I Overview

Jean-Pierre Briffaut, George Iden, Peter Hayward, Tonny Lybek, Hassanali Mehran, Piero Ugolini, and Stephen Swaray
Published Date:
October 1998
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The countries of sub-Saharan Africa have witnessed a distinct improvement in their economic performance in recent years, with increasing growth rates, declining inflation, and narrowing financial imbalances. The improvement is attributable in large part to the implementation of sound economic, fiscal, and financial policies, including policies to liberalize trade and improve the investment climate. In addition, these countries embarked on fundamental structural reform.

To build on this progress, the sub-Saharan African countries need to sustain their adjustment efforts, further strengthen economic and financial policies, and complete the building of a market-oriented economic framework. At the same time, globalization is proceeding rapidly, posing further challenges, as well as opportunities, for these countries. Foreign assistance, particularly official development assistance flows, on which many of the countries have so far relied, is on a long-term declining trend. Therefore, if sub-Saharan African countries are to attain higher per capita incomes in the future, they must make further efforts to attract and retain needed private capital—both domestic and foreign—in order to accelerate growth.

Many of these countries are working to meet this challenge. To support their efforts, the international community has expressed its willingness to enter into a partnership with these countries through the Africa Initiative, which is directed at promoting trade and investment, mobilizing global private capital flows, and building up human resources.1 The IMF, the World Bank, and other donors could make an important contribution to this initative. To determine the nature and extent of such a contribution, MAE has conducted this study of financial sector issues in 32 selected sub-Saharan African countries.2 The study reviews the progress made by these countries in reforming their financial sectors and identifies areas in which further progress is required.

The Financial System Prior to Reforms

By the mid-1980s, financial systems in most sub-Saharan African countries were manifesting signs of weakness and vulnerability primarily because of deteriorating macroeconomic conditions and also because of political interference in the operations of financial institutions, negative real interest rate policies, and directed credit policies. These were compounded by structural weaknesses, including the absence of an appropriate legal framework to grant independence to central banks in the pursuit of price stability; weak operating procedures and the absence of effective instruments for market-oriented monetary management; ineffective and noncompetitive financial market structures; an inefficient bank regulatory and supervisory environment partly caused by a lack of supervisory autonomy and capacity; inefficient payments systems; the absence of an effective legal mechanism for debt collection; and inadequate accounting standards and reporting and disclosure requirements. These weaknesses limited the financial system's efficiency and its ability to perform its financial intermediation function.

Historically, sub-Saharan African countries placed great emphasis on developing and protecting the real sector, with the financial sector having only an ancillary role. Most countries strongly believed that they could support their development objectives through selective credit allocation mechanisms. As a result, governments became directly involved in the operations of the financial sector and even set up financial institutions (mainly commercial and development banks) to ensure that the monetary and financial systems contributed to the achievement of the developmental goals; these institutions were used mainly as vehicles to direct credit to specific sectors of the economies. Banking resources were used to finance the government budget deficit and to provide financing for state-owned companies. Banking sector claims on government increased from 1.8 percent to 3.9 percent of GDP during this period. Credit to the private sector was crowded out and rationed, and interest rates were controlled at below the market-clearing rate—often at negative rates in real terms. Most countries also introduced price controls and foreign exchange restrictions and rationed many goods and services, including foreign exchange. Excessive controls encouraged the development of parallel markets, which led to the hoarding of foreign currencies.

The debilitating effects of these trends on the development of the financial systems of sub-Saharan African countries during the 1970s and 1980s may be characterized as follows:

  • First, the growth of these economies was not commensurate with the level of investment, largely because of low efficiency in the use of capital, which was mostly provided to poorly managed state-owned companies.

  • Second, the bias of directed credit in favor of selected sectors, particularly the agricultural and mineral, resulted in an overconcentration of credit in these sectors, thereby increasing the banking system's vulnerability to risks. Owing to deteriorating terms of trade, bad weather, and mismanagement, many of these directed credits became nonperforming loans. In addition, the ability to borrow at cheap rates encouraged less productive investments. Those who borrowed for projects with low financial returns could not repay their loans. In other cases, borrowers willfully defaulted because many believed creditors could not force court action against those considered to be in priority sectors. The distorted allocation of resources and erosion of financial discipline left intermediaries unprofitable and, in many cases, insolvent.

  • Third, macroeconomic instability, primarily originating from fiscal deficits, compounded the difficulties that the financial systems faced. Against the background of rising fiscal deficits, most governments resorted to borrowing from central banks because the domestic financial markets were too shallow to meet the financing requirements. This resulted in high inflation. Volatility in economic growth and rising inflation made it even more difficult for banks to assess borrowers' creditworthiness, leading to the granting of more bad loans. In particular, volatility in inflation rates led to asset price bubbles that have proved to be extremely detrimental to the asset portfolios of financial institutions.

  • Fourth, the negative real interest rates that resulted from interest rate ceilings undermined the allocative efficiency of the financial system and led to capital flight. In addition, the artificially low lending rates caused excess demand for credit, thereby forcing financial institutions to ration loans—sometimes favoring borrowers with projects that had lower rates of return.

  • Fifth, the misalignment of the real exchange rate in many sub-Saharan African countries arising from maintaining overvalued currencies in real terms for a long time proved detrimental to some sectors and biased the economy toward import dependency.

  • Sixth, the use of direct credit and interest rate ceilings constrained liquidity management by banks, resulting in disintermediation and reducing the client base and profitability of the banking system. In addition, it did not encourage central banks to develop market instruments and build capacity for their use.

With these circumstances at play, the banking systems in these countries effectively failed to serve as a pivot for the implementation of monetary policy. With banking systems virtually in crisis, the financial intermediation process suffered; the efficiency of the payments system deteriorated; financial and borrower discipline eroded; and banks ceased to be a safe haven for savings, distorting resource mobilization and allocation. Consequently, economic policy management and performance were undermined, thereby adversely affecting real incomes and prices.

Implementation of Economic Reforms

Against the background of the deteriorating economic and financial situation, by the late 1980s and early 1990s, sub-Saharan African countries had embarked upon a policy of adjusting their economies and dismantling the controls and restrictions that had become institutionalized. This policy was largely instituted within the framework of IMF-supported SAF/ESAF programs and World Bank–supported SAC and SAL programs.3 The overall objective was to achieve noninflationary, private sector–led growth within a market-based economic system. In the context of the overall adjustment program, a large number of sub-Saharan African countries also undertook structural reforms of the financial sector. In general, these reforms included granting central banks more autonomy in conducting monetary policy; liberalizing interest rates and eliminating administrative allocation of credits; instituting the transition from direct to indirect monetary policy implementation; restructuring banks to restore their solvency; developing financial markets; and improving infrastructures, including bank supervision and accounting and auditing practices.

The reforms in the financial sector were implemented using different strategies and approaches. In Ghana, for example, reforms proceeded gradually in essentially three phases. In the first phase, reforms were directed at regaining control of credit expansion by the banking system, particularly to the government. At the same time, reforms were designed to support the exchange rate policy and achieve the targets for inflation and the overall balance of payments position. To this end, ceilings were placed on the net domestic assets of the banking system and on net bank credit to the government to avoid crowding out the private sector. Although administrative controls on interest rates remained during this period, these controls were raised in discrete steps while inflation was coming down. In the second phase, the focus of reform was broadened to include greater emphasis on the liberalization of controls on interest rates and bank credit. In the third phase, there was the gradual introduction of an indirect system of monetary control, entailing a shift from direct controls toward increased reliance on market-based instruments of policy.

As part of this process, the Bank of Ghana rationalized the minimum reserve requirements for banks, introduced new financial instruments, intensified the absorption of excess liquidity from the economy through open market operations at market-determined yields, and strengthened its monetary management capacity. In addition, the financial position of the Bank of Ghana was strengthened. These policies were complemented by a major program of reform with a view to enhancing the soundness of the banking system by improving the regulatory framework and strengthening bank supervision, and to improving the efficiency and profitability of banks, including replacing their nonperforming assets. To complete the reform process, Ghana has recently embarked on a strategy to increase the competitiveness of the banking system by privatizing the major publicly owned banks as part of a comprehensive privatization strategy.

Uganda's progress with reforms was somewhat more rapid. After initial difficulties with the implementation of reforms, the government's strong commitment to adjustment and consistency in its actions led to a significant recovery. Uganda embarked on an early removal of domestic price distortions and a progressive liberalization of the trade, payments, and exchange systems. Responsibility for monetary policy formulation and implementation was completely transferred from the ministry of finance to the Bank of Uganda. With the liberalization of interest rates, all rates are now market determined, except for the Bank of Uganda's lending rates, which are in any case tied to market interest rates. Action was also taken to widen the scope of the treasury bill market and introduce new instruments to the public. A strategy for improved monetary control through reserve money programming was developed. Open-ended lending by the Bank of Uganda to commercial banks, which was a significant source of inflationary pressure, was eliminated. Initial steps have been taken to facilitate the development of an interbank market.

To raise the efficiency of the financial system as a whole, actions were also taken to foster competition among banks. In that regard, the government has been reducing its own participation in the financial system, and its new Financial Services Act has liberalized entry and exit barriers in the banking sector. Institutional reforms in the Bank of Uganda and the commercial banks were also implemented at the same time. Regarding the former, the Bank of Uganda significantly enhanced its position in policy formulation, implementation, and prudential supervision. With regard to the supervisory function, it also developed new banking laws, designed supporting regulations, modernized supervision methodology, and instituted ongoing on-site examinations and off-site monitoring. As a member of the Cross-Border Initiative, Uganda also significantly liberalized its trade and payment arrangements within the zone.

The examples provided by Ghana and Uganda generally reflect the reform efforts of countries in west, east, and southern Africa that are not part of the CFA franc zone,4 particularly those countries that are undertaking reforms under the IMF's ESAF arrangements.

Reforms in the CFA franc zone have proceeded somewhat differently. Because of the CFA franc arrangements and the discipline that they imposed, the CFA countries benefited from low inflation and sustained economic growth until 1985. After 1985, however, the economic and financial situation of the zone deteriorated as a result of external shocks, the appreciation of the real exchange rate, rigidity in the labor market, bloated government expenditures, and sizable domestic and external payments arrears. Between 1985 and 1993, attempts were made to overcome these difficulties through internal adjustments, especially through fiscal measures and restructuring the banking system and public enterprises. A number of key banks, which had been performing badly, were restructured. In addition, two banking commissions were established with supervisory powers and functions within the two CFA subzones. The commissions established prudential regulations governing the activities of commercial banks. In January 1994, the CFA franc was devalued by 50 percent.

Within this framework, the CFA countries acted to preserve the existing regional monetary and exchange arrangements, strengthen monetary cooperation, and deepen regional economic integration. Since 1994, reforms have proceeded rapidly. These reforms were designed to replace direct instruments with indirect instruments of monetary policy to the extent allowed by the link with the French franc. Within this context, credit controls were progressively abolished, and crop credit was brought under an overall credit ceiling. Approval requirements for individual loans were also replaced by a new credit-worthiness rating system to govern the overall central bank refinancing policy. Later, the banks moved to a system of monetary management based on indirect monetary policy, operating in the context of a regional interbank and money market. These instruments consist primarily of money market auctions and a discount window at the central bank. A form of repurchase agreement was also introduced to provide temporary liquidity for banks. In addition to these measures, interest rates were liberalized. The supervision capabilities of the two banking commissions continue to be strengthened, and the new regulatory and prudential standards are gradually being enforced.

Progress with Reforms

With the introduction of overall reforms, including in the financial sector, sub-Saharan African countries as a whole have made significant strides in adjusting their economies. As a result, growth is beginning to gain momentum and per capita incomes are once more on the rise. Even though the period of adjustment has been relatively short, these countries, as a group, have made significant progress on most macroeconomic indicators5 (see Fischer and others, 1998).

  • Real GDP growth averaged 4¼ percent a year in 1995–97, up from 1½ percent in 1990–94 (Table 1). Per capita output has risen at an average annual rate of almost 1½ percent in the past three years, compared with an annual decline of 2 percent a year in the first half of the 1990s.

  • After reaching a high of 44 percent in 1986, annual inflation dropped to 13 percent in the first half of the 1990s.

  • The overall fiscal deficit (excluding grants) fell from a peak of 9 percent of GDP in 1992 to 4½ percent of GDP in 1997.

  • The region's current account deficit (excluding grants) widened to about 6 percent of GDP in the mid-1990s, but then fell to 4 percent of GDP in 1997.

Table 1.Sub-Saharan Africa: Key Economic Indicators
(Percent change)
Real GDP2.
Real GDP per capita-1.4-1.5-3.9-2.4-
(Percent of GDP)
Private sector11.312.111.911.011.712.212.412.411.612.3
Domestic saving17.916.714.713.715.516.815.915.515.716.1
Current account balance2-4.8-4.7-5.5-6.0-5.7-6.1-3.3-4.0-5.3-4.5
Overall fiscal balance2-6.0-7.2-9.1-8.6-7.8-6.1-5.8-4.6-7.7-5.5
Primary fiscal balance3-1.4-2.3-3.7-3.2-1.9-0.8-0.40.7-2.5-0.2
(Percent change)
Broad money growth21.130.132.627.344.128.230.317.831.025.4
Consumer price inflation19.727.237.739.144.440.532.813.233.628.8
Source: IMF, World Economic Outlook database.

Data for 1997 are preliminary.

Excluding grants.

Overall balance, excluding interest payments.

Source: IMF, World Economic Outlook database.

Data for 1997 are preliminary.

Excluding grants.

Overall balance, excluding interest payments.

As noted in Fischer and others (1998), these regional averages conceal significant differences in performance among countries; the strong performers experienced average annual growth in per capita GDP of more than 7 percent during 1995–97, and some others experienced declining per capita GDP over the same period. Overall, however, regional performance improved, mainly the result of improved policies in a number of countries.

Equally encouraging results are emerging from the financial sector. For one, monetary authorities are becoming more effective in controlling monetary aggregates. Intermediation has increased, with claims on the private sector as a percentage of GDP rising from the prereform level of 15.1 percent to 18.9 percent at the end of 1996, while net claims on government as a percentage of GDP have decreased from 5.2 percent to 4.1 percent. The structure of the financial system itself is changing rapidly: less than 40 percent of banks are publicly owned compared with more than 50 percent during the prereform era (Appendix I, Table A2).

Notwithstanding these trends, progress with financial sector reform has been varied and uneven. While some countries have progressed faster and further than others and are gradually transforming the financial sector and their economies, others have yet to make significant headway with overall reforms. In like manner, considerably more success has been achieved in some areas of reform than in others, even within the same country.

In terms of performance in the key areas of the financial sector, sub-Saharan African countries have made considerably more progress in the area of domestic monetary operations—that is, in establishing market-based monetary policy instruments and procedures—than in any other area of financial sector reform. In all countries except Angola, Ethiopia, and Lesotho, where some restrictions remain, interest rate and credit policies have been fully liberalized, and the central bank is increasingly relying on some form of open market operations. While open market operations prevail, however, trading in government securities in primary markets constitutes the major element of these operations. Interbank markets, though being promoted, are still limited, and secondary markets are still only embryonic or virtually nonexistent.

Together with domestic monetary operations, most sub-Saharan African countries have also made tangible progress in liberalizing the external sector current account as well as in developing foreign currency interbank market activities, including the opening of foreign exchange bureaus. In terms of foreign exchange arrangements, a larger number of countries today maintain unpegged arrangements than in 1975, when the overwhelming majority of countries maintained pegged arrangements (see Figure 1). Although some progress has also been made with the liberalization of capital account transactions, most countries are still considered restrictive because they maintain controls over capital receipts and outflows, including investment liquidation. Controls over portfolio investments, within the limits of the existing capital markets, appear to be discouraging private capital flows.

Figure 1.Evolution of Exchange Rate Regimes of Selected Sub-Saharan African Countries

Note: Angola, Mozambique, and Zimbabwe did not become members of the IMF until 1989, 1984, and 1980, respectively.

In recent years, all countries have also made considerable progress in strengthening banking supervision activities. Although not all the countries have promulgated basic legislation granting full autonomy for supervision to the central bank, many have adopted or are adopting prudential regulations that are basically in line with the Basle Committee's Core Principles. In addition, all countries conduct both off-site monitoring and on-site inspection of banks and, in some cases, other financial institutions. Moreover, to reinforce sound banking systems within regions, they are pursuing regional coordination and harmonization of supervision policies. Two significant examples of these are (1) the arrangements under the East and Southern Africa Banking Supervisors Group, where the governors of the central banks of 16 countries have committed themselves to cooperating and coordinating development on matters regarding banking supervision, and (2) the establishment of the two banking commissions by the CFA countries as supranational supervisory bodies whose authority transcends loyalty to any single national interest. These examples of regional cooperation are likely to augur well for the development of the financial sector. At present, however, notwithstanding the improved regulatory and institutional setup, effective banking supervision in sub-Saharan African countries continues to be hampered, including by the mismatch between the growing number of institutions being licensed and the skilled personnel available to central banks to supervise these institutions; the paucity and low quality of accounting records; and, in many cases, lingering political interference, which delays critical actions that central banks would otherwise take promptly.

Despite the progress that sub-Saharan African countries have made in the aforementioned areas, a number of other key functional areas require further and urgent attention. In the area of central bank autonomy, over 75 percent of the sampled countries still confer only limited and selective autonomy on their central banks in the conduct of monetary policy; only three countries—Botswana, Kenya, and South Africa—have central banks with significant autonomy. A conducive legal and regulatory framework is critical to the development of the financial sector.

Other areas in need of improvement are payments system development and central bank accounting and auditing. With respect to the former, except for South Africa—and to a lesser extent Mauritius and, quite recently, Zambia—where payment arrangements are fully developed and automated, most other countries have inefficient manual systems, which are prone to individual bank and systemic risks. The inefficient payments system and the high level of reserve requirements as the main tool of domestic liquidity management are some of the major causes of the large spread in interest rates observed throughout sub-Saharan Africa and are also the main reasons for the limited credit expansion to the private sector. The accounting and auditing of financial institutions—which are crucial for effective banking supervision—also need work. Finally, almost all the countries need to modernize or replace obsolete information technology and data management systems.

Problem Areas in Financial Sector Development

Sub-Saharan Africa continues to face challenges that will need to be overcome rapidly if the financial sector is to play its part in fostering growth and raising per capita incomes in these countries. The most relevant ones are highlighted below:

  • Most of the countries continue to provide only limited autonomy to central banks to perform appropriate monetary and supervisory functions. Government interference in credit extension, bank licensing, and supervision encroaches on the fulfillment of the main mandates of the central bank—that is, maintaining price stability and ensuring the soundness of the financial system.

  • The financial sector still suffers from a lack of competition created by the still-dominant position of large government-owned banks, and the lack of a level playing field continues to discourage the entry of private and foreign banks.

  • The large share of nonperforming loans on the balance sheets of the largely government-owned commercial banks impedes the development of interbank markets because sound banks do not want to deal with weaker banks.

  • The absence of a complete array of monetary instruments and a dearth of expertise constrain the ability of central banks to deal with the excess liquidity created by government expansionary policies.

  • The large share of nonperforming loans, the crowding out of the private sector, the lack of competition in the financial sector, and high administrative costs, as well as high reserve requirements and inefficient payments systems are at the root of the large spreads between deposit and lending rates.

  • The crowding-out effect of government borrowing pushes the interest rate structure upward and discourages borrowing for long-term investment.

  • The regulatory framework for supervision is not entirely satisfactory, and its implementation not always effective. The authorities are tardy in dealing with insolvent financial institutions. Loan recovery is also hampered by bottlenecks in the judicial system.

  • The uncertainties surrounding the political and economic situation of some countries have an impact on investor preference for short-term speculative investments and discourage savings and long-term credit expansion.

  • The inefficiency of payments systems hinders financial sector development, keeps payments system risks high, and hampers the transmission mechanism of monetary policy.

  • The constraint imposed by the dearth of well-trained and qualified nationals limits the formulation and implementation of sound monetary policy.

Areas for Further Reform

To meet these challenges, sub-Saharan African countries will have to intensify their efforts to maintain macroeconomic stability and accelerate structural reforms. In other words, they must first build a macroeconomic, regulatory, and institutional environment that fosters domestic savings and attracts private capital and must then channel these resources into long-term, broad-based, and sustainable growth. The lessons that have emerged from the experiences of countries in Europe, Latin America, and Asia indicate that the first steps should be to get the fiscal deficit under control and establish macroeconomic stability. Clearly, reforms cannot proceed effectively against the background of an unstable macroeconomic environment. In addition, given the dual relationship between macroeconomic stability and financial sector development, macroeconomic stability must be accorded high enough priority in the reform of the financial sector if the two are to catalyze and reinforce each other.

With regard to structural reforms, further measures are generally required in a number of areas.

Legal and Regulatory Framework

To attain a suitable level of autonomy for central banks, governments would have to promulgate central bank legislation containing, at a minimum, provisions that (1) give explicit priority to price stability as the objective of monetary policy; (2) grant the central bank, when it is responsible for supervising the banking system, enough authority to perform this function efficiently as well as to oversee the financial system; (3) consolidate the licensing and revocation of bank licenses in one body, preferably the central bank, at the early stages of development; (4) require an institutionalized, transparent mechanism for resolving divergences between fiscal policy and monetary policy; (5) ensure that governors of central banks and members of boards of directors do not come under undue political influence; (6) place explicit and reasonable limits on the amount of credit that the central bank can grant to the government and ensure that the central bank has the means to manage the level of liquidity in the banking system; (7) protect the central bank from the obligation to undertake quasi-fiscal activities; and (8) ensure the financial viability of the central bank.

A well-conceived legislation, however, represents only a minimum condition for central bank autonomy. A further condition would be commitment by governments to ensure compliance with the provisions of the legislation. In this regard, it could be useful to set up independent, specialized courts that deal only with matters relating to the financial sector. These are likely to not only speed up the settlement of financial contractual cases, but will also, above all, send a clear signal as to the direction and intention of monetary policy.

Development of Market-Based Financial System Infrastructure

For sub-Saharan African countries to make further progress in this area, they must address a number of issues simultaneously. One is to get fiscal policy under control; a second is to restructure banks and strengthen the soundness of the financial sector; a third involves acquiring the means and developing instruments to absorb excess liquidity; a final issue is to modernize the payments system.

Foreign Exchange Operations

Despite the progress made in external liberalization, further efforts are needed to improve the policy mix with respect to macroeconomic balance, bank soundness, and political stability. Progress in structural reforms, such as privatization of public and state enterprises, recapitalization of financial institutions, and removal of obstacles to interbank trading and efficient payments systems, is needed to establish the systemic resilience required to withstand financial shocks associated with capital volatility.

In general, with the progress in the worldwide integration of financial markets, attention must be focused not only on the benefits but also on the risks of external liberalization. While there should be general interest in reaping the benefits of financial technologies and integration into external trading systems, the risks associated with capital volatility can be serious. To liberalize capital markets without being sufficiently prepared in terms of structural reforms and financial soundness could be counterproductive.

Banking Supervision

As economic stabilization has progressed in sub-Saharan African countries and inflation rates have come down, there is a corresponding need for commercial banks to strengthen their balance sheets, increase provisioning for nonperforming loans, and strengthen their credit and market risk analysis. In this connection, firm, timely, and effective supervision is required to ensure that these imperatives are adhered to. In this regard, these countries must make greater efforts to comply with the basic supervisory standards relating to prudential regulations guided by the Basle Committee's Core Principles for banking supervision and further strengthen examination procedures, including on-site inspections and off-site surveillance, that are capable of identifying weaknesses.

The guidelines contained in the Basle Core Principles are minimum requirements. Sub-Saharan African countries, because of their current higher bank and systemic risks, may need to set higher standards than those suggested in the Basle Principles.

Meeting the challenges outlined above requires, first and foremost, a strong commitment to reform and strong leadership on the part of sub-Saharan African governments to create an atmosphere of economic security and good governance within which reforms can take place. Second, sub-Saharan African countries must develop the capacity to design and implement monetary and exchange policies as well as supervisory functions on a regular basis. It is in this area that these countries will require the greatest assistance of the international community. Taking into account the requirements of globalization, sub-Saharan African countries as a whole still do not have enough financial regulators, supervisors, and managers who can maintain the high professional standards required for the smooth and rapid development of the financial sector. The IMF and the World Bank should continue to play their complementary roles in supporting the reform efforts of those countries that show the requisite commitment to reform through a program of focused and intensive technical assistance. The existing cooperation between the two institutions should be enhanced and intensified, where necessary, to ensure efficient and coherent delivery of assistance consistent with their respective areas of expertise and comparative advantage.

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