Kenya, Uganda, and United Republic of Tanzania: Selected Issues

This Selected Issues paper for Kenya, Uganda, and United Republic of Tanzania highlights their private sector credit markets, identifies their main obstacles in promoting credit to the private sector, and suggests a reform strategy. If the East African Community (EAC) countries decide to pursue a coordinated approach to investment incentives, one possible solution would be to agree on a Code of Conduct for Investment Incentives and Company Income Taxation. A transparent tax system with a broad base would reduce the demand by investors for tax holidays.

Abstract

This Selected Issues paper for Kenya, Uganda, and United Republic of Tanzania highlights their private sector credit markets, identifies their main obstacles in promoting credit to the private sector, and suggests a reform strategy. If the East African Community (EAC) countries decide to pursue a coordinated approach to investment incentives, one possible solution would be to agree on a Code of Conduct for Investment Incentives and Company Income Taxation. A transparent tax system with a broad base would reduce the demand by investors for tax holidays.

II. Promoting Private Sector Credit in the East African Community: Issues, Challenges, and Reform Strategies1

I. Introduction

1. As in m low-income countries in the Saharan Africa (SSA), in Kenya, Tanzania, and Uganda—the members of the East African Community (EAC)—the financial sectors provide relatively little credit to the private sector. While the level of private sector credit in the EAC is around the average of SSA,2 it is significantly lower, and, with the exception of Tanzania, is growing at a slower pace than in other low-income countries (LICs).

2. The link between access to credit and economic development and poverty reduction is well documented. Access to credit promotes growth by enhancing the efficiency of resource allocation and facilitating the exchange of goods and services (Levine, 1997). Low access by the private sector to credit is likely to impede poverty reduction because small firms, which are likely to be drawn from poorer populations, are more likely to be subject to credit rationing (Beck, Demirguc-Kunt, and Maksimovic, 2005). Hence, to fulfill the aspirations of their populations for growth and poverty reduction, the EAC countries need a strategy to promote private sector credit.

3. This paper explores private sector credit markets in the EAC, identifies the main obstacles EAC members face in promoting credit to the private sector, and suggests a reform strategy. The main findings of this chapter include:

  • Despite strong growth, private lending in Tanzania and Uganda falls significantly short of the levels seen in other LICs. While credit to the private sector in Kenya was generally in line with average levels in other LICs in the late 1990s, it has been lagging behind recently;

  • High interest rates, deeper structural weaknesses such as a poor legal system for property and creditor rights, and lack of credit information on borrowers are major impediments to increased private sector lending. In Tanzania, credit to the private sector was also crowded out by government borrowing in the late 1990s.

  • A new reform strategy needs to create the opportunity for banks to lend profitably at lower spreads by removing obstacles to lending and forcing them to use newly available opportunities by supporting competition in the banking systems. The authorities should exercise caution and prudence in introducing any new kinds of direct government involvement in the private sector, which should not distract from broader structural reforms.

II. Issues and Challenges

A. Background

4. The EAC is a low-income region in SSA. Per capita income there is around 5 percent of the world average—and lower than the average for LICs or SSA. Agriculture is a key sector in the region, accounting for a third of GDP. Kenya is the largest, richest, and most developed economy in the EAC (Table 1.).

Table 1.

EAC and Comparator Groups and Countries: General Economic Indicators, 2004

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Sources: World Development Indicators (WDI)

5. There is a significant disparity between the financial sectors in the EAC countries. Kenya has a well-developed financial sector compared with other low-income countries (LICs); the financial sectors in Tanzania and Uganda are underdeveloped compared with other SSA and LICs. Specifically:

  • Total financial assets in Kenya are around 80 percent of GDP, in Tanzania around 30 percent, and in Uganda 26 percent.1

  • Kenya’s financial depth, measured as the ratio of M2 to GDP, is more than twice as much as its EAC neighbors, although it has recently fallen behind the average for LICs; the Tanzania and Uganda financial sectors are considerably shallower than other SSA countries or LICs (Figure 1).

  • Kenya’s deposit-to-GDP ratio is around the average for LICs, while Tanzania, despite strong growth, and Uganda lag behind considerably (Figure 1).

Figure 1.
Figure 1.

EAC and Comparator Countries: M2/GDP and Deposit/GDP, percent

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: WEO and staff calculations

6. EAC banking sectors, the most prominent segments of financial systems, have low concentration but mixed performance in terms of efficiency and soundness.2 Their concentration ratios—measured by the share of banking assets held by the three largest banks—are lower than the average in other LICs and SSA generally.3 In fact, even Tanzania and Uganda, where the financial systems are relatively undeveloped, have banking systems significantly less concentrated than other LICs and middle-income economies like Mauritius and South Africa. Moreover, there is considerable foreign ownership. In Kenya, foreign banks account for 40 percent of total assets, while the banking systems in Tanzania and Uganda are dominated by foreign bank ownership. In terms of efficiency, the banking sectors in Kenya and Tanzania have lower overhead costs and net interest margins than other LICs and SSA countries. Uganda, however, has significantly higher interest margin and overhead costs than the regional standard (Table 2). In terms of soundness, while Kenya has a very high share of nonperforming loans (NPLs), NPLs in Tanzania and Uganda are low compared to other SSA countries (Table 3). Capital adequacy ratios in the EAC are high in international terms, ranging from 17 percent to over 20 percent of risk-weighted assets. The banking sectors are profitable in all three EAC countries, with the return on equity well over 20 percent.

Table 2.

EAC and Comparator Groups & Countries: Concentration and Efficiency of the Banking Industry - International Comparison, 2003

(In percent)

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Source: World Bank Financial Structure Database; and IMF staff calculations

Assets of three largest banks as a share of assets of all commercial banks in the system.

Accounting value of a bank’s overhead costs as a share of its total assets.

Accounting value of bank’s net interest as a share of its interest-bearing (total earning) assets.

Table 3.

EAC and comparator groups and countries: Non-peroforming loans (in percent of total loans), average of 2000-2004

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Sources: WDI and staff estimates.

7. As in other SSA countries, access to financial services is limited in the EAC. While Kenyans have more access than people in Tanzania and Uganda, they still have lower access than the average for residents of SSA countries and LICs, as manifested by relatively few bank branches per 100,000 people and large areas per branch (Table 4). In Tanzania and Uganda access to financial services is significantly lower than the averages for SSA countries and LICs.

Table 4.

EAC and Comparator Groups & Countries: Banking Branch Density in International Comparison

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Source: WDI; WEO; and staff calculations.

B. Characteristics of Private Sector Credit in EAC

8. Private sector credit in the EAC is limited and is concentrated in the secondary and tertiary sectors. While at around 28 percent of GDP, private sector lending in Kenya in 1995-2005 was slightly higher than in other LICs and significantly higher than other SSA countries, NPLs account for a large share of total loans. Once NPLs are excluded, private sector credit falls to around the LIC average for 1995-2000 but because it until recently grew more slowly than credit in other LICs, it fell further behind. Excluding NPLs, private lending in Uganda is only around 5 percent of GDP—a third of the SSA average and significantly below the LIC average, and is also low in Tanzania.1 While agriculture accounts for a third of GDP in the EAC, it only receives about 10 percent of private sector lending (Figure 3).

Figure 2.
Figure 2.

EAC and Comparator Groups: Private Sector Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: World Development Indicators and staff calculations.
Figure 3.
Figure 3.

EAC: Distribution of Loans, Most Recent Available Data

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: Authorities and staff estimates.

9. Real lending rates and lending-deposit spreads are relatively high in the EAC. The real lending rate is higher than the averages of LICs and SSA countries. Although the lending-deposit spread in the EAC was slightly below the average of SSA and LICs, it is significantly higher than the average for middle-income countries.

Figure 4.
Figure 4.

EAC and Comparator Group: Real Lending Rate and Lending-Deposit Spread, percent

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: IFS and staff calculations

C. Factors that Deter Private Sector Lending

10. The question of why private sector lending is low in the EAC has two aspects. First, low private sector credit is itself a function of widespread poverty and a high share of population engaged in subsistence farming, which limits the financial resources available for intermediation. As illustrated in Figure 5, across LICs, private sector credit correlates positively with per-capita income and negatively with the size of the agriculture sector.

Figure 5.
Figure 5.

EAC and Comparator Groups: Private Lending and Economic Developments, 2004

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: WDI and staff calculations.

11. The second aspect of the question pertains to whether financial resources are effectively channeled into private sector lending. Figure 6 illustrates the positive relationship between total deposits—a major financial resource—and private sector lending across the globe. It appears that given the level of financial resources available in the EAC, private-sector lending is low relative to the level that would be predicted by the regression line, suggesting that financial resources are not mobilized into lending.

Figure 6.
Figure 6.

EAC and Comparator Groups: Deposits and Private Sector Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Sources: WEO, WDI and staff calculations. Total Deposits

12. The remainder of the chapter will focus on the second aspect. Here, the main impediments to increased private sector lending are high interest rates, weak legal systems for property and creditor rights, and insufficient credit information on borrowers. In Tanzania, excessive government borrowing also crowded out private sector lending in the 1990s.

High interest rates

13. High real lending rates in EAC make enterprise financing expensive, thereby depressing private lending. According to the World Business Environment Survey (WBES), firm managers in EAC reported high interest rate to be a major obstacle to financing (see also Table 5).2 On a scale from 1 to 4, with 1 meaning no obstacle and 4 meaning a major obstacle, the EAC rates 3.46 on high interest rates, slightly higher than the SSA average of 3.38 and the LIC average of 3.40. The survey suggests that Kenya, with a score of 3.53, is particularly affected by the high interest rate problem, though scores for the other two countries were also higher than the SSA average.

Table 5.

EAC and Comparator Groups & Countries:Main implements to Financing

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Source: World Business Environment Survey (WBES), 2000 and IMF staff calculationsReported are average scores on scale 1-4 (4 - major obstacle, 1 - no obstacle)

14. The high interest rates and spreads are symptoms of deeper structural impediments to private lending. A foremost obstacle in each EAC country is a poor legal system that does not adequately protect property and creditor rights. In particular, an inefficient corporate bankruptcy process is detrimental to increased private lending. An efficient bankruptcy process will decrease borrower moral hazard, increase bank willingness to lend, and decrease the interest charged on loans, which currently must be high enough to cover the onerous costs of collection. Bankruptcy bottlenecks in the EAC, particularly Kenya, are associated with a protracted and costly judicial process. It takes on average 4.5 years to resolve a bankruptcy case in the EAC, compared with 1.8 years in high-income countries and 3.5 years in middle-income countries (Table 6). It also takes 30 percent of the bankrupt estate to resolve a bankruptcy case, compared with an SSA average of 19.5 percent and a world average of 16.4 percent.

Table 6.

EAC and Comparator Groups & Countries: Bankruptcy Procedures

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Source: Doing Business 2005, International Finance Corporation; and IMF staff calculations.

15. Lack of credit information on the borrowers and high collateral requirements also significantly deter private lending in the EAC. On a scale of 1 to 4, with 1 indicating no obstacle and 4 indicating a major obstacle (Table 5), the same survey gave the EAC an average score of 2.8 on credit information, compared with the worldwide average of 2.3. Without sufficient information on the borrowers, creditors have to rely on high collateral. Consequently, the EAC gets an average score of 2.8 on collateral requirements as a financing obstacle, compared with a worldwide average of 2.5. As Table 7 shows, 90 percent of the loans in EAC require collateral, compared with a worldwide average of 81 percent.

Table 7.

EAC and Comparator Groups & Countries: Collateral Requirements 1/

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Source: Doing Business 2005, International Finance Corporation; and IMF staff calculations

All data are for 2003, except Mauritius which is 2005; Note: Sub-Saharan Africa excludes Nigeria and South Africa.

Crowding-out by government borrowing

16. High government borrowings appear to have contributed to low private sector credit in the EAC. This is particularly true for Tanzania in the late 1990s, as indicated by a high ratio of claims on the government to total domestic claims. For Kenya and Uganda, while government borrowing is not excessive compared to other SSA countries and shows a declining weight in total domestic credit, it is still higher than in LICs outside SSA. As is well-documented, issuance of government debt absorbs domestic savings, potentially exerting upward pressure on interest rates, and crowding out lending to the private sector (Figures 7, 8, and 9).3

Figure 7.
Figure 7.

EAC and Comparator Groups: Banking Sector Claims on Government

(Ratio on total claims)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Figure 8.
Figure 8.

Government Debt and Private Sector Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Figure 9.
Figure 9.

Government Debt (percent of GDP) and Real Lending Rate

(percent)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Other macroeconomic factors

17. Other macroeconomic variables do not appear to have significantly contributed to low private sector credit or high lending rates in the EAC. As shown in Figure 10, key macroeconomic indicators in the EAC, like fiscal balance and inflation, do not seem to have substantially deviated from the global mean during 1995-2004, suggesting that they have played a relatively small role in contributing very low private sector credit in the region, which was substantially below the global average.

Figure 10.
Figure 10.

Macroeconomic Factors and Private Lending, Deviations from the Means

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: WEO and staff calculations.

III. Recent Policies and Reform Strategy Going Forward

A. Recent Policies to Improve the Availability of Private Sector Credit

18. The EAC authorities have implemented major reforms in recent years in an effort to improve access to private sector credit and enhance financial intermediation generally. Since many banks had a very weak financial position and poor management capabilities in the early 1990s, in Tanzania and Uganda (and to a lesser extent Kenya) the banking sector was not in a position to provide substantial amounts of new credit to the private sector. The Tanzanian and Ugandan authorities had to rebuild the banking systems, through liberalizing the sector, creating a new prudential framework, opening the system to foreign banks, and restructuring and privatizing state-owned banks. Perhaps because the situation was less pressing, reforms in Kenya were slower and much less radical.

19. The position of financial systems in the EAC was very problematic in the early 1990s. Economic mismanagement in Tanzania and civil unrest in Uganda left their financial sectors in a very weak position (Box 1). The main problems were large numbers of NPLs, lack of capital, outdated banking methods, and a decrease in intermediation. Similarly, while Kenya’s financial system has been traditionally more open, it had many of the same problems—a high ratio of NPLs and a lack of capital in government-owned banks, exacerbated by harmful regulation.

Historical Context of Banking Sector Reforms

In Tanzania, the poor performance of the state-owned financial sector in late 1980s forced the government to search for new policy directions. Nonperforming loans (NPLs) accounted for over 65 percent of the loan portfolio, fiscal and financial operations were intermingled, and the regulatory system was inappropriate.

Civil disturbances in Uganda in the 1970s and 1980s led to a significant decline of financial intermediation, so that financial services became concentrated in only a few commercial banks in the capital. Aleem and Kasekende (2001) find that nonprofessional management was common in financial institutions and normal business discipline collapsed. Financial repression in the form of interest rate controls and directed credit contributed to disintermediation; parallel markets evolved in foreign exchange, trade, and credit; and the use of credit instruments declined. The two dominant banks, which accounted for about two-thirds of commercial bank business, were insolvent; they required massive liquidity support from the central bank to operate.

Kenya’s banking system has traditionally been more open and modern. The banking system after independence consisted only of foreign-owned banks; while their dominance has since eroded, they still accounted for a substantial part of the system over time. However, the soundness and efficiency of intermediation was also undermined by the presence of large, weak government-owned banks, which accounted for most of the banking system’s NPLs. The National Bank of Kenya (NBK, the sixth largest bank) has been insolvent for many years. Though the Kenya Commercial Bank (KCB, the second largest) has fared better, it has suffered considerably from its bad loan portfolio.

20. The rebuilding of EAC banking systems started with liberalization and introduction of new prudential frameworks in Uganda and Tanzania early in the 1990s. In both countries, the authorities decided to reduce government’s role in the financial sector and allow the market to play a more substantial role in resource allocation. They started a comprehensive program to liberalize interest rates, phase out subsidies, remove directed credit, and license new banks; they also introduced a new regulatory and prudential system. In Kenya, a variety of reforms to the financial system were introduced in the early 1980s through the mid-1990s; monetary policy reforms in the 1990s liberalized interest rates and replaced direct controls on lending with open market operations.

21. With the reforms in Tanzania and Uganda, all three EAC countries became open to foreign banks, which were expected to make the banking systems more competitive and more active in providing credit. In Tanzania, the first major foreign bank (Standard Chartered) started operations in 1992; other international banks soon followed Stanbic (1993), Citibank (1995), and Barclays (2000). Several other smaller foreign banks set up subsidiaries between 1995 and 2002. In Uganda, the number of banks increased from nine in 1991 to 20 in 1996. Foreign bank entry was never a major issue in Kenya, where foreign banks have been playing an important role since independence.

22. All three EAC countries have restructured and privatized their state-owned banks, which were mostly insolvent and unable to allocate credit efficiently. In Tanzania, the two largest state-owned banks, the National Bank of Commerce (NBC) and the Cooperative and Rural Development Bank, were financially restructured relatively quickly and both were privatized. Partial privatization of the National Microfinance Bank (NMB) took longer, but has also been completed.1 In Uganda, the government gradually sold most of its shares in financial institutions, most importantly shares in the Uganda Commercial Bank, the largest bank in the system.2 In Kenya, the Kenya Commercial Bank has been restructured but the government continues to hold a substantial stake in it, and progress in restructuring and privatization of the National Bank of Kenya has been very slow.

23. The major first generation reforms have strengthened the banking systems in Tanzania and Uganda, but have resulted in a modest increase in private sector credit in Tanzania; in Kenya, progress of reform has been too slow to effect a major improvement (Figure 11). In Tanzania, major reforms have created a new market-based financial system and limited direct fiscal costs, but have so far yielded only limited improvements in access to financial services. The history of nonrepayment explains bank reluctance to replace the stock of NPLs by new credit. Instead, banks have been accumulating extensive holdings of government paper and off-shore deposits in foreign exchange, further limiting the amount of credit available to the private sector. In Uganda, while the reforms did improve the performance and depth of the financial system, but the amount of private credit remained very small. In Kenya, Brownbridge and Harvey (1998) found some evidence that liberalization in the 1990s led to more vigorous competition among banks for deposits and in providing services. However, the liberalization may not have been able to improve the efficiency of credit allocation because of distortions in the banking system, where weak government-owned banks have been allowed to operate. Therefore, while the level of private sector credit remains higher in Kenya than in Tanzania and Uganda—reflecting Kenya’s higher per capita income and smaller subsistence sector—it has exhibited a clear declining trend in Kenya in recent years. Moreover, a significant part of the existing credit in Kenya is nonperforming, as described above.

Figure 11.
Figure 11.

Private Sector Credit

(Percent of GDP)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

Source: IFS and staff calculations

24. The relatively slow improvements have had two results: the authorities (i) embarked on further, second generation, reforms; and (ii) started planning limited government initiatives in development finance. The slow progress brought by the initial reforms led to pressure to deliver more substantial improvements, especially in the availability of term finance and support to the agricultural sector. This led to second generation reforms and new government initiatives.

25. The second generation reforms, which are still work in progress in all three countries, are mainly directed to removing structural obstacles to lending. In Tanzania, in an attempt to create an environment more conducive to lending and financial sector development in general, the authorities have introduced reforms in the areas of legal, judicial, and information infrastructure, including the Land Act 1999 and the Companies Act 2002. However, these reforms have not been comprehensive and their implementation takes time. The 2003 Financial Sector Assessment Program found that little progress has been made in judicial reforms: training and facilities still need special attention; and land registries, company registries, and registries of mortgage interests are inefficient and need considerable improvement before they can become a useful information basis for credit decisions. Tanzania is now accelerating its implementation of second generation reforms in the context of its comprehensive FSAP-based financial sector reform plan. Uganda has focused on similar issues, but the 2005 Financial Sector Stability Assessment found a number of weaknesses in provision of credit reference information, land and company registries, the commercial court system, and the corporate insolvency regime. Kenya has seen no major reforms to improve the lending environment recently; instead, the authorities tried to spur private sector credit by lowering interbank and T-bill interest rates through a relaxation of monetary policy, which caused inflation to accelerate.

26. The authorities have also become more active in trying to provide credit to the private sector directly. The authorities in Tanzania and Uganda are returning to development finance activities, while the authorities in Kenya have never abandoned their direct role in the financial system. In Tanzania, new initiatives include (both operational and planned) the Export Credit Guarantee Scheme, restructuring and recapitalization of the Tanzania Investment Bank, the SME Credit Guarantee Scheme, and the Development Finance Guarantee Facility. The government has committed to following best practices regarding governance and transparency in these initiatives, and to strictly limit fiscal risks. In Uganda, the government has decided to restructure the Uganda Development Bank—currently under a new professional management team—to provide longer-term credit. In Kenya, the government continues to operate development finance institutions in addition to controlling two large commercial banks.

B. Strategy for Further Reform

27. While the EAC countries have made substantial progress in stabilizing and reforming their financial sectors, more needs to be done. Though the major first generation reforms and the partially implemented second generation reforms have increased private sector credit in Tanzania and Uganda in recent years, both countries still lag significantly behind other LICs. Although banks have generally become financially sound and profitable, as of 2003 they still charged relatively high spreads and lend relatively little compared with the amounts of deposits Figure 12).

Figure 12.
Figure 12.

Spread and Loan to Deposit Ratio, 2003 (Difference from Sample Mean)

Citation: IMF Staff Country Reports 2008, 353; 10.5089/9781451811612.002.A002

28. The main goal of further banking reforms is to improve the intermediation of savings. The goal would thus be to move the banking systems to the northwest quadrant of Figure 8—for banks to lend more and at a lower spread. However, this shift cannot be forced by direct government intervention (e.g., regulation of interest rates or mandatory lending targets) because the improvement needs to be sustainable, i.e., the banks need to continue to operate on commercial principles and remain profitable. The strategy needs to create the opportunity for banks to lend profitably at lower spreads, by removing obstacles to lending, and force them to use the new opportunities (by supporting competition in the banking systems). The authorities should be very careful about introducing new forms of government involvement in the financial sector that may ultimately impede development of sustainable private lending.

29. The recent experience of transition economies in Central and Eastern Europe (CEE) can serve as an example of successful structural reforms that led to strong growth of private sector credit. At the start of transition from centrally planned to market economy, in the early 1990s, banking systems were in a bad shape—banks were burdened with high nonperforming loans, had limited management capabilities, lacked capital and proper governance, and operated in an environment of vaguely defined and poorly enforced creditor rights. These issues were addressed through recapitalization, operating reforms, privatization (mainly to foreign banks), and legal and institutional reforms. Growth of bank credit to the private sector picked up substantially since the second half of the 1990s in most CEE countries. For instance, the ratio of private sector credit to GDP increased by 35 percentage points in Estonia and 21 percent in Croatia between 1994 and 2002. Cottarelli et al (2003) analyzed credit growth in CEE and found no clear evidence that the credit growth performance reflected primarily initial conditions in banking intermediation or was driven by financing from abroad. While crowding-in may have been a factor (bank credit to the public sector declined as percentage of GDP), the progress of structural reforms, private sector ownership of banks, and the degree to which legislation protects creditor rights were found to be important.3

Remove impediments to lending

30. As discussed, major impediments to lending are insufficient enforcement of already weak creditor rights, lack of information about borrowers, and administrative barriers to using assets as collateral. All three countries recently participated in the FSAP (2003-05), which made specific recommendations in each of these areas. While some progress has been made in implementing these recommendations, mainly in Tanzania and Uganda, virtually none has yet been fully implemented. In Uganda, there should be the foundation of reforms going forward. Tanzania has made its FSAP recommendations the core of its financial sector strategy.

31. All three countries need to continue improving and enforcing creditor rights. The FSAPs suggested that Tanzania should give the commercial court more resources for rapid settlement of cases and undertake to strengthen the judicial system generally. Kenya should modernize the insolvency procedures set out in the Company and Bankruptcy Acts, strengthen the capacity of the commercial court to administer cases efficiently, give judges more training, and expand the specialized commercial court to other regions, such as Mombasa. Uganda should overhaul its corporate insolvency regime and supporting taxation system and strengthen the capacity of the commercial court and the Official Receiver.

32. Information about borrowers should be improved by making credit reference bureaus fully operational and effective and making company and land registries more efficient. In Tanzania, the FSAP suggested that the company and land registries be modernized and that the central bank take the lead on the credit registry/bureau project and push ahead speedily with a simple—and if necessary compulsory—system of credit reporting by all licensed lenders. Tanzania launched a limited credit reference bureau last year, and its developing a more comprehensive credit information system to be completed in 2007. In Kenya, commercial registries were to be modernized to provide access to current, accurate, and reliable information. At the same time as the legal basis for sharing credit information among financial service providers was established, a fully effective system of credit information should be made operational. In Uganda, a credit reference bureau should start operations soon. Also, the land and companies registry needs to be rehabilitated.

33. The use of collateral should not be restricted by legal problems and outdated laws. Land and real estate are important as collateral in most countries, but administrative problems in EAC countries complicate their use as collateral. In Tanzania, the Land Act was intended to allow mortgage financing but technical issues have kept it ineffective. The authorities have made only partial progress in resolving these issues so far. In Kenya, barriers to creating, registering, and enforcing a security interest need to be removed, the land registry systems integrated, hidden liens and excessive registration costs removed.

Increase competition

34. Further increasing competition is important to force banks to exploit new opportunities, be innovative, and actively identify ways to overcome impediments to lending. Because banks have recently been very profitable in all three countries, they may be less motivated to innovate and build new business. There are several ways to increase competition; among them are being open to new reputable entrants, restructuring and privatizing state-owned banks completely, improving the transparency of fees and charges, not tolerating the operation of weak banks and possibly raising the minimum capital requirements, and developing professional institutional investors (insurance companies and pension funds) while allowing them to finance the best companies through the capital market.

Some specific recent recommendations in the EAC:

  • In Kenya, restructure the technically insolvent NBK and divest the government stake in all commercial banks; the authorities should intervene in any weak bank that fails to develop and implement a time-bound recovery plan, ideally within a prompt corrective action framework; the minimum capital requirement for banks should be raised.

  • In Tanzania, liberalize investment requirements for insurance companies, restore public confidence in the insurance market by resolving the National Insurance Corporation (NIC); facilitate the emergence of securitized loans or guaranteed bonds by pension funds, and develop investment guidelines for all pension funds.

  • In Uganda, improve the disclosure and transparency of interest and account-related bank charges, restructure the governance of NSSF restructured, including by hiring independent professional board members, and issue investment regulations for insurance companies.

Exercise caution about direct government intervention

35. Since there is an abundance of examples of failed efforts by government to involve themselves directly in the financial system, caution is certainly warranted. The three EAC countries have themselves had a number of state-owned banks that had to be rescued or closed; none of their development finance institutions was successful. Therefore, recent attempts to revise, redesign, or continue operating government schemes in the three countries risk repeating these failures. On the other hand, other countries have had some recent success with vehicles to support agricultural and rural finance, which are also areas that seem to have priority on the agendas of EAC governments. We therefore attempt to identify factors that contributed to their success.

36. State-owned agricultural and rural development banks have had the dual objective of operating profitably (or at least covering their costs) and supporting the government in achieving rural development goals. In the 1970s and 1980s, many countries started state banks with high hopes of establishing permanent access to credit, especially for agriculture, in underserved areas.4 Often, the banks neglected, or were forced to neglect, the first objective that would ensure their sustainability. The result in many cases was decision-making by and for special interests, high transaction costs, high loan losses, and corruption. Consequently, many of these institutions were closed or privatized in the late 1980s and early 1990s.

37. Often, the rural branch network significantly contracted or disappeared once the state banks were privatized or closed, prompting attempts to revive them. While the shortcomings of state-owned banks have been extensively documented, many countries also recognized the disadvantages of the disappearance of agricultural development banks and have tried to set up new banks or reform the remnants of these institutions.

38. Several formerly state-owned banks have managed to provide services in rural areas on a significant scale while keeping their operations sustainable. The organizational structure does not appear to be crucial—the successful banks are reformed development banks, start-ups or specialized units within commercial banks. The Agricultural Bank of Turkey, the Agricultural Bank of Mongolia, and BAAC in Thailand were reformed or turned around; for instance. For these, the authorities faced a difficult choice when confronted with large losses caused by subsidized lending and weak management and governance and decided to put the operations on commercial footing, while using the advantages of substantial branch presence, which in turn allowed the focus on rural areas to be preserved. The Agricultural Development Bank of Latvia and the Kyrgyz Agricultural Finance Corporation were startups. The state-owned Bank Rakyat of Indonesia set up a specialized micro finance unit. See Box 2 for more information about some of these cases.

Successful Turnaround Efforts in Rural and Agricultural Banks

Agricultural Bank of Turkey (T.C. Ziraat Bankasi). Ziraat, like other state banks in Turkey, accumulated large losses from subsidized directed lending to political constituencies, which were covered by claims on the government. The 2000-01 crisis exposed its vulnerability to liquidity and interest rate shocks when the bank suffered massive losses as short-term interest rates increased sharply. In April 2001 the government took radical steps to restructure Ziraat’s finances and operations. The bank was recapitalized; its overnight exposure was eliminated; a new board (joint with another state bank) professional bankers with a strong commercial mandate was appointed; a substantial number of branches were closed; staff was reduced; and lending was temporarily halted (it resumed in 2002). These steps, combined with other reforms, led to a notable improvement in performance, and Ziraat remains the largest bank in Turkey in terms of assets. The government intends to privatize the bank, but progress has been relatively slow.

Bank for Agriculture and Agricultural Cooperatives (BAAC) in Thailand. BAAC was established in 1966 as a government-owned agricultural development bank. The original mandate was to provide credit to farm households. Over almost four decades BAAC was transformed into a diversified rural bank. In the two most recent phases of reform, the bank strove for viability and self-reliance under conditions of controlled interest rates through savings mobilization, improved loan recovery, and increased staff productivity (1988–96). Since 1997 BAAC has adjusted to central bank prudential regulations and diversified into nonagricultural lending. BAAC has demonstrated how reform can be gradual, but the reform agenda is still unfinished.

Bank Rakyat of Indonesia (BRI). Until early in the 1980s BRI was the main provider of heavily subsidized agricultural credit. The government then decided to reform the bank. Interest rate were fully deregulated and new management decided to commercialize the 3,000 credit outlets and turn them into self-sustaining profit centers. Changes made ranged from introducing new products to making the information system more efficient. The BRI microfinance units reached their break-even point in about 18 months, have been consistently profitable, and supported the whole bank during the 1997-98 crisis. However, the microfinance division accounts for only about one third of the BRI activities, and the other operations have accumulated substantial losses in recent years.

Agricultural Bank of Mongolia (AgBank). After overcoming strong opposition, the government of Mongolia has obtained support from bilateral donors to turn around the loss-making Agricultural Bank of Mongolia (renamed Khan Bank in 2004). In two years, the bank was restructured on sound banking principles, though it kept its mission of providing financial services in rural areas. AgBank is an example of a privatized bank that recognized significant business opportunities in rural areas and took advantage of its competitive position as the only bank with an extensive branch network. It was able to increase its rural penetration by such good practices as offering demand-responsive products based on extensive market research. It also decided to extend its network from 250 to 350 branches. A key success factor was an experienced hands-on international management team, free from loyalties to special interests within the country and backed by government and generous donor support. The new private owners did not change the focus of the bank on rural activities after it was privatized in 2003.

Sources: Nagarajan and Meyer (2005), Siebel, Siebel, Giehler, and Karduck (2005), World Bank (2005), and company information.

39. The success factors in these rural and agriculture bank examples are the following:

  • clear separation of banking operations and decision-making from government influence, and strong political will from all parties for an independent institution;

  • a governance structure that included majority private sector representation on the board and political independence of the board and managing director;

  • consistent government policies directed to making rural finance sustainable, such as no debt forgiveness, interest rate subsidies, or interest rate caps;

  • sufficient no-strings-attached funding for expert international technical assistance to build systems and create products;

  • ability to charge full cost-recovery interest rates, net of time-bound technical assistance and initial operating expenses;

  • access to local current funding and a long-term approach that recognized that progress may be only gradual.

40. The recent revival of development finance efforts in the EAC is worrisome. In Tanzania, the large number of initiatives planned and in operation will require strong management, and continuous commitment to strong governance and transparency, and strict limits on fiscal risks. In Uganda, the decision to strengthen the Uganda Development Bank may prove problematic, unless the bank is independently managed and properly supervised. In Kenya, the government continues to operate development finance institutions even though the recent FSAP recommended that their lending should be suspended and that future development financing be done either through properly supervised financial institutions or in the form of grants rather than credit. These development bank-related activities risk creating new fiscal costs for the government and—perhaps more important—sending the wrong signal to private providers of financial services and potentially stifling their activities.

41. The most useful role for government is to create the conditions in which the financial system can grow without being directly involved in the provision of financial services; however, when some direct government involvement is inevitable, its structure should minimize risks for the government and the financial sector. Improving financial sector performance can take time, and political pressure on the government to step in can be very strong. Drawing on lessons from previous failures and successful examples in some countries, the authorities should design their involvement so that the risks, both for the government’s fiscal position and financial sector development, are minimized. Some basic principles include:

  • The schemes or institutions should be sustainable and have a well-defined mandate. Sustainability can be achieved by allowing them to charge at least cost-recovery interest rates or fees, net of donor or government financed technical assistance and possibly initial expenses. Any government assistance—start up, product development, or operating expenses, if applicable—should be clearly identified, tied to a specific mandate, and paid from the current government budget.

  • The governance and management arrangements should be independent from political influence and minimize the risk of corruption and decision making by and for special interests. This could be accomplished by majority private sector representation on the board. Attracting a private partner would be helpful. In any case, professional management with a performance-based contract is critically important.

  • The schemes or institutions need to be properly supervised and their operations transparent. Banking supervisors may be in the best position to the supervisory role even if there is no deposit-taking activity; experience shows that line ministries often fail to properly supervise. Operations should be transparent and independently audited.

IV. Conclusion

42. The three EAC countries have generally followed sound strategies in reforming their banking systems, but the improvement in private sector credit has been slow. Tanzania, Uganda, and to a lesser extent Kenya have adopted major reforms and stabilized and strengthened their banking systems. However, the improvement in private sector credit has been relatively slow and credit availability does not compare favorably with other low-income countries. Banks in the EAC countries are generally sound and profitable, but achieve this by charging relatively high spreads and lending relatively little compared with the amount of their deposits.

43. The main goal of a forward-looking strategy should be to further improve the intermediation of savings, leading to a cheaper and more widely available private sector credit and thus supporting a general strategy of accelerating sustainable growth. Put simply, the goal should be to facilitate bank lending with lower spreads and to a broader swath of the population. But such a shift needs to be sustainable and therefore cannot be forced by direct government intervention; banks need to continue operate profitably and base their decisions on commercial principles. The strategy needs to create the opportunity for banks to lend profitably at lower spreads by removing obstacles to lending, and force them to use new opportunities by supporting competition in the banking system. While improvements in intermediation will inevitably be gradual, the experience suggests that shortcuts are, in reality, costly dead ends.

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1

Prepared by Kevin Cheng and Richard Podpiera.

2

Throughout this paper, all reference to sub-Saharan Africa (SSA) exclude South Africa and Nigeria, unless otherwise indicated.

1

The Uganda figure may be understated because data on nonbank financial institutions are not available.

2

Kenya has a relatively well developed nonbank financial system, comprising around 40 percent of the financial assets; in Uganda and Tanzania the banking sectors dominate the financial systems.

3

Concentration ratios may not necessarily give a good indication of the amount of competition.

1

In the rest of the paper, all private lending figures exclude NPLs.

2

The World Bank conducted the WBES in 1999 in more than 80 countries. The survey elicited answers from firm managers about their perception of the extent to which various obstacles inhibit the operation and growth of their business, including obstacles to financing.

3

Christensen (2004) and Adam and Bevan (2004) find some evidence of crowding out in African countries.

1

The largest bank in the system, the state-owned National Bank of Commerce, was split in 1997 into the new National Bank of Commerce Limited (NBC), with most of the loan portfolio and city branches, and the National Microfinance Bank (NMB), with an extensive branch network outside main cities and virtually no loans. The South African banking group ABSA then bought a majority stake in the NBC.

2

The Uganda Commercial Bank accounted for half of the banking business and more than 80 percent of the national branch network. The first attempt to privatize the UCB in the late 1990s failed due to irregularities in the transaction, but UCB was at last acquired by the South African bank Stanbic in 2002.

3

The fast credit growth in CEE has brought a new set of policy issues—i.e., how it should be managed so that it does not create macroeconomic imbalances or jeopardize financial stability. Hilbers et al. (2005) provides a detailed discussion on this.

4

For an overview of agricultural development banks, see Agri-Stat, an inventory developed by FAO and the German Agency for Technical Cooperation, available at http://www.fao.org/ag/ags/agsm/banks/index.htm. Siebel, Giehler, and Karduck (2005) describe and analyze the data.

Kenya, Uganda, and United Republic of Tanzania: Selected Issues
Author: International Monetary Fund
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    EAC and Comparator Countries: M2/GDP and Deposit/GDP, percent

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    EAC and Comparator Groups: Private Sector Credit

    (Percent of GDP)

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    EAC: Distribution of Loans, Most Recent Available Data

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    EAC and Comparator Group: Real Lending Rate and Lending-Deposit Spread, percent

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    EAC and Comparator Groups: Private Lending and Economic Developments, 2004

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    EAC and Comparator Groups: Deposits and Private Sector Credit

    (Percent of GDP)

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    EAC and Comparator Groups: Banking Sector Claims on Government

    (Ratio on total claims)

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    Government Debt and Private Sector Credit

    (Percent of GDP)

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    Government Debt (percent of GDP) and Real Lending Rate

    (percent)

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    Macroeconomic Factors and Private Lending, Deviations from the Means

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    Private Sector Credit

    (Percent of GDP)

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    Spread and Loan to Deposit Ratio, 2003 (Difference from Sample Mean)