Mission Concluding Statement 

Uganda: Staff Concluding Statement of the 2019 Article IV Mission

February 14, 2019

An IMF mission visited Uganda January 29 to February 12, 2019 to hold discussions for the 2019 Article IV consultations. Economic growth has recovered, while progress on social indicators is mixed and poverty reduction has stalled. Fiscal and external vulnerabilities have increased, reflecting scaled-up infrastructure investment, but also weaknesses in the budget process. To achieve more inclusive growth, the trend towards reduced budget allocations for social sectors should be reversed. Monetary policy has maintained low inflation and can stay the course. Banking sector health has improved, and credit to the private sector has increased.

Recent Economic Developments and Outlook

1. Uganda’s economy maintains momentum. The economy grew by 6.1 percent in FY17/18, supported by improvements in the services sector and a rebound in agriculture from the previous year’s drought. Investor surveys indicate that business conditions and sentiment are strong. Credit to the private sector has improved, helped by a supportive monetary policy stance. Growth is projected at 6.3 percent in FY18/19, as manufacturing, construction, and services continue to expand.

2. Social indicators show mixed progress. Literacy and numeracy improved until 2010 but have stagnated since. Primary education completion rates have declined. Child and maternal mortality rates have been reduced. Poverty reduction has stalled in the four years to the 2016/17 household survey, recording an increase to 21 percent from 19 percent in 2012/13. About 70 percent of the population depends on agriculture which has grown at 2 percent on average in the five years to 2016/17. With population growth of 3 percent, workers in agriculture have thus experienced a decline in per capita income. In 2017/18, growth in agriculture rebounded to 3.8 percent, as the sector recovered from drought.

3. Inflation remains subdued. Headline inflation stood at 2.7 percent year-on-year in January—core inflation was 3.4 percent. Low food and energy price inflation, the decline in international oil prices, and the stable exchange rate were the main drivers. Core inflation is projected to accelerate and converge to the authorities’ 5 percent target over the next 12 to 18 months, with a gradual shilling depreciation, higher food prices, and demand pressure from fiscal spending.

4. The fiscal deficit widened to 5 percent of GDP in FY17/18. Revenue collection improved by 0.3 percent of GDP, less than the government’s objective of raising tax revenues by ½ percent of GDP each year. Infrastructure spending increased by over 1 percent of GDP. Current spending exceeded the budget, triggering additional domestic borrowing. Still, the deficit was largely financed externally. Public debt went up by 3 percentage points to 41 percent of GDP.

5. The current account deficit increased to 6.1 percent of GDP in FY17/18. Imports of goods and services grew by 17 percent—mostly capital goods associated with the large infrastructure projects—outweighing the 9 percent growth of exports. Financing came from foreign direct investment, public-sector debt disbursements, and a decline in international reserves. Reserves amounted to US$3.2 billion at end FY17/18.

6. Financial soundness indicators for September 2018 suggest that the banking sector is healthy. Banks remain well capitalized, liquid, and profitable, except for some smaller banks. Non-performing loans have declined. Bank of Uganda’s stress tests suggest that the system’s ability to withstand shocks has improved, though concentration risks are rising.

7. The medium-term outlook is positive. Over the next 5 years, growth could reach 7 percent, if infrastructure and oil sector investments proceed as planned, and private sector credit remains supportive. Key open issues in the nascent oil sector have recently been resolved in principle. Still, the IMF mission now projects oil production to start in 2023.

8. Risks are tilted to the downside. Risks include further delays in oil production, weak implementation of infrastructure projects, political tensions, adverse weather conditions, health concerns in the region, and global trade tensions. At the same time, private sector activity could gain further strength, and improvements in regional security could boost Ugandan exports.

Macroeconomic policies for inclusive growth

9. Uganda’s key challenge is to ensure that economic policies translate into inclusive growth and jobs. Uganda needs to create more than 600,000 jobs a year to accommodate its growing population. Raising productivity in agriculture would contribute to rising incomes and facilitate an employment shift towards other growing sectors, including light manufacturing and services. This requires infrastructure investment as well as investment in human capital. In particular, policies to close the education gap and promote gender equality would help translate aggregate growth into shared prosperity. This will require reversing the trend of declining budget allocations for spending on education and health, while enhancing the effectiveness of this spending. The mission was encouraged by the authorities’ intentions in this regard.

Fiscal policy

10. Uganda lacks an effective fiscal anchor. Although Uganda has formally adopted a debt target in its Charter for Fiscal Responsibility, the projected debt path in successive budgets has been revised upwards since the beginning of the infrastructure scaling up drive. In 2013, debt was targeted to peak at 31 percent of GDP, in 2016 at 44 percent of GDP, and currently debt is projected to peak at 49½ percent in FY21/22. At the same time, capital investments have been lower than planned. Because of the deterioration in debt metrics, the budget now spends one in five shillings collected in revenue on interest payments. That is more than the allocations for health or education. To counter further increases in projected debt and provide a buffer against shocks, the authorities could set an operational debt ceiling of 50 percent of GDP in nominal terms. This ceiling would then determine the annual budget deficit and define a binding expenditure envelope. This framework could guide fiscal policy until oil production starts at which time the authorities plan to adopt a fiscal rule for managing oil revenues and their inherent volatility. The mission notes ongoing work to develop the 2019-2024 Public Debt Management Framework which the authorities believe will help them keep debt at sustainable levels.

11. The budget process is not providing sufficient top-down guidance for resource allocation. Budget execution has systematically deviated from the approved budgets, altering expenditure composition. Capital spending is under-executed, while other current expenditure allocations have typically been higher than budgeted. The budget document would benefit from a high-level summary that clearly describes the budget’s quantitative targets, and these targets need to gain a binding character during budget implementation. Public investment management should be further strengthened to address difficulties in costing and the lack of comprehensiveness in original estimates. Plans to contain current spending would require specific identified measures to be adopted with the budget but must protect social sectors.

12. The challenges to manage current spending pressures have adverse implications for financial markets. Spending pressures have led to domestic arrears which have contributed to non-performing loans in the banking sector. Moreover, unanticipated large issuances of domestic securities have surprised the market, leading to jumps in yields, for example in June 2018. Both channels hold back private sector credit or exert upward pressure on lending rates. The authorities’ domestic arrears strategy, including the settlement of validated arrears, is welcome. A predictable issuance calendar for government securities that spells out the targeted auction volumes can contribute to lower interest rates.

13. Against this background, the FY19/20 budget should set a path to ensure that public debt stays below 50 percent of GDP. In FY18/19, the overall deficit is expected to increase to 6.3 percent of GDP, mitigated by strong revenue collection. Supplementary budgets before parliament would raise spending and require additional domestic borrowing. For FY19/20, the authorities should set the FY19/20 deficit at around the same level to ensure that debt stays below 50 percent of GDP as currently projected. To accommodate the increase in infrastructure investment planned for FY19/20, measures to raise an additional ½ percent of GDP in tax revenue are required. In this regard, the authorities should finalize and adopt their five-year Domestic Revenue Mobilization Strategy. The strategy is expected to include tax policy reforms, including a rationalization of exemptions, and tax administration reforms to improve compliance.

14. While Uganda would remain at low risk of debt distress based on a preliminary debt sustainability analysis, significant vulnerabilities loom large. The finding rests on four assumptions: (i) infrastructure investments yield the envisaged growth dividend; (ii) revenue collection improves by ½ percent of GDP per year over the next five years; (iii) oil exports commence in 2023; and (iv) infrastructure investment is reduced once the current projects are completed. Uncertainties around new spending pressures, including for power transmission lines, realization of contingent liabilities, as well as shocks to the growth outlook could push public debt above the ceiling in the Charter of Fiscal Responsibility (50 percent of GDP in net present value terms).

Monetary policy and external position

15. Bank of Uganda has successfully balanced its inflation objective with supporting economic activity. Monetary policy has achieved low levels of inflation which supports macroeconomic stability, encouraging investment. Low inflation also protects the purchasing power of Ugandans, in particular for poor households. The recent decision to keep monetary policy on hold was appropriate, and Bank of Uganda should be able to maintain its policy rate over the next few months, given current projections for the shilling exchange rate, food and fuel prices, as well as the global interest rate environment.

16. The central bank’s deficit complicates the conduct of monetary policy operations. The financial position is affected by low income due to the low global interest rates, necessary costs to mop up excess liquidity in support of the monetary policy objective and rising operating expenditures. A prompt recapitalization of Bank of Uganda in the FY19/20 budget would ensure that the central bank can continue pursuing its operations efficiently. The finalization of the pending Memorandum of Understanding between Bank of Uganda and Ministry of Finance, Planning, and Economic Development and a review of the bank’s cost structure would also be welcome. An independent, efficient central bank is essential to maintain Uganda’s hard-earned macroeconomic stability.

17. Uganda’s current account deficit has widened, and vulnerabilities have increased. Uganda’s external position is weaker than implied by medium-term fundamentals and desirable policies. The current account deficit is expected to widen further during the preparation phase for oil production. Therefore, it is important to ensure Uganda maintains an adequate level of reserves. At present, international reserves are equivalent to 4.1 months of next year’s imports which is a sound buffer against potential shocks. Bank of Uganda appropriately plans to continue to build reserves opportunistically to maintain this reserve coverage. The flexible exchange rate regime continues to serve Uganda well.

Financial sector

18. Financial inclusion is improving, with around 85 percent of the population now having access to financial services. In 2018, access to financial services benefited from the introduction of agency banking. The authorities’ 2017‒22 National Financial Inclusion Strategy to develop the credit infrastructure and promote formal savings, investment, and insurance instruments is welcome.

19. As a new credit cycle starts, it is important to maintain Bank of Uganda’s strong supervision and regulation. Regulatory structures in Uganda broadly follow international best practices. Bank of Uganda has successfully ensured financial sector stability, including through resolving banks that posed systemic risks. This protects the savings of the many small depositors. Ongoing work to ensure that banks strengthen their financial reporting, internal controls and governance are welcome and need to be stepped up. Weaknesses in these areas were at the core of the most recent bank failure. The prompt adoption of the National Payments System Act to provide legal basis for Bank of Uganda to supervise the mobile money sector is also necessary.

Governance issues

20. Uganda has a sound legal framework to deal with governance and corruption, but implementation needs to be strengthened. Moreover, further improvements in fiscal transparency and management of public investment projects are necessary to enhance good governance. In this regard, cabinet’s recent decision to start the accession process to become a member of the Extractive Industries Transparency Initiative is a welcome step. Uganda has achieved important progress in addressing technical compliance issues with the Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) standards and was removed from the Financial Action Task Force’s (FATF’s) grey list in FY17/18. The authorities are encouraged to continue their work to align their AML/CFT regime with strengthened international standards to ensure that Uganda’s regime is fully compliant with FATF requirements. Uganda’s application to the Egmont Group is one step in this direction.

The mission met with Minister Matia Kasaija, Governor Emmanuel Tumusiime-Mutebile, Permanent Secretary/Secretary to the Treasury Keith Muhakanizi, Deputy Governor Louis Kasekende, Commissioner General Doris Akol, Acting Director Uganda Bureau of Statistics Imelda Atai Musana, senior government officials, civil society, unions, and the private sector. The IMF team welcomes the open and constructive discussions with the authorities and expresses its gratitude for their hospitality and excellent cooperation.