VI Tanzania

Andrew Berg, Mumtaz Hussain, Shaun Roache, Amber Mahone, Tokhir Mirzoev, and Shekhar Aiyar
Published Date:
March 2007
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Mumtaz Hussain

Tanzania’s good record of sound macroeconomic policies and structural reforms has earned it the support of the donor community and debt relief under the Heavily Indebted Poor Countries (HIPC) Initiative. While structural adjustment started in the early 1990s, the government has increased its reform efforts since the late 1990s. Strong support from the donor community and from programs supported by the International Monetary Fund has helped the authorities implement prudent macroeconomic policies and economic reform. Aid inflows have been high throughout the period and have continued to increase in recent years. In 2004, budgetary aid inflows financed about 40 percent of public spending and stood at about 10 percent of GDP.

Large and increasing levels of aid inflows provide new opportunities for Tanzania, but also pose a number of macroeconomic policy challenges for the government. This case study covers the most recent seven-year period—from the 1997/98 through the 2003/04 fiscal years—during which Tanzania continuously implemented programs supported by the Poverty Reduction and Growth Facility (PRGF).1

Pattern of Aid Inflows

Net aid inflows have increased substantially more than gross inflows, reflecting partly lower debt service payments following the debt relief received under the HIPC Initiative (Table 6.1).2 Moreover, donors are increasingly channeling their assistance through the government budget; the net resource transfer to the budget has quadrupled (from 2.2 percent of GDP in 1996/97 to 9.4 percent in 2003/04). This shift in favor of budget aid reflects a number of factors such as improvement in public expenditure management and increased donor confidence in the poverty reduction budget support (PRBS) mechanism and sector-wide assistance programs (SWAPs) in Tanzania.3 In fact, Tanzania is considered a success story in terms of the usefulness of both the PRBS and SWAPs as tools for increasing program support.

Table 6.1.Tanzania: Aid Flows(In percent of GDP, unless otherwise indicated)
Official aid flows in the balance of payments1
Gross inflows15.213.312.712.812.710.510.512.1
Debt service paid–6.5–4.8–2.3–2.7–2.4–2.0–1.6–1.3
Net inflows3.
Official assistance for budget2
Gross inflows4.
Of which: Grants3.
Debt service paid2.
Net inflows2.
Net inflows (millions of U.S. dollars)157220306461395482780983
Note: Figures in bold represent the aid-surge period.

Aid Absorption

This section focuses on absorption of aid inflows and real exchange rate trends. Table 6.2 reports changes in net aid inflows and corresponding changes in the balance of payments. In Tanzania, net aid during the aid-surge period increased substantially. However, the current account deficit excluding aid narrowed over most of the aid-surge period, and a significant portion of incremental aid was saved as international reserves. The reserves rose from two months coverage of imports in 1997/98 to about seven months in 2002/03 (from $500 million to almost $1.7 billion). The authorities generally accumulated more reserves than was targeted under the PRGF-supported programs. More recently, however, aid absorption has increased, as evidenced by the expansion of the non-aid current account deficit by about 3.4 percent of GDP—more than the size of the aid surge.

Table 6.2.Tanzania: Aid Absorption(Annual averages in percent of GDP)
Pre-Aid-Surge AverageAid-Surge AverageDifferenceIncremental Aid Absorbed?
Net aid inflows5.67.82.2
Non-aid current account balance1–9.2–6.82.3
Non-aid capital account balance24.11.7–2.4
Change in reserves (increase –)–0.6–2.7–2.2Not absorbed
Net aid inflows5.67.82.2
Non-aid current account balance–9.2–6.92.3
Non-aid capital account balance4.11.4–2.7
Change in reserves (increase –)–0.6–2.3–1.8Not absorbed
Net aid inflows7.19.42.3
Non-aid current account balance–5.7–9.1–3.4
Non-aid capital account balance2.11.6–0.4
Change in reserves (increase –)–3.5–2.01.5Absorbed
Source: IMF staff reports.

Real Exchange Rate and Dutch Disease

Consistent with partial absorption of aid, the real effective exchange rate did not appreciate much over the aid-surge period (Table 6.3). The real exchange rate trends do not provide any evidence of Dutch disease.

Table 6.3.Tanzania: Real Effective Exchange Rate and Its Components(Percent change)
June 1995–June 1998June 1998–June 2001June 2001–June 2004
Change in REER (depreciation –)64.3–0.2–35.4
Change in NEER (depreciation –)8.6–12.7–36.6
Change in relative prices51.314.41.8
Change in NER (depreciation –)–9.0–25.5–20.2
Change in RER (depreciation –)38.3–17.1–19.1
Notes: REER = real effective exchange rate; NEER = nominal effective exchange rate; NER = nominal exchange rate of local currency with respect to U.S. dollar; RER = real exchange rate of Tanzanian shilling against the U.S. dollar.

This overall story for the aid-surge period, however, hides significant year-to-year fluctuations in the real exchange rate (Figure 6.1). Before the aid surge, the Tanzanian schilling appreciated significantly in real terms at a time when the authorities implemented an exchange-rate based stabilization program. This trend of real appreciation continued through 2000 despite a brief period of depreciation in 1999; the currency appreciated by about 15 percent in 2000. Concerned with Dutch disease, the authorities took a policy stance—lack of aid absorption—that subsequently encouraged depreciation of the real exchange rate. The currency depreciated in real terms over 2001–04 despite a significant increase in aid inflows over the same period.

Figure 6.1.Tanzania: Monthly Exchange Rates and Consumer Price Inflation

(Left scale: index, December 1995 = 100; right scale: in percent)

Note: REER = real effective exchange rate; NEER = nominal effective exchange rates; ER = exchange rate.

Despite the real depreciation of the currency during most of the aid-surge period and significant structural reform over the past decade, the performance of the export sector was mixed. Following a good performance of both traditional and manufactured exports in the first half of the 1990s, exports declined over 1997–99, partly because of a sharp real appreciation of the currency (Figure 6.2). Since 2000, growing gold exports have helped aggregate exports to recover. However, traditional exports such as coffee, cotton, and tea have not recovered, despite favorable developments in the real exchange rate.

Figure 6.2.Tanzania: Exports and Real Effective Exchange Rate

(Left scale: in millions of U.S. dollars; right scale: index, 1990 = 100)

Note: REER = real effective exchange rate.

Spending Out of Aid

Net aid resources for the budget have increased dramatically over the past seven years, from 2.7 percent of GDP in 1997/98 to 9.4 percent in 2003/04. All of the budget aid was spent. As a result of increased aid, public expenditures increased significantly and the fiscal deficit before aid increased (Table 6.4). On average, net aid to the budget rose by 3.3 percent of GDP over 2000–04 and the fiscal deficit before aid grew by about 3.1 percent.

Table 6.4.Tanzania: Allocation of Incremental Net Budgetary Aid Spent or Saved(In percent of GDP)
Pre-Aid-Surge Average1Aid-Surge Average1DifferenceIncremental Aid Spent or Not?
Net fiscal aid inflows3.16.43.3
Revenue (excluding grants)11.812.10.3
Expenditure (excluding external interest)15.318.53.3
Overall fiscal balance before aid–3.6–6.7–3.1Spent

The changes in net aid inflows and expenditures were highly correlated (Table 6.5). In particular, changes in capital expenditures were highly correlated with changes in net aid inflows to the budget—the correlation coefficient was about 0.97. Although foreign assistance was not absorbed in the early years of the aid surge, it played a role in encouraging the government to improve the pro-poor orientation of public expenditures. Between 1998/99 and 2003/04, the central government’s spending on priority sectors such as health, education, and other poverty reduction programs increased by 5 percentage points of GDP (from 4.8 percent of GDP to 9.9 percent).

Table 6.5.Tanzania: Changes in Net Aid Inflows to Budget and Fiscal Spending(In percent of GDP, unless otherwise specified)
Net aid inflows (in budget)
Of which:Grants (program and project)
Program aid2.
Net aid inflows (millions of U.S. dollars)219.8305.6461.4394.7481.5779.9983.2
Expenditure and net lending (excluding interest)14.516.117.916.417.019.522.1
Current expenditures10.611.912.612.713.614.516.3
Development expenditures3.
Of which:Foreign financed3.
Overall balance before net aid–2.4–4.7–7.1–4.7–4.9–7.4–9.2
Domestic financing (net)–0.4–0.20.1–0.0–0.3–0.4–0.2
Of which:Bank financing–0.9–0.0–0.4–0.2–0.7–0.1–0.3
Net aid inflows (in budget)1.01.8–
Expenditure and net lending (excluding interest)2.81.6–
Overall balance before grants and interest–2.4–2.41.9–0.2–2.9–2.1
Domestic financing (net) (decrease −)0.20.3–0.2–0.2–0.10.2
Source: IMF staff reports.

Revenue collection remained fairly steady, but fell short of the indicative targets under the PRGF programs. While domestic revenues remained stagnant at around 12 percent of GDP over the sample period, revenue collection has improved substantially in the last two years, partly as a result of tax administration reforms.4 Given current expenditures (including social spending) well above domestic revenues, budgetary spending is highly vulnerable to aid shocks.

In Tanzania, PRGF-supported programs allowed substantial fiscal space to spend the aid inflows. These programs anticipated the aid increments reasonably accurately and accordingly allowed for a larger fiscal deficit before aid. Moreover, IMF program targets generally allowed for the spending of the aid in excess of program levels and did not require a reduction in domestic financing of the budget (Table 6.6). In the event of a negative aid surprise, the PRGF-supported programs (especially recent ones) allowed for an increase in net domestic financing of the government and lowered international reserve targets. The generally predictable aid increments combined with the flexibility of the PRGF program targets allowed Tanzania to spend almost all of the aid increments.

Table 6.6.Tanzania: Aid Fluctuations and Domestic Financing of the Budget
Excess AidShortfall in Aid
2002–041No effect on domestic financingRaised domestic financing of the budget by 100 percent of the shortfall
20012No effect on domestic financingRaised domestic financing of the budget by 100 percent of the shortfall, up to a maximum of $60 million
1996–20002, 3Reduced domestic financing by 100 percent of the excessRaised domestic financing of the budget by 60 percent of the shortfall

Monetary Policy Response

Incremental aid in Tanzania was spent by the government, but for most of the aid-surge period (2000–04) the additional aid was not absorbed and the current account deficit before aid narrowed. This pattern of the spending of aid exceeding absorption has macroeconomic consequences similar to that of domestically-financed public spending.

The monetary policy stance varied significantly during 1997–2004. From 1997–99, the government’s main objective was to bring down inflation from relatively high levels and to build sufficient international reserves to support the exchange rate and ensure against exogenous shocks. To maintain price stability in the wake of the first aid surge in 1999/2000, the Bank of Tanzania resisted the monetization of aid-related fiscal spending by selling domestic securities and raising interest rates and public debt. Once inflation dropped to single digits, policymakers became increasingly concerned about the adverse impact of high interest rates and the costs of sterilizations. Consequently, the authorities let the money expand as the government spent aid. This also led to a large buildup of international reserves and excess money growth, particularly in 2002–03. By late 2003, however, concerns about overheating the economy became important, and policymakers took steps to increase aid absorption and actively managed excess liquidity through large foreign exchange sales—a policy consistently encouraged by the IMF-supported programs in the aid-surge period. The rest of this section discusses these varying policy responses.

Pre-Aid-Surge Period: Achieving Macroeconomic Stability

Formulated against the backdrop of significant macroeconomic instability, monetary policy during this period was aimed at reducing the inflation rate and building international reserves. Policymakers took steps to achieve programmed levels of money growth, largely through the sale of government securities. Both reserve money growth and broad money growth was reduced from above 20 percent to single-digit levels (Figure 6.3). Real interest rates became positive, and interest rate volatility increased significantly (Figure 6.4). Consequently, inflation was brought down to single digits from about 25 percent. Fiscal policy was also geared toward achieving macroeconomic stability. Domestic financing of the budget deficit was curtailed substantially, which opened up room for an increase in credit to the nongovernmental sector (Table 6.7). In order to build up reserves, the Bank of Tanzania was a net purchaser of foreign exchange from the market.

Figure 6.3.Tanzania: Program vs. Actual Growth in Broad Money

(In percent)

Figure 6.4.Tanzania: Bank Reserves and Treasury Bills/Liquidity Paper Holdings

(In percent)
Table 6.7.Tanzania: Policy Response to Aid Surges
Aid Spent But Not Absorbed
Before aid surge1Domestic sterilization2Monetary expansion3Aid spent and absorbed4
Average annual overall inflation (percent)
Nonfood inflation (percent)
Gross international reserves (millions of U.S. dollars)604.9814.61,908.92,003.1
In months of imports coverage3.
Change in gross reserves (millions of U.S. dollars)364.8209.81,094.294.3
Bank of Tanzania’s intervention in foreign exchange market (−, net sales) (millions of U.S. dollars)209.3101.81.5–323.1
Reserve money growth rate (percent)8.222.317.510.9
Average treasury bill rate (percent)10.712.84.37.7
Average deposits rate (percent)
Bank reserves (percent of deposits)15.714.416.911.2
Treasury bills and liquidity papers (percent of deposits)16.020.725.833.1
Government deposits at the Bank of Tanzania (12-month growth rate)–1.849.047.5–13.1
Credit to nongovernmental sector from banking sector (12-month growth rate)29.39.341.531.7

1999–2003: Aid Spent but Not Absorbed

In 1999–2000, the authorities aggressively sold domestic securities to mop up the liquidity resulting from aid-related expenditures. The results were stable inflation, higher interest rates, a decline in private investment, and an increase in reserves. Aid to the budget rose by about 2 percent of GDP and the government spent this incremental aid on social and other development projects. However, the central bank accumulated almost all of the additional aid in official reserves. To limit upward pressure on the currency, the central bank had also purchased over $100 million worth of foreign exchange from the market (Table 6.7). The currency appeared to be pegged against the dollar from mid-1999 to end-2000 (Figure 6.1). The excess liquidity associated with spending but not absorbing this incremental aid created potential inflationary pressures.

To offset the excess liquidity, the Bank of Tanzania undertook open market operations and sold liquidity papers of about 1 percent of GDP. The treasury bill rate increased from 6 percent in May 1999 to 15 percent in October, where it remained until April 2000. In addition to monetary tightening, “corrective” actions also were taken on the fiscal front in early 2000. Nevertheless, broad money growth was above the authorities’ target in this period. The private sector was crowded out, as credit to the nongovernmental sector grew by only 9 percent, compared with a 29 percent expansion in the previous period (Table 6.7). Private investment declined, although that decline was more than offset by the increase in public sector investment.

Overall, monetary policy was successful in limiting inflation to single digits. While broad money expansion was well in excess of the program targets (Figure 6.3), inflation remained low, especially nonfood inflation, which declined to 2.5 percent a year. A structurally higher demand for money following the achievement of price stability in the preceding years may have helped in achieving low inflation. In sum, the domestic sterilization restricted the benefits from the higher aid resources in this period.

While net aid inflows declined slightly in 2000/01, they recovered in 2001/02 and surged by 2.7 percent of GDP in 2002/03.5 The authorities were concerned that high interest rates could hinder development of the private sector. At the same time, a resurgence of real appreciation of the currency in 2000 increased policymakers’ concerns about external competitiveness. Sterilization through the sale of treasury bills was curtailed and the Bank of Tanzania accumulated more than $1 billion in gross foreign exchange reserves in order to limit further real appreciation of the currency. Thus, this period could be characterized as an increased “fear of floating” policy regime, though such fear was present in the previous period as well.

In order to reconcile the objectives of limiting interest rate increases and avoiding appreciation of the currency, authorities had to let the money supply increase even more rapidly. Policymakers were convinced that there was a structural increase in money demand in response to stabilization and economic reforms. For example, they noted that currency in circulation grew by only 5 percent in 2001, but bank deposits increased by 22 percent. This conviction justified very limited open market operations to control liquidity generated from spending of the budgetary aid.

In its efforts to avoid appreciation, the central bank intervened heavily in the foreign exchange market and this, along with the aid inflows, accelerated the pace of reserves accumulation (Table 6.7). By August 2003, gross international reserves reached almost $2 billion (or seven months of imports). This policy stance contributed to the depreciation of the currency, which fell against the U.S. dollar by more than 30 percent from January 2001 to August 2003. Combined with low inflation, the real exchange rate also depreciated to levels of early 1996.

The combination of reserve accumulation and low domestic interest rates resulted in money growth well above the program targets (Figure 6.3). Nonfood inflation rose from nearly zero in late 2001 to almost 10 percent in early 2003. The impact on overall inflation was not large, however, because food accounts for about three-quarters of the consumer basket and food prices remained stable. Overall inflation remained relatively low and stable (Figure 6.5). Banks had substantial excess reserves—for example, at one point in 2002, excess bank reserves reached as high as 12 percent of these banks’ deposits. Treasury bill yields fell even below the rate of inflation (Table 6.7). In 2003, the IMF Financial Sector Assessment Program team evaluated banking system performance in Tanzania and identified management of excess liquidity and large excess reserves of banks as important policy concerns for maintaining macroeconomic stability (IMF, 2003b).

Figure 6.5.Tanzania: Inflation and Reserve Money Growth

(In percent)

Tanzania overperformed under the PRGF-supported programs. The central bank accumulated more reserves than PRGF targets and, consequently, net domestic assets levels also overshot (that is, were below) program targets. The PRGF programs were designed to allow greater absorption of aid inflows. For example, during 2001–03, program targets on international reserves were not adjusted upward for any unanticipated additional aid, and these targets were revised downward in case of a shortfall in aid. Despite this flexibility in the program, most of the aid increments were not absorbed in this period.

In sum, policy during this period was in effect to finance aid-related expenditures largely through a domestic monetary expansion. Compared with the previous policy of aggressive domestic sterilization, the benefit was that interest rates came down. The feared rapid inflation did not materialize, despite very rapid money growth. However, there were limits to the scope for monetary financing, and authorities had to pursue a relatively tight fiscal policy in 2000/01, which helped control inflationary pressures by cutting capital spending well beyond the drop in aid inflows (Table 6.4). The cost of this strategy, in addition to the risk of inflation, is that the country did not fully benefit from the higher aggregate demand and net imports that the aid inflows might have allowed. Achieving real depreciation through a 30 percent decline in nominal value of the currency within two and a half years while accumulating about $1.1 billion in official reserves did not result in aid absorption.

Since Mid-2003: Aid Spent and Absorbed

The policy dilemmas of effectively managing higher aid became increasingly obvious over this period. Aid inflows continued to increase, with net aid inflows to the budget up by a further 1.7 percent of GDP in 2003/04. In mid-2003, the government delayed some capital spending financed by foreign assistance because of concerns about excess money growth and inflation. The large aid inflows, the failure of the Bank of Tanzania to sterilize the liquidity emanating from spending of these inflows, and the lack of adequate lending avenues for the commercial banks had created large structural excess liquidity in the banking system.

Although this excess liquidity did not produce higher inflation, the authorities and IMF staff were concerned about the inflationary pressures. First, net aid inflows in 2003/04 were much higher than in previous years. Second, with foreign exchange reserves equal to seven months of imports, authorities ran out of room for a further rapid build-up of reserves. Third, the costs of sterilization were becoming significant: the quasi-fiscal cost was rising, as outstanding liquidity papers were about 23 percent of the broad money supply in September 2003, and treasury bills rates started to pick up (Figure 6.4).

In this period, the authorities moved to more use of foreign exchange sales to reduce aid-related liquidity injections. After consultation with IMF staff, the Bank of Tanzania started to make adjustments in its monetary operations to meet the challenge of aid absorption. The bank was no longer reluctant to carry out sterilization operations through sales of foreign exchange, which it had not done previously owing to considerations about appreciation of the currency. In fact, the Bank of Tanzania sold more than $300 million of foreign exchange (3 percent of GDP) in this period (Table 6.7). Sales of liquidity papers were also sizable. The domestic and foreign exchange sterilization operations reduced excess liquidity in the banking system to 11.2 percent of total deposits in September 2004—barely above the 10 percent required reserve ratio. The tightening of liquidity increased short-term interest rates, although the real deposit rate remained negative and the nominal exchange rate did not appreciate much (Figure 6.1).

With this policy switch, the incremental aid was absorbed. The non-aid current account deficit expanded more than the incremental aid inflows, financed partly by drawing down international reserves (Table 6.2). On the fiscal front, the budget deficit before aid increased, as spending went up by about 2.6 percent of GDP, partly reflecting higher development expenditures. Combined with good performance in revenues and a small amount of bank financing, the higher aid financed these expenditures (Table 6.5). Moreover, the government deposits at the Bank of Tanzania declined, which suggests that the fiscal policy was focused on full utilization of aid resources instead of delaying the spending of aid to limit inflationary pressures (Table 6.7).

Increasingly passing on incremental aid inflows to the foreign exchange market, the Bank of Tanzania was able to bring money growth in line with the program targets. Food prices drove a small increase in inflation, as nonfood inflation was reduced below 1 percent (Figure 6.5). Despite the tightening of liquidity and some bank financing for the budget, credit to the private sector continued to grow rapidly (by about 32 percent over a 12-month period). There also was a significant pick-up in economic growth. In sum, the recent increase in aid inflows is being absorbed and its effects on the exchange rate, interest rate, and prices have been well managed, although the currency has started to appreciate in real terms in recent months.

Findings and Conclusions

The major findings of this chapter are as follows:

  • The increased aid to the government budget was spent. Total public expenditures and the fiscal deficit before aid expanded in line with the increased budgetary aid. Spending of the aid was focused on priority and development expenditures. Public investment appears to have encouraged real GDP growth, which rose from 3.2 percent on average during the pre-surge period to 5.9 percent in the most recent three years.

  • For most of the period, the incremental aid was not absorbed. A significant portion of aid resources was saved through a large build-up of reserves, which rose from two months of import cover in 1997/98 to about seven months in 2002/03. Moreover, the current account excluding aid narrowed for most of the period, despite increased financing via higher aid inflows.

  • Recently, absorption of aid inflows has been improving. In 2003/04, the current account deficit before aid widened by 3.7 percent of GDP, well above the aid increment.

  • Tanzania avoided appreciation of the real exchange rate. In fact, the real exchange rate depreciated by about 30 percent over the aid-surge period. The Bank of Tanzania intervened heavily in the foreign exchange market to purchase dollars, depreciating the exchange rate and accumulating international reserves well above the level envisaged under the IMF-supported programs. However, this policy stance has also discouraged absorption of the incremental aid.

  • IMF-supported programs allowed Tanzania sufficient fiscal space to spend the expected increase as well as most of the unexpected increase in budgetary aid. The targets for the fiscal deficit before aid were expanded considerably with the additional projected budget aid.

  • The reserve targets envisaged under these programs were modest, reflecting a desire to increase aid absorption. However, the Bank of Tanzania accumulated reserves well in excess of these targets.

  • The authorities struggled with tensions resulting from the competing objectives of external competitiveness and absorbing the increased aid. The authorities opted to spend but not absorb the incremental aid in the early years of the aid-surge period. The Bank of Tanzania had to undertake aggressive open market operations to sterilize excess liquidity emanating from increasing public spending locally and saving aid dollars as reserves. As a result, interest rates remained high and the credit growth for the private sector was rather limited in some years.

  • Over the last year, policymakers have been adopting a policy of spending and absorbing additional aid. They are sterilizing liquidity emanating from the fiscal spending of aid inflows through large foreign exchange sales and some open market operations. This policy has resulted in some appreciation of the exchange rate, but aid absorption has also improved. Moreover, the recent increased emphasis on infrastructure spending is likely to help in absorbing aid by increasing the import content of aid expenditures.

Following the presidential election in late 1995, the new government implemented a short staff-monitored program from January-June 1996. An Enhanced Structural Adjustment Facility (ESAF) arrangement was implemented between July 1996 and August 1999. This was followed by another PRGF arrangement between April 2000 and July 2003. Almost all of the disbursements under both arrangements were made on time. Currently, a third PRGF arrangement is in place.

Tanzania reached the HIPC decision point in April 2000 and the completion point in November 2001.

For example, Tanzania met 11 of the 16 benchmarks used to assess public expenditure management systems (IMF, 2005b).

Revenues as a percentage of GDP declined slightly over 1998–2000 owing mainly to trade liberalization that lowered revenue from trade taxes. For a more detailed discussion of revenue performance, see IMF (2006).

In 2000/01, net aid to the budget declined by 1.2 percent of GDP and recovered only partially (about 0.8 percent) in 2001/02.

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