Uganda
Background Paper on Issues in Financial Sector Reform, and Statistical Appendix

This Background Paper examines issues in Uganda’s financial sector reform. In Uganda, reforms in the financial sector have included the liberalization of interest rates, the development of instruments of indirect monetary control, the modernization of banking legislation, the restructuring of the central bank, and reforms in the commercial banking system. These reforms are aimed at improving monetary management, which would enhance the prospects for achieving stabilization. Ultimately, financial sector reforms will contribute to long-term sustainable growth by mobilizing domestic savings and channeling these resources to the most profitable investment projects.

Abstract

This Background Paper examines issues in Uganda’s financial sector reform. In Uganda, reforms in the financial sector have included the liberalization of interest rates, the development of instruments of indirect monetary control, the modernization of banking legislation, the restructuring of the central bank, and reforms in the commercial banking system. These reforms are aimed at improving monetary management, which would enhance the prospects for achieving stabilization. Ultimately, financial sector reforms will contribute to long-term sustainable growth by mobilizing domestic savings and channeling these resources to the most profitable investment projects.

I. Introduction

Since 1987, Uganda has pursued a comprehensive adjustment program, including the implementation of policies to achieve macroeconomic stabilization and reforms in several key structural areas. 1/ In any structural adjustment program, macroeconomic stabilization and structural reforms are usually complementary objectives. Although stabilization policies are primarily focused on restoring short-run internal and external macroeconomic equilibrium, microeconomic and institutional obstacles, which distort the allocation of resources, will usually prevent sustained stabilization in the long run or will discourage saving, investment, and growth. Thus, in the case of Uganda, the pursuit of stabilization has been accompanied by structural reforms in the domestic goods market, the removal of price controls, the liberalization of foreign trade and the exchange system, reforms to the public sector and the tax system, and the deregulation and reform of the financial system.

The focus of this paper is on current reform issues in the financial sector. In Uganda, reforms in the financial sector have included the liberalization of interest rates, the development of instruments of indirect monetary control, the modernization of banking legislation, the restructuring of the central bank, and reforms in the commercial banking system. These reforms are aimed at improving monetary management, which would enhance the prospects for achieving stabilization, and removing obstacles to increased savings and investments. Ultimately, financial sector reforms, which increase the efficiency of financial intermediation, will contribute to long-term sustainable growth by mobilizing domestic savings and channeling these resources to the most profitable investment projects. Likewise, an efficient financial system with sound institutions will permit the increased use of indirect monetary policy instruments. Thus, it is important to discuss both reforms aimed at improving financial intermediation, as well as those aimed at improving the functioning of the central bank.

Although Uganda’s financial sector comprises both commercial banks and nonbank financial institutions, the emphasis of the paper is principally on reforms in the central bank and in the commercial banking system. Nonbank financial institutions are as yet not fully developed and account for a relatively small share of assets in the financial system, although they are likely to become increasingly significant in the future. Currently, the financial assets of nonbank financial institutions consist mainly of bank deposits and to a lesser degree treasury bills. Furthermore, with the exception of building societies, they have not yet been brought under the supervision of the central bank.

Section II of the paper provides an overview of the structure of the financial system and describes important financial indicators, including the current state of monetary management. Section III describes reforms in the Bank of Uganda (BOU), and discusses issues affecting the relationship between these reforms and improved monetary management. Section IV discusses systemic issues affecting the performance of the banking system in Uganda. This section also assesses the current efforts to privatize the Uganda Commercial Bank (UCB), the largest commercial bank in Uganda, as well as efforts to restructure and improve the performance of other weak banks. Section V discusses issues related to the provision of rural financial services, development finance, and long-term lending, and Section VI presents concluding remarks, with an emphasis on what needs to be achieved over the medium term.

II. Overview of the Structure of the Financial Sector

The financial sector in Uganda is characterized by a generally weak banking system, high intermediation costs, and low levels of monetization. The commercial banking system has been plagued by profitability problems associated with a high stock of nonperforming loans, insider lending, inadequate management practices, and undercapitalization. Many of these deficiencies can be linked historically to improper supervision by the central bank, and the granting of licenses to banks that did not meet normal banking requirements. The consequences of the weak state of the banking sector have been large interest rate spreads, and periodic liquidity problems, which have led to inefficiency in the mobilization of savings for productive investments.

The weak state of the financial system has also contributed to a lack of financial depth (Table 1). The ratio of the stock of monetary aggregates (as measured by M2) to GDP is estimated at only about 10 percent, compared with about 40 percent in Kenya, or about 30 percent in Tanzania. Additionally, the economy is cash oriented, with about 34 percent of the outstanding stock of money in the form of currency. The strong preference for cash reflects partly a lack of confidence in the banking system, but more specifically, deficiencies in the payment and clearing system, which discourage the use of demand deposits. Nevertheless, the ratio of time and savings deposits to broad money has increased from about 14 percent in 1990 to 25 percent in 1995. It is difficult to establish whether this increase in financial savings is sensitive to movements in real interest rates, since such rates fluctuated significantly over the period.

Table 1.

Uganda: Financial Indicators, 1990/91-1994/95

article image
Source: Calculated from data provided by the Ugandan authorities.

Calculated as [(1+interest rate)/(1+inflation rate) -1].

Financial depth in Uganda is also affected by the relatively large volume of transactions in the economy, which are not monetized. Although increasing, the ratio of monetary GDP to total GDP is still estimated at only about 76 percent. With a weak banking system and generally low rates of monetization in the economy, it is to be expected that financial markets would be undeveloped. This has limited the development of financial instruments and the effective conduct of monetary policy.

1. Financial institutions, bank lending, and financial markets

Uganda’s financial sector currently comprises the BOU, 17 commercial banks (with 2 others scheduled to start operations shortly), 3 development finance institutions, about 10 credit institutions specializing in long-term finance, about 25 insurance companies, over 70 foreign exchange bureaus, and 1 active building society. Although the number of financial institutions may appear to be large, commercial banks are by far the dominant financial intermediaries. For instance, as of end-December 1995, total assets in the commercial banking system stood at about U Sh 718 billion with private deposit liabilities of more than U Sh 350 billion, whereas for 1994, total premiums paid in the insurance industry amounted to less than U Sh 20 billion. Similarly, the activities of long-term credit institutions, besides the development banks, are relatively insignificant. The Housing Finance Company of Uganda is one of the more important of these institutions, and its current portfolio contains liabilities of only about U Sh 3 billion and mortgage assets of about U Sh 2.7 billion. Another potentially significant source of long-term funds is the National Social Security Fund (NSSF). For 1995, its estimated contributions were only U Sh 9 billion, and its assets are mainly held in the form of real estate and short-term deposits with commercial banks. Issues affecting the three development finance institutions are discussed in Section V.

Uganda’s commercial banking system can be divided into three main groups: (i) 100 percent public sector banks; (ii) majority-owned or 100 percent-owned private foreign banks; and (iii) privately owned domestic banks. Of the 17 currently operational commercial banks, 2 fall in the first category--the Uganda Commercial Bank (UCB) and the Cooperative Bank (COOP)--6 are in the second category (Barclays, Baroda, Standard, Stanbic, Tropical Africa, and Cairo), and the remaining 9 are in the third category (Nile, Gold Trust, Greenland, Centenary, Sembule, International Credit, Orient, Kigezi, and Crane). The two banks expected to open shortly--Trust Bank and Trans Africa--are both privately owned foreign banks.

In terms of deposit shares, the banking system is quite concentrated, though less so than a few years ago. As of end-December 1995, the UCB accounted for about 35 percent of all deposit liabilities, and the COOP for another 8 percent. Excluding Cairo, which only recently started business, the remaining five foreign banks accounted for another 35 percent of deposit liabilities. In the last few years, the most significant development in terms of market shares has been the decline in the UCB’s relative importance. Although the bank remains dominant, its market share of deposit liabilities has declined to its current level from a previous high of 47 percent in 1993. The main winners have been the domestic banks, whose collective share at that time was only 11 percent. The relative decline of the UCB’s share has been directly due to the bank’s financial problems and consequent downsizing.

Bank lending has historically been concentrated in three main areas: manufacturing, agriculture, and trade and commerce (Table 2). Although in recent years foreign coffee prefinancing has become increasingly important, most agricultural loans by banks continue to be in the form of crop finance, which provides short-term funds to coffee exporters until they receive payment from foreign purchasers. With the continued rehabilitation of the manufacturing sector and with new investments, the share of commercial banks’ advances to these industries has steadily increased over the last several years. As with deposit liabilities, the UCB and the COOP have the largest market shares in terms of gross loans (over 50 percent), with the foreign banks responsible for about another 30 percent. Banking services in Uganda are concentrated in the capital, Kampala. Despite the large share of deposits, the foreign banks operate principally in the capital and focus mainly on financing international trade. The vast majority of rural branches are operated by the UCB and the COOP. The limited presence of banking institutions in the rural areas has severely curtailed the availability of credit, thus preventing economic growth from being more broad based.

Table 2.

Uganda: Commercial Banks’ Advances to the Private Sector by Economic Activity, 1990–95

(In percent of total, end of period)

article image
Source: Bank of Uganda.

The most serious systemic issue facing the commercial banking sector is the high percentage of nonperforming loans, estimated at about 42 percent of the outstanding stock of private sector credit. The poor performance of loans has led to a growing insolvency of banks, with the result that interest rate spreads have remained large. Additionally, as banks have become more cautious in making loans, the loan/deposit ratio has fallen, dropping from 82 percent at end-1992 to about 77 percent by end-December 1995. 1/ These issues, together with others affecting the commercial banking system, are discussed in more detail in Section IV.

The weak state of the banking system has had a negative effect on the development of financial markets and indirect monetary management. The primary treasury bill market has now become the main domestic financial market and the most important medium for indirect monetary management. Prior to April 1992, treasury bills were used as nonbank financing of the Government’s deficit, and commercial banks were prohibited from holding these instruments. However, over the last several years, the weekly auction of bills has become increasingly important in affecting liquidity conditions in the banking system. This switch to the treasury bill market has replaced a system of administered interest rates and the reliance on changes in required reserves to achieve monetary objectives. Currently, bills are sold with 91-day, 182-day, 273-day, and 364-day maturities. The treasury bill auctions are conducted on a regular and predictable basis. The 91-day treasury bills are auctioned weekly, with the longer dated bills auctioned every four weeks.

The effectiveness of the treasury bill is nevertheless constrained by a number of factors. Auctions continue to be supported by only a few banks, even as banks’ holdings of nonearning excess reserves remains high (Chart 1). The strong demand for excess reserves is directly related to the weak state of the banking system and the consequent underdevelopment of domestic markets. Banks hold excess reserves for clearing purposes in the absence of an interbank domestic shilling market, the development of which is in turn constrained by the lack of mutual trust in the banking system. This lack of mutual trust has led to the development of a segmented banking system, consisting of a few stronger, mainly foreign-controlled banks, and a group of very weak or insolvent banks. The lack of confidence not only undermines the development of an interbank shilling market, by encouraging the holding of high excess reserves, but threatens the reliability of the clearing system, and contributes to the lack of liquidity of treasury bills and the development of secondary market transactions. This lack of secondary market transactions in treasury bills has implications for the effectiveness of monetary policy. First, the absence of such trading limits the development of meaningful prices for treasury bills, as the instruments are typically held until maturity. Second, with no secondary trading, the transmission link of monetary policy via interest rates is weak. This appears to be particularly true of lending rates, which have not been very sensitive to movements in the treasury bill rate in Uganda. Third, the inclusion of nonbank financial institutions and the nonbank public as market participants is likely to remain limited, thus further constraining the effectiveness of monetary policy. Although the reform of the commercial banking system may resolve many of the issues affecting the development of markets and improve the effectiveness of monetary policies, the strengthening of the central bank’s functions are also critical. Bank of Uganda reforms have been pursued in several areas, including general restructuring and recapitalization, the strengthening of supervision, and enhanced monetary management (see Section III). These reforms have been and continue to be underpinned by important recent revisions in banking legislation and the BOU statute.

CHART 1
CHART 1

UGANDA: COMMERCIAL BANKS’ EXCESS RESERVES, JUNE 1994–DECEMBER 1995

Citation: IMF Staff Country Reports 1996, 051; 10.5089/9781451838602.002.A001

Sources: Data provided by the Ugandan authorities; and staff estimates.

2. Recent changes in banking legislation

In May 1993, a revised Bank of Uganda Act and a Financial Institutions Act were passed by the Ugandan parliament. These new statutes greatly strengthened the legal and prudential framework covering the banking sector, and gave the BOU the primary responsibility for the formulation and implementation of monetary policy.

The BOU Act was designed to give new independence to the central bank through a clear mandate and more autonomy in decision making. According to the Act, the primary mandate of the BOU is the maintenance of monetary stability. Although the central bank now has greater autonomy in the internal management of its operations and in its regulatory functions over the banking sector, the statute calls for a seven- to nine-member Board of Directors that is strongly influenced by the Ministry of Finance and Economic Planning (MFEP). The Board’s members include the Governor and Deputy Governor, who are appointed by the President, the Secretary to the Treasury, and four to six other Directors, who are all appointed by the MFEP. Should the Minister of Finance and the Governor of the BOU disagree over the course of monetary policy, the Minister is empowered to redirect policy, although he is required to explain his actions to the legislature. Consequently, under these arrangements, considerable efforts are required for the BOU to pursue an independent role in monetary affairs. Furthermore, these provisions of the statute imply that for monetary policy implementation to be effective, it is imperative that there be regular policy meetings between the Governor of the BOU and the Minister of Finance to ensure the sharing of information and the prevention of misunderstandings. Additionally, the conduct of effective monetary policy by the BOU requires that it be financially independent, 1/ and that it continue to strive to improve its technical operational capacity.

The Financial Institutions Act of 1993 represents significant improvements over the 1969 Banking Act. It brings the legal framework up to international standards in such areas as bank licensing, capital adequacy, legal lending limits, the role of auditors, enforcement powers, and steps to protect depositors’ funds. In accordance with the Financial Institutions Act of 1993, a deposit insurance fund was formally established on July 1, 1994 (see Section IV for a further discussion). Prior to the 1993 Act, the BOU had no legal role in the licensing of new banks. This was the responsibility of the MFEP. Under the current Act, the BOU now has the opportunity to combine its ongoing prudential supervision of banks with a policy of ensuring that new banks entering the industry meet the appropriate initial prudential norms from the outset. This relates in particular to the issue of capital adequacy. The new Act also provides the BOU with powers to address issues of abuse of insider lending, to act swiftly to take over unsound banks and remove management if circumstances warrant, and to initiate substantial restructuring of weak banks. Also, as part of the foreign exchange system unification in 1993, the BOU now exercises its powers to license, regulate, and supervise the large number of foreign exchange bureaus.

III. Reform of the Bank of Uganda and Monetary Management

Over the past five years, the BOU has made significant progress in reforming its activities. These reforms have included restructuring of its operations, in particular retrenchment of staff and other cost-cutting measures, recent steps to initiate its recapitalization, improvements in bank supervision, and progress toward more efficient monetary management. However, there is clearly a need to strengthen further banking supervision in light of the continued weak state of the banking system, and to develop strategies to deal with insolvent banks. Additionally, the BOU needs to improve its managerial and operational capacity, and to continue the promotion and development of domestic markets. Lastly, although the process has been initiated, it is imperative to reach a final resolution of the central bank’s recapitalization needs.

1. Restructuring and recapitalization of the Bank of Uganda

The main elements of the BOU restructuring plan were approved by its Board in December 1994. These included staff reductions under two phases, the transfer to the Government of operations at the central bank that were not directly related to central banking functions, such as the Agricultural Secretariat and the External Debt Management Office, the sale of residential houses and vehicles, and proposals for the recapitalization of the bank to ensure both that its capital is restored, and that it has an income stream to cover operational expenditures.

Since then, the BOU has substantially implemented both phases of its staff reduction plans. The first phase involved the voluntary retrenchment of 500 staff members and was completed by the beginning of 1995. The second phase includes the involuntary retrenchment of about 300 persons through staff rationalization, and the transfer of the Agricultural Secretariat and the External Debt Management Office to the MFEP. During 1995, the second phase of the staff reduction plans was completed, except for the transfer of the departments to the Government. These staff rationalizations are expected to reduce employment levels in the central bank to about 1,000. On an annual basis, it is expected that the staff reductions will save the bank some U Sh 6 billion. This is equal to about 25 percent of the central bank’s actual expenditures for the fiscal year 1993/94, and in excess of its operating losses of about U Sh 4 billion for that period. In improving its operating budget, the BOU has been careful to protect certain core functions in its operations, for example, research, supervision, and foreign exchange operations.

Other cost-cutting measures introduced by the BOU over the last year included the selling of about half the 118 vehicles it owns, and the putting up for sale of 10 of its 35 residential houses. The expected savings from these measures are approximately U Sh 650 million on an annual basis. On its income side, the BOU is receiving technical assistance to increase its earnings through better management of its foreign exchange reserves. This technical assistance has been provided by the World Bank and the Federal Reserve Bank of New York.

In order to achieve the BOU’s reorganization objectives of becoming a smaller but more efficient and effective institution, it is now necessary to upgrade management and operational capacity. Senior management should continue the process of improving its organizational skills, and should receive ongoing training in both management techniques and accepted central banking practices. The activities of departments, especially in relation to development objectives, need to be carefully defined, and job specifications should reflect, for example, tasks related to the development of financial markets and instruments. Given Uganda’s present state of development, there is likely to be a human resource constraint in furthering the modernization of central banking. Nevertheless, the BOU needs to be fully conscious of implementing its mandate over the medium to long term.

The issue of the recapitalization of the BOU has become increasingly important for a number of reasons. First, a central bank needs to be fully capitalized in order to perform its leadership role effectively. Second, there is a direct relationship between the central bank’s balance sheet and the Government’s fiscal budget, in that if the central bank runs losses, the Government’s fiscal deficit is underestimated. The converse is true in the case of central bank profits. In this vein, BOU recapitalization is needed to: (i) give transparency to its balance sheet--serving as both an example and a source of guidance to other financial institutions under its surveillance; (ii) to give it operational autonomy by allowing it to break even; and (iii) to enable it to conduct effective monetary operations in a transparent and accountable manner.

The BOU’s recapitalization needs have been subject to varying estimates, depending on how past losses, including the valuation losses associated with IMF debt, have been treated. Estimates vary from about U Sh 88 billion to U Sh 260 billion. Essentially, there are three main accounting elements to the BOU’s recapitalization needs: (i) IMF obligations, including accumulated charges and valuation losses; (ii) non-performing assets, which include government-secured debt, and the debts of parastatals; and (iii) a deficiency in its authorized capital. In addition to restoring the BOU’s balance sheet to eliminate its negative net worth, there is also the more immediate issue of ensuring that the central bank’s operating needs can be met with a sufficient stream of income, and that it can conduct monetary policy efficiently. The current initial recapitalization of U Sh 60 billion in interest-bearing securities of varying maturities is designed to provide the BOU with a stream of income to meet its operational expenses, including the regular payment of IMF charges, and a portfolio of tradable instruments to effect monetary operations. With this assured income, the BOU will also be in a position to issue, if necessary, its own short-term instruments for liquidity absorption purposes.

The second and final stage of recapitalization is aimed at resolving all past positions on the BOU’s books. This will be facilitated by an external audit currently under way. It is expected that these past positions would be settled in ways that do not lead to real effects in a flow sense, for example, by converting government deposits with BOU to equity or by the injection of non-interest-bearing paper. As a matter of principle, it is to be expected that the Government will cover BOU losses or any future impairment to its capital. Likewise, the BOU statute provides for the transfer of any profits made to the government accounts after adding a certain portion to reserves.

2. Banking supervision

The role of banking supervision in a financial system is to ensure that banks conduct their business in a lawful and prudent manner, and to demand timely correction of any deviations. Important elements of supervision are on-site inspections, off-site monitoring, and the ability to analyze and evaluate banks’ internal risk management systems. Corrective actions should include targets and timetables for achieving conformity with established prudential norms. Although this task is taken seriously by the Banking Supervision Department (BSD) of the BOU, there are still deficiencies in terms of capabilities, in particular the carrying out of frequent on-site inspections. To this end, and especially given the need to quickly strengthen the financial system, the recruitment and retention of high-quality staff have become critical.

The BOU statute provides it with considerable discretionary powers in the field of banking supervision. Nevertheless, the BSD has historically been quite indecisive and slow to deal with problem banks. Much of this is due to the fact that the BOU is still unsure of its independence, and decisions regarding such issues as the licensing of banks have only recently been transferred to the central bank. In the future, the BOU is likely to be called upon to act more quickly to arrest the decline in the financial condition of banks. It may also have to be more assertive in ensuring that banks follow the prudential norms regarding capital adequacy, provisions against bad debts, and insider lending.

In the area of licensing of new banks, the Government has adopted a moratorium on the issuance of new licenses until the current financial sector reform program is sufficiently advanced. The policy, however, does make provisions for exceptions in cases such as where the applicant has substantial experience in international banking, or is prepared to offer new services, or is willing to exceed substantially minimum capital requirements, or take over weak banks. The BOU will need to rigorously implement its current policy on licensing new banks, and even when the moratorium ends, will need to ensure demanding entry criteria for new banks.

3. The development of indirect monetary management

The BOU has made significant progress in the adoption of an operational framework for indirect monetary management based on a reserve money program. This program is built on the link between the individual components of the central bank’s balance sheet and the ultimate goals of monetary policy. This approach requires sufficient knowledge by the BOU of items on its balance sheet that are relatively easy to control, the availability and the freedom to use instruments in a manner consistent with the reserve money target, and refined forecasting skills and accurate data for the projection of those items that it does not control.

Although the construction and monitoring of the reserve money program are well established in the BOU, there are still several weaknesses. First, the forecasting of various components of the demand for base money, particularly currency and excess reserves, should be improved. This is not easy, especially given the current structural changes taking place in the financial sector. As mentioned before, commercial banks’ demand for excess reserves is somewhat unpredictable, given the weakness of the banking system and the embryonic state of a domestic interbank shilling market. Additionally, the Ugandan economy remains largely unmonetized, but here also, structural changes and increasing confidence in the shilling are likely to lead to shifts in the preferences to hold currency, which may be difficult to anticipate. Second, the forecast for net foreign assets is constrained by the lack of reliable and timely information on the movements in the balance of payments, in particular, trade data and private transfers. Third, the forecast for net credit to the Government is based mainly on the cash-flow projections prepared by the MFEP, which are frequently inaccurate and subject to large fluctuations. In this respect, an important issue is the need for ongoing coordination between the BOU and the MFEP at the technical level. Fourth, the ability to carry out ongoing analysis of the relationships between reserve money, broad money, and other macroeconomic aggregates is limited. Finally, the instruments available to the central bank to affect the main items of base money are insufficient.

Of these five weaknesses, the first four refer mainly to the need for the BOU to develop its technical capabilities to enhance monitoring, and for the reform efforts of the financial system to continue, so as to improve the stability and predictability of financial aggregates. The last weakness, however, points to the need for the continued development of indirect financial instruments. The reliance on periodic primary auctions of treasury bills does not amount to true open market operations and is very limited if there is a sudden need to absorb excess liquidity in the banking system. The increase in liquidity in the banking system during the recent coffee boom of 1994/95 is one example of the types of monetary control problems that the BOU can face. The reliance on primary auctions of treasury bills significantly limited the extent to which the BOU may have been able to sterilize these temporary inflows. The consequences of a lack of a secondary market in treasury bills have already been alluded to (Section II), and the need to develop such a market cannot therefore be overstressed. Notwithstanding the issue of trust between banks, from the BOU’s point of view, this market can be given encouragement through a number of initiatives.

First, the BOU should take up undersubscribed amounts of treasury bills in primary auctions so as to build up its own portfolio of instruments that can potentially be traded in a secondary market. Historically the BOU’s holdings of treasury bills have been quite small, averaging less than 3 percent of the total stock outstanding between June 1992 and June 1995. Recently, however, the central bank has begun to increase its holdings, and at end-December 1995, they were equivalent to 15 percent of the outstanding stock. The current recapitalization exercise should also contribute to an improved portfolio of treasury bills for potential secondary market transactions. Second, the BOU can improve the liquidity of the treasury bill and the interbank shilling market, by increasing the bill’s use as collateral for same-day funds from the central bank. This policy is currently being adopted by the BOU, through adapting its lending facilities to provide each bank with a line of credit that would provide fully collateralized access to these funds within strict limits and at a penal rate. Third, the BOU is also implementing an automated central registry to streamline the permanent or temporary transfer of treasury bills. Fourth, in order to improve both the liquidity of the treasury bill and the signaling content of the rediscount rate, the BOU, in 1995, adopted a more market-determined rediscount facility (Chart 2). The rediscount rate is now set at a margin of 2 percentage points above the latest four-week average of 91-day treasury bill rates at auction. However, this rate is not changed as long as it stays within the 2 percent margin. In order to enhance interest rate signals and the liquidity of treasury bills, this rate needs to be truly market related, and allowed to fluctuate in a fixed ratio to the treasury bill rate. Finally, the BOU can enhance the possibilities for secondary trading in treasury bills, and indeed the effectiveness of monetary policy, by increasing its efforts to maintain a sufficiert presence of nonbank financial institutions and the nonbank public in the market. After commercial banks were allowed to participate in treasury bill auctions in 1992, the nonbanks’ share of total bills outstanding steadily declined from a high of 59 percent in June 1992 to a low of 22 percent in December 1995.

CHART 2
CHART 2

UGANDA: TREASURY BILL AND REDISCOUNT RATES, 1990–95

Citation: IMF Staff Country Reports 1996, 051; 10.5089/9781451838602.002.A001

Sources: Data provided by the Ugandan authorities; and staff estimates.

IV. Reforms in the Commercial Banking System

This section focuses on several issues affecting reforms of the commercial banking sector, including systemic issues of nonperforming loans, and undercapitalization of banks, intermediation costs, and the critical agenda of privatizing the UCB and restructuring the two banks taken over by the BOU in 1995, as well as other weak banks. The section also considers the role of deposit insurance in the reform process.

1. Systemic issues

The incidence of nonperforming loans is both an outcome and a cause of several systemic problems affecting the Ugandan banking sector. Historically, the rise in nonperforming loans throughout the banking sector can be linked to inadequate bank supervision, the interference of the political directorate in bank operations-particularly in the UCB and the COOP--and what has often been described as “a culture of nonrepayment” in Uganda. The last is probably more a reflection of the first two, especially the failure of the central bank to enforce regulations on insider lending. Also, until recently, strict rules on the classification of nonperforming loans were not adhered to, and the practice of capitalization of interest was widespread. As a result of the enforcement of accounting rules that require provisioning against bad debts, many banks have now become technically insolvent. Currently, seven banks have negative core capital--including the UCB and the COOP. The UCB’s negative net worth of more than U Sh 100 billion--together with a nonperforming loan portfolio equivalent to more than 70 percent of its gross loans and advances--dwarfs that of other banks.

It should be pointed out that the problem of nonperforming loans affects even the banks rated as satisfactory by the BOU. In fact, credit discipline in Uganda has been exceptionally poor, with many borrowers pledging defective security and banks being unable to use the legal system to collect on bad debt. Although the legal system allows for the enforcement of repayment obligations, lenders in Uganda have serious problems bringing legal action against defaulting borrowers because of congestion of court cases, delays in court orders for foreclosure or the seizure of assets, and the frequency of injunctions preventing the sale of assets. Credit discipline has also been affected by inadequate management practices, the aforementioned insider lending problems, and, for those banks that are part of a larger group of companies, lending to their members without proper credit evaluations.

Besides leading to a generalized problem of undercapitalization, the large share of nonperforming loans in banks’ portfolios has created periodic problems of liquidity and high intermediation costs. Whereas liquidity management has significantly improved in recent times, the problem of high intermediation costs and associated riskiness of loans continues to be reflected in substantial spreads in interest rates, particularly since the liberalization of these rates in 1992 (Chart 3). While real lending rates have remained relatively high, savings rates have been low, and sometimes negative (Table 1). Furthermore, although the maintenance of high lending rates reflects an attempt by banks to earn a larger return on new loans, given the problem of previous bad debts, this objective may actually be offset through the attraction of relatively riskier borrowers. Such adverse selection results will, in fact, add to systemic fragility in the financial system. Although difficult to quantify, the problems associated with inefficient financial intermediation in relation to the real economy, can, potentially be significant. As mentioned before, the allocation of credit to agricultural production is limited and alternative sources of capital are scarce. Efforts are currently being made to set up a stock exchange, but as yet, there are no equity markets. The strategy of the BOU and the Government for dealing with these systemic issues has been to address the problems faced by the UCB separately, given its status as a government bank that dominates the financial system, and to restructure and reform the other banks within specified timetables.

CHART 3
CHART 3

UGANDA: LENDING AND DEPOSIT RATES, 1990–95

Citation: IMF Staff Country Reports 1996, 051; 10.5089/9781451838602.002.A001

Sources: Data provided by the Ugandan authorities; and staff estimates.

2. Reform and privatization of the Uganda Commercial Bank

Initially, the focus of reforming the UCB consisted of two phases. The bank would be restructured and recapitalized, and subsequently privatized. Some progress was made in restructuring the UCB’s operations, including the reduction of its extensive and unprofitable branch network from 188 branches in 1991/92 to 84 full branches and 53 agencies currently. 1/ In addition, in 1994, a new management team was appointed, and further efforts were made to reorganize the bank. As part of this restructuring process, the UCB’s huge nonperforming loan portfolio--as identified by a 1994 audit--was to be transferred to the Nonperforming Assets Recovery Trust (NPART), following which the bank would be recapitalized. Despite these restructuring efforts, the bank has continued to make losses, and its nonperforming loan portfolio is estimated to have deteriorated beyond what was identified in the 1994 audit. As a result, the Government’s focus has shifted from restructuring the bank to accelerating its privatization. In this vein, the Government has contracted with a merchant bank to prepare the UCB for privatization, and to seek bidders.

The process of privatizing the UCB remains the single most critical aspect of the Government’s financial sector reform program for a number of reasons. First, the UCB dominates the financial sector, and is essentially the main provider of rural financial services. Second, the potential liabilities of the Government are large in the case of a decision to liquidate the bank or even to recapitalize its balance sheet. Third, credibility and discipline within the financial system are not likely to be restored until the problems associated with the UCB are resolved.

Recently, some progress has been made in the strategy to privatize the UCB. Not only has the merchant bank begun its work to prepare the UCB for sale, but after several delays, the transfer of nonperforming loans to the NPART has begun. The NPART has also set up its tribunal, and the initial focus will be on the top 100 borrowers who account for more than 45 percent of the total amount to be transferred. The important issue facing the Government is to ensure that credible amounts of the UCB’s nonperforming loans are collected in order to send a positive signal to the financial system that it is aggressively dealing with the systemic problem of bad debts. For this to happen, constraints currently facing the legal system and the ability of the NPART tribunal to carry out its work efficiently will have to be addressed. From the point of view of the cost of financial sector reforms, loan recovery will also reduce the net recapitalization of the UCB that may be needed in order to sell the bank.

3. Restructuring and reform of other weak banks

The restructuring and reform of the other weak banks involve two aspects. First, separate policies are needed to restructure the Nile and Sembule banks, control of which has been assumed by the BOU. Second, the BOU needs to address the issues of undercapitalization and poor management of the remaining weak banks.

The BOU took over Nile and Sembule in 1995 primarily to ensure compliance with provisioning and debt collection. The two banks, particularly Sembule, were plagued by insider lending. Although ownership was not affected by the seizure, management objectives have been temporarily determined by the BOU. The main focus since the takeover has been on loan recovery. Currently, the BOU is putting together a restructuring package, which includes the surrender of majority shareholding by the current owners, strategic investments from outsiders, and the restoration of the banks’ net worth through a financial package from the BOU that includes soft loans, interest forgiveness, and guarantees. New capital injections from the strategic investors are expected to bring the banks’ capital up to the BOU’s specified risk-weighted level. It is also expected that the new investors will provide management for the banks. Strategic investors have already been identified for the banks. An important issue is to ensure that previous shareholders return as part owners only if they extinguish their insider loans. While the need to provide liquidity to the restructured banks is important, the BOU should ensure that any guarantees or cash deposits are placed against nonperforming loans that are likely to be recovered, and that injections in the form of loans have a minimal impact on the prevailing monetary conditions.

With respect to the other weak banks, the main focus has been on setting targets for prudential improvement. Requirements for banks’ total net worth, as of December 31, 1996, are 8 percent of risk-adjusted assets in core capital plus a minimum capital requirement of U Sh 500 million for local banks and U Sh 1 billion for foreign banks. To understand the problem of undercapitalization in Uganda, it needs to be recognized that, historically, the BOU placed more emphasis on the minimum absolute capital rather than as a percentage of risk-adjusted assets. As a result, banks were not required to raise their capital levels, even as the quality of their loan portfolio deteriorated. More importantly, the real value of initial capital paid in by banks established in the mid-1980s has been severely reduced by high rates of inflation, particularly in the period 1985-89.

A weakness in the current reform program is that no clearly defined strategy has been spelled out to deal with banks in the event that they do not meet the prudential objectives. The Government’s policy until now has been to formally agree with the affected banks on performance contracts that aim at improvements in their operations. Some progress is being made as three of these remaining four weak banks have managed to receive some capital injections and begin to restructure their operations. The COOP is being restructured by the United States Agency for International Development (USAID), which has provided a number of capital infusions. The main problems with this bank continues to relate to managerial issues and its large negative net worth caused by a significant nonperforming loan portfolio. Both Tropical and Centenary have received new capital injections and have managed to reduce their nonperforming loan portfolios.

4. Deposit insurance

Deposit insurance schemes are typically adopted in many countries for three main reasons: (i) to provide asset protection for small and unsophisticated savers; (ii) to uphold confidence in bank deposits as the basis for a modern payments system; and (iii) to avoid bank runs, and liquidity shocks associated with the loss of confidence. The deposit insurance fund (DIF) has been set up in Uganda with an initial capital of U Sh 2.5 billion, including U Sh 2 billion provided by the Government, and allows coverage for up to U Sh 3 million in individual accounts. Annual premiums of the commercial banks are set at 0.2 percent of deposits. The role of a deposit insurance scheme is to complement a well-functioning banking supervision system and prevent individual banking problems from becoming systemic. Given that the scheme in Uganda has been introduced at a time when banking problems are already widespread, there is a risk that the fund could very quickly become insolvent, making government involvement inevitable. The currently underfunded DIF would therefore provide protection only in the event of a very small bank failure. The Government needs to clarify its obligations in the event that a bank failure quickly exhausts the resources of the fund. In this connection, a decision will have to be made on the optimal level of coverage for the fund and the required capital base. Otherwise, in its present form, the DIF will provide depositors with little comfort or confidence.

The rules of deposit insurance require clarification as well, in particular whether coverage is provided only for deposit accounts, or customer deposits less liabilities in a failed bank. The current guidelines seem to suggest the latter, which has the implication of providing more protection to customers having deposits and loans from the same bank. For example, suppose that two persons have equal deposits and loans of U Sh 5 million and U Sh 3 million, respectively. Suppose further that one of the individuals has both his loan and deposits in the same bank, while the other has deposits in this bank but a loan from another. In the event of a failure of the bank in which both have their deposits, the person with deposits and a loan in the same bank will receive compensation of U Sh 2 million, leaving his net worth unchanged. On the other hand, the second person will lose U Sh 2 million, because his deposit is not fully insured, while his loan in the other bank remains unchanged. Deposit insurance should be confined to deposits only and not have the effect of linking the deposit and borrowing decisions, as this will deter competition and distort the retail market for banking services.

V. Rural Finance, Development Finance, and Long-Term Lending

It is estimated that 89 percent of Uganda’s population is rural. Furthermore, in 1994/95, agricultural production is estimated to have contributed about 50 percent of GDP, and the overwhelming bulk of exports. By contrast, the mobilization of deposits outside the capital, Kampala, was put at 10-15 percent of the country wide total in 1994. As of December 31, 1995, loans outstanding for agriculture and crop finance amounted to U Sh 60 billion (22 percent of all loans), of which loans for crop finance represented U Sh 53.7 billion. Formal lending for agricultural production, therefore, represented only about 2 percent of the total of all loans and advances. As mentioned before, crop finance essentially includes the financing of coffee purchases, processing, and export marketing.

1. Privatization of the Uganda Commercial Bank and impact on rural finance

The mobilization of financial resources, and the provision of loans and advances are not only limited, but dominated by the UCB and the COOP Bank in rural areas. The UCB presently has 60 branches and 53 agencies outside the Kampala area, while the COOP has 21 rural branches. The only other banks with significant rural branch networks are the Bank of Baroda, with six non-Kampala branches, and the Centenary Bank, with seven. There is also an all but defunct rural post office savings network. The recent downsizing of the UCB, along with its impending privatization, is likely to lead to significant financial disintermediation in rural areas. Many of the UCB’s rural branches are located far outside district capitals, are not profitable, and would not be retained by any private commercial bank. Nevertheless, from a social point of view, it can be argued that a reasonably well-distributed network of financial institutions is necessary to support the development of an increasingly monetized economy and to foster enterprise development around the country.

In the light of the potential impact of the UCB’s restructuring on rural finance, the Government is currently carrying out a study on commercial banks’ rural branch network and the likely intervention that may be required to ensure the delivery of adequate financial services to rural areas. One issue is whether the COOP can be expanded to take up the slack that would be created by the downsizing of the UCB. The COOP is well placed, through its association with various farmers’ societies, to serve as a rural intermediary focusing on microenterprises. However, given the COOP’s recent difficulties, its ability to play this role would require continued restructuring and improvement in its lending practices. 1/ The Government, in the meanwhile, is experimenting with other mechanisms of rural finance delivery. Credit for the Cotton Sub-sector Development Project, for example, is being on-lent by commercial banks to farmers through rural intermediaries, including cooperative societies, registered farmers’ groups, and nongovernmental organizations.

2. Development finance schemes and long-term lending

The provision of development finance and long-term lending is inextricably linked to the development of rural finance in Uganda. Given the bias of short-term bank lending to the commercial sector, the Development Finance Department was established in the BOU to promote production-oriented medium- to long-term lending to the rural and agricultural sector. Starting in 1986, several development finance schemes have been tried in Uganda. These include: (i) the Development Finance Fund (DFF) financed by compulsory bank contributions; (ii) the Rehabilitation of Productive Enterprises (RPE) supported by USAID; (iii) the Crop Finance Fund (CFF) financed by the Libyan Government and the BOU; (iv) the BOU Export Refinance Scheme; (v) the World Bank’s Investment Term Credit Finance Fund (ITCFF); (vi) the Ugandan Apex Private Sector Loan (APEX) financed by the European Investment Bank; and (vii) the aforementioned Cotton Sub-sector Development Project, financed by the World Bank and the International Fund for Agricultural Development.

Credit provided under many of the various schemes has been relatively small, with the most significant being the RPE, ITCFF, the APEX, and the Cotton Sub-sector Development Project. Funds provided under the larger schemes have been in the range of US$13-25 million. Most of these schemes have faced problems related to project design and the limitation of commercial banks to evaluate projects, and entrepreneur capacity limitations. These credit facilities have also been affected by nonrepayment of loans, especially in earlier years. Some schemes, such as the BOU Export Refinance Scheme, continue to suffer from being underfunded. The more recent schemes, such as the ITCFF and the APEX scheme, have shifted their focus from agricultural loans to encompass industrial production, and private sector development in general. These schemes also limit participation to commercial banks that meet basic BOU prudential requirements, and also have an important technical assistance component.

Other sources of long-term finance in Uganda include the East Africa Development Bank (EADB), the Uganda Development Bank (UDB), the Development Finance Company of Uganda (DFCU), and the recently established Uganda Leasing Company (ULC). The EADB operates in Kenya, Tanzania, and Uganda, and intermediates funds provided by international lenders and donors. The bank has recently been restructured and, for 1994, recorded a profit. Out of total new loans of about US$25 million in 1994, Ugandan businesses received about US$10 million, making the EADB the largest source of long-term loans in Uganda. The EADB is always looking for viable projects and has recently expanded its activities to the field of equity financing. The DFCU receives funding from the Commonwealth Development Corporation (CDC), International Finance Corporation (IFC), Uganda Development Corporation and Deutsche Investitions-und Entwicklungsgesellschaft, a German institution. While the DFCU currently has enough resources to fund viable investment proposals, its main problem is the existing nonperforming loans on its balance sheet, equal to about 24 percent of all loans. The UDB is a government-owned parastatal, with significant negative net worth. In recent years, it has been very inactive, and unless current reform efforts aimed at restructuring the bank can be strengthened, its efforts to intermediate long-term finance is likely to be unsuccessful. The ULC is jointly owned by the DFCU, CDC, IFC, and two local financial companies. In Uganda, as in many developing countries, leasing can potentially be a popular financing option for medium-sized companies in need of funds for equipment and commercial vehicles. The shareholders have committed US$10 million in equity investments, but because leasing arrangements are new, the future growth of ULC is likely to be slow.

VI. Concluding Remarks

Financial sector reforms have proved to be one of the more challenging of the structural reform measures attempted in Uganda over the past eight years. The reform agenda called for the improvement of monetary management to achieve stabilization goals, but this entailed the strengthening of the financial system to improve its response to monetary signals. The improvement of monetary management through the adoption of indirect instruments required the development and integration of domestic money markets, the restructuring of the banking system to develop confidence and trust, the strengthening of regulation and the supervisory framework, and the enhancement of the capacity of the central bank. All of these areas are mutually reinforcing. For the medium term, Uganda continues to face several challenges in its financial reform program, particularly with respect to bank restructuring. Uganda’s experience has shown that bank restructuring in a situation where the financial sector faces several systemic problems can be protracted and can potentially be quite expensive. It is still not clear what the budgetary costs of privatizing the UCB will be, but the Government’s liabilities are potentially large. There will also be costs associated with the recapitalization of the two banks taken over by the BOU, and there is always the possibility of a bank failure leading to the insolvency of the deposit insurance fund.

The weak banking system has also created additional costs for the economy. It has led to disintermediation, particularly in the area of rural finance and the provision of long-term credit, and has raised the real interest rate to borrowers. If the reforms do not gather momentum, the potential effects on the mobilization of savings and the provision of investment funds to facilitate long-term growth can become quite significant.

The Government clearly recognizes these risks for Uganda’s medium- and long-term prospects. Progress in the reform efforts has been made on all fronts, and in recent times has begun to quicken. In general, the problem of nonperforming loans seems to have been arrested, and supervision has improved. The BOU today is much more capable of carrying out its mandate, and the effectiveness of monetary instruments has improved. The maintenance of confidence and the development of mutual trust among financial institutions requires, however, that current efforts be vigorously sustained, and the remaining challenges be addressed. In particular, over the medium term, the following should be addressed in order of priorities: (i) the completion of the privatization of the UCB; (ii) the implementation of a strategy for rural and development finance; (iii) the achievement of adequate capital by all banks; (iv) the strengthening of on-site inspections by the BOU; (v) the provision of adequate capital for the deposit insurance fund; and (vi) further development and refinements in the BOU’s technical ability to utilize indirect instruments of monetary management.

References

Fund sources

  • International Monetary Fund, “Uganda - Background Paper on the Response of Output and Investment to Adjustment Programs, and Statistical Appendix,” SM/95/72, April 12, 1995.

    • Search Google Scholar
    • Export Citation
  • Sharer, Robert L., Hema R. De Zoysa, and Calvin A. McDonald, “Uganda: Adjustment with Growth, 1987-94,” IMF Occasional Paper No. 121 (Washington, D.C.: International Monetary Fund, March 1995).

    • Search Google Scholar
    • Export Citation

Outside sources

  • Hossain,M.,Credit for Alleviation of Rural Poverty: The Grameen Bank of Bangladesh,Research Report No. 65, Washington, D.C., International Food Policy Research Institute, 1988.

    • Search Google Scholar
    • Export Citation
  • Otero, M., and E. Rhyne (eds.), “The New World of Microenterprise Finance,” Kumarian Press, 1994.

APPENDIX I Uganda: Summary of the Tax System as of February 1996

(All amounts In Uganda shillings)

article image
article image
article image
article image
article image
article image

APPENDIX II

Table 1.

Uganda: Gross Domestic Product by Industry, at Current Prices, 1990/91-94/95 1/

(In millions of Uganda shillings)

article image
Source: Data provided by the Ministry of Finance and Economic Planning.

The national accounts series was revised in June 1995.

In Uganda shillings.

Table 2.

Uganda: Gross Domestic Product by Industry, at Constant 1991 Prices, 1990/91-1994/95 1/

(In millions of Uganda shillings)

article image
Source: Data provided by the Ministry of Finance and Economic Planning.

The national accounts series was revised in June 1995.

In Uganda shillings.

Table 3.

Uganda: Gross Domestic Product by Expenditure at Current Prices, 1990/91-1994/95

(In millions of Uganda shillings)

article image
Sources: Data provided by the Ugandan authorities; and staff estimates.

Includes change in stocks.

Table 4.

Uganda: Gross Domestic Product by Expenditure at Current Prices. 1990/91-1994/95

(As a percentage of total GDP)

article image
Sources: Data provided by the Ugandan authorities; and staff estimates.

Includes change in stocks.

Table 5.

Uganda: Gross Domestic Product by Sector at Constant 1991 Prices (Annual Growth Rates), 1990/91-1994/95 1/

(In percent)

article image
Source: Data provided by the Ministry of Finance and Economic Planning.

The national accounts series was revised in June 1995.

Table 6.

Uganda: Composite Consumer Price Index, July 1990-December 1995

(Base: September 1989 = 100)

article image
Source: Data provided by the Ugandan authorities.

Calculated as the percentage increase in the avarage index for the previous 12 months, over the average index for the 12 months preceding that period.