A. Introduction

1. Zambia about two years ago embarked on a financial sector development plan (FSDP) for 2004–09 that is designed to create a sound, well-functioning financial system that will support economic diversification and sustainable economic growth.² The plan draws on the findings of the financial sector assessment exercise undertaken by the IMF and the World Bank in 2002 and follows more than a decade of economic reform during which key prices and various restrictions, including on capital flows, were liberalized. Zambia began the current reforms from a relatively low starting point in terms of financial development, which the country’s stage of economic development alone cannot explain, so the potential for early improvement was arguably considerable.

2. This paper takes a look at progress made about half-way into the agenda to identify areas where the reform strategy needs more attention. It suggests that while progress is being made in several areas, a tighter focus on obstacles to more rapid growth of financial intermediation would support the growth objective. Also, reforms of financial system regulation need to be speeded up to assure the stability of the system.

B. Recent Developments in the Financial System

3. The economic and financial environment in Zambia has improved markedly in the last several years. In 2002 when a financial sector assessment was carried out, the economy was characterized by high government deficits, very high interest rates, high external debt, and sluggish growth (see table). Under those conditions, financial sector development was severely constrained; Zambia’s indicators in that area were among the lowest in sub-Saharan Africa (see Figure 1). In the past few years, with improved management of the economy, extensive debt relief, and the boom in copper prices, constraints on financial sector development have eased considerably. The fiscal deficit has declined to sustainable levels, interest rates have plunged, inflation has recently come down to single digits, and growth has been robust for several years.

Selected Indicators of Financial Development

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Sources: IFS; IMF, African Department database.

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Selected Indicators of Financial Development

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Sources: IFS; IMF, African Department database.

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Selected Indicators of Financial Development

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Sources: IFS; IMF, African Department database.

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Zambia: Selected Economic Indicators, 2001-2006

(In percent; unless otherwise indicated)

¹Including grants.

Zambia: Selected Economic Indicators, 2001-2006

(In percent; unless otherwise indicated)

		2001	2002	2003	2004	2005	2006
Real GDP growth		4.9	3.3	5.1	5.4	5.2	6.2
Inflation rate (average)		21.7	22.2	21.4	18.0	18.3	9.2
External current account/GDP1		−19.9	−15.3	−14.8	−10.3	−5.1	2.9
Internation reserves (in months of imports)		1.4	4.1	1.7	1.9	1.5	2.2
Overall fiscal balance/GDP1		−4.4	−7.2	−5.1	−1.7	−2.6	−2.8
External debt/GDP		…	…	156.5	126.8	86.0	8.8
Interest rates:
	Average yield on 90-day Treasury bills	49.1	31.3	20.8	17.8	16.2	9.3
	Yield on 2-year government bonds	55.4	41.6	26.1	22.0	19.0	10.7
	Commercial lending rate	46.7	42.4	38.4	29.8	26.7	21.6

¹Including grants.

View Table

Zambia: Selected Economic Indicators, 2001-2006

(In percent; unless otherwise indicated)

		2001	2002	2003	2004	2005	2006
Real GDP growth		4.9	3.3	5.1	5.4	5.2	6.2
Inflation rate (average)		21.7	22.2	21.4	18.0	18.3	9.2
External current account/GDP1		−19.9	−15.3	−14.8	−10.3	−5.1	2.9
Internation reserves (in months of imports)		1.4	4.1	1.7	1.9	1.5	2.2
Overall fiscal balance/GDP1		−4.4	−7.2	−5.1	−1.7	−2.6	−2.8
External debt/GDP		…	…	156.5	126.8	86.0	8.8
Interest rates:
	Average yield on 90-day Treasury bills	49.1	31.3	20.8	17.8	16.2	9.3
	Yield on 2-year government bonds	55.4	41.6	26.1	22.0	19.0	10.7
	Commercial lending rate	46.7	42.4	38.4	29.8	26.7	21.6

¹Including grants.

4. Nevertheless, financial intermediation as measured by indicators of financial depth has grown only modestly. The ratios of broad money to GDP and bank deposits to GDP are both flat. The ratio of private sector credit to GDP, on the other hand, rose markedly in 2006. Zambia’s indicators are somewhat below the average for sub-Saharan African countries excluding South Africa and Nigeria. They are also generally below the average for the group of low-income sub-Saharan African countries and are well below the group of African middle-income countries (Figure 1).³

Zambia: Indicators of Financial Deepening

(Percent)

Source: Calculations based on data from the Bank of Zambia.

¹Broad money is end-period M3.

Zambia: Indicators of Financial Deepening

(Percent)

	2001	2002	2003	2004	2005	2006
Broad money/GDP1	21.0	22.3	21.8	22.4	18.0	21.6
Bank deposits/GDP	17.9	19.6	18.9	21.4	17.1	20.2
Private sector credit/GDP	7.2	6.3	6.8	7.9	7.5	9.6

Source: Calculations based on data from the Bank of Zambia.

¹Broad money is end-period M3.

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Zambia: Indicators of Financial Deepening

(Percent)

	2001	2002	2003	2004	2005	2006
Broad money/GDP1	21.0	22.3	21.8	22.4	18.0	21.6
Bank deposits/GDP	17.9	19.6	18.9	21.4	17.1	20.2
Private sector credit/GDP	7.2	6.3	6.8	7.9	7.5	9.6

Source: Calculations based on data from the Bank of Zambia.

¹Broad money is end-period M3.

5. Commercial banks remain the dominant financial intermediaries; they have about 70 percent of total financial sector assets. In 2006 total assets of the banking sector were about 27 percent of GDP; the sub-Saharan average was 67.4 percent (2005) and the average for low-income countries in the region was 38.3 percent.⁴ The banking system is relatively well capitalized; the ratio of capital to risk-weighted assets is above the statutory requirement, which is in line with international best practice; indicators for nonperforming loans and liquidity are generally satisfactory; and profitability is relatively high, all of which suggest that the banking sector as a whole is sound (Table 1).

Table 1:

Zambia: Financial Soundness Indicators, 2002–2006

(Percent)

Source: Bank of Zambia

¹Liquid assets were redefined to exclude one-year Treasury bills beginning in 2005.

Table 1:

Zambia: Financial Soundness Indicators, 2002–2006

(Percent)

	2002	2003	2004	2005	2006	2006 Jun
Regulatory capital to risk-weighted assets	28.0	23.0	22.2	28.4	20.4	18.9
Past due loans (NPL) to total loans	11.4	5.3	7.6	8.9	11.3	8.5
Loan loss provisions to nonperforming loans	73.9	89.3	102.8	90.7	83.3	104.9
Return on average assets	6.5	5.4	3.1	6.5	5.1	4.7
Return on equity	52.8	48.5	29.8	46.4	30.6	30.9
Net interest margin	15.3	13.2	11.8	11.8	12.8	10.9
Liquid assets to total assets1	78.6	74.7	66.6	41.0	41.3	36.5
Liquid assets to total deposits	69.7	73.5	73.7	51.0	49.6	44.7
Advances to deposits ratio	29.9	33.3	37.3	44.5	49.0	56.6
Foreign currency loans to total gross loans	42.8	46.8	41.2	36.2	34.0	30.3
Foreign currency liabilities to total liabilities	62.2	58.4	58.4	31.0	61.2	…
Household debt to GDP	0.0	0.0	0.0	1.5	1.2	…

Source: Bank of Zambia

¹Liquid assets were redefined to exclude one-year Treasury bills beginning in 2005.

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Table 1:

Zambia: Financial Soundness Indicators, 2002–2006

(Percent)

	2002	2003	2004	2005	2006	2006 Jun
Regulatory capital to risk-weighted assets	28.0	23.0	22.2	28.4	20.4	18.9
Past due loans (NPL) to total loans	11.4	5.3	7.6	8.9	11.3	8.5
Loan loss provisions to nonperforming loans	73.9	89.3	102.8	90.7	83.3	104.9
Return on average assets	6.5	5.4	3.1	6.5	5.1	4.7
Return on equity	52.8	48.5	29.8	46.4	30.6	30.9
Net interest margin	15.3	13.2	11.8	11.8	12.8	10.9
Liquid assets to total assets1	78.6	74.7	66.6	41.0	41.3	36.5
Liquid assets to total deposits	69.7	73.5	73.7	51.0	49.6	44.7
Advances to deposits ratio	29.9	33.3	37.3	44.5	49.0	56.6
Foreign currency loans to total gross loans	42.8	46.8	41.2	36.2	34.0	30.3
Foreign currency liabilities to total liabilities	62.2	58.4	58.4	31.0	61.2	…
Household debt to GDP	0.0	0.0	0.0	1.5	1.2	…

Source: Bank of Zambia

¹Liquid assets were redefined to exclude one-year Treasury bills beginning in 2005.

6. Other than pension funds, which hold about 25 percent of the assets of the financial system, the contribution of nonbank financial institutions (NBFIs) is small. Most of the pension industry, which comprises the National Pension Scheme Authority (NAPSA) and occupational pension schemes, is generally sound. However, the two state funds, the Public Service Pension Fund (PSPF) and the Local Authority Superannuation Fund (LASF), both have continuing deficits that are projected to climb sharply over the medium term. The eight insurance companies and various other financial institutions, which include leasing companies, microfinance institutions (MFIs), building societies, and one development finance institution, together account for about 9 percent of total financial system assets.

Zambia: Structure of Nonbank Financial Institutions

Source: Computed from data provided by Zambian authorities

¹Covers seven institutions registered by the Bank of Zambia and six of about 50 other NBFIs.

Zambia: Structure of Nonbank Financial Institutions

Average, 2005-2006
			As Percent of
		Number	Total Financial Assets	GDP
Pension funds		21	21.5	7.9
Insurance companies		8	3.7	1.3
Other NBFIs			5.1	1.9
	Leasing companies	9	1.8	0.7
	Microfinance institutions1	12	1.0	0.4
	Building societies	3	0.8	0.3
	Savings and loans	1	0.6	0.2
	Development finance institutions	1	0.6	0.2
	Other NBFIs	…	0.2	0.1

Source: Computed from data provided by Zambian authorities

¹Covers seven institutions registered by the Bank of Zambia and six of about 50 other NBFIs.

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Zambia: Structure of Nonbank Financial Institutions

Average, 2005-2006
			As Percent of
		Number	Total Financial Assets	GDP
Pension funds		21	21.5	7.9
Insurance companies		8	3.7	1.3
Other NBFIs			5.1	1.9
	Leasing companies	9	1.8	0.7
	Microfinance institutions1	12	1.0	0.4
	Building societies	3	0.8	0.3
	Savings and loans	1	0.6	0.2
	Development finance institutions	1	0.6	0.2
	Other NBFIs	…	0.2	0.1

Source: Computed from data provided by Zambian authorities

¹Covers seven institutions registered by the Bank of Zambia and six of about 50 other NBFIs.

7. Despite the growth of credit and the decline in interest rates on commercial lending in the last few years, financial intermediation by the banking sector is low by regional standards, and lending interest rates are high. Intermediation spreads are wide and profitability is relatively high despite high overhead costs. Although banks have responded to the robust growth in economic activity and the marked decline in the yield on government securities by expanding credit to the private sector, even the increase in private sector credit to 9.6 percent of GDP in 2006 still leaves Zambia below the low-income sub-Saharan average of 12.3 percent in 2004.⁵ Based on the average commercial lending rate in 2006, the real lending rate was over 12 percent. The sector’s net interest margin, a measure of the cost of intermediation, is at the high end of the regional average, and the ratio of overhead costs to total assets is above the regional average for low-income countries (Figure 2). Profitability as measured by return on equity was 5.1 percent in Zambia in 2006, compared to the low-income sub-Saharan average of 3.2 percent (2004)⁶.

Indicators of Intermdiation Costs

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Sources: World Bank Financial Structure database; Gulde, Anne-Marie, Catherine Patillo, Jakob Christensen with Kevin Caray and Smita Wagh.

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Indicators of Intermdiation Costs

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Sources: World Bank Financial Structure database; Gulde, Anne-Marie, Catherine Patillo, Jakob Christensen with Kevin Caray and Smita Wagh.

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Indicators of Intermdiation Costs

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Sources: World Bank Financial Structure database; Gulde, Anne-Marie, Catherine Patillo, Jakob Christensen with Kevin Caray and Smita Wagh.

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8. Various factors push up intermediation costs. Relatively high overhead costs in particular reflect the comparatively high cost of doing business in Zambia associated among others, with high transportation and communications costs. Given the economies of scale in banking, the cost of providing services on a relatively low scale is likely to be an important contributor. Inefficiencies associated with the lack of competition could also be a factor where services are concerned. However, bank concentration ratio—the market share of the leading three banks—which is moderate in Zambia relative to the regional average of 75 percent suggests that competition may be less of a factor than in most countries in the region.⁷ An important contributor to the high interest spread was the large amount of unremunerated required reserves, which were only recently reduced from 14 percent to 8 percent. More to the point, perhaps, high interest rates are symptomatic of a weak credit culture and a lack of institutional infrastructure for obtaining credit information, registering collateral and enforcing contracts, and enforcing creditor rights more generally.

Bank Concentration Ratios

(Percent)

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Source: World Bank Financial Structure database.

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Bank Concentration Ratios

(Percent)

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Source: World Bank Financial Structure database.

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Bank Concentration Ratios

(Percent)

Citation: IMF Staff Country Reports 2008, 029; 10.5089/9781451841329.002.A003

Source: World Bank Financial Structure database.

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9. A large proportion of the population has no access to financial services, even though access to institutions, both formal and informal, compares favorably with the rest of sub-Saharan Africa. A FinScope survey in 2005 found that 15 percent of the population were served by banks and another 8 percent had access to other formal financial institutions. Informal providers accounted for another 11 percent, making for a total of 33 percent that had some access to financial services. Similar surveys carried out in 2004 and 2005 found the proportion of the population with access to banking products to be over 43 percent in Botswana, 47 percent in South Africa, and over 51 percent in Namibia. Access to nonbank providers, however, was comparatively lower in these countries, underscoring the importance of the growth of NBFIs in achieving a more inclusive financial sector. The findings of the survey also touched on the use of bank products by small enterprises run by the self-employed: A full two-thirds of such businesses kept their business cash at home, and 96 percent had never applied for a loan.

Access to Financial Services¹

Source: FinScope

¹Percentage of the population served with financial services

Access to Financial Services¹

	Botswana	Namibia	South Africa	Zambia
	2004	2004	2005	2005
Banks	43	51.5	47	14.6
Formal and informal institutions	11	3.3	16	19.1
Financially excluded	46	45.2	37	66.3

Source: FinScope

¹Percentage of the population served with financial services

View Table

Access to Financial Services¹

	Botswana	Namibia	South Africa	Zambia
	2004	2004	2005	2005
Banks	43	51.5	47	14.6
Formal and informal institutions	11	3.3	16	19.1
Financially excluded	46	45.2	37	66.3

Source: FinScope

¹Percentage of the population served with financial services

C. Development Challenges and the Government’s Reform Strategy

10. The financial sector has some way to go to meet the medium-term objectives set out in the Fifth National Development Plan, which are to expand financial intermediation and access to finance to support strong and broad-based growth and poverty reduction. The major challenges are to improve the ability of the banking system to lend profitably at lower spreads by addressing obstacles to bank lending; deal with the legal and regulatory deficiencies that impede the operation and growth of NBFIs, which have the potential to offer services different from those typically provided by banks, such as contributing to the supply of long-term finance for investment; and create regulatory structures to support the soundness of the financial system as whole.

11. The FSDP is a comprehensive response to the stability and development needs of the financial system. In general, the plan is designed to create a regulatory and supervisory framework for banks and NBFIs to underpin the development of a sound financial system; promote competition to foster growth and expansion of financial services at affordable costs; and establish or reinforce supporting infrastructures, especially the legal and informational structures that are essential to the growth of financial intermediation:

• On regulation and supervision, key reforms are to make the Bank of Zambia (BoZ) independent and strengthen bank supervision; establish an autonomous Pensions and Insurance Authority (PIA), with adequate funding to exercise its supervisory responsibilities; create an agency to regulate the National Pension Scheme Authority; and introduce legislation to strengthen the Securities and Exchange Commission with a sustainable funding base.

• Major reforms designed to foster competition in order to lower costs and widen access to financial services include promotion of a second tier of banks; formulation of a scheme to provide financial services to the rural population; and consumer education to stimulate competition, in the banking sector in particular. The cash reserve requirement, which was high by regional standards, would be reduced to lower the cost of funds to banks.⁸ New regulation would be introduced to encourage the orderly development of MFIs, which were viewed as central to the strategy for expanding credit to small and micro enterprises and the rural sector. Priority was given to the resolution of three state-owned NBFIs seen as filling specific gaps in the financial sector including the provision of banking services for rural and low-income households and small businesses.

• Reforms to address the support infrastructure of the financial system include a wide range of legislative initiatives, the most extensive being harmonization of all legislation relating to the financial sector, with a view to among other things reducing or eliminating the scope for supervisory arbitrage. Other legislative initiatives are laws on money laundering, credit bureau services, consumer protection, the payments system, and deposit protection. To make it easier to enforce contracts, the administration of insolvency, bankruptcy, and banking laws would be harmonized and legal processes for repossession of leased assets strengthened. Staffing and training would be improved to enhance delivery of the justice system. Accounting and auditing practices would be aligned with international best practice, and well-defined corporate governance codes would be introduced for banks and other financial institutions.

• To promote money and capital markets, which are largely illiquid, market-makers would be introduced to develop secondary markets in securities. The BoZ would move to repos as the main instrument of monetary policy and, to improve liquidity management, government cash management would be enhanced.

12. Though considerable progress has been made in implementing the FSDP in the past two years, much remains to be done. In particular, while a number of the reforms to reinforce financial system infrastructure have gone forward, progress has been less notable on reforming the regulatory framework, promoting competition and access to services, and deepening money and capital markets. One major achievement was the licensing of a credit bureau in January 2006, after the BoZ had developed the necessary guidelines. Progress has also been made on introducing a payments system law to underpin the continuing modernization; adoption of international accounting guidelines for banks and NBFIs, which will strengthen the integrity of financial reporting; and issuance by the BoZ of corporate governance guidelines to banks and NBFIs that lay down standards for management based on best practice. Regulations for MFIs have been introduced; the BoZ will supervise deposit-taking MFIs and the larger institutions among non-deposit MFIs in terms of capital. The pension and insurance laws have both been amended and investment guidelines issued, to pave the way for more effective supervision and of those industries by the PIA. Work on the necessary regulations and funding arrangement for the PIA is underway.

13. Where FDSP implementation is lagging is in certain areas critical to the objective of supporting growth and diversification, as envisaged in the Fifth National Development Plan. Considering the importance of banks in the financial system, giving priority to reforms that address obstacles to bank lending has considerable potential to speed up the expansion of lending to the private sector, at lower spreads. At the same time, measures to support competition are necessary to induce banks to take advantage of new opportunities.⁹ Laws relating to the use of collateral and the operation of leasing companies are another area that is critical for lending to medium and to some extent small-scale enterprises that are important for achieving broad-based growth. The regulatory structures especially for NBFIs, is also worth more immediate attention.

14. The poor credit culture, which has been identified as the major obstacle to lending, deserves special consideration. The licensing of a credit bureau is a major step; it can help unlock access to credit for many more in the private sector while reducing the high risk premium that is currently priced into credit. To realize its full potential, however, it is important that the information available from the bureau is not limited to data on loan defaults, as some market participants have suggested, but covers as comprehensively as possible other borrowers and credit in its various forms. The World Bank’s Doing Business in 2006 Survey suggests that countries that only went half-way in this reform achieved little from it.¹⁰ In addition, to help boost the growth of credit, practice and regulations on the creation and use of collateral need prompt reform, considering how attracted banks are to salary-backed loans. Anecdotal evidence suggests that these loans are being used for a wide variety of purposes, including investment, housing improvements, and new construction. The FSDP recognizes the considerable potential of leasing as an instrument for providing credit, especially for medium and small-scale enterprises, given that the enterprise’s receivables serve as collateral, helping to address one of the main constraints on access of smaller businesses to bank credit. However, the legislation that is seen as necessary to remove the obstacles has not materialized, and leasing activity has stagnated in recent years.

15. Only limited progress has been made on reforming the institutions regulating the financial system, which has important implications for the stability of the NBFIs in particular. Although amendments to the Pension and the Insurance Act have clarified the authority of the PIA as supervisor, the vital issue of sustainable funding for the agency has yet to be resolved. The lack of resources meanwhile, continues to hamper PIA operations and make it difficult for it to train and retain staff. Even more pressing, the plan to draw up a regulatory arrangement for NAPSA, which in 2006 held about 10 percent of the assets of the financial system, has yet to be implemented. Because insurance companies and pension funds are the major contractual savings institutions in the system and the main sources of long-term finance, timely action is crucial to ensure that they are well-managed. The operational independence of the BoZ is also recognized as critical for it to avoid undue forbearance in case of insolvency or liquidation and to perform its role as lender of last resort. However, although the FSDP clearly identifies the changes required, this critical reform still has no clear timetable.

16. Reform of the money and capital markets is also high on the list of priorities, but not much is happening. Introduction of longer-term government bonds has established a reference point that could encourage private bond issues. Three- and 5-year government bonds were introduced in 2005, and 7-, 10-, and 15-year bonds were introduced in August 2007. There have also been a small number of private bond issues. However, the weaknesses of the money and capital markets identified in the FNDP are yet to be addressed. The lack of liquidity of the secondary market impairs its price discovery role and the guidance it can provide for operators in the financial markets. Moreover, the lack of clear settlement rules in the secondary market is a source of risk. The lack of liquidity together with the highly punitive rate on borrowing by banks from the discount window contributes to large bank holdings of idle balances. Also, weak liquidity management by BoZ associated with difficulties in forecasting government cash flow contribute to volatility in the money market. The need to create a role for some type of market-makers to encourage trading in securities has been recognized but has yet to take a concrete form.

17. A clear strategy for promoting access to the financially excluded is still evolving. A supervisory arrangement for MFIs is in place, although they have responded slowly to the BoZ’s calls for them to register, as is required. The FinScope surveys on the demand and supply of financial services are expected to provide information on which to base a strategy to broaden access to financial services. Meanwhile, the government has unveiled a rural credit program, with support from International Fund for Agricultural Development (IFAD). The National Savings and Credit Bank, which has been insolvent for several years, is being recapitalized to provide banking services for low income households and emerging entrepreneurs throughout the country. There are also indications that the Zambia Building Society is to be recapitalized to offer savings services and loans for home improvement and new construction. There are questions, however, about the long-term viability of these initiatives, especially as commercial banks expand into these markets. One major bank recently embarked on an aggressive plan to expand its branch network to both urban and rural low-income locations. Moreover, while the governance structures in these institutions are being realigned to ensure that they are managed on a commercial basis, the new arrangements may yet be tested.

D. Conclusion

18. The FSDP is adequate for promoting development of the financial sector. While significant progress has already been made across a broad front, elements of the reform agenda that are key to expanding financial services so as to support the growth and diversification objectives of the FNDP needs to be given priority. The licensing of a credit bureau should ease informational constraints on the expansion of credit, but this initiative needs to be followed through. Furthermore, to facilitate credit appraisal by lending institutions, the goal should be to ensure that this translates into more readily available information not only on bad credit but on as broad a range of credit as possible. To enhance the expansion of credit to medium- and small-scale enterprises in particular, the law relating to the creation and use of collateral is demonstrably an important area of reform, as experience in several countries has shown. Facilitating the use of collateral, including movable assets, would boost private credit, which to date has largely taken the form of salary-backed lending. Reform to remove the distortions and constraints in the leasing area should also bring increased lending to small and medium-scale industries.

Beyond these, the planned reforms of the regulatory institutions—the BoZ, PIA, and NAPSA—are vital to a sound financial system. Also of high priority are reforms to address the volatility that characterizes the interbank market and facilitate the flow of long-term and risk finance from institutional and other investors into productive enterprises. Central to the development of the financial markets, is the reform of the secondary market in government securities.