Uganda: Selected Issues and Statistical Appendix

This Selected Issues paper analyzes the underlying sources of growth in Uganda, suggesting that the contribution to growth from total factor productivity has been minor, while the high population growth poses a significant challenge to sustain a rapid improvement in living standards. The paper takes a closer look at the monetary transmission mechanisms in Uganda, aimed at assessing the appropriate choice of intermediate target and mix of liquidity sterilization instruments. It also focuses on the recent financial sector reforms undertaken by the government.

Abstract

This Selected Issues paper analyzes the underlying sources of growth in Uganda, suggesting that the contribution to growth from total factor productivity has been minor, while the high population growth poses a significant challenge to sustain a rapid improvement in living standards. The paper takes a closer look at the monetary transmission mechanisms in Uganda, aimed at assessing the appropriate choice of intermediate target and mix of liquidity sterilization instruments. It also focuses on the recent financial sector reforms undertaken by the government.

III. Financial Sector Reforms in Uganda 1999-200437

A. Introduction

39. The financial system in Uganda is small, underdeveloped, and dominated by commercial banks (Appendix, Figure 1). The banking sector is characterized by a large share of foreign ownership and high concentration. The level of financial intermediation is low by regional and LIC standards (Table 1), partly reflecting the weak supervisory framework, bank failures, and state ownership and directed lending problems of the past that led to a significant loss of confidence. The structure of banks’ balance sheets also reflects their preference for liquid and low-risk assets with bank lending constrained by a number of structural impediments (for example, contract enforcement problems, poor credit discipline and information sharing, and the narrow range of assets acceptable as collateral). Interest spreads are also high by comparator standards, attributed to higher operating cost, credit risk, and/or weak competition.

Table 1.

Financial Intermediation Across Countries, 2003

(In percent)1/

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Sources: International Financial Statistics (IFS) and banks’ balance sheets

Private credit-to-GDP is total claims of financial institutions on the domestic private nonfinancial sector as share of GDP. Bank deposits/GDP is total deposits in deposit money banks as share of GDP. Loan-deposit ratio is the aggregate ratio of lending to the private sector to total deposits for deposit money banks. Overhead costs are banks’ operating costs relative to total earning assets.

40. Uganda has made substantial progress in establishing the basis for a sound and profitable financial system. The health of the banking system improved remarkably following the closure of several distressed banks, substantial improvements to banking supervision with the introduction of a risk-based approach, and the privatization of the Uganda Commercial Bank (UCB) in September 2002 to a reputable international bank. The regulatory framework has also been modernized with the passage of the new Financial Institutions Act (FIA), 2004 and Microfinance Deposit-Taking Institutions Act (MDI), 2003. Despite growing microfinance institutions (MFIs) and Non-Bank Financial Institutions (NBFIs), gaps remain in the provision of deposit and payment services in rural areas and in financing agriculture, small-and medium-sized enterprises (SMEs), and infrastructure. The MFI and NBFI sector is also more vulnerable, requiring strengthened supervision and eliminating harmful government interventions.

41. A more efficient and deeper financial system should, over time, contribute moreto economic development. While a sound and healthy banking system provides a good foundation for growth and financial deepening, the FSAP update identified the need for a second-generation wave of reform while maintaining strong prudential oversight by ameliorating the structural impediments to lending, promoting competition, and minimizing distortions in the form of subsidized and/or directed lending (Box 1). Key long-term challenges are to restructure the pension system, promote long-term financing through nondistortionary channels, and develop capital markets.

Preliminary Summary of Key FSAP Update Recommendations

Improve financial system efficiency and outreach

  • Accelerate licensing and establishment of a credit reference bureau.

  • Accelerate rehabilitation of the land and companies registry.

  • Overhaul the corporate insolvency regime and supporting taxation framework, including by passing new insolvency legislation that gives creditors the right to commence bankruptcy procedures.

  • Strengthen institutional capacity of Commercial Court and of Official Receiver.

  • Improve disclosure and transparency of interest-and account-related charges.

  • License tier 3 institutions in compliance with the principles set out in the MDI Act.

  • Focus government capacity-building efforts on regulated institutions and high performing tier 4 entities.

  • Dismantle any remaining government schemes that lend funds for microfinance.

  • Avoid politically driven promotion of new MFIs and SACCOs.

  • Expand access to the payment system to tier 2 and 3 institutions.

Promote term financing and develop capital markets

  • Restructure governance of NSSF, including by hiring independent professional board members.

  • As soon as the regulatory authority for pensions is established and functional, rescind the monopoly status of the NSSF.

  • Verify the arrears of the public service pension scheme and undertake actuarial evaluation with a view to establishing a contributory trust fund.

  • Any future donor support to term financing, such as the EIB facility to be provided at market rates.

  • Expeditious assignment of an incentive-based management contract and partial sale of UDBL combined with the DFD of BOU.

  • Increase private participation in HFCU, minimizing the involvement of government and NSSF.

Prudential sector stability and regulation

  • Continue to monitor and improve the risk-based supervisory regime.

  • Establish DIF as a separate legal entity without creating a separate institution outside the BOU.

  • Invest DIF assets in safe but high-return securities, such as government paper.

  • Issue investment regulations for insurance companies.

Systemic liquidity management

  • Find a mechanism for decoupling the bank rate from the rediscount rate to signal the monetary policy stance.

  • Reemphasize the role of fiscal policy in liquidity management.

  • Consider the consequences of shifting project accounts to the BOU.

  • Review the demand for long-term government debt and consider issuing floating rather than fixed-rate debt.

B. Background

42. Liberalization of the financial system was one of the main pillars of Uganda’s highly successful Economic Recovery Program of the early 1990s. In 1992, all interest rates were allowed to become market determined, including treasury bill yields. In 1993, a new financial institutions bill and central bank charter were enacted, which, among others things, clarified the role of the BOU as the regulator and supervisor of the banking system. Although its supervisory capacity was weak, owing largely to an acute understaffing of qualified bank inspectors, the BOU made a concerted effort to develop its capabilities over time. Largely as a result of these measures, the public gained greater confidence in the banking system, which led to strong growth in financial intermediation from levels that were among the lowest in sub-Saharan Africa.

43. Efforts in the mid-to-late 1990s focused on cleaning up and recapitalizing the banking sector. Reflecting Uganda’s history of civil strife in the 1970s and early 1980s and the pattern of government ownership and intervention in the banking system, Uganda’s banks were riddled with nonperforming loans (NPLs) and insolvent. In 1994, a sharp rationalization of bank branches and personnel of two state-owned banks was executed. In 1995 two banks were intervened and recapitalized with subsidized long-term loans from the BOU. In 1998 and 1999, as banking supervision was gaining strength, four more banks (accounting for 12 percent of total system deposits) were intervened and closed. Only deposits of up to a maximum of U Sh 3 million (about US$2,000 in 1999) were protected by the Deposit Insurance Fund (DIF), but the government fully paid all of the deposits in some failed banks, and then later rescinded its payments. Also, in the same period, the state-owned Uganda Commercial Bank Limited (UCBL) (accounting for 22 percent of total system deposits) was declared insolvent. The Non-Performing Assets Recovery Trust (NPART) was established in 1995 to recover over U Sh 60 billion (US$34 million) in unpaid loans owed to UCBL as well, of which U Sh 28 billion has been recovered by June 2003, at a good recovery rate by LIC standards. An attempt to privatize the UCBL in the 1 990s failed because of irregularities in the transaction. After that, the UCBL’s operations were largely restricted to purchasing treasury bills until its eventual privatization in 2002.

C. Reforms, Growth, and State of Play

44. The banking sector has expanded in a sound manner led by the privatization of UCB, the closure of distressed banks, and strengthened supervision. The privatization of UCBL was the key reform to spur growth and reduce stability risks of the system, one of the few successful privatizations of a dominant state-owned commercial bank in the African region (Box 2). The clean-up of some small weak banks and the substantial improvements to banking supervision with the introduction of risk-based approach and passage of the new FIA Act, 2004, which conforms to international standards, have also helped make the banking system well capitalized, profitable, and resilient.38 With a sufficiently strong capital base, profits, good corporate governance, and well-designed systems and controls, the system is well placed to increase its contribution to the development of the economy.

Privatization of UCBL and Stanbic’s Performance

The acquisition of UCBL by Stanbic and its subsequent performance have, for the most part, fulfilled or exceeded the objectives set forth by the Ministry of Finance and the BOU. Stanbic remains a major player in the banking system, with the widest geographic coverage of any financial institution, having not closed any of the original 68 branches. It serves 28 percent of loans and 29 percent of deposits of tier 1–3 institutions; and the same shares of loans and deposits in the less-than 3 million size category, which represents the lower end of the banking market.

Stanbic has recorded strong growth with improved service quality, outreach, and efficiency. It has reduced the number of dormant accounts and reports a net increase of 150,000 deposit accounts, a reversal of the negative trends of 1999-2002, when deposits stagnated. It has also brought down the minimum opening balance to U Sh 10 thousand, a limit only one other tier 1 bank has (CERUDEB). Moreover, Stanbic has aggressively introduced ATMs throughout its branch network, substantially increasing convenience and reducing transaction costs. Delays in checks clearing and money transfers have also been reduced within the Stanbic network. Stanbic has established a business development unit that originates SME loans and is more active in agricultural lending, particularly by developing finance for out growers of commercial crops, who have had a long-term relationship with multinational buyers. The effects of these changes have resulted in a 55 percent growth rate from 2002 to 2004. In addition to capital investments in the branch network and new systems implementation, human resource changes, including redundancies, hiring young and better-qualified staff at higher wages, and training, have resulted in significant productivity gains

The performance of Stanbic, as measured by CAMEL ratings, is far superior to that of UCBL, and there are no obvious signs of impeding market development or competition. There is clear progress in all key categories of the CAMEL rating of the combined bank, with an increase in capital in December 2003 and profitability in line with the composite tier 1. Stanbic’s market share has declined since 1999 as tier 1 competitors have increased their commercial lending and increased their deposit base by offering lower transaction costs to their clients, particularly in the competitive ATM market. Stanbic’s share of tier 1 investments in t-bills has also declined from 46 percent to 39 percent as lending has increased. Furthermore, the perception in the sector is that Stanbic’s dynamism and introduction of modern techniques and services have had a demonstration effect, with the potential to enhance competition. At the same time, concerns are voiced about possible negative effects of the substantial market dominance by a single bank. An often-cited example is the large share of treasury bills held by Stanbic, as it may be able to corner the market.

45. Banks’ asset quality and profitability have substantially improved although balance sheets still reflect a preference for liquid and low-risk assets. The quality of banks’ risk portfolio has improved, with NPLs falling from 29 percent of the portfolio in 1998 to 12 percent in 1999 and further to 2.6 percent at end-September 2004 (Figure 1).39

Figure 1.
Figure 1.

Uganda: Capital and Nonperforming Assets, 1999-2004

(In percent)

Citation: IMF Staff Country Reports 2005, 172; 10.5089/9781451838749.002.A003

Source: Bank of Uganda

The NPL ratio rose through end–2003 because of the default of a large trading company.40 High interest rate margins and the marked reduction in NPLs have underpinned banks’ profitability (Figure 2). It is also noteworthy that banks’ income structure has changed recently, reflecting the diversification strategy of some large banks. The changes entail lower dependence on government securities income and higher income from fee and charges (Appendix, Figure 2). Despite the decline in income from government securities, profitability has remained strong on the back on growth in noninterest income and private sector lending. Sector liquidity is still high (Figure 3), although funds invested in government securities (29 percent) and placed abroad (22 percent)41 now comprise roughly half of total sector assets in September 2004, down from a combined 63 percent in 2000. Therefore, the structure of banks’ balance sheets still reflects the high credit risk in the economy.

Figure 2.
Figure 2.

Uganda: Indicators of Profitability, 2000-04

(In percent)

Citation: IMF Staff Country Reports 2005, 172; 10.5089/9781451838749.002.A003

Source: Bank of Uganda
Figure 3.
Figure 3.

Uganda: Indicators of Liquidity, 2000–04

Citation: IMF Staff Country Reports 2005, 172; 10.5089/9781451838749.002.A003

Source: Bank of Uganda

46. The maturity structure, degree of concentration, and range of products is a constraint. Only 12 percent of total loans, 35 percent of loan volume, 17 percent of total deposits, and less than 0.4 percent of time deposits have a maturity of more than one year. Moreover, long-term lending is limited to on-lending of a European Investment Bank (EIB) line of credit, channeled through the Development Finance Department (DFD) of the BOU. There is also a high degree of concentration on both the loan and deposit sides, reflecting both the structure of the economy and the size of the banking system (Appendix, Figure 3). Loans to the top five borrowers for each bank in the aggregate, represent, about 24 percent of total loans, while the top five depositors account for about 21 percent of total deposits.

47. Interest rate spreads are high by regional standards and are mainly explained by overhead costs, credit risk, and weak competition. Interest rate spreads—the difference between the weighted average lending rate and the weighted average deposit rate—are about 20 percentage points at present. Operating costs explain about 50 percent of the spread, and profits are the second largest component with 30 percent of the overall spread (Table 2). Ugandan banks have higher overhead costs than comparable banks in Kenya, partly because they do more outreach and have recently invested in physical infrastructure, such as branches and ATMs. Cross-country comparisons show that smaller banks have higher overhead costs because they find it difficult to exploit economies of scale and scope. This is confirmed by a significant positive correlation between the share of deposits and loans below U Sh 3 million in total deposits and loans and overhead costs, as well as the relatively low ratio of loan and deposit volume per branch in Uganda. While the 2 percentage points in the spread explained by loan loss provisions can be directly attributed to this high credit risk, the high overhead costs and the high profit margin can also be partly explained by high credit risk, as banks incur high evaluation, monitoring, and enforcement costs. The high interest spread and profit margin may also reflect weak competition. A lack of sharing of credit information on borrowers, widespread fraud, dysfunctional land and company registries, and deficiencies in the insolvency laws and their administration increase credit risks for banks and reduce competitive pressures.

Table 2.

Decomposition of Interest Spread in Uganda and Kenya 1/

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Source: World Bank and FSAP Update 2004.

Data are from annual financial statements for 2003/04 in Uganda and 2002 in Kenya. Calculations are averages across banks weighted by market share in the lending market.

48. Stress testing confirms that, while the banking system is exposed to certain risks, particularly large exposures, it is relatively robust and can weather plausible macroeconomic shocks. Moreover, the vulnerability of the banking sector should be further reduced by the implementation of the Financial Institutions Act 2004, particularly by reducing credit concentrations.

49. The NBFIs have shown strong growth since liberalization and the introduction of regulatory supervision, but are more vulnerable and thus require enhanced supervision and reform:

  • Recent trends in the insurance industry raise concerns about the adequacy of reserves, despite raising minimum capital requirements in 2002, given the robust growth of policy liabilities and the large share of illiquid assets in the form of real estate investments representing two-thirds of total assets in nonlife insurance companies. The recent acquisition of a Ugandan insurance firm by a regional player, further consolidation, and the expeditious sale of a majority share and management control of the National Insurance Corporation should improve the capital base of the sector.

  • In the pension sector, the performance and governance of the National Social Security Fund (NSSF), to which private sector employees are required to make contributions (15 percent of salary), have continued to be poor with negative real returns and a significant part of contributions absorbed by administrative expenses and fraud. The change of management and initiation of corporate restructuring in 2002 has not produced results as yet, although the recent transfer of the NSSF from the Ministry of Gender and Labor to the Ministry of Finance due to poor governance and controversial investments in the real estate sector provides an opportunity to reform the largest pool of long term saving in the country.

  • The nascent housing finance sector is showing strong growth, led by the Housing Financing Corporation of Uganda (HFCU) and entrants of new players, although the recent acquisition of a 70 percent stake by NSSF and government involvement continue to distort the market.

  • The leasing market is essentially limited to two providers each and lack medium-to long-term funding sources. While leasing rates have decreased, they are still above the rates for unsecured lending. A further expansion of leasing toward the small end of borrowers is limited by the tax deductibility of capital depreciation by the lessee rather than the lessor and the absence of factoring.

  • The ongoing licensing of collective investment schemes (mutual funds) under the new law should also provide competition to commercial banks by offering retail savers shares in a money market funds invested in treasury instruments and equities, serving to increase returns to savers and decrease the governments’ and private sector’s cost of borrowing.

50. Uganda has made good progress in expanding outreach and access of financial services to its population. Branches of financial institutions of tiers 1 to 3 exist in 51 of the 55 districts in the country, with a population per branch of about 87 thousand, when all three tiers are considered, a substantial coverage by African standards. The FSAP Update estimated the total number of deposit accounts held in financial institutions (tiers 1 through 4, using partial data for the last) to be just over 1.7 million, or about 35 percent of households. Tier 1 and tier 3 institutions—15 banks and 4 MDIs—dominate the market. The inclusion in the analysis of about 80 entities from tier 4 (together accounting for a large majority of the tier 4 market) adds only about 150 thousand deposit accounts and 85 thousand loans. The new Micro-Finance Deposit-Taking Institutions Act, 2003 and nurturing the transformation of MFIs into tier 3 institutions should further encourage rural financial intermediation.

51. Gaps remain, however, in the provision of financial services to rural areas, and in financing SMEs, agriculture and infrastructure. Although the coverage of deposit accounts as a proportion of the total number of households is relatively large as reported above, the use of deposit and payment services could be substantially expanded. Moreover, only about 11 percent of bank credit is reported as being allocated to agriculture, a more acute level of credit rationing to the sector than in most other countries, given the large contribution of agriculture to GDP. The entire single-borrower capacity of the Ugandan banking system also totals only about U Sh 66 billion and the single largest borrowing capacity of any one bank is only U Sh 14 billion. It is thus unrealistic to expect that substantial initiatives (such as large infrastructure projects) can be financed through the domestic financing system. In addition, Development Finance Institutions (DFIs) play a minor role in Uganda, particularly given the insolvency and associated freeze on lending by the Uganda Development Bank (UDB).

52. Uganda continues to make progress, supported by FSAP follow-up technical assistance, in improving liquidity management and deepening debt and foreign exchange markets. The BOU has developed a liquidity management plan that separates the management of short-term “temporary” and long-term “structural” liquidity resulting from government domestic expenditures financed through foreign donor inflows. The BOU uses repos for fine-tuning temporary liquidity variations and a mix of foreign exchange sales and net treasury bill issuance to sterilize structural liquidity, clearly signaling sterilization and intervention actions in the foreign exchange market. Overall, these actions have lowered the volatility of interest rates and helped anchor market expectations. The development of a daily liquidity forecast of government operations, reform of the computation and level of reserve requirements, introduction of a primary dealership, and the issuance of treasury bonds have enhanced monetary management, established a yield curve for the nascent corporate bond market, and facilitated secondary trading of government debt securities. On the government debt market, it would be important to have a medium-term issuance calendar based on a comprehensive government debt management strategy. The calendar should be conservative as to the amount and frequency of offers, particularly at the long-end of the market (5-10 years) and consider issuing floating-rate rather than fixed-rate instruments.

53. The Uganda Stock Exchange (USE) has served a useful purpose for the privatization strategy of the government, but has not yet raised equity finance for domestic enterprises or provided a viable trading platform. Trading in the six listed issues is sporadic and negligible measured both in real terms and relative to market capitalization. The costs of issuance on the USE are too high in light of the small number of investors reached. The Capital Markets Authority (CMA), the securities regulator, does not distinguish between types of securities market investors. The USE may be more effective if it is focused on a lower disclosure standard for new issues combined with a greater reliance on collective investment schemes to reach the broader public while targeting the regional market of sophisticated and international investors.

D. Lessons and Challenges

54. Uganda has made remarkable progress in establishing the basis for a sound and profitable financial system, but financial intermediation remains low. The low financial intermediation partly reflects past problems, including a weak supervisory framework, bank failures, and state ownership that led to a significant loss of confidence. The health of the banking system improved substantially following the closure of several distressed banks and the privatization of the UCBL in September 2002. However, the balance sheets of banks still reflect their preference for liquid and low-risk assets related to a number of structural impediments (e.g., contract enforcement problems, poor credit discipline and information sharing, and limited use of collateral). Interest spreads, also high by regional standards, are attributed to higher operating cost, high credit risk, and weak competition. Despite the growing number of MFIs, gaps remain in the provision of financial services for agriculture, SMEs, and infrastructure.

55. A key challenge will be to foster a more efficient and deeper financial system by ameliorating the structural impediments to lending, promoting competition, and minimizing distortions in the form of subsidized and/or directed lending while maintaining an effective supervisory regime, as presented in Box 1. The vulnerabilities in the insurance sector also require the urgent issuance of investment regulations, with a view to ensuring greater diversity and liquidity in insurance portfolios. Key longer-term challenges are to restructure the pension system, promote long-term financing through nondistortionary channels, and develop capital markets:

  • The reform of the pension sector should be properly sequenced. Immediate steps should be taken to improve governance of the NSSF by strengthening investment processes, ensuring professional management, and supervision by the BOU until the establishment of a new pension regulator to oversee all retirement benefits schemes in Uganda (public and private).

  • Term financing should be allocated by qualified private financial intermediaries at market prices. Incentives, governance, and controls should be appropriate to avoid the directed lending, distortions, and governance problems that, for example, led to UDBL’s insolvency in the past.

  • Deepening debt, equity, and foreign exchange market will reduce the financing costs of the government and the private sector, and lower the sterilization costs of government liquidity injections related to donor inflows.

56. Increased access, product innovation, and concerns about the safety of small–balance deposits in unregulated institutions should be addressed. The authorities can do this by fostering regulated financial institutions and high-performing tier 4 entities by enforcing basic mandatory prudential standards, governance and transparency requirements for savings and credit cooperatives (SACCOs) while focusing on building the capacity of a small number of high-performing institutions to minimize distortions introduced by government and political interference in the microfinance sector.

References

  • Brownbridge, M., 2002, “Resolving Bank Failures in Uganda: Policy Lessons from Recent Bank Failures,” Development Policy Review, 2002, Vol. 20.

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  • IMF and World Bank, 2001, “Financial Sector Assessment Program: Selected Financial Sector Issues,” November 2001 (unpublished).

  • IMF and World Bank, 2004, “Financial Sector Assessment Program: Update: Aide Mémoire,” November 2004 (unpublished).

  • Kasekende, L. and Atingi-Ego, M. (1996), “Financial Liberalization and Its Implications for the Domestic Financial System: The Case of Uganda,” AERC.

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APPENDIX

Figure 1.
Figure 1.

Uganda: Structure of the Financial System, 2003/04

Citation: IMF Staff Country Reports 2005, 172; 10.5089/9781451838749.002.A003

Figure 2.
Figure 2.

Uganda: Banking System Balance Sheet and Income, 2003/04

Citation: IMF Staff Country Reports 2005, 172; 10.5089/9781451838749.002.A003

Figure 3.
Figure 3.

Uganda: Banking System Concentration, 2003/04

Citation: IMF Staff Country Reports 2005, 172; 10.5089/9781451838749.002.A003

Table 1.

Uganda: Gross Domestic Product by Industry at Current Prices, 1997/98–2003/04 1/

(In billions of Uganda shillings, unless otherwise indicated)

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Sources: Ministry of Finance, Planning and Economic Development; and Fund staff estimates.

Fiscal year begins in July.

In thousands of Uganda shillings.

Based on the 1991 and 2002 census and assumed rates of population growth.

Table 2.

Uganda: Gross Domestic Product by Industry at Constant 1997/98 Prices, 1997/98–2003/04 1/

(In billions of Uganda shillings)

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Source: Ministry of Finance, Planning and Economic Development.

Fiscal year begins in July.

Table 3.

Uganda: Growth of Gross Domestic Product by Sector at Constant 1997/98 Prices, 1997/98–2003/04 1/

(Annual growth rates, in percent)

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Sources: Ministry of Finance, Planning and Economic Development; and Uganda Bureau of Statistics.

Fiscal year begins in July.

Table 4.

Uganda: Gross Domestic Product by Expenditure at Current Prices, 1997/98–2003/04 1/

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Sources: Ugandan authorities; and Fund staff estimates.

Fiscal year begins in July.

Includes change in stocks.

Table 5.

Uganda: Gross Domestic Product by Expenditure at Constant 1997/98 Prices, 1997/98–2003/04 1/

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Sources: Ugandan authorities; and Fund staff estimates.

Fiscal year begins in July.

Includes change in stocks.

Table 6.

Uganda: Composite Consumer Price Index, July 1997–September 2004

(1997/98 = 100)

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Source: Uganda Bureau of Statistics.

Underlying inflation.