o The attainment of balance of payments viability. * The achievement of higher rates of saving and investment. 0 Improvements in governance and public administration.  - 19 - Part II. The Second Structural Adjustment Credit 2.1 Against the background of the recent CEM focusing on poverty, the proposed Second Structural Adjustment Credit has as its theme poverty reduction through accelerated economic growth and rapid human resource development. To that end it will assist the Governmenw to achieve the following key objectives: further deregulation of the economy, focusing on liberalization of the cotton and coffee subsectors; completion of the divestiture of the Custodian Board properties; further improvement in revenue generation; prioritization of public expenditure; and raising efficiency in the civil service. The following sections describe the main components of the credit. The reform program is presented in a policy matrix in Annex HI. A. The Regulatory and Business Climate 2.2 The regulatory and business climate has greatly improved over the past five years. This has come about as a result of the following actions: import and export licensing was eliminated; except for a handful of items, import prohibitions were lifted; price controls have been abolished; export monopolies have been eliminated; a new Investment Code was introduced and the Uganda Investment Authority created to administer the Code; the restrictive Industrial Licensing Act was repealed; the exchange and payments system has been nearly fully liberalized; and for all exports the requirement that export proceeds be surrendered to the central bank was eliminated. 2.3 In spite of the above actions, regulatory barriers still hold back private sector activity in certain areas. Removing these barriers will involve, in the main, legislative and institutional changes. The key issues which form the basis of the program being supported by SAC IH are discussed below. 2.4 Further Liberalization of the Coffee Subsector. The opening up of coffee exports to private traders, with the support of ASAC, has had important beneficial effects on the economy. To start with, the availability of crop financing has ceased to be a problem since financing is now provided by the traders, their foreign principals or local banks, or some combination of these three, rather than by the central bank. Moreover, owing to increased competition for the crop, farmers are receiving prompt payment and somewhat higher prices in spite of low world prices. Consequently, they are showing renewed interest in replanting old coffee bushes, especially with clonal varieties. The Government has decided to reinforce this positive trend by removing the remaining barriers to the coffee trade. In January 1994 it removed the restriction on the method by which exporters can sell coffee. Before then exporters were not allowed to sell coffee by any method other than by tender, unless the, transaction was prefinanced. At the same time the Government lifted the ban on road transport of coffee to the sea ports. This ban had meant that all coffee had move to the coast by rail. In theory, the Government could have issued permits for road transport of coffee when the Uganda Railways Corporation (URC) proved incapable of meeting demand from coffee exporters but no such permits were issued. The result was that URC had a complete monopoly on the transport of coffee to the ports. At the peak of the coffee season URC had been known to let exporters down by failing to move coffee to the ports in time to meet delivery dates. The Government has also begun to deal with another restraint on the coffee trade; that is, the floor price mechanism which allows the Uganda Coffee Development Authority (UCDA) to fix minimum export prices below which traders cannot sell coffee. Given real competition in domestic procurement of coffee and a very liberal exchange and payments  - 20 - system, there is no longer any justification for the floor price mechanism. The Government will, as a condition of second tranche release, abolish the floor price mechanism. In the meantime the Government, in consultation with the private exporters, revised the formula used to calculate the export floor price and started to announce the export floor price before 10:00 a.m. each day. To give exporters some flexibility in their marketing decisions, the announced floor price is kept a few US cents per pound below the price given by the formula. The Government also amended the UCDA Statute to restructure the UCDA and eliminate licensing of exporters. Prior to the amendment the Minister responsible for Trade and Industry appointed all the members of the UCDA Board of Directors, most of whom were civil servants. The new membership of the Board is more representative of the industry. The ultimate goal is to turn the UCDA into an industry-based organization. Licensing was abolished because it had served as barrier to entry into the coffee export business. In place of licensing the Government will, by regulations made under the UCDA Statute, introduce a system of registration under which an exporter will pay a registration fee and post a performance bond prior to commencing business. Issuance of these regulations is a condition of credit effectiveness. The Government will also change UCDA's role in export quality control to the training of coffee graders and monitoring of quality. Actual quality control will be the responsibility of the coffee processors. As a condition of eredit effectiveness the procedures governing the delegation of quality control authority to the processors will also be laid down through regulations made under the UCDA Statute. 2.5 Since 1990 the Coffee Marketing Board Limited (CMBL) has operated in a competitive environment. Still, the Government wants to ensure that CMBL does not squander the considerable assets (estimated at U Sh 67 billion) that it accumulated as a parastatal. These assets include warehouses in Mombasa, real estate in Kampala and the Bugolobi coffee processing plant. CMBL has suffered a heavy loss of market share (down to 40 percent compared to 100 percent three years ago) without a commensurate reduction in its overheads. As a result, its coffee trading activity is now effectively subsidized with profits from other activities, especially coffee processing at Bugolobi. CMBL needs to disengage from unprofitable activities which have necessitated cross-subsidies in its operations. The Government's medium-term objective for CMBL is to privatize it. 2.6 Liberalization and Revitalization of the Cotton Subsector. In the 1960s and early 1970s, Uganda derived up to 25 percent of its foreign exchange earnings from cotton. The political, military and economic turmoil that engulfed the country between 1972 and 1986 was accompanied by a sharp decline of the cotton industry. The seed multiplication system collapsed and, with the rapidly declining crop size, seed for replanting became increasingly scarce. In the scramble for seed in the northern growing areas, the seed cotton and planting seed for the two varieties, SATU and BPA, became mixed, with the result that some of the characteristics that earned Ugandan lint a premium on the international market were lost. Not only was seed in short supply but mandatory seed dressing with cuprous oxide to prevent bacterial blight was not done or was not done properly, leading to the breakdown of genetic resistance of both SATU and BPA to the disease. Moreover, the SATU-growing areas of the northeast which depended on work oxen to prepare land for cotton lost almost all the animals as a result of the civil wars and cattle raiding. Moreover, the late 1960s cotton ginning had become the monopoly of the cooperative unions while the Lint Marketing Board (LMB) was granted a complete monopoly of the cotton lint and cotton seed trade.  -21 - 2.7 For a variety of reasons, including political interference, management standards in the cooperative unions and LMB deteriorated drastically. At present all but four or five of the eighteen cooperative unions are insolvent or nearly so. Another prime cause of their insolvency is the heavy burden of debt that they owe to the Cooperative Bank, the Uganda Commercial Bank and LMB. The bulk of the debt was incurred for the purpose of rehabilitating the ginneries, but in most instances the work was never completed. LMB Is also indebted to foreign buyers of cotton for failing to honor supply contracts. The management and financial difficulties of the unions and LMB led to a complete erosion of two of the key factors responsible for the earlier rapid expansion of cotton output namely, ease of marketing the crop at the village level and the reliability and promptness of payment. By the 1990191 season production had fallen from a peak of 467,000 bales in the early 1970s to 46,000 bales which accounted for about 6 percent of foreign exchange earnings. In the absence of a striking improvement in these two areas namely, ease of marketing seed cotton and promptness of payment, no dramatic production increases can be expected. Recent efforts to revive the crop without addressing these issues testify to this; production has increased to only 65,000 in the 1992/93 season. 2.8 The Govermment has initiated actions aimed at improving the policy and institutional framework relating to cotton production, ginning and marketing. It recently removed, de facto, the LMB's export monopoly by granting export licenses to four cooperative unions. In addition, some unions have started negotiating to sell or lease their ginneries to private investors. However, further measures are needed to foster competition in ginning and marketing of cotton. In this regard, the parliament enacted the Cotton Development Statute in January 1994; the Statute was amended in April 1994 to remove the provision which empowered the Minister to acquire a ginnery in the national interest. Among other things, this Statute abolished the unions' monopoly over cotton ginning and LMB's monopoly over cotton exports; eliminated licensing and other regulatory barriers; and established a new organization, the Cotton Development Organization, whose main fiucdon is to regulate and organize cotton seed production, dressing and distribution. It is the Government's intendon to turn the Cotton Development Organization (CDO) into an industry-based organization as soon as the industry is strong enough to perform the relevant functions. 2.9 The revitalization of the ginning industry is critical to restoring a reliable, easy and prompt payments system at the farm level. This requires the emergence of ginneries which are under competent management and are controlled by creditworthy operators. This in turn would mean alliances between private investors and the cooperative unions for the purpose of rehabilitating existing ginneries, or green-field investments in ginneries by private investors. In principle, joint ventures between the unions and private operators offer the best prospect of revitalizing the ginning industry in the short to medium term. However, the large overhang of ginnery rehabilitation loans constitutes a serious impediment to the striking of such alliances between the unions and private investors. The debts originated from ADB and IDA loans which the Government passed on to UCB and the Coop Bank which in turn on-lent the funds to the unions. These loans, which were instrument in creating the present installed ginning capacity of 400,000 bales of cotton, are now nonperforming assets in the books of the two banks. Rather than wait for these bad loans to be dealt with under the Nonperforming Loans Recovery Trust to be set up under FSAC, the Government has decided to use the nonperforming ginnery rehabilitation loans as leverage over the unions to facilitate the striking of business alliances between the unions and private investors. The plan is' this: the Govermnent, together with the  -22 - Coop Bank and UCB, would enter into a business cum debt restructuring arrangement with any union which is ready to reorganize its ginning operations. For its part, the Government would, if requested, provide a union with technical assistance in preparing a business plan designed to restore financial viability within the medium term. Based on an acceptable business plan, the Government would agree to substantially write down the union's outstanding debt, subject to the union meeting certain benchmarks. 2.10 In November 1993 the Government notified the unions and the creditor banks of the proposed arrangements for the restructuring of each union's ginnery business, which would provide the basis for debt relief for the unions. The banks and interested unions have already signified their acceptance of the Government's proposals. To prepare the way for the restructuring and debt relief the Government has, with the assistance of a firm of auditors recalculated each union's debt to the banks and LMB and the fair market value of the ginneries. As a condition of second tranche release the Government will take all necessary measures to facilitate the transfer, by way of outright sale, lease, management or by restructuring, of ginneries with installed capacity of at least 100,000 bales to creditworthy and viable operators (see paragraph 20 of the Letter of Development Policy). 2.11 Review of the Investment Code. The Investment Code, 1991, was brought into effect in January, 1991 after having gone through a fairly long period of gestation during the latter part of the 1980s when the economic policy environment was still very restrictive. The main objectives of the Code are to provide favorable conditions for investment and to establish the Uganda Investment Authority (UIA) to promote, facilitate and monitor investments and to advise the Government on investment promotion policies. The establishment of the UIA and the abolition of the Industrial Licensing Act 1969 were among the measures supported by SAC I. 2.12 The Government has had three years of experience implementing the provisions of the Investment Code. This experience has brought out a number of issues which need to be studied and appropriate actions taken where necessary. As presently structured, the fiscal incentives provided under the Code (tax holidays and exemptions from customs duty and import sales tax) pose the danger of undermining the Government's efforts aimed at stepping up domestic revenue mobilization. In addition to having a negative revenue impact, the Investment Code creates a bias against labor and distorts effective rates of protection by providing duty-free access to plant and machinery. Moreover, there are grounds for concern about the ambitions of the Uganda Investment Authority: it has plans to establish industrial estates and construct a headquarters building for its own use and for lease. Furthermore, the UIA's style of vetting of investment applications is so bureaucratic as to border on licensing. The Government has therefore agreed with IDA to carry out the review of the Investment Code and UIA's activities, which will take into account the regional context within which Uganda must operate. Terms of reference for the study have been agreed with IDA and consultants have been invited to submit proposals. Signing of the contract with the consultants selected to carry out the study is a condition of credit effectiveness, As a condition of second tranche release the Government will consider, in consultation with IDA, the recommendations arising from the study. 2.13 Decontrol of Petroleum Product Prices. Since FY89 the Government has implemented fill pass-through of import and local costs of petroleum products. It has also taxed petroleum heavily to encourage efficient use. In the case of kerosene, no firther increases in taxation are  - 23 - now contemplated, as it Is a preferred substitute for fuelwood. However, the Government maintained price controls on petroleum products long after all other price controls had been abolished. Given the liberal economic environment that prevails in the country the Government finally lifted the controls on the prices of petroleum products with effect from January 1, 1994. B. Divestiture of the Custodian Board Properties 2.14 In August 1972 Idi Amin expelled large numbers of Asians from the country by canceling their entry permits and certificates of residence. By Decree No. 27 of 1973, the Assets of Departed Asians Decree, Amin vested the properties of the departed Asians in the Government and created the Departed Asians Property Custodian Board (DAPCB) to administer the properties. Furthermore, by the Properties and Businesses (Acquisition) Decree of 1975 (Decree 11 of 1975) Amin nationalized 53 properties and businesses. After the overthrow of the Amin regime Parliarm1ent passed the Expropriated Properties Act of 1982 (Act No. 9 of 1982), whose main object is the return of the properties to the former owners. However, for a long time, the lack of political will and the power of vested interests precluded any serious effort being made to return the properties to the owners. 2.15 Things have changed radically over the past three years. In 1991 the Government launched a serious effort to return the properties to the owners. The results have been impressive. Of the original 686 noncitizen claims for repossession of properties, 640 were found to be supported by the requisite documentation and the properties were accordingly returned to the owners. In the case of citizen claims, over 2,000 claims have been received by the Custodian Board, of which about 1,860 met the documentation requirements and were approved and the properties returned to the owners. 2.16 The return of a large number of expropriated properties to the owners is one of the most powerfil signals that the Government has given investors that Uganda respects property rights and is serious about attracting investment. A number of the properties returned have already undergone, or are undergoing, major rehabilitation. The Government has now embarked upon the final phase of divestiture of the Custodian Board properties. To aid this process, a local consultant prepared a report which clarifies many of the legal issues pertaining to the properties. 2.17 The final phase of divestiture involves a combination of repossession, compensation, sale and reversion of the properties to the landlords. With regard to repossession the Government issued in May 1993 a notice to all claimants, including those who had applied for compensation, inviting them to repossess their properties. In terms of this notice the deadline for filing claims for repossession was October 30, 1993. The properties remaining unclaimed after that date will be disposed of in accordance with the law. 2.18 Repossession. Once the October 30, 1993 deadline for making claims for repossession passed the Government moved swiftly to complete the repossession exercise. All the citizen and noncitizen properties with valid repossession claims have now been returned to the owners. At the request of would-be repossessors, the Government has given ciaimants whose documents are incomplete up to the end of April 1994 to furnish the missing documents to the Custodian Board, falling which their claims would be dismissed.  - 24- 2.19 Dbposal of Unclaimed Properties by Exercise of landlords' Reversionary Interats. One of the cardinal points of the law pertaining to the Custodian Board properties is that citizen properties are not covered by the Expropriated Properties Act. The Government could conceivably take over the properties remaining unclaimed after the October 30, 1993 deadline for making claims by invoking the principle of bona vacantia, i.e. goods without an owner. The Government has decided not to follow this approach. Rather it decided to allow the unclaimed properties which did not vest in the state to revert to the controlling authorities (i.e. urban and town councils) and other landlords. Accordingly, the Government announced in January 1994 that the controlling authorities and other landlords are free to exercise their reversionary interests in all the remaining unclaimed properties that are not covered by the Expropriated Properties Act. To aid the process of reversion, as well as the sale of properties and the settlement of noncitizen compensation claims, the Government classified the remaining properties into citizen and noncitizen properties. 2.20 Disposal of Properties by Sale. As required under Section 8 of the Expropriated Properties Act, the Government must issue an Order to give notice of its decision to sell or otherwise dispose of the unclaimed noncidzen properties, including those for which compensation cla-rms are pending. Moreover, the properties to be sold must be gazetted and a Board of Valuers appointed as required by Section 11 of the Regulations. The Government issued the Order to sell in January 1994. It also gazetted the properties to be sold and appointed the Board of Valuers. 2.21 Properties will be sold by competitive tender. Prospective buyers will have 30 days within which to submit sealed bids. A 10 percent deposit will accompany each bid. Once a winning bid has been announced the buyer will have 60 days within which to pay. Properties may be offered for sale in lots. Properties that remain unsold after baving been offered for sale may be re-offered for sale a second time or allowed to revert to the controlling authority or landlord, as is the case with citizen properties. The Govement has agreed with IDA on the procedures that will govern sales of the properties. As a condition of second tranche release the Government will offer for sale all the properties covered by the 1982 Expropriated Properties Act that have not been claimed by the owners or for which compensation claims are pending, taking into account prevailing market conditions. The proceeds of sale of noncitizen properties 'which are not the subject of compensation claims will be deposited into the Divestiture Account and will be used to setde any other compensation claims against the Custodian Board. 2.22 Settlement of Compensation Clims. The Expropriated Properties Act does not specifically provide for application for compensation but at the time the law came into force a total of about 1,700 owners actually applied for compensation rather than repossession. At any rate, in terms of Sub-section (1) of Section 11 of the Act, the Government is liable to pay compensation to noncitizens who choose not to apply for repossession. The Government accepts the obligation to pay compensation. Its policy is that the proceeds of sale of noncitizen properties which are the subject of compensation claims, less a deduction of not more than 5 percent to cover sales expenses, will be remitted to the claimant. Every effort will be made to remit the proceeds of sale to the claimant within 90 days, once he/she has provided the necessary address and account particulars. The Government has developed and announced the detailed procedures that will govern the setdement of compensation claims.  - 25 - 2.23 Management of the Divestiture Program. In view of the fast-dwindling revenue base of the Custodian Board in tandem with repossession and given the fact that the distinction between citizen and noncitizen properties is now largely irrelevant to the repossession exercise, the Government replaced the Verification Committee and the Executive Committee by a small committee of four members. Prior to this change the annnual bill for the two committees ran as high as U Sh 136 million, a cost which the Custodian Board could ill-afford. The Government has taken other measures to control costs at the Custodian Board. It will continue to downsize the Custodian Board to reflect the reduced level of activity. C. Domestic Revenue Mobilization 2.24 Over the past few years the Government has taken a number of measures to bolster revenue generation. It has tried to exploit most of the available tax bases to the maximum. Thus, it has levied high rates of tax on the two products (beer and cigarettes) for which demand is fairly inelastic and raised tariffs on petroleum products to a very high level. Super petrol is taxed at 175 percent, diesel at 130 percent and kerosene at 90 percent. In view of the fact that kerosene is an environmentally preferred substitute for fuelwood, no further increase in the rate of tax on this product is contemplated. Attempts have also been made to broaden the tax base, as illustrated by the enforcement of the commercial transactions levy and the Imposition of the rental income tax. Furthermore, with assistance from the IMF, IDA and ODA, the Government has devoted a great deal of effort to improving tax administration, culminating in the establishment of the Uganda Revenue Authority (URA) in 1991. In spite of these and other actions the tax base remains narrow and tax administration is still in need of improvement. The ratio of revenue to GDP increased from 5.8 percent in FY88 to only 7.2 percent in FY93. That the tax base is very narrow is shown by the fact that almost 50 percent of total revenue comes from just four products namely, petroleum, beer, cigarettes and soft drinks. The challenge is to broaden the tax base significantly while continuing to improve tax administration and bringing tax rates down in an effort to improve taxpayer compliance. 2.25 Broadening the Tax Base. The Government has continued its efforts to broaden the tax base, as shown by the revenue measures introduced in FY94. The key measures that were passed in FY94 are: o more effective taxation of rental income from real estate at a rate of 20 percent on 80 percent of gross rent in excess of U Sh 840,000 per annum, regardless of the age of the property; o elimination of the customs duty exemption provided under the Investment Code for construction materials; * reimposition of a minimum 10 percent customs tariff on raw materials; * imposition of a 10 percent customs duty on agricultural inputs, excluding fertilizers, pesticides and seeds; a elimination of the tax-free status enjoyed by the army shop;  -26- o outright exclusion of certain goods (mineral waters, alcoholic beverages, tobacco products, motor vehicles of a cylinder capacity of 2,000 c.c. and above etc) from eligibility for exemptions except where bilateral/multilateral agreements apply. 2.26 lRationalizing the Tax Structure. The FY94 budget session of parliament also saw a number of measures aimed at rationalizing the tax structure and improving the yield of various taxes adopted. With regard to income tax these were the key changes: the Government brought all employment benefits and allowances into the tax net; increased the personal income tax threshold from U Sh 600,000 to U Sh 840,000 per annum; lowered the top marginal rate from 40 percent to 30 percent on personal incomes above U Sh 4.2 million; reduced the number of personal tax brackets from four to three; and reduced the rate of corporation tax from 35 to 30 percent. The sales tax on domestic goods as well as imports was simplified to four rates (0, 10, 20 and 30 percent) compared to the previous rate structure with a top rate of 100 percent. The Government plans to move to a Value Added Tax (VAT) in the medium term. The customs tariffs were rationalized by elimiating the two top rates of the present six-rate structure comprising 0, 10, 20, 30, 40, and 50 percent. The Govemment hiked the excise tax rates from 50 to 80-100 percent on cigarettes and 80 percent on beer, and from 30 percent to 50 percent on soft drinks. It also raised the maximum graduated tax (a local government tax) from U Sh 40,000 to U Sh 80,000 per annum. 2.27 Improving Tax Administration. With the establishment of the URA, the institutional framework for much more effective tax administration is in place. The URA now has the full complement of tenior managers; it pays salaries which are very generous by civil service standards; and it is reasonably well supplied with motor vehicles and other equipment. Against this background, the URA is inteDsifying its efforts to improve revenue collection. One of the factors hampering these efforts has been lack of a proper valuation system for imports procured with funds secured through the foreign exchange bureaus. With effect from August 1, 1993 the Government extended preshipment inspection to all imports valued above US$2,500 compared to US$5,000 previously. This should facilitate the valuation of imports for customs purposes and bolster customs revenue collection. 2.28 The absence of a comprehensive taxpayer identification system has also impacted adversely on revenue collection. URA needs such a database to be able to monitor systematically and in a timely manner the status of each taxpayer's account; i.e. to determine whether or not a return has been filed, an assessment made, tax due paid or is in arrears, penalties and interest have been applied etc. Moreover, a comprehensive taxpayer database is needed to facilitate the exchange of taxpayer information between one tax department and another. To address this problem URA has initiated actions to create a comprehensive taxpayer database and develop and install a system for assigning each taxpayer a permanent identification number. So far over 10,000 taxpayer identification numbers (TINs) have been generated and assigned to limited liability companies. In addition, personal TINs have been created for all government employees. The Government intends to complete the assignment of TINs to existing limited liability companies and individual taxpayers by October 1994.  -27 - 2.29 Tax Policy Formulation. The Ministry of Finance and Economic Planning needs a strong capacity to formulate tax policies. Such a capacity is needed to continue the process of broadening the tax base, rationalizing the tax structure and making the tax system simpler, more efficient, equitable and stable. The Government is reviewing the structure and staffing of the Tax Policy Unit in MFEP with a view to strengthening it. The unit is expected to be restructured and properly staffed by the end of FY94. D. Public Expenditure Prioritization 2.30 In FY91 the Government began a process of expenditure prioritization, starting with the recurrent budget. It identified primary education, primary health care, water supply, agricultural research and extension, and road maintenance as high priority programs. The selected programs were to receive substantial real increases in allocations in successive budgets. The allocations in turn were to be protected from expenditure cuts when revenue collection fell short of the approved estimate. In effect, the high priority programs were to benefit from automatic releases of funds by the Treasury during the fiscal year. 2.31 The above approach to expenditure prioritization has had a measure of success. The designated programs have benefitted from increased budget allocations and, except for the difficulties experienced in the final quarter of FY92, allocations have been protected from cuts and releases made automatically. As a result, the repetitive budgeting that flows from revenue shortfalls is confined to programs that are not protected. This makes the task of budget management easier. 2.32 Prioritizing Recurrent Expenditure. With effect from FY94 the Government expanded the list of high priority recurrent expenditure programs to include the Police Service, Justice and the Judiciary, the Office of the Auditor General and Office of the Inspector General of Government. The Government's policy is to continue to channel more resources into the high priority programs, particularly those which provide basic social services. Allocations for the high priority recurrent programs would be made after taking care of the following items which have first call on resources: wages, interest, amortization, domestic arrears, statutory expenditure, funding for the URA and counterpart funds for the core development budget. Against all the competing demands, the Government decided to channel about 60 percent (U Sh 11 billion) of the net incremental resources towards boosting spending on the high priority programs in the FY94 budget, to a total of U Sh 67.0 billion. In reflection of this, the share of the high priority programs in total resources after satisfying the first-catl demands on the budget would increase to 41 percent from 39 percent in the previous year. As a condition of second tranche release the Government will release all the agreed recurrent budget allocations for the high priority programs in FY94 and for FY95 agree with IDA on the level and composition of nonwage recurrent expenditure. 2.33 Rationalizing the Development Budget. Just as with recurrent expenditure, the Government has tended to spread its limited resources and implementation capacity thinly over a large number of development projects, some of doubtfil economic value. The shortage of counterpart funds to support donor projects and the slow implementation of projects strongly suggest that the development budget has grown too big. The development budget is also too large in relation to the recurrent budget. Also, insufficient consideration is being given to the  - 28 - recurrent cost implications of new projects. Moreover, many projects do not fit into the Government's highest expenditure priorities namely, provision of essential infrastructure and more rapid development of human resources. Accordingly, the Government has decided that, in a time of extreme scarcity of resources, it should concentrate on its core functions of: a providing basic social services (basic education, basic health and water supply) with broad impact; e providing basic economic infrastructure (roads, with emphasis on feeder roads, agricultural research, extension and disease control); a protecting the environment; and o mainting law and order. 2.34 In line with the above criteria, the development budget was divided into core and noncore projects in FY94. The core projects, numbering 160, are to receive full conerpart funding. The total FY94 allocation for government counterpart funds is U Sh 42.7 billion, of which U Sh 33.2 billion will be for the support of core projects. The balance of U Sh 9.5 billion will support a large nunber of noncore projects, many of which will receive only minimal releases of counterpart fiuds or none at all, and will therefore proceed at a slow pace or even come to a saundstill. For this reason, it is necessary that, with effect from FY95, the Government work closely with the donors to start the process of terminating projects which no longer fit into its development priorities. As a condition of second tranche release the Government will release in full the FY94 counterpart allocations for the core projects and for FY95 agree with IDA on the level and composition of the development budget. 2.35 Salay Enha t. Remuneration within the civil service continues to be characterized by extremely low levels of basic pay combined with an inequitably distributed array of allowances and nonmonetary benefits. Government has endorsed the recommendations of the Public Service Review and Reorganization Commission (PSRRC) for improving the transparency and equity of the remuneration structure and committed itself to a staged progression towards a level of total emoluments that is commensurate with the qualifications, experience and responsibilities of serving officers, subject to its own budget constraint. It recognizes that the introduction of a significant real increase in the level of civil service emoluments is essential to the attraction, retention and motivation of suitably qualified personnel. Accordingly, it has increased the wage bill by 42 percent, from U Sh 62.5 billion in the previous year to U Sh 89 billion in FY94. This in turn has meant that the share of wages and salaries in total noninterest recurrent expenditure has gone up to 27 percent in FY94 compared to 25 percent last year and 22 percent in FY91. Owing to the low levels of civil service pay, reductions in the workforce do not provide sufficient budgetary savings to underwrite large increases in wages and salaries. 2.36 The bulk of the incremental resources available for civil service wages in FY94 (U Sh 20 billion out of U Sh 26.5 billion) were used to improve salaries in the teaching service. As a result, the salary of the lowest tained teacher on the U7 scale has roughly doubled to U Sh 35,000 per month while that of his or her counterpart on U7 in the traditional civil service has risen by only 19 percent. The Government gave the teachers preferential treatment becaume it  -29 - is keen to bring about early Improvements in education. It was, however, necessary to delay the payment of the new salaries (not just for teachers but for all civil servants) until October 1, 1993 in order to give the Ministry of Public Service time to remove overdue leavers and audit the payroll of more schools and eliminate duplicate names and ghost teachers from the payroll. Preliminary results show that the Government has succeeded in removing from the teaching service payroll a large number of teachers, most of them ghost teachers. Thus the number of teachers on the payroll shrank by 15,417 between June and September 1993; based on the new U7 teacher's salary, this would translate into budgetary savings of U Sh 6.5 billion (which is equivalent to US$6.21 million) in a full year. Agreement with IDA on the FY95 wage bill and Its distribution will be a condition of second tranche release. E. Civil Sevice Reform 2.37 The policy framework for civil service reform is derived from the analysis and recommendations of the PSRRC which were presented to the Government in September 1990. Government reviewed the report and responded through Sessional Paper No. 1 of 1992 which defines the policy framework for civil service reform. The primary objective of civil service reform is to strengthen Government's capacity to deliver services to the people. That means that reform measures must foster the development of service delivery systems that are cost-effective and affordable within the resource constraints facing Government. The key issues in civil service reform are rationalization and downsizing of the service; reform of remuneration policy and payroll administration; restructuring of ministries and decentralization of governmental functions; and development and introduction of improved personnel management systems. 2.38 Rationalizing and Downsizing the Civil Service. The total number of ministries and self-accounting departments and offices was re-luced through consolidation from 34 to 21. From FY89 a number of actions have been taken to reduce the numbers of civil servants. These actions include: the elimination of about 40,000 ghost workers from the civil service payroll following the reintroduction of a computerized payroll for the traditional civil service based on verified staff lists; a reduction of the number of group (or temporary) employees from 110,000 to 44,000; and retrenchment of 6,339 established civil servants in June 1992, followed by the layoff of another 7,469 civil servants in July 1993. All the retrenchees have been paid their severance package which was more attractive than current pension benefits. A selective hiring freeze has been in effect for a number of years. However, the freeze has not been entirely effective in controlling staffing levels as new hiring appears to have offset some of the retrenchment that has occurred. 2.39 Over the past year the Government has achieved a furither substantial reduction in the size of the civil service. This was done largely through cleaning up the teachers payroll and sharply reducing the number of group or "temporary' employees. introducing a voluntary redundancy scheme. The number of teachers was reduced from 115,912 in June to 100,495 in September 1993. In the same period the number of group employees was cut by nearly 16,000. The Government's intention is to absorb up to 13,000 of the remaining group employees into the traditional civil service and abolish this category of staff altogether. The Government has already introduced a voluntary redundancy scheme which is expected to lead to the separation of another 10,000 or more civil servants. The scheme includes safeguards against Government losing most of its skilled manpower. Trimming the Government workforce is a necessary step towards rationalizing the payroll and setting the stage for payment of a living wage. However, this effort  - 30 - has to be complemented by measures to address the payroll management problem. In this regard, the Government must accelerate the development and installation of establishment, staffing and payroll control systems that offer protection against corruption of databases. In this way MPS would be in a position to ensure that civil servants who have been laid off are no longer on the payroll and ghost workers do not reemerge. 2.40 Monetization of Benefits. The purpose of monetization is to make fully transparent the present composition anid value of the remuneration package as a first step towards reform of the overall structure of pay and emoluments. Monetization of benefits will contribute to efficiency by reducing the overhead costs associated with the procurement, allocation, repair and maintenance of houses and vehicles. It will also make the remuneration structure more transparent. Monetization of benefits is not to be confused with salary enhancement; it is just the cash commutation of an existing benefit as defined in the Unified Terms and Conditions of Service of the Uganda Public Service. These state, for exanple, that a civil servant will receive a housing allowance equivalent to 40 percent of basic salary. The cash value of this allowance falls far short of what is needed to meet housing costs under current market conditions but the inadequacy of the allowance derives from the low level of basic salaries. As part of the process of monetization of benefits, all cash allowances should be consolidated into a single salary that comprises the total remuneration of a civil servant. The existing overall salary structure for the civil service is characterized by excessive compression, particularly in the middle ranges of the professional and management cadres, and by extensive anomalies within and across ministries and services. Reform of the existing salary structure should follow the monetization of benefits. 2.41 The Government has decided to divest itself of pool houses allocated mainly to senior civil servants (but not institutional housing units allocated mainly to staff of the police, prisons, teaching and health services). Civil servants occupying pool houses are to be given the option of first refusal to buy the houses. The Government has also decided to abolish the transport benefit which involves: (i) transfer, under the co-ownership scheme, of a government vehicle to senior civil servants at a fraction (10 percent) of the cost, together with a fuel allowance of up to U Sh 500,000 per month; (ii) allocation of official vehicles for personal use; and (iii) allocation of pool vehicles to transport staff to and from work. In January 1994 the Government terminated the vehicle co-ownership scheme. The Government has also prepared and agreed with IDA an implementation plan for the divestiture of the pool houses, and "personal use" and pool vehicles. The monetization of the housing benefit (except for those accommodated in institutional housing), if done in accordance with the existing terms and conditions of service, would mean that the basic pay of eligible civil servants would be increased by 40 percent. Continued progress towards the replacement of the housing and transport benefits with cash payments and satisfactory progress towards the disposal of pool houses, personal vehicles and pool vehicles (except for a limited number of office-holders who are entitled to government housing and transport) will be j condition of second tranche release. The pace of monetization of the housing and transport benefits will be determined by the incremental resources that are available for wages and salaries. In applying the additional resources that will be available for wages in FY95, the Government will give priority to the monetization of benefits. Since the salary structure that will emerge from the monetization exercise will look unduly compressed the Government will have to move quicldy to decompress this structure in order not to penalize those in the skilled and professional categories.  - 31 - 2.42 Mnisterial Restructuring and Decentralization. A key aspect of civil service reform is ministerial restructuring. Assessments of the functions and staffing of ten ministries have been completed and the Government endorsed proposals for restructuring five of these ministries. However, on closer examination, it became apparent that the functions and total establishment recommended for the first ten ministries for which reviews had been completed do not adequately reflect the liberalized economic environment and the severe resource constraints facing the Government. In view of this the Government decided to carry out additional assessments, taking into account decentralization initiatives underway, with a view to cutting out noncore functions and activities and revising the staffing rationalization plans for the following ministries for which reviews had been completed: Agriculture, Animal Industry and Fisheries; Trade and Industry; Works, Transport and Communications; Natural Resources. (he terms of reference for the remaining seven ministries/offices were amended to include a more rigorous examination of the functions and activities and preparation of an implementation plan). The Government then decided on the noncore functions and activities from which the Ministries of Agriculture, Trade, Works and Natural Resources will disengage as well as on staffing levels commensurate with the redefined role of these ministries. Elimination of the noncore functions and implementation of the first-stage (i.e prior-to-decentralization) staffing rationalization plans for the ministries of Agriculture, Trade, Works and Natural Resources as agreed with IDA will be a nditiono second tranche release. 2.43 The Government has initiated decentralization of administrative authorities and responsibilities to the district level. Conceptually, the central headquarters functions will be reduced to policy formulation, planning, inspection and the management of national programs. The framework for implementing the decentralization policy is outlined in the restructuring assessments of the ministries but more detail, together with a fuller costing, is needed before the budgetary impact of this policy can be assessed realistically. What is certain is that decentralization will be costly in terms of developing the physical infrastructure at the district level and, for some functions, in terms of staffing requirements. As the practical details of decentralization are worked out there will be a need to reassess the core functions and activities of the central ministries vis-a-vis the districts. Implementation of the decentralization policy has started on a pilot basis in PY94, with thirteen districts allotted separate budget votes covering recurrent expenditure. 2.44 Improved Personnel Management and Establishment Control. The development and introduction of improved systems for personnel and payroll management are essential elements of the reform program. Efforts to develop a computerized personnel and payroll database were initiated in FY89. The principal operational legacy of these earlier efforts is the computerized payroll system for the traditional civil service, the police service and the prisons service. The Establishment and Staff Control System (ESCS), developed in MPS for the teaching service and made operational in February 1993, represents a more comprehensive attempt to develop an integrated personnel and payroll records system. The system is being used to establish control over the teaching service payroll, by among other things, identifying and removing ghost teachers from the payroll. The extension of ESCS to the traditional civil service is in progress, and, reinforced by audit and verification procedures now being installed, will establish MPS control over staffing levels and payroll changes in the various services. Another problem facing the civil service is the breakdown of the system of staff performance evaluation. This is an issue that needs to be addressed.  - 32 - Part I. Ihe Proposed Credit A. Credit Amount and Expected Cofinandng 3.1 The borrower is the Republic of Uganda. The borrower's program of reforms to be supported by the credit are set out in the Letter of Development Policy (LODP) in Annex I. The IDA credit amount is SDR 57.8 million (US$ 80 million equivalent). Ihe credit would start to disburse in FY94 but it will meet the bulk of Uganda's import finncing gap for FY95. Additional Import financing for the program to be supported by the proposed credit is expected from the EEC, African Development Fund, ODA (UK), the Netherlands, Japan and USAID. The proposed credit amount compares with US$125 million for SAC I and US$100 million for PSAC, representing a continuing decline in quick-disbursing commitments by IDA. B. Tranching 3.2 The proposed credit will be disbursed in two tranches of approximately equal amounts. The first tranche will be available upon credit effectiveness. The second tranche would become available about nine months later, subject to satisfactory Implementation of the adjustment program and fulfillment of the specific conditions for second tranche release. The program supported by the credit is expected to be completed by June 1995 and the credit will close by December 1995. C. Disbursement 3.3 The proceeds of the credit will be used to finance general imports, subject to a negative list, and will be disbursed on a reimbursement rather than a replenishment basis. Expenditures for goods procured under conuuct costing less than US$2,500 or its equivalent will not financed under the credit. Procurement of goods costing less than US$500,000 or its equivalent may be done on the basis of statements of expenditure. The Government has put in place a system which generates the documentation required for reimbursement of prior foreign exchange expenditures financed through the commercial banks and the bureaus. The documentation to be submitted to IDA to justify expenditures out of the proceeds of the credit includes Form E, the customs biUl of entry and the final invoice, and where post-payment is involved, evidence of payment. The new disbursement procedures were introduced in the context of the unified interbank foreign exchange market which became operational on November 1, 1993. A number of reforms have accompanied the introduction of the interbank market. These include: the delegation of more powers to authorized foreign exchange dealers; the application of a uniform set of regulations to the commercial banks and the bureaus; and the transfer of transactions relating to oil imports and coffee exports from the Bank of Uganda to the interbank market. With the implementation of the interbank market the Bank of Uganda ceased to auction donor import support funds. D. Procurement 3.4 The credit will finance 100 percent of the foreign exchange cost (c.i.f. Kampala) of general imports, except those on the negative list. Imports procured under contracts of less than US$2,500 will not be financed under the credit. Procurement will follow standard Bank Guidelines. Simplified international competitive bidding will apply to individual import tansactions worth US$2 million or more. Procurement below the ICB threshold by the private sector and parastatals using import support funds conforms with internaionally accepted  - 33 - commercial practice. Government procurement is subject to Tender Board procedures based on competitive bidding which are acceptable to IDA. Procedures exist for ex post review of procurement documentation below and above the ICB threshold. Government continues to use the services of an import inspection firm. 3.5 Financing of petroleum products will be limited to SDR14.5 million. Up to the end of October 1993 the Bank of Uganda allocated foreign exchange administratively at the auction rate to each of the six oil companies operating in Uganda for the procurement of petroleum products. Prom November 1, 1993 individual oil companies have obtained their foreign exchange requirements from the interbank market. The Government has decided in principle to move to ICB for the procurement of petroleum products and is now examining the practicality of such a step. E. Management, Monitoring and Accounts 3.6 Ihe Ministry of Finance and Economic Planning will have overall responsibility for the management of the program. The Government has established a Coordinating Group made up of key staff from the ministries and agencies which will actually carry out the various proposed actions to be supported by the credit. This group has worked closely with IDA staff in the preparation of the credit and will provide the focal point for the implementation of the program. The resident mission will play an important role in program supervision. The Government's capacity to ma=inn adequate records and accounts in respect of quick-disbursing credits has shown some improvement. It is therefore in a better position to comply with the standard covenants relating to accounts and audit reports. F. Conditionality 3.7 Prior to submission of the proposed Credit to the Board, the Government has, inter alia: (a) abolished LMB's monopoly over cotton exports; (b) abolished the cooperative union's monopoly over cotton ginning; (c) agreed on the modalities for restructuring the cotton industry, including transferring a large part of the industry to private ownership; (d) eliminatd licensing of coffee exporters and provided for registration only; (e) restructured the Uganda Coffee Development Authority to increase industry participation; (f) revised the floor pricing formula for coffee exports to introduce greater flexibility for exporters, removed the restriction on method-of-sale for coffee and eliminated the requirement that coffee be transported to port by rail only; (g) removed the controls on pump prices of petroleum products; (h) returned all remaining properties with valid repossession claims to their owners and agreed on procedures for the sale of unclaimed non-citizen properties;  I - 34 - (i) terminated the vehicle co-ownership scheme and agreed with IDA on a plan to divest 'personal use' and pool vehicles; and (j) agreed with IDA on a plan to divest Government "pool" houses. During the implementation of the program to be supported by SAC II the Government of Uganda will pursue appropriate economic and financial policies in the context of an IMF-supported program. In addition to keeping the macroeconomic program on track, the Government will implement a number of actions as conditions of credit effectiveness and second tranche release of the credit. 3.8 Before the Credit becomes effective the Government will: (a) Gazette regulations covering registration of coffee exporters and quality control of coffee exports. (b) Sign a contract with the consultant selected to carry out the UIA study to review the Investment Code and the operations of the UIA. 3.9 Before second tranche release the Government will implement these actions: (a) Abolish the floor price mechanism for coffee exports. (b) Cause all necessary measures to be taken to facilitate the transfer, by way of sale, lease, management or the restructuring, of ginneries with installed capacity of at least 100,000 bales to creditworthy and viable operators. (c) Review, in consultation with IDA, the recommendations of the study relating to the Investment Code and the operations of the Uganda Investment Authority. (d) Take all necessary measures to offer for sale (taking into account market conditions) all properties covered by the 1982 Expropriated Properties Act not claimed by their owners or for which compensation claims are pending. (e) Release all the agreed FY94 budget allocations for the high priority recurrent programs and for the core projects; and for FY95 agree with IDA on the level and composition of the wage bill, nonwage recurrent expenditure and development expenditure. (f) Continue to make progress in replacing transport and housing benefits with cash payments and make satisfactory progress towards the disposal of the pool houses and personal-use and pool vehicles for civil servants other than Judges, Ministers, Deputy Ministers and those entitled to institutional houses; and eliminate the noncore functions and implement the first-stage staffing rationalization plans for the ministries of Agrculture, Trade, Worls and Natural Resources.  - 35 - Part IV. Benefits and Risks A. Benefits 4.1 After a number of years of somewhat uneven progress, Uganda has only very recently become a very strong reforming country. It has achieved macroeconomic stabiliq bait needs to sustain it. It has implemented important structural reforms needed, principally, to spur growth and develop human resources. The credit will support a program designed to deepen the reforms through regulatory and institutional measures. It will contribute towards maintenance of macroeconomic stability by generating local currency counterpart funds for the government budget. Until the Government's efforts to improve revenue generation start to show significant results, these funds will be crucial to progress towards budgetary balance. By providing import financing while Uganda's own foreign exchange earnings remain depressed, the credit will promote growth. 4.2 The specific actions to be supported by the credit will benefit Uganda in a number of ways. Improvements in the regulatory and business climate are intended to help unleash the fill potential of the private sector as the engine of growth. The final phase of divestiture of the Custodian Board properties is expected to spark increased rehabilitation investment and reinforce Uganda's pro-business image. Civil service reform is aimed at building a competent, results- oriented service without which the present ineffectiveness of government programs will persist. Sharp increases in domestic revenue are needed to underwrite not only civil service reform (salaries in particular) but also much higher levels of expenditure in the social and economic sectors, especially health, education and roads. Public expenditure rationalization will lead to more productive use of the Government's own limited resources and the resources provided by donors. B. Poverty Category of the Proposed Opertion 4.3 The proposed operation has a strong poverty focus. First, on the production side, the credit will support actions to revitalize the coffee and cotton subsectors. These two crops have traditionally been important sources of cash income for smallholder farmers. The restoration of favorable conditions for the expansion of cotton output will be especially beneficial to the peasants in the north and east, regions which have lagged behind the rest of the country because of the late cessation of rebel activities. Second, the credit aims to bring about improvements in the social indicators by reforming public expenditure and shifting resources into programs (primary education, primary health, feeder roads etc) that benefit the poor. C. Risks 4.4 There are both external and internal risks to the program to be supported by the credit. On the external front the risk lies mainly in the possibility of a fiuther deterioration of the world economic situation and a worsening of relations between Uganda and her neighbors. Coffee prices on the world market have picked up, partly in reflection of the decision by producing countries to operate a stock retention scheme, but the risk of a furher slide in prices cannot be ruled out. The best way Uganda can protect itself against such an eventuality is to promote noncoffee exports vigorously. Uganda has no control over international developments but it has demonstrated a readiness to respond to external shocks. The political and military turmoil in  -36 - some of the neighboring countries could spill over into Uganda and create pressures for increased defense spending. To forestall this risk Uganda is very active in promoting peace In the subregion. On the domestic front, the main risks are a return to fiscal laxity in the run-up to presidental and parliamentary elections in 1994 and a weakening of resolve in implementing structural reforms, especially those involving retrenchment and revenue generation. There will, no doubt, be strong pressures to increase government expenditure in the period leading up to the elections. That i the negative side. On the positive side, there is a much greater commitment to fiscal prudence, and the central bank has become more vigilant in managing the Government's accounts. Moreover, the merger of finance and planning has resulted in a more cohesive budget mangement stucture. To reduce the risk of lost momentum on structural reform SAC II has supported many up-front actions. Part V. Recmmendation 5.1 1 am satisfied that the proposed Development Credit would comply with the Articles of Agreement of the Association and recommend that the Executive Directors approve the proposed Development Credit. Lewis T. Preston President Atachments Washigton D.C. April 18, 1994  ANNEX I Page 1 of 17 Tesbom _ e \} Mof a C o' 1D ECOnOI Plmi r-See470~S (10 Liurn) P.O. Sx 8147. Tdepwis WinO. ~~Kamp"la tna~ mz . h I W 116 tA U rLanda. April IZ,.1994. Le(e of Deelopmet Pwolcy Mr. Lewis T. Presron Prident Inenaional Development Association lI8s H Seteet NW Wasblngron, DC 20433 USA Denr Mr. Poeston, 1. As you know, the Govrnmen of the Nationul Resistance Moumn lauched in May 1987 an economic rcovery program aimed at recomuemng our economy which had been devated by poldcal and miliaryupheaval. ae Govem of Ugandapratthe sptprovridedbylDA In the form of two Economic Recovey Craeds (ERC I and ERC ). an Agricurl SeoMr Adjustmet Credit (ASAC), a Strcmral AdJustmea Creft (SAC 1), a Fnanal Sector Adj'usmen Credk SAC) and severa investment credi. Our economic recovey prgm bas also amacud substata resource flows from the DI4F and other multilal and bilata donos. Iu November 1992 we negotated the sixth PolUcyF ramework Paper (PM) coveing FY93-PY95 wh MDA and tW DO. On Novembe 22, 1993 the IMF exended the fouth amwaal under the ESAF to 'ime 30, 1994. 2. In the long run we expect an increasing perenta of our foreign exchmp i be met from our own export earnings. However, we wn. In the medium tetm, coinue to rdy oD fripn assist to a significan ette Accordingy, by dhs la1tr the Govemen of Uganda reques frther assmnce from IDA iii suppott of the an phase of its stuctural adjusnme program. The objectives of the program, Its a sco m o-da a the actio plannd for te nt two or dhree yeas, which will be suppoted by-the Second SruC Ad*tmem Credit (SAC m are dc ed below. Objecdves of Eonomic Reform 3. Overte past six fiscai years our economy grew, o0 avage, by 5.7 pecn a yraw, whic men ta pe capita income rosve by 2.8 percem per annum. This has, hower made only a small den in povey: at US$170, avage per capta income remains very low. even by developilg comtny sdards. Our oveidi onomic goal. theefore nains the reducdon of povey at a fasoer pac. To this end weill seek to consolida macroeconmic sabiity, ster pivat seor development and improve public socor W_r We conv.rced hat good 3 i an estal gediof dewopmem In etection of this e Govenmehas mrd *eedomof th  ANNEX I Page 2 of 17 - 38 - press and independence of th judiciay. We have an eleaed Parliamen A draft nationlW Constition is due to be debated and adopted by a Constituent Assembly in 1994. This will be followed by parlilmenty and presidential elecdons. Recnt Economic Adjustment Efforts and the Resuls 4. Over the pa%t eigbteen months we have accelerated the pace of maoconomic and strunral reform. As a result one key objective of economic policy has ftnally been ahievedi: btladon has been brought zmder control. Year-on-year inflatiOn, Measured by chnges in the consm prc index for Kaupa1aO has dropped sharply. In June 1992 it was 63 percent. A year lIter It was minus 0.5 percent In March 1994 it edged up to 12.5 percen We reckon that undedying inflaion is Of *h order of 9.2 percent per annum. 'he sharp drop In oflaton Is partly explained by good weather which resulted in bumper harvests which In turn ransated Io falling food prices. The main reason, however, is the tdgening of control over public axpendimre. This has meant limt peding eau month to the dometic revenue collected and the local currency generated fron sales of Import supr finds. The success against ilation has brought greater exchange rae smbilty. Morcver, high rea interest tatu, couplb w tabl hgerare, seem to have aaCW large inw of privt funds into Ugnda. S. While rening in inflation, we have pressed ahead with structural rdorms. Suffice It to menton omly four of the notable actions that: we have aken recendy. Flrsty, we have retund over 2,5w of the propeies oxpropriated by Amin in thfe ealy 1970s to fte owners. We are beginn to see major rehabiliion Invesments in a number of the properts repossased by the ovne, wih a resultan expansion of employment and income opportunities. 6. Secondly, we have conffnued die process of prioring public expenditur. he des ted hIgh priorm recurrent programs (primary education, primary heblth, wat supply, agicultmal search and etesion and road mainenance) received increased budgetary alocatons FY9 and wer protected fom expendime cuts necessid by the shortfl in the local cmrency genated *om Import support fis. 7. Thirdly, we have completd faciWial reviews often miniss. Retruuig proposals for these minist e being reviewed wkh a view to enuing dt Govermet miniie" amd depatmesu focus on their core functions. Over the past e _he months we laid Off about 40,000 cii seaants; mny of these were ghost workers. In addilon, during FY93 we compled the Mu phase of miittay demobiltadon which resulted in tMe s_reoTZ3,UUU so_otus kom the aTSonal Resisancc Army. This will ald our efforts to further reduce defense expeture wbIch had alreadyr gone down frm 41 percent of reurrent expenditue in FY91 to 25 percent in FY93. 8. Fourhly, we have liberalized makes. Thus, we abolished the xpo moopolY enjoyYd by theCofeMarkeiag Board. Wehavealso deld theforeignehagemad Weinoduced u kinubak tbreign exagema rket in November 1993. We now have pracdally no otols on curt account osaIons. We have also made progress towards liberalizing ints rar; rats as ether marktrdevxilned or linked t a moving average yield on treaSUY bills whi arm aucdoned weekdy.  ANNEX I Page 3 of 17 -39 - 9. We believe that the benefits of stabiliadon cam stuctural adjustment bgS to show. We see signS of an upswing in private sectr confidence and in inves t The econowmy ha rebounded from the drought-induced recession of FY92: povisional data suggest tiu GDP grew by 7.2 percent in FY93. Purditimore, from a very low base, nonoffee xport show sigs of expandig songly, although statistics tend to under-record this cagory of exports. The Medium Term Program of Adjustment Meawres 10. Over thLe pasn six years we have adopted a wide range of structural polcies ta havo reted in the creaion of free markers and some improvemet in public sector zanagemet In spite of *Js progress, m;jor challenges remain. This means ha we must address th nex geneaon ofstructal csmainu vigorously in order to susmln the recovy of output gmwth ad acceleate human resource development. We see dure main areas as reqiring priority atention over the coming 2-3 years. First and foremost, we recognze that the prvae ivestment rae (around 6 percent of GDP), while rising, is too low to provide a sound basis for faste econamic gow. Invnesmen Is constained by low domesic saving but in some areas it is also hampered by lega and regultory barriers. Under the program for which we are seek 3 DA support we intend to do away wh theme legal and reultry bariers. We know tha pivate insment wil also be stimulated by acdons to complete the divesdwe of the Custodian Board properdes and speed up the privataion of public enterprises and we intend to Implement the required acdons as expidouly as posible 11. Second, we are awae that domestic savings remain inadeqtate compared to the performsanc of most African counties- Tis constrains domesc investme whlch has to be oe engine of g3owth. On the one hand, private savings are very low. On the o*er had, public sVIgP aX negaive. The prae savings/GDP ratio is of th order of 6-7 pe