Public Information Notice No. 05/66

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Uganda

May 23, 2005

On February 22, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Uganda.¹

Background

With implementation of sound economic policies and an ambitious program of economic reforms, Uganda experienced an impressive economic recovery through the 1990s that resulted in a significant reduction in poverty. However, the pace of economic growth has slowed somewhat down in recent years and the incidence of poverty increased. Some improvements in economic performance have been observed in 2003/04 (July-June) relative to 2002/03. Real GDP grew by an estimated 5.9 percent, led by growth in construction and communication, while improved weather conditions contributed to a rebound in agriculture. With one of the highest population growth rates in the world, real GDP per capita only grew by 2.4 percent in 2003/04. After peaking at 10.2 percent by the end of 2002/03, annual headline inflation fell sharply during 2003/04 to 5.1 percent through September 2004, driven by restrained money growth and lower food prices. The easing of inflationary expectations also contributed to a reduction of interest rates. In recent months, headline inflation has been picking up again, as food prices rebounded due to the current drought.

Strong growth in noncoffee export volumes and improved terms of trade helped to narrow the external current account deficit, excluding grants, to 11.8 percent of GDP in 2003/04. Greater-than-anticipated donor support and private capital inflows more than covered the deficit, allowing international reserves to build up faster than envisaged to about 6½ months of imports. Following a large depreciation in 2002/03, the Ugandan shilling appreciated in real effective terms by about 10 percent since December 2003. Buoyant export proceeds, demand for domestic currency from donor-funded projects, and increased sales of foreign exchange by the BOU contributed to this exchange rate appreciation.

There were several slippages under the program. Overall, four quantitative performance criteria for end-June 2004 were breached. Although the structural performance criteria for June and September were met, progress in implementing the structural reform program was slower than envisaged, with eight out of ten structural benchmarks breached.

The fiscal consolidation envisaged in the program for 2003/04 was not achieved. The overall central government deficit, excluding grants, remained at 11.3 percent of GDP in 2003/04, or 0.6 percent higher than programmed. The domestic deficit, which excludes external interest payments due and externally financed development expenditures, fell short of the program target by a similar magnitude. While tax revenues were lower than envisaged, reflecting weak VAT and trade tax collections, the higher deficit primarily reflected an excess in spending (0.4 percent of GDP), covering public administration needs, including from the Presidency, and net lending operations to private enterprises. As a result, the quantitative performance criterion on net credit to the government for end-June 2004 was breached by nearly 0.8 percent of GDP. The indicative ceiling on public administration spending and the performance criterion on domestic arrears accumulated under the Commitment Control System (CCS) were also breached. However, the core poverty-reducing outlays of the Poverty Action Fund (PAF) remained above their indicative floor.

Based on preliminary information, the overall central government deficit, excluding grants, was slightly smaller than projected during the first quarter of 2004/05. While revenues remained in line with the program, development expenditures were lower than envisaged, as programmed cash releases were delayed to several ministries and local governments. This, however, generated further accumulation of arrears under the CCS.

The program ceiling for base money growth was slightly missed for end-June 2004, but broad money growth and excess reserves have declined as programmed. Domestic credit to the private sector maintained its robust growth at 17 percent. Large variations in government liquidity injections, volatile currency demand, and a shifting emphasis by the Bank of Uganda (BOU) on its sterilization tools led to substantial interest rate volatility. However, treasury bill rates fell significantly in the third quarter of 2003/04 and remained relatively stable thereafter due to intensified sterilization through foreign exchange sales, and a steadier execution of the base money program. As of September, base money was below the targeted ceiling. Recently, however, the BOU once again shifted away from foreign exchange sales for sterilization purposes, with a risk of placing an excessive burden on treasury bill issuances to meet monetary targets.

The banking sector remains sound. The profitability and capital base of the banking system has remained high with a very low level of nonperforming loans, as highlighted by the recent Financial Sector Assessment Program (FSAP) mission. Stress tests confirm that the banking system can weather plausible macroeconomic shocks. The nonbank financial institutions (NBFIs) show strong growth, but are more vulnerable.

Uganda has made progress in obtaining debt relief. Thirty-one creditors have agreed to provide debt relief to Uganda accounting for 96 percent of total HIPC assistance. The authorities will continue to engage the remaining creditors, particularly Libya and India, to provide debt relief under the HIPC Initiative.

Executive Board Assessment

The impressive economic performance of recent years based on the first wave of reforms has tapered off, while the conditions for achieving stronger long-term growth and lasting poverty reduction have not yet been established. Directors accordingly called on the Ugandan authorities to launch a second round of reforms aimed at increasing productivity, reducing poverty, and achieving the Millennium Development Goals (MDGs). Steadfast implementation of such reforms within a transparent and predictable policy environment will be key to strengthening investor and donor confidence. In this context, Directors looked forward to the implementation of the revised Poverty Eradication Action Plan (PEAP), and they emphasized that peace and security throughout the country will be needed to achieve sustained economic development.

Directors noted that performance in 2003/04 under the PRGF-supported program had been mixed. They welcomed the fall in inflation and the rebound in economic growth. At the same time, they were concerned about slippages in the fiscal area―reflecting strong spending pressures and revenue shortfalls―and the accumulation of new domestic payments arrears. Directors also expressed disappointment that implementation of structural reforms was significantly weaker than envisaged. Against this background, they welcomed the strong commitment of the authorities to address the recent slippages through a set of front-loaded measures to bring the program back on track. Strong political will and follow through will be essential to achieve program objectives going forward.

Directors stressed that fiscal consolidation will remain a cornerstone of efforts to maintain debt sustainability, create room for private sector investment, and ensure that adequate resources are available to achieve a lasting reduction in poverty. They concurred that the authorities' medium-term fiscal consolidation strategy will need to rest on increasing revenue mobilization and enhancing expenditure management, including through significantly improved monitoring of the government's domestic arrears and the strengthening of administrative capacity at the local government level.

Directors welcomed the steps taken by the authorities to strengthen the operations and management of the Uganda Revenue Authority (URA) to raise revenues from the current low level and enable Uganda to reduce its reliance on external assistance. They emphasized that determined actions to complete the full restructuring of the URA will be critical for meeting these goals, especially in light of the revenue reduction expected as a result of the implementation of the East African Community (EAC) customs union. Moreover, Directors noted the importance of forcefully tackling corruption in the URA as a key part of steps to build confidence in public institutions. It will also be important to ensure that the legal and regulatory framework of the envisaged Export Processing Zones meets international standards. In particular, to avoid undermining fiscal revenue mobilization, Directors recommended that the zones should be ring-fenced with the strict application of customs duties and the sales tax to Ugandan residents. They supported the authorities' plan to work with the other EAC partners to establish a common code of conduct for investment incentives.

Directors emphasized the need to adhere strictly to the current budget by avoiding supplementary appropriations during the fiscal year, especially on defense, public administration, and bailouts of private firms. They observed that, in the past, such expenditures had undermined the appropriate execution of the budget and contributed to the accumulation of domestic arrears.

Directors welcomed the authorities' commitment to revive the public administration reform program. This will be essential for improving the efficiency of government spending and ensuring appropriate wages for public employees. In addition, Directors encouraged the authorities to address governance issues steadfastly, both to ensure budget implementation and enhance the investment climate. In this connection, crucial steps will be needed to strengthen the role of the Inspector General of Government and implement a code of conduct for public servants.

Directors considered that the authorities' monetary policy stance, as well as the liberalization and reform of the financial sector, have helped maintain macroeconomic stability and a healthy financial system. They encouraged the authorities to continue pursuing a prudent monetary targeting framework, while implementing a more balanced mix of foreign exchange sales and open market operations to avoid volatile movements in interest rates. Directors encouraged the authorities to act with caution in moving donor-funded government accounts from commercial banks to the Bank of Uganda so as to minimize the liquidity impact on the commercial banks.

Directors took note of the recent cabinet approval of anti-money laundering legislation, and looked forward to its early adoption by parliament. They agreed that the sale of minority shares and management responsibilities of the Uganda Development Bank (UDBL) could contribute to enhancing the delivery of credit to productive private sector activities.

Directors welcomed the emphasis given to the reform of the pension system and to the deepening of the financial system. The development of a sound network of microfinance institutions will facilitate the provision of the necessary financing to small-scale enterprises and to the agriculture sector. Directors encouraged the authorities to strengthen the land registry to promote collateralized lending.

Directors noted that the flexible exchange rate regime has served Uganda well by helping to cushion the impact of exogenous shocks while maintaining external competitiveness. They encouraged the monetary authorities to ensure that the exchange rate remains broadly in line with macroeconomic fundamentals.

Directors shared the authorities' concern about the sustainability of external debt and supported their intention to seek more grants while limiting new loans on concessional terms. The authorities' strategy aimed at expanding and diversifying the export base will also serve to enhance debt sustainability. Directors called on all creditors to quickly reach agreement with Uganda on the full delivery of HIPC Initiative assistance.