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AfricaMay 2 2004

Uganda’s plan for a brighter future

Despite enviable economic growth stretching back 16 years, Uganda still has many hurdles to overcome, says James Eedes.
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In Africa, 16 straight years of positive economic growth is certainly something to be proud of. And that’s exactly what Uganda has achieved, a sparkling performance matched only by Botswana and Mauritius. As a consequence, the total number of Ugandans living in poverty plummeted from well over half of the population at the start of the 1990s down to 34% of the population by the end of the decade.

But it’s a success story with a bitter twist. Poverty levels are rising again, the country remains heavily indebted and dependant on donor support, and in the north, the government continues to battle the Lords Resistance Army, a cult-like guerrilla movement responsible for killings and the abduction of thousands of children.

Combating poverty

The government, however, is setting its sights on a second growth boom, a decade of increased growth that will knock back poverty and ensure self-sufficiency. The second revision of the Poverty Eradication Action Plan, the country’s national planning framework, is close to adoption. It promises to deepen reform but equally toapply the lessons learnt since the first planning framework in 1997, according to the minister of finance, planning and economic development, Gerald Ssendaula.

Real GDP growth has averaged 6.5% a year since 1990, benefiting from improved security; the restoration of macroeconomic stability (for instance, annual headline inflation averaged just 4.8% a year over the last decade); liberalisation of the economy; and strong export performance. Macroeconomic stability generated increased private investment, up from 9.1% of GDP in 1990 to 17% in 2003, while improved security and Uganda’s economic reforms enabled the economy to move back towards full output.

So why has the progress in rolling back poverty stalled? “It is likely that the Ugandan economy has already realised most of the gains arising from reforms implemented in the 1990s,” says Mr Ssendaula. “Any deterioration in the economic policy environment would greatly damage Uganda’s growth prospects, but maintaining the current policies of macroeconomic stability and openness to trade will not in itself enable GDP growth to rise above the 5%-6% annual level. The challenge, therefore, is to identify the kind of policies that can boost growth above 5%-6% while at the same time ensuring that it is broad-based and pro-poor.”

Uganda’s underlying problems are difficult but clear-cut. The country’s dependence on donor aid makes it vulnerable. At its peak in 2001/2002, 40% of Uganda’s government expenditure and debt repayments were being funded by donor aid. If aid is cut, the resources to meet the shortfall are limited and it would soon be necessary to slash government spending. The second point is that the resultant double-digit fiscal deficit before grants (government expenditure including donor aid being far higher than government revenue) has an inflationary effect by expanding money supply. To mop up the extra money supply, the Bank of Uganda either sells domestic securities or foreign exchange. The former crowds out private sector borrowing while the latter leads to appreciation of the Ugandan shilling – not what the doctor ordered for an export-orientated economy trying to protect the terms of trade on its low-value traded goods.

The second problem follows from the first. Forty per cent of donor aid is in the form of external loans, albeit – to the credit of the government – on vastly more concessional terms than before. Since 2000, Uganda has borrowed $1.5bn, raising the ratio of the net present value of debt to exports to 305%. Although the sustainability of the debt is, for the moment, not in question because of the concessional terms, the numbers are intimidating to investors.

Furthermore, the persistent insecurity in the north of the country is estimated to cost Uganda 3% of its GDP. If real consumption had grown during the period 1992-2003 in the north at the same rate as the rest of the country, real consumption would now be 38% higher in that region and aggregate national consumption would be about 3.3% higher.

Also economic growth is being eroded by the effects of population growth, which at 3.4% a year is the third fastest worldwide.

Poverty template

Lastly, as a consequence of the aforementioned and in a characteristically African way, Uganda is struggling to escape the poverty trap. Output is mostly low-valued-added agricultural goods, subject to the vagaries of international commodity prices and the weather, and battling stiff tariff and non-tariff trade barriers. The manufacturing sector is small and uncompetitive. Farmers are under-skilled and under-capitalised, tending to focus on subsistence rather than commercial-scale farming. The infrastructure is deficient; institutions are weak and corruption is a problem. Growth has been off a low base and has lacked the punch to push Uganda onto a new development plane, where incomes rise, public revenues can meet social spending needs and debt can be paid down.

Democratic commitment

Clouding the picture is the 2006 elections, the country’s first multiparty ballot and a litmus test of Uganda’s commitment to good governance. Observers are keenly watching and waiting to see whether President Yoweri Museveni will stand for a third term, a move outlawed under the constitution. The mood in Uganda is split, both in terms of the desirability and likelihood of such a move, but it is straining investor perceptions.

If there is a mood of uncertainty, the Ministry of Finance, Planning and Economic Development is quick to quash it. Keith Muhakanizi, director of economic affairs, says the technocrats have the ear of the politicians and he’s adamant that the economic plan will not be derailed. Macroeconomic stability (inflation below 5%), fiscal conservatism and trade openness are non-negotiable.

To unlock faster growth, Mr Muhakanizi says Uganda’s long-term economic strategy is to promote private sector-led economic growth. Government research suggests that sustained higher growth over the next five years can only be achieved with much higher investment rates: total investment as a percentage of GDP needs to jump from 22.1% in 2002/2003 to 27%.

Financial sector reform is key is to this. Uganda’s financial markets are both shallow – they are small in relation to GDP – and poorly developed, being dominated by commercial banks. Commercial bank lending to the private sector plays a key role in supporting the growth of the private sector in the country because there are so few alternative sources of finance.

Sources of finance

The main alternatives are non-bank financial institutions (NBFIs), such as leasing companies and the sole housing finance company, and the stock exchange, but the NBFIs are small relative to the commercial banks, while listing and compliance costs prohibit all but the strongest, most established firms from tapping the equity market.

To keep the brakes on inflation, the growth in bank lending to the private sector must be in line with money supply targets. In order for bank lending to the private sector to grow quickly, the growth of other, competing demands on commercial banks’ resources must be restrained. And here lies a problem: the most important competitor to the private sector for commercial banks’ resources is the government, mainly through Treasury Bills issued by the central bank to stabilise money supply expansion fuelled by fiscal deficit expenditure. The latest data to June 2003 showed that government securities comprised 29% of commercial banks’ total assets, whereas loans to the private sector comprised 26% of total assets.

It follows that the most effective strategy for promoting more rapid growth of bank lending to the private sector without jeopardising the control of money supply and inflation is for the government to cut the fiscal deficit, therefore reducing its demand for funds from commercial banks.

The target is to reduce the fiscal deficit before grants to 6.5% of GDP by 2010, down from 11.4% last year. Reducing the deficit to this level should enable private sector credit to grow at 20%. The deficit before grants has widened because of increased donor aid, which permitted government expenditure to rise eight percentage points to 25.3% of GDP between 1996 and 2002, whereas domestic revenue increased less that two percentage points to 12.5% of GDP. Ironically, Uganda’s sound policy track record has been rewarded with more much-needed donor aid but the structural fiscal deficit that followed as a consequence has proved problematic.

To trim the deficit, the government plans to hold expenditure at 22%-23% of GDP while raising domestic revenues to around 16% of GDP. Even if fanciful, Mr Muhakanizi recognises the challenge is to spend existing resources more efficiently and not simply to spend more.

Pool of funds

Of course, the other dimension to this problem is to increase the pool of funds available for investment in the first place. Financial deepening refers to the increase in the holding of financial assets by economic agents relative to GDP, which in turn strengthens financial intermediation, which in its simplest terms involves the channelling of savings into investments. Financial depth as measured by money supply as a percentage of GDP has grown steadily from 8% in 1990 to 20% in 2002. As the Ugandan economy becomes increasingly monetised and domestic savings grow, the government estimates financial depth to rise to 27% of GDP in the next 10 years.

More cash means more bank deposits, and more savings. Gross domestic savings grew rapidly in the early 1990s, from just 2% of GDP to 7.5% as inflation was slowed. It is anticipated that in the next decade savings could almost double, as GDP growth outpaces consumption growth and the reduction in the fiscal deficit increases public savings.

It’s an ambitious target but it promises a dramatic impact on the amount of risk capital available to private sector investors. According to Mr Muhakanizi, the government and the Bank of Uganda are encouraging financial product development to mobilise savings. Currently, the main financial assets available, apart from bank deposits, are corporate bonds and equities, of which there are few, and government Treasury Bills. A government long-term bond was introduced recently, and further areas of possible product development include mortgage and insurance products and mutual funds.

A further opportunity exists for wholesale deposit taking and credit extension to micro finance institutions that have filled the vacuum in rural areas where the reach of formal financial institutions is limited. With the legal status of the micro finance deposit institutions now clearly defined, the formal banking sector is now in a position to increase their transactions with these institutions.

Pensions reform

The final leg of government’s plan to increase capital for the private sector is to liberalise the pension sector, unlocking a major source of long-term capital for the domestic financial market. Uganda’s National Social Security Fund, a defined contribution pension scheme, has an asset base of roughly $125m, equivalent to 10% of the total assets of commercial banks. To date it has invested almost all its liabilities in short-term government securities and property, depriving the private sector of a vital source of long-term investment funds.

Mr Muhakanizi says the government intends to liberalise the pension sector to allow Ugandans to choose their pension service providers. Competition, it is hoped, will improve the efficiency with which pension funds are invested, bringing greater long-term capital to the financial markets.

Projections are that total investment could rise to 26.2% of GDP in the next 10 years, just shy of the government’s 27% targets. In this time, private sector investment will rise to 21% of GDP, an increase of four percentage points over present levels.

Entrepreneurial spirit

However, efficient channelling of savings into investments is only one piece of the puzzle – entrepreneurs need to be willing to embark on projects in the first place, and to this end, Uganda’s government is pursuing a raft of measures to improve and strengthen the investment environment.

In addition to maintaining macroeconomic stability and a liberal trade policy, the plan is to boost exports of value-added products. Given than 55% of all Ugandan households, and 75% of poor households, earn their main source of income from agriculture, not surprisingly pro-farming policies are being targeted. Specifically, the aim is to add value and stimulate exports (increased production for the domestic market would simply depress farm gate prices) of both traditional products such as coffee and cotton as well non-traditional goods such as horticulture, vanilla and honey.

Sensibly, Uganda is pursuing the path of greatest comparative advantage, recognising realities (it will never compete with China or India in terms of labour costs, for instance).

Investors face a number of physical and bureaucratic barriers to investment in Uganda which increase transaction costs and reduce competitiveness. These arise from corrupt and inefficient procedures in key areas for investors, such as customs and tax administration and business registration and licensing, as well as the physical constraints of poor infrastructure. Mr Muhakanizi candidly admits there is “enormous scope” for improvement and is actively targeting this.

To address the infrastructure problem, Uganda is developing Export Processing Zones, a means to deal with infrastructure and public service-related weaknesses by creating economies of scale.

The final measure is a more pragmatic approach to global trade liberalisation that sees Uganda engaging more proactively with informal country groupings or acting through multilateral bodies to make the case on trade issues.

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