Uganda: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix describes how to improve value-added tax (VAT) compliance in Uganda. The paper highlights that although the VAT in Uganda has a single positive rate and broad coverage, its initial threshold of U Sh 20 million may have been set too low, and a number of items that should have been exempted were zero rated. This paper presents a brief survey of the financial sector of Uganda. Public sector reforms and the privatization program are also discussed.

Abstract

This Selected Issues paper and Statistical Appendix describes how to improve value-added tax (VAT) compliance in Uganda. The paper highlights that although the VAT in Uganda has a single positive rate and broad coverage, its initial threshold of U Sh 20 million may have been set too low, and a number of items that should have been exempted were zero rated. This paper presents a brief survey of the financial sector of Uganda. Public sector reforms and the privatization program are also discussed.

II. Brief Survey of the Financial Sector4

10. This section summarizes the salient features of the banking sector in Uganda. There are currently 20 commercial banks in Uganda. Their number is restricted by the requirement that new banks may not be licensed unless they offer new financial products. In addition to the commercial banks, there are 6 small credit institutions and building societies and 72 licensed foreign exchange bureaus; these foreign exchange bureaus are permitted to buy and sell foreign currency and traveler’s checks, and are closely monitored to ensure that they do not engage in other banking activities. A number of informal, unsupervised microfinance institutions have proliferated that make small, short-term, loans to groups of individuals in small towns and organized communities in rural areas. Most of them are operated on a nonprofit basis by donor agencies. The Bank of Uganda (BOU) has initiated a review of these microfinance institutions to learn about them and to monitor their activities.

11. The commercial banking sector in Uganda comprises ten established domestic banks (including the large, majority government-owned Uganda Commercial Bank (UCB)), four foreign-owned banks, and six new, tax-exempt banks. Aggressive competition for deposits from these new, tax-exempt banks may have raised deposit rates and contributed to a sharp lowering of the lending-deposit rate spread since 1995. The banking system in the past has been hampered by a large portfolio of nonperforming loans and, particularly in the case of the UCB, the politicization of its operations. Newer banks have a significant advantage in that a lower proportion of their loans are nonperforming. They are also enjoying temporary tax-exempt status granted under the previous (tax holiday) investment incentives scheme, allowing them to offer higher deposit rates than other banks.

12. There are several other obstacles to efficient banking activity in Uganda. First, Uganda still has a low rate of monetization. In the early 1970s, money velocity (GDP/broad money) in Uganda was close to 4, but political and economic instability adversely affected confidence in the late 1970s and the 1980s, and led to an increase in velocity to close to 20. In recent years, confidence has returned; velocity has fallen steadily to about 10, and the number of banks has doubled since 1990. Although cash held by the public as a proportion of broad money continues to decline, part of broad money is still held as cash by individuals who prefer not to hold deposits at a bank or who have no access to banking services. As confidence improves further and competition in the banking sector increases, Uganda’s relatively high deposit-lending spread (currently at about 9 percent) should come down further. A decrease in this spread could be regarded as a barometer of the success of financial sector reforms.

13. Second, many banks hold reserves that exceed not only the required reserve ratio but also the needs for cash availability or clearance of notes. These excess reserves are unevenly distributed among banks, but there is no formal interbank market to allow banks to redistribute them. Large, creditworthy banks are able to obtain short-term loans with no collateral, and some less-established banks are able to borrow using treasury bills as collateral, but overall this interbank market has little activity, Additionally, problems with the payment system result in unforeseen obligations at clearing time; as a result, banks have to hold additional reserves to cover these added uncertainties.

14. Third, loan collateral is of questionable value. Court judgments have been slow in spite of the recent establishment of a commercial court. In rural areas, where banking activity is already hampered by transportation and communication difficulties, local sympathies may make realization of court judgments difficult in some cases. Banks have been reluctant to lend in rural areas, where they consider the risks of default to be even higher than in urban areas. Banks report high costs caused by courts that appear to be lenient both on fraud by borrowers and on malfeasance by employees. This is another reason why some banks will not lend outside the Kampala area.

15. The BOU has strengthened bank supervision. Two out of four identified problem banks have been restructured, and the two remaining banks, the UCB and the Cooperative Bank, are being restructured. Forty-nine percent of the UCB has been sold to a private foreign investor, who has the option to buy another 2 percent within three years; the investor will manage the bank on the basis of a management contract for three years. Twelve banks have been selected for on-site inspections; six of these inspections have already taken place. The on-site inspection for the Uganda Commercial Bank is expected to take place near the time that the new management takes over.

16. The BOU has required provisioning for, and writing off of, nonperforming loans. In 1994 a credit recovery agency, the Nonperforming Assets Recovery Trust (NPART), was established to take over the UCB’s nonproforming portfolio and as part of the restructuring operations of the UCB. The share of remaining nonperforming loans and advances as a proportion of total assets of the banking sector declined to about 27 percent as at end-September 1997, compared with 40 percent a year earlier.

17. In pursuit of capital adequacy targets set by the BOU, Ugandan commercial banks have improved their capitalization recently. Most banks are in compliance with these targets. Some of them remain marginally below the required ratio, though there has been improvement during the past year. The exceptions are the UCB and the COOP Bank which are being restructured. To address capital adequacy, banks will need to carefully monitor and, in some cases, improve earnings, and this concern may partly account for the large deposit-lending rate spreads in Uganda.

18. The BOU has several tools at its disposal to implement monetary policy. The main one is treasury bills. Although treasury auctions are run with regularity and transparency, and offer a diversity of maturities, the auctions are conducted manually, and the only secondary market in treasury bills is one between large banks that are willing to make transactions based on trust. Additionally, the physical transfer of bonds is problematic, especially in rural areas. Recently, the BOU has introduced a computerized book-entry system that will be used alongside the manual system until it has proved its reliability. The BOU has been authorized to offer its own debt if its stock of treasury bills is insufficiently deep to accommodate a sale, and it has availed itself of this option in moderation. The BOU controls reserve requirements, and the current ratios are 8 percent for time and saving deposits, 9 percent for demand deposits, and 20 percent for foreign exchange deposits. However, these may not always be binding because of the high levels of excess reserves. The BOU also maintains discount and lending facilities to provide credit to the banking system, but these are rarely used.

19. To assist in enhancing the efficiency of the financial sector operations, the BOU intends to improve its supervisory role by training and hiring more people, and to encourage the closing of weak banks once these are identified. It is considering establishing a credit risk bureau to provide information about credit already extended by an institution; the bureau, however, would not rate the creditworthiness of that institution. A strengthening of the framework and operation of legal institutions would better ensure the soundness of commercial banks’ assets.

20. The market for treasury bills could be deepened. The implementation of a book-entry system for the use of treasury bills as interbank loan collateral should help, as will publication of market information. The Master Repurchase Agreement, which will serve as a guide for all repurchase agreements made among commercial banks between treasury bill auctions, should improve the interbank treasury bill market and allow the BOU to better respond to the needs of monetary policy.

21. Once the current tax holdings expire, banks would face equal tax treatment as the new Income Tax Act has replaced tax holidays by provisions for higher depreciation allowances. The merits of requiring equal reserve requirements for all deposits—foreign exchange deposits in particular—at all banks should be considered. In order to better manage liquidity, the BOU could further improve its already impressive information-gathering and forecasting capabilities; this could be done, for example, by conducting more frequent liquidity-forecasting exercises. The BOU plans to improve its information technology.

22. In the long run, the BOU could help to develop a secondary asset market by setting up a dealer system, offering training in markets, and standardizing trading practices. It could also help to develop capital markets by publishing market information, ensuring adequate supervision, and encouraging development of an independent credit rating agency. In the current circumstances, the option of a regional credit rating agency could be considered.

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This section was prepared by Joseph Crowley. It draws on a report by the Fund’s Monetary and Exchange Department, following a technical assistance mission in December 1997.

Uganda: Selected Issues and Statistical Appendix
Author: International Monetary Fund