1. General economic environment

The general macroeconomic situation in these countries prior to 1991 was one of instability, ranging from hyperinflation in Argentina, to high inflation in Bulgaria and Ecuador, to less severe inflation (below 30 percent) in the rest of the countries. In all cases, the fiscal position was difficult and was a basic reason for the inadequate inflation performance. The general monetary situation was also difficult: Argentina was at a moment of grave monetary disorder reflected in hyperinflation; Bulgaria was barely in the initial stages of creating a modern monetary system in the context of its transition to a market economy, and had a large monetary overhang resulting from the central planning period; the rest of the countries started from a rather complex and inefficient system, although some like Kenya had already gone through some years of an attempted reform. The exchange rate system was of a managed floating rate variety in Argentina, a crawling or adjustable peg in Ecuador and India, and a dual or multiple controlled rates in the remaining countries. All countries, but to a lesser extent India, had a heavy burden of external debt.

The structural situation was also difficult in all these countries but to a different degree. While Bulgaria was a typical transition economy in the early stages of comprehensive reform toward a market economy, and while Tanzania and Uganda were at the early stages of exiting from a state dominated economy, the other countries were typical examples of a controlled market economy, that is, a market economy marred by comprehensive government intervention in the markets as well as by large and inefficient public sectors. A comprehensive price control system existed only in Bulgaria, but extensive controls were also applied in the remaining countries: in Argentina and Ecuador mainly on the prices of public sector enterprises, but in the rest also on many private sector prices. The general regulatory system was one of a comprehensive central planning in Bulgaria, and of a heavily regulated environment in all the rest except for Argentina and Ecuador which were somewhat more liberal; in Kenya, Tanzania and Uganda a movement out of excessive regulation was already underway. The tax system was complex and inefficient in all countries, and in Bulgaria it had yet to be developed. The trade system was fairly liberal in Argentina and Ecuador, where it was accompanied by a virtual absence of exchange controls on current account transactions; but, on the other extreme, Bulgaria still maintained a state trading system, and the remaining countries maintained extensive intervention, although Kenya, Tanzania, and Uganda were already undergoing substantial liberalization. Exchange controls on current account transactions were pervasive only in Bulgaria, whereas other countries had a fairly liberal system, especially Argentina and Ecuador. In all countries there were fairly comprehensive controls on capital account transactions, although in some of them (especially in Argentina and Ecuador) they probably were no longer effective.

2. Financial sector situation

The initial situation of the financial sectors of the eight countries differed in many ways but all of them had one or more deficiencies that needed reform. A significant initial difference was the absence of direct interest rate controls in Argentina, whereas comprehensive controls were maintained in the remaining countries, except for Ecuador which had already undertaken some liberalization.

The situation of the countries also varied considerably regarding the initial degree of financial deepening (as represented by a broad measure of banking system liabilities in relation to GDP). ^7/ The situation was best, although by no means perfect, in countries like Ecuador, Egypt, and India, which had maintained approximate overall long-term macroeconomic stability, whereas it was worse in other countries—especially Argentina, where recurrent hyperinflation had been a problem—which had seen the size of their respective financial sectors reduced to a small fraction of GDP as a result of persistent financial repression. Another basic difference was in the degree of public ownership of banks, which in terms of market shares varied from being total in Bulgaria, to near total in India and Tanzania, to significant in the remaining countries. Partly in relation to the level of development, the structure of the financial sectors was also rather different across countries, with extensive networks in Argentina and India, somewhat less extensive ones in Ecuador, Egypt, and Kenya, and least developed networks in the remaining countries (Table 3). ^8/ Several countries (Bulgaria, Kenya, Tanzania, and Uganda) started from a situation of serious difficulties in relation to the financial health of the banks, their liquidity and solvency position, and the quality of their portfolios; only Ecuador’s financial system appeared to be largely free of these problems.

Table 3.

Structure of the Financial Sector

Sources: Authorities’ reports and Fund staff estimates. Note: It has not been possible to compile a table referring to the same date for all countries (ideally both the start of reforms and the present situation). However, the institutional structure of the financial sectors did not change significantly during the period of examination, except that some failed banks and other financial institutions were closed in some countries (e.g., Argentina and Kenya) and some banks (including foreign ones) were open in some other countries (e.g., Bulgaria, Egypt, and India).

^1/All except two of these banks had been created as a result of the 1989 banking reform which terminated the monobank system from early 1990 (the other two were newly established private banks). By early 1995 there were already 15 private banks, some of which were however “pocket” banks established to lend to the owner of the bank.

^2/The banking system accounted for about 90 percent of financial system liabilities to the private sector.

^3/This total counts the National Bank for Development and its 17 provincial affiliates (independently licensed) as one bank. The four fully government-owned commercial banks held both majority and minority shareholdings in a number of other commercial banks. At end-June 1989, the commercial banks held 86 percent of total private sector deposits.

^4/The 27 state commercial banks dominate the financial sector, with close to 90 percent of assets, and 92 percent of bank branches.

^5/These included the large state-owned National Bank of Kenya.

Table 3.

Structure of the Financial Sector

Argentina	As of end-1993, the financial system consisted of 206 institutions, including banks, credit unions, finance companies, and savings and loan associations.
Bulgaria	As of March 1991, the banking system comprised the BNB, the Bulgarian Foreign Trade Bank, the State Savings Bank, 8 specialized commercial banks, and 61 commercial banks. 1/
Ecuador	As of late 1992, the financial system comprised the CBE, 32 commercial banks, 3 specialized state-owned banks, and many small intermediaries including finance companies and savings and loan associations. 2/
Egypt	As of end-August 1989 the financial system comprised the CBE, 27 commercial banks, 3/ 33 business and investment banks, and 4 specialized banks.
India	As of March 1993, the financial system comprised the RBI, 81 commercial banks (27 state owned, 27 private domestic, and 27 foreign owned), 196 regional rural banks, 180 center and cooperative banks, 3 state term-lending institutions, 18 state finance corporations, and many specialized institutions and non-bank finance companies. 4/
Kenya	As of March 1992, the financial sector comprised the NBK, 28 commercial banks, 5/ and 55 NBFIs,
Tanzania	As of early 1995, the financial system comprised the BOT, The National Bank of Commerce (a state bank which dominates the financial sector), 2 other state banks, 5 private banks and 2 development banking institutions.
Uganda	As of early 1995, the financial system comprised the BOU, 15 commercial banks, 10 credit institutions, 19 insurance companies, 2 development banks, and 1 building society. Uganda’s banking system is dominated by one government-owned bank—the Uganda Commercial Bank (40 percent of deposits of the system)—and 5 foreign-owned banks (39 percent of deposits).

Sources: Authorities’ reports and Fund staff estimates. Note: It has not been possible to compile a table referring to the same date for all countries (ideally both the start of reforms and the present situation). However, the institutional structure of the financial sectors did not change significantly during the period of examination, except that some failed banks and other financial institutions were closed in some countries (e.g., Argentina and Kenya) and some banks (including foreign ones) were open in some other countries (e.g., Bulgaria, Egypt, and India).

^1/All except two of these banks had been created as a result of the 1989 banking reform which terminated the monobank system from early 1990 (the other two were newly established private banks). By early 1995 there were already 15 private banks, some of which were however “pocket” banks established to lend to the owner of the bank.

^2/The banking system accounted for about 90 percent of financial system liabilities to the private sector.

^3/This total counts the National Bank for Development and its 17 provincial affiliates (independently licensed) as one bank. The four fully government-owned commercial banks held both majority and minority shareholdings in a number of other commercial banks. At end-June 1989, the commercial banks held 86 percent of total private sector deposits.

^4/The 27 state commercial banks dominate the financial sector, with close to 90 percent of assets, and 92 percent of bank branches.

^5/These included the large state-owned National Bank of Kenya.

View Table

Table 3.

Structure of the Financial Sector

Argentina	As of end-1993, the financial system consisted of 206 institutions, including banks, credit unions, finance companies, and savings and loan associations.
Bulgaria	As of March 1991, the banking system comprised the BNB, the Bulgarian Foreign Trade Bank, the State Savings Bank, 8 specialized commercial banks, and 61 commercial banks. 1/
Ecuador	As of late 1992, the financial system comprised the CBE, 32 commercial banks, 3 specialized state-owned banks, and many small intermediaries including finance companies and savings and loan associations. 2/
Egypt	As of end-August 1989 the financial system comprised the CBE, 27 commercial banks, 3/ 33 business and investment banks, and 4 specialized banks.
India	As of March 1993, the financial system comprised the RBI, 81 commercial banks (27 state owned, 27 private domestic, and 27 foreign owned), 196 regional rural banks, 180 center and cooperative banks, 3 state term-lending institutions, 18 state finance corporations, and many specialized institutions and non-bank finance companies. 4/
Kenya	As of March 1992, the financial sector comprised the NBK, 28 commercial banks, 5/ and 55 NBFIs,
Tanzania	As of early 1995, the financial system comprised the BOT, The National Bank of Commerce (a state bank which dominates the financial sector), 2 other state banks, 5 private banks and 2 development banking institutions.
Uganda	As of early 1995, the financial system comprised the BOU, 15 commercial banks, 10 credit institutions, 19 insurance companies, 2 development banks, and 1 building society. Uganda’s banking system is dominated by one government-owned bank—the Uganda Commercial Bank (40 percent of deposits of the system)—and 5 foreign-owned banks (39 percent of deposits).

Sources: Authorities’ reports and Fund staff estimates. Note: It has not been possible to compile a table referring to the same date for all countries (ideally both the start of reforms and the present situation). However, the institutional structure of the financial sectors did not change significantly during the period of examination, except that some failed banks and other financial institutions were closed in some countries (e.g., Argentina and Kenya) and some banks (including foreign ones) were open in some other countries (e.g., Bulgaria, Egypt, and India).

^1/All except two of these banks had been created as a result of the 1989 banking reform which terminated the monobank system from early 1990 (the other two were newly established private banks). By early 1995 there were already 15 private banks, some of which were however “pocket” banks established to lend to the owner of the bank.

^2/The banking system accounted for about 90 percent of financial system liabilities to the private sector.

^3/This total counts the National Bank for Development and its 17 provincial affiliates (independently licensed) as one bank. The four fully government-owned commercial banks held both majority and minority shareholdings in a number of other commercial banks. At end-June 1989, the commercial banks held 86 percent of total private sector deposits.

^4/The 27 state commercial banks dominate the financial sector, with close to 90 percent of assets, and 92 percent of bank branches.

^5/These included the large state-owned National Bank of Kenya.

The initial degree of central bank independence with regard to the conduct of monetary policy ranged from limited in Argentina, Ecuador and Kenya, to very limited in the remaining countries, with no scope for independent action in Bulgaria. The quasi-fiscal losses of most central banks were significant, and in Argentina and Uganda they had led to substantial total central bank losses that loomed large in the fiscal picture. ^9/

Indirect monetary policy instruments were in use only in Argentina, although in Kenya preparations for their use had already been going on for a while. Money markets that could support indirect monetary policy instruments were moderately developed only in Argentina and embryonic in Kenya and India, whereas they were non-existent (Bulgaria) or undeveloped in the remaining countries. Treasury bills were issued in Argentina, Ecuador, Egypt, and India, but secondary markets did not practically exist. In Kenya, treasury bill auctions had just been liberated (late 1990) from all intervention. In Bulgaria, Tanzania, and Uganda, treasury bill auctions had not yet been introduced.

The prudential regulation and supervision systems were undeveloped or inefficient in all countries, although some efforts to improve these systems had already been underway for a while in some countries, like Kenya.

In sum, significant problems affected all countries. Argentina was most In need of macroeconomic stabilization, but this had to be built on a solid foundation of deep structural reforms. Bulgaria, Tanzania, and Uganda, were most in need of structural reforms, so that they could return their economies to a market model, without losing perspective of the continuous need for macroeconomic stabilization. The remaining countries needed a combination of measures to enhance both stabilization and structural reforms. All the countries were in need of better prudential regulation and supervision.

1. Financial sector reforms

The following discussion presents financial sector reforms in four broad categories, beginning with a general overview of interest rate liberalization and its relationship to external capital account liberalization. The second category discusses the development of indirect monetary policy instruments, with particular attention to open market operations and the development of supporting money markets, especially the market for treasury bills; reserve requirement policies are also discussed. The third category comprises reforms of the central bank as the apex institution of the system and it discusses the issues of central bank independence, restructuring of the central bank, and reduction or elimination of quasi-fiscal operations of central banks that cause operating losses. Finally, the fourth category discusses reforms of prudential regulation and supervision and the structure of the financial sector including the entry of new financial institutions, the restructuring, privatization, and liquidation of financial institutions, and the development of securities markets and stock exchanges. (For a brief chronological summary of the major financial sector reforms in the eight countries, see the Appendix.)

Interest rate liberalization is often considered the fulcrum of financial sector liberalization, as no market can function as such without a free price. Argentina was the only country in this study where interest rates were already market determined before the recent reforms of the financial sector were initiated. ^10/ In Bulgaria, Egypt, and Kenya, the liberalization of interest rates was undertaken in 1991—right at the start of the main reforms—and in Ecuador in 1992; whereas India, Tanzania, and Uganda, carried out a more phased liberalization.

Full capital account liberalization was introduced early in 1991 in Argentina by the so-called Convertibility Law, which also involved the introduction of a currency board system with an exchange rate pegged to the U.S. dollar. This pegged system, supported by a 100 percent foreign exchange cover of domestic central bank liabilities, ^11/ was (together with fiscal consolidation) the main pillar of the disinflation strategy. Capital account liberalization gained increasing significance in the remaining countries as a complement to the liberalization of the domestic financial sector. A near complete removal of capital controls was effected early in the reform process in Bulgaria and Egypt. The other countries adopted a more gradual approach.

At the beginning of the recent reforms, indirect monetary policy instruments were used only in Argentina. The introduction of the currency board system meant, however, that Argentina gave up monetary policy independence from the rest of the world and that, therefore, monetary instruments were not to be used except to smooth out short-term liquidity fluctuations. A possible remaining monetary policy instrument was the use of reserve requirement ratios. The authorities, however, decided against the use of this instrument: except in exceptional circumstances, and instead focused on a phased reduction of all reserve requirements and their uniform application across instruments and financial institutions to avoid distortions in the financial system.

In Ecuador and Egypt, the introduction of indirect monetary policy instruments was effected rapidly after the liberalization of interest rates. This necessitated the further development of the incipient money markets and, in particular, of the market for short-term government securities (treasury bills) which could be used in open-market operations by the central bank. ^12/ In Egypt the authorities introduced weekly treasury bill auctions from the beginning of the liberalization (January 1991), and shortly thereafter began to use treasury bills for monetary purposes. In Ecuador, the Central Bank began to operate in treasury bills for monetary control in late 1992 after setting a coordinated system of money and foreign exchange desks. In the remaining countries the introduction of indirect monetary policy instruments was staged more gradually, although for two different reasons. In India and Kenya gradualism was largely voluntary as the authorities proceeded to introduce indirect instruments only slowly despite the fact that they had already accumulated some experience operating in the money markets. By contrast, in the other countries the authorities had little choice but to proceed slowly; not only they had to start treasury bill auctions from scratch—Bulgaria (July 1991), Tanzania (August 1993), and Uganda (May 1992)—but they also had to establish from scratch a framework for the conduct of monetary policy in a market-oriented environment.

With a view to eliminating their implicit tax on financial intermediation and reducing distortions, reserve requirements were more or less rapidly reduced and harmonized in five of the eight countries (Argentina, Ecuador, Egypt, India, and Uganda); in some cases (Argentina and Ecuador) they were reduced from very high initial levels. By contrast, in Kenya and Tanzania, reserve requirements, while uniform, tended to be increased in order to restrain monetary expansion. This was the unfortunate result of inadequate progress in introducing other, more market-oriented monetary policy instruments and the accompanying development of money markets. In Bulgaria, a system of moderate reserve requirements came into operation with the breakup of the monobank and the creation of a decentralized banking system.

Central bank independence was introduced relatively early in Argentina (1992), Bulgaria (1991), and Uganda (1993) and more recently in Tanzania (1995). ^13/ In Argentina, this came about through a new central bank charter, which complemented the earlier Convertibility Law. ^14/ In Ecuador and Kenya, central bank independence was considered relatively early but legislative amendments to this effect are still pending from approval by their respective legislatures. No action has yet been considered in Egypt and India.

In most countries (Argentina, Bulgaria, Ecuador, Tanzania, and Uganda) the central banks themselves were the focus of substantial structural reforms. In Argentina, the Central Bank was subject to substantial downsizing and reorganization to conform with its new mandate under the Convertibility Law. In Bulgaria, restructuring was undertaken following the enactment of the new central bank law which provided the National Bank of Bulgaria with the powers of a central bank. In Ecuador, the new Monetary and State Bank law of May 1992 removed the development banking functions from the Central Bank and attributed them to the newly created State Bank. In both Tanzania and Uganda, the central banks underwent a process of reorganization and downsizing designed to strengthen performance and reduce operational costs.

Central bank losses were characteristic of most of these countries before the recent financial reforms, being especially large in Argentina and Uganda. Following best accepted practices suggested by the Fund, these losses when quantified were in most countries added to the deficit of the nonfinancial public sector to obtain a more complete picture of the overall public sector performance, as they in fact stemmed from quasi-fiscal operations of the central bank (one of the likely results of lack of central bank independence). Argentina very quickly and Ecuador more gradually eliminated these losses by discontinuing the operations giving rise to them or by transferring them to the government. In Uganda, a plan for the recapitalization of the central bank through a Government bond is under consideration.

Reforms of the prudential regulation and supervision systems were undertaken in all countries to some extent, with a particular focus on appropriate bank capitalization, limits on loan concentration and insider transactions, and norms for loan losses, income recognition and provisioning against nonperforming loans. However, progress in these areas was generally slower than anticipated, and much remains to be done. In Bulgaria, the authority of the central bank to dictate prudential regulations and supervise the financial sector was not established until March 1992. Progress in bank supervision was especially slow, and none of the countries—except, beginning recently, Argentina—yet carries out comprehensive on-site inspections of financial institutions based on an effective off-site surveillance system (See Table 5).

Table 5.

Current Bank Supervision Systems

^1/Semi-autonomous part of the Central Bank.

^2/In February 1995, a Banking Board with representatives from the Central Bank and the Superintendency of Banks with responsibility for strengthening the banks’ regulatory framework and reinforcing the reforms of the Superintendency of Banks was established.

^3/However, the reporting system currently excludes offshore banking activities and reporting still suffers from considerable time lags.

Table 5.

Current Bank Supervision Systems

	Supervisory Authorities	Off-site Monitoring Capability	On-site Bank Inspection
Argentina	Central Bank of the Republic of Argentina: Superintendency of Financial Institutions 1/	Reporting system for banks and NBFIs is used to analyze both solvency and compliance with prudential regulations.	Plan of regular inspections or audits put into effect and regular inspections of financial institutions commenced.
Bulgaria	Bulgaria National Bank	Limited capability; there is a plan to establish an early warning system.	Limited on-site inspections carried out since 1993.
Ecuador	Superintendency of Banks (separate from the Central Bank 2/	Reporting system for banks and NBFIs seems operative. 3/	Bank audits required, but only partial on-site inspections carried out.
Egypt	Central Bank of Egypt	Reporting system for banks and NBFIs needs upgrading.	Limited audits and off-site inspections being carried out.
India	Reserve Bank of India: Department of Supervision Department of Banking Operations and Development	Automated system to be developed in three-years time for banks, NBFIs, and AIFIs.	Carried out by 700 inspectors, but without benefit of good off-site monitoring capability.
Kenya	Central Bank of Kenya Bank Supervision Department	Reporting system for banks and NBFIs needs upgrading for financial analysis purposes.	Limited on-site inspections being carried out.
Tanzania	Bank of Tanzania Directorate of Bank Supervision	New bank reporting forms for both supervisory and analytical purposes have been implemented.	Limited on-site inspections being carried out.
Uganda	Bank of Uganda Bank Supervision Department	New surveillance system to be applied to all banks and NBFIs.	limited on-site inspections being carried out.

^1/Semi-autonomous part of the Central Bank.

^2/In February 1995, a Banking Board with representatives from the Central Bank and the Superintendency of Banks with responsibility for strengthening the banks’ regulatory framework and reinforcing the reforms of the Superintendency of Banks was established.

^3/However, the reporting system currently excludes offshore banking activities and reporting still suffers from considerable time lags.

View Table

Table 5.

Current Bank Supervision Systems

	Supervisory Authorities	Off-site Monitoring Capability	On-site Bank Inspection
Argentina	Central Bank of the Republic of Argentina: Superintendency of Financial Institutions 1/	Reporting system for banks and NBFIs is used to analyze both solvency and compliance with prudential regulations.	Plan of regular inspections or audits put into effect and regular inspections of financial institutions commenced.
Bulgaria	Bulgaria National Bank	Limited capability; there is a plan to establish an early warning system.	Limited on-site inspections carried out since 1993.
Ecuador	Superintendency of Banks (separate from the Central Bank 2/	Reporting system for banks and NBFIs seems operative. 3/	Bank audits required, but only partial on-site inspections carried out.
Egypt	Central Bank of Egypt	Reporting system for banks and NBFIs needs upgrading.	Limited audits and off-site inspections being carried out.
India	Reserve Bank of India: Department of Supervision Department of Banking Operations and Development	Automated system to be developed in three-years time for banks, NBFIs, and AIFIs.	Carried out by 700 inspectors, but without benefit of good off-site monitoring capability.
Kenya	Central Bank of Kenya Bank Supervision Department	Reporting system for banks and NBFIs needs upgrading for financial analysis purposes.	Limited on-site inspections being carried out.
Tanzania	Bank of Tanzania Directorate of Bank Supervision	New bank reporting forms for both supervisory and analytical purposes have been implemented.	Limited on-site inspections being carried out.
Uganda	Bank of Uganda Bank Supervision Department	New surveillance system to be applied to all banks and NBFIs.	limited on-site inspections being carried out.

^1/Semi-autonomous part of the Central Bank.

^2/In February 1995, a Banking Board with representatives from the Central Bank and the Superintendency of Banks with responsibility for strengthening the banks’ regulatory framework and reinforcing the reforms of the Superintendency of Banks was established.

^3/However, the reporting system currently excludes offshore banking activities and reporting still suffers from considerable time lags.

The opening of new financial institutions and branches of existing institutions was given new impetus in some countries with a view to increasing competition. Private bank entry was deliberately encouraged in Bulgaria, Egypt, Tanzania, and Uganda. India further liberalized the entry of private banks to compete with the long-established public banks, although the latter still continue to dominate the financial system. In Argentina, regulations from early 1994 allowed the establishment of new banking facilities for the first time in many years. Ecuador and Kenya, countries with extensive private banking systems, had no explicit policy, but new entry was not discouraged. In all countries, the new tendency was to accept the entry of foreign banks to compete with the domestic banks. This policy was also related to the liberalization of capital movements across borders.

Restructuring of commercial and development banks and other financial institutions was undertaken in all the countries, and substantial progress was achieved in some of them. In Argentina, Tanzania, and Uganda, state-owned banks were forced to become more efficient by shedding excess labor, rationalizing operating costs, and closing loss-making branches, although in some cases the objectives of cost rationalization were not fully achieved. By contrast, only modest progress in restructuring of banks was made in Bulgaria, where the main issue was the appropriate consolidation of the numerous small and weak banks resulting from the breakup of the monobank system in 1990. ^15/ Measures for the recapitalization of banks, strengthening their liquidity base, and other measures to ensure the solvency and liquidity of the financial sectors, were adopted in most countries, especially in Argentina and Egypt. In 1993 Kenya proceeded to close a number of banks and NBFIs that were insolvent and had engaged in irregular transactions with the Central Bank.

Bank privatization was a goal in virtually all countries, although to a different degree. In Argentina, Ecuador and Kenya, where the banking system was already largely private, the restructuring of public sector banks was accompanied by some privatization. In Argentina, consideration also has been given recently to the possibility of privatizing most provincial banks, which are a major source of inefficiency in the system. In Bulgaria, Tanzania, and Uganda, bank privatization of their largely state-owned banking systems has been an ultimate goal since the beginning of financial reforms, but little has yet been accomplished, because of delays in restructuring of banks in anticipation of sale. In Egypt, the privatization of banks was conceived as a medium-term process, ^16/ but progress has in practice been slow. In India, besides the licensing of private banks, the privatization policy also involved the sale of minority shares in public banks to the private sector, a goal falling short of outright privatization.

The development of the securities markets was considered necessary in all countries, as was the need for stronger prudential regulation and supervision in this area. ^17/ Promotion of stock exchanges was considered necessary in all countries except Tanzania where it was considered premature. In Bulgaria, stock exchanges were opened in 1992 as part of the process of institutionalization of a market economy, and in anticipation of privatization of public enterprises and banks. In Uganda the establishment of a stock exchange is under consideration. In Ecuador and Egypt new modern security laws were enacted, and in Ecuador the stock exchanges were privatized. Further development of existing securities markets and stock exchanges was promoted in Argentina, India, and Kenya.

2. Other economic reforms

Macroeconomic stabilization through fiscal and other reforms was one of the policy goals in all countries. Fiscal reform was closely associated with the improvement in the public finances and was attempted in all countries with various degrees of effort and success. Substantial fiscal reform was accomplished in Argentina, involving the rationalization of expenditures (through staff attrition, salary correction, and general expenditure control), a substantial improvement in the tax system, and substantial privatization of public sector enterprises. These reforms quickly permitted switching from significant overall public sector deficits (including the deficit of the central bank) to an overall public sector surplus, which, together with the exchange rate anchor supported by the new currency board system, permitted a quick disinflation strategy. In Egypt, significant progress was made over time in fiscal consolidation primarily through tax reforms. Ecuador—and most recently Kenya—also achieved substantial fiscal consolidation. In the other countries the achievements were more modest and public sector deficits continued to pose a challenge for macroeconomic stabilization and the success of ongoing structural reforms. Thus, despite initial efforts undertaken in Tanzania and Uganda, involving civil service retrenchment, expenditure rationalization, tax reform, and restructuring and privatization of public enterprises, fiscal consolidation remains an unfinished business. Fiscal consolidation was not pursued with any vigor in Bulgaria or India, where deficits continued to be very large.

In addition to helping to close the fiscal gap, privatization of public enterprises was viewed in most cases as having a significant effect on liberating the financial sector from the burden of government-imposed obligations to provide concessional credit to maintain afloat these inefficient enterprises. However, implementation posed numerous problems, and delays were frequent. Privatization of public enterprises was a major issue in Bulgaria in its transition from central planning to a market economy, but in its circumstances it proved to be an arduous and slow process which still has to be implemented. Similarly, Tanzania and Uganda only slowly initiated the process of privatization of their dominant public enterprise systems. In the absence of domestic capital markets it was difficult to find suitable buyers. In Egypt and India, where large and inefficient public enterprise sectors operated side by side the private sector, only slow privatization was contemplated and little was accomplished. Of the remaining countries with less intrusive public enterprise sectors, only Argentina engaged in a substantial privatization program. ^18/

Price liberalization was undertaken in Bulgaria through a sweeping measure in early 1991, simultaneously with the freeing of interest rates and the adoption of a flexible unified exchange rate system. This liberalization led to an initial outburst of inflation resulting from the burning out of the monetary overhang inherited from the central planning period. In most other countries price liberalization referred mostly to periodic adjustment of public sector prices and to the deregulation of some controlled prices (often dictated by special marketing boards) in the private markets, in addition to the decontrol of prices inherent in the privatization of public enterprises.

Significant trade reform was accomplished in Argentina, Bulgaria and Ecuador. In Bulgaria, trade reform and currency convertibility were the main pillars in the establishment of a competitive price system in the short run, given the absence of a domestic market. Kenya, Tanzania, and Uganda made significant progress toward trade liberalization, the latter two starting from a highly restrictive regime. ^19/ Egypt and India made only slow progress in dismantling their complex and inefficient trade systems.

Except for Argentina—which from the beginning of reforms maintained an exchange rate pegged to the U.S. dollar as part of its anti-inflationary policy—all countries adopted or maintained a flexible exchange rate system. In some cases, the authorities operated a dual or multiple exchange rate system for a while, with at least one free market rate, before complete unification and floating of the exchange rate was achieved. Interbank foreign exchange markets became the typical arrangement in all countries.

All seven countries that were heavily indebted before reforms (all except India) made progress in working out substantive agreements to reduce the level of external debt and debt burden. Argentina’s debt and debt-service reduction operation (DDSR) with foreign commercial banks was completed in April 1993, thereby opening the door for the country’s return to the international capital markets. Ecuador’s DDSR operation was completed in April 1995. Egypt’s Paris Club agreement went through two phases of implementation, before the third and final phase was withheld pending either approval by the Fund of a new arrangement or the conclusion of a review under the existing arrangement. In Bulgaria, both a Paris Club agreement and an agreement with the banks are awaiting approval of a structural adjustment program supported by the Fund. Kenya, Tanzania and Uganda moved to reach understandings with official creditors, following adoption of structural adjustment programs supported by the Fund. ^{20/ 21/} However, because of their low per capita income and their external vulnerability, Tanzania and Uganda continue to depend heavily on concessionary support from the international financial community.

3. Sequencing issues

In all countries financial sector reforms formed part of wider efforts to improve general economic efficiency and achieve macroeconomic stabilization in the context of a market economy. ^22/ Thus, financial sector reforms were viewed as essential to the success of the overall reform and stabilization process. They were expected to bring increased monetary policy effectiveness to cope with inflation and to establish efficient intermediation as a focus for market-oriented savings and investment decisions, and therefore economic growth.

The degree of macroeconomic stability ranged from bad to poor in all these countries before the start of reforms, but none of them considered it appropriate to delay the implementation of financial and other structural reforms until after the achievement of advanced macroeconomic stability. In Argentina, which started from a severe hyperinflation, the authorities nevertheless already maintained free interest rates and were prepared to introduce further structural reforms simultaneously with macroeconomic stabilization. In Bulgaria, interest rates were freed early and simultaneously with prices and the exchange rate, and were accompanied by a substantial initial reduction of exchange and trade restrictions, in order to promptly subject the economy to the forces of international competition. Given the initial monetary hang up, inevitably this rapid liberalization resulted in high inflation initially, but it was hoped that with the introduction of fiscal and monetary restraint this would constitute a temporary phase in the adjustment process, and would not undermine the liberalization nor the further structural reforms that were being contemplated. In the remaining countries, although macroeconomic stabilization was being attained at a slower pace than anticipated, there was no question of turning back on the financial (and other structural) reforms and, in fact, both processes were viewed as reinforcing each other.

In all the countries, financial sector reforms were initiated before or simultaneously with attempting the removal of exchange controls on capital account transactions. In Argentina, interest rates had already been freed before the starting of the 1991 reforms, when an immediate and complete liberalization of the capital account was effected under the Convertibility Law. In Egypt, capital account liberalization was introduced in early 1991, at about the same time that interest rates were liberalized. In the remaining countries capital account liberalization was envisaged as a gradual process, to be achieved simultaneously with or shortly after financial reforms. India was perhaps the slowest to start the process of removal of capital controls, in consonance with its gradualist approach to financial sector reforms. ^23/

The internal sequencing of financial sector reforms was in all cases—although not necessarily by design but because of practical realities—one of relatively rapid removal of interest rate controls (liberalization) but a much slower resolution of structural issues. As noted, Argentina already had a free interest rate system at the start of the reforms, and Bulgaria, Egypt and Kenya introduced interest rate liberalization right from the start of the reforms in 1991, with Ecuador following in 1992, Tanzania in 1993, and Uganda in 1994; only a remaining ceiling on term deposit rates is still maintained in India. By contrast, all these countries to a larger or lesser extent still have to complete the process of restructuring and privatization of their financial sectors; this process involves many complex decisions and takes more time. In some countries, as in Tanzania, remaining structural deficiencies impeded progress toward effective interest rate flexibility in the new liberal environment. ^24/

Although the strengthening of prudential regulation and supervision systems is generally viewed by both analysts and policy makers as a precondition for the success of interest rate liberalization, these reforms were only slowly introduced in most of these countries and, in fact, several of them still have relatively weak regulatory and supervisory systems, with largely inadequate on-site inspection. These weaknesses attest to the practical difficulties encountered in the reform of these systems, which require very significant legal and institutional undertakings, substantial training and technical assistance, and the appropriate level of funding. As discussed later on, the shortcomings of inadequate prudential and supervisory policies have become one of the major concerns regarding the efficiency and even future viability of the reforms.

The introduction of indirect monetary policy instruments has to be built, of course, on already functioning money markets or at least on auctions of treasury bills or central bank short-term market instruments. In Argentina, the only country with some traditional money markets, indirect instruments were already the principal vehicle for monetary control at the start of the reforms. ^25/ In Ecuador, the switch from direct to indirect monetary policy instruments was effected rapidly after the liberalization of interest rates in 1992. The process of substitution of indirect for direct instruments took about two years in Egypt, following the near complete liberalization of interest rates in 1991, during which period the two systems were run in parallel. In the remaining countries, the development of indirect instruments was a slow process, which is still ongoing in some and not yet started in Bulgaria. It was risky to rely solely on indirect monetary policy instruments in a financial system that suffered from the lack of, or the insufficient, development of the treasury bill and other money markets on which to target the instruments. The necessary reduction of inappropriately high reserve requirement ratios to promote the efficiency of financial intermediation, in particular, required the application of offsetting instruments to prevent the expansionary monetary effects derived from such reduction. As mentioned earlier, some of the countries, in fact, had to recur to large increases in reserve requirement ratios during the reform period—a setback for reform—because market-based indirect monetary policy instruments had not yet reached sufficient development to be used as primary control mechanisms.

4. Unresolved questions

In all the countries reviewed in this paper financial sector reforms are still an ongoing process. ^26/ This is particularly true of those that started from a more primitive and/or a more controlled system, which are all except for Argentina and Ecuador.

The situation of the financial sector in Argentina is probably the most advanced of the group. One of the main structural problems still pending from resolution is the restructuring and privatization of the provincial banks. ^27/ Another area where reforms are at present being intensified is the further refinement and implementation of prudential norms and supervision to ensure the soundness and liquidity of the financial system. This issue came recently to the forefront because of the liquidity difficulties suffered by some private banks as a result of a sharp reversal of capital inflows in the aftermath of the Mexican financial crisis. ^28/

Among the most pressing reforms still to be implemented in Ecuador are those related to the amendment of the central bank charter to grant independence to the Central Bank (a reform stalled in the opposition-controlled legislature for two years); implementation of a program to strengthen bank supervision; enforcement of tighter capitalization requirements; reform of official financial institutions; and clarification of conditions for entry of new institutions. ^29/

The situation in Bulgaria remains one of slow progress and numerous unresolved issues. The main pending reforms are the consolidation of indirect monetary policy instruments (impeded by the lack of sufficient progress in the development of the money and securities markets); ^30/ implementation of a clean-up program of nonperforming loans, completion of the restructuring of the banking system, and recapitalization and privatization of banks; improvement in the legal and institutional capacity to restructure the financial sector and to enforce prudential regulations and supervision; implementation of a long-contemplated program to establish bank credit limits on 100 selected state-owned enterprises as a way to stop credit expansion and impose a hard-budget constraint on these enterprises; initiation of steps to develop further the capital markets by selling government bonds and promoting trade in stocks of privatized companies; and enactment of appropriate legislation on commercial contracts, securities, and stock market transactions.

In Egypt, after a strong start with liberalization in 1991, the pace of financial sector (and other) reforms went through a period of consolidation before being reinvigorated in 1993. Reforms still pending are the completion of a program of reduction and eventual elimination of subsidized credit and the phased reduction of reserve and liquidity requirements; continuation of the sale of state shares in joint-venture banks and privatization of state banks and insurance companies (with at least one of the larger public banks and insurance companies to be privatized); certain refinements in bank supervision; strengthening of the monitoring and enforcement capacity of the capital markets authority; and enactment of modern general exit and bankruptcy legislation.

Progress in India has been slow. Despite financial liberalization efforts made in recent years, major distortions remain, including priority and concessionary lending requirements, as well as high cash and liquidity ratios; ^31/ a ceiling on bank term deposit rates; a banking system still dominated by the public sector, which suffers from large nonperforming assets and high operating costs; weak income recognition norms and a system still struggling to meet capital adequacy requirements along the lines of the Basle Committee; lack of competition in the insurance industry, still a government monopoly; inadequate prudential regulation and supervision over the financial system and over the capital markets; and lack of independence of the central bank. The development of money and securities markets has suffered in part as a result of the gradual and unfinished liberalization of interest rates and of financial transactions, and this has also slowed the introduction of effective indirect monetary policy instruments.

Financial sector reforms in Kenya dating back to the mid-1980s suffered from the vagaries of stop-go policy cycles and, although interest rates were freed in mid-1991, the following two years were marked by macroeconomic mismanagement and public financial scandals that culminated in an economic crisis in March 1993. To face this crisis the authorities implemented substantial measures to reform the financial (and other) sectors in the following two years. Nevertheless, there remain important issues to be resolved, including restructuring and sale of government shares of public commercial banks (especially the National Bank of Kenya); amending the Central Bank of Kenya Act and the banking legislation to strengthen the role and independence of the Central Bank in monetary policy; implementing a gradual reduction in the cash reserve requirement and enforcing this requirement on banks’ affiliated financial institutions; improving prudential regulation and bank supervision and furthering judiciary reform to enforce financial regulations; ^32/ developing a secondary market in treasury bills; reforming insurance institutions and enacting a modern insurance law; converting the National Social Security Fund into a pension fund and strengthening supervision over insurance companies and pension funds; encouraging further development of the capital market and the stock exchange; and amending the legislation on bankruptcy, liquidation, and recovery of debts.

Despite substantial progress made in Tanzania and Uganda in reconstructing their financial sectors after years of considerable disorder, some serious problems remain in both cases. In Tanzania, remaining structural issues in the financial sector include consolidating and extending institutional reforms through the restructuring and privatization of the three existing public banks, especially the National Bank of Commerce (the dominant bank), and the continued encouragement of entry of new private financial institutions, including foreign banks, to promote market competition; strengthening the supervisory, regulatory and market related functions; ^33/ improving monetary policy design and implementation, with better integration of monetary and fiscal policy; strengthening the use of indirect monetary policy instruments and the development of reserve money programming; creating a wider array of financial instruments, including longer-term government securities with market-related yields; and establishing a stock exchange.

In Uganda, the main remaining issues are increasing the scope for flexible implementation of monetary policy and for further broadening and deepening of the treasury bill market; ^34/ encouraging the development of a shilling interbank market to reduce the need for banks to rely on overdrafts with and rediscounts from the Bank of Uganda; completing the restructuring and recapitalization of the Bank of Uganda, and improving its regulatory and supervisory capabilities; improving check clearing procedures; implementing the restructuring and privatization of the Uganda Commercial Bank (the dominant bank) and other weak banks; and enacting legislation to facilitate the development of a capital market and establishing a stock exchange.