On July 7, 2017, the Executive Board of the International Monetary Fund (IMF) concluded the 2017 Article IV consultation with Uganda and completed the eighth review of Uganda’s economic performance under the Policy Support Instrument (PSI).

Uganda has made remarkable achievements over the past decades. Growth averaged 8 percent per annum during 1992-2010, tripling per capita GDP and more than halving poverty to 35 percent – one of the strongest performances in sub-Saharan Africa. The performance was underwritten by sound macroeconomic policies and institutions, and a reliance on the private sector as the engine of growth. The inflation targeting framework introduced in 2011 has served Uganda well. Uganda hosts over one million refugees in an integrative approach that has been praised as international best practice. The country’s challenge going forward is to rebuild momentum for continued high and inclusive growth.

The outlook is broadly favorable. With steadfast policy implementation and assuming improved weather conditions, growth could accelerate to 5 percent in FY17/18. Over the medium term, infrastructure and oil sector investments could yield growth rates of 6 to 6½ percent. Core inflation is projected to stay close to the 5 percent target. With the planned infrastructure investments, public debt would increase but remain manageable, assuming that the investments lead to higher growth and the government continues to increase its revenue collections. Reserves are projected to remain at comfortable levels. Risks to this outlook are tilted to the downside, in particular from weak implementation of public investments, adverse weather, and difficult regional developments.

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Staff Report

Recent developments

Growth slowed during the first half of FY16/17, reflecting domestic factors and external headwinds. The drought in the Horn of Africa is likely to have reduced growth by about ½ percentage point, mainly in the agricultural sector and food processing industry, exposing some 11 million Ugandans to food insecurity. In addition, subdued credit growth was a significant drag, and the slow execution of externally-financed public investment and the impact of spillovers from regional conflict also had a negative impact on growth. The initial estimate from the Ugandan Bureau of Statistics has growth at 1.6 percent in H1-FY16/17. Leading indicators suggest a pickup in economic activity in the second half of FY16/17, following a resumption of normal weather patterns. Projections assume that the fall armyworm infestation can be controlled, and renewed momentum in the growth of services. With this, the authorities and staff estimate growth of 3.9 percent for the year (about ½ percent in per-capita terms), down from 4.7 percent in FY15/16. This assumes that the initial H1 estimate will be revised up.

Macro-financial linkages explain part of the growth slowdown. Non-performing loans (NPLs) have become elevated (6.3 percent at end-March), and banks have tightened lending standards in response. As a result, real private sector credit growth (adjusted for valuation effects) turned negative in late 2016, and is recovering only slowly. NPLs are concentrated in agriculture, construction, and trade and commerce. A BoU survey suggests that NPLs arose from government domestic arrears in FY15/16, diversion of borrowed funds and fraudulent activities, the effect of political instability in South Sudan, and the impact of the economic downturn and recent exchange rate and interest rate volatility.

Headline inflation has edged up, mainly reflecting the effects of the drought. Food price inflation rose from 5 percent year-on-year in September 2016 to 23.1 percent in May 2017. With this, headline inflation registered 7.2 percent year-on-year in May. Core inflation was 5.1 percent year-on-year in May, in line with the BoU’s 5 percent target.

The current account deficit narrowed. The deficit dropped to an estimated 2 percent of GDP in H1 FY16/17, driven mainly by lower investment-related imports. Financial inflows remained broadly stable. The overall balance of payments registered a surplus of 0.6 percent of GDP. The Ugandan shilling has stabilized against major currencies, while the real effective exchange rate depreciated by 2 percent since July 2016.

Implementation of the FY16/17 budget has been mixed. Revenue collection in nominal terms was slightly lower-than-projected through March, reflecting lower nominal growth than underlying the program. Policy and administration measures have performed well, yielding a near ½ percent of GDP increase in the revenue ratio. Recurrent expenditures were ¼ percent of GDP ahead of program projections at end-March – broadly corresponding to additional domestic arrears clearance – and the government had prepared two supplementary budgets to meet the additional needs, including for drought-related food relief. Domestically-financed development spending is on track, but there was significant under-execution of the foreign-financed development budget and construction of the two hydropower dams. Given the slow pace of public investment execution, the overall fiscal deficit for Q1-Q3 FY2016/17 was 3 percentage points of GDP lower than anticipated, and is projected at 3½ percent of GDP for the year, compared to 6 percent at the time of the seventh review.

With only a few weeks to go in the fiscal year, the authorities revised their financing strategy, relying again on BoU advances. The government decided to curtail domestic securities issuance compared to the program, given concerns over the pace of debt accumulation. They also decided against repaying the BoU advances taken in FY15/16, contrary to their original intentions of repaying in full. Instead, the government again took recourse to BoU advances as defined under the program, though in their interpretation it is a drawing down of government deposits at BoU. Given that BoU had already issued securities in line with the program, all June auctions were cancelled, entailing a large injection of liquidity that subsequently had to be mopped up with costly repo issuance.

Economic outlook and risks

With sound and steadfast policy implementation, Uganda’s economic outlook is broadly favorable. If weather conditions continue to improve, private sector credit recovers, and the public investment program is implemented as planned, growth could accelerate to 5 percent in FY17/18. Over the medium term, infrastructure and oil sector investments could yield growth rates of 6 to 6 ½ percent (Box 2). Such growth rates would require private sector credit to grow by 10-11 percent per annum in real terms. The authorities broadly agree with the outlook, while anticipating a somewhat higher growth dividend over the medium term from the planned infrastructure and oil sector investments.

The current account deficit will be driven by developments in the oil sector in the coming years. Initially, the deficit is projected to widen, driven by investment-related imports. Once oil exports start, the current account is projected to gradually improve and turn into a surplus. International reserves are projected to remain at around 4½ months of prospective imports.

Risks are tilted to the downside. Weak implementation of public investment and regional developments (conflicts, possible disruptions during upcoming elections), could undermine growth, as could a slowing of global trade. Renewed accumulation of government domestic arrears would aggravate banks’ NPL problem, and hit growth via the credit channel. Uncertainty persists over when oil production will commence and the phasing of investment in the sector. The agricultural sector remains exposed to climate conditions and pest infestations, with the spread of the fall armyworm posing an immediate danger. A large shilling depreciation could impact foreign investor holdings of government securities and contribute to rising NPLs. Tightening global financing conditions could hold back portfolio inflows and reduce offshore participation in Uganda’s Stock Exchange. Lastly, cuts in aid flows would undermine the sustainability of spending, particularly in the social sectors.

Box 2. Managing Oil Wealth

Uganda has approximately 1.7 billion barrels of recoverable oil reserves, the fourth largest in sub-Saharan Africa. The authorities aim to have oil production commence in 2020. Production would continue for over 40 years. During this period, the government expects to receive between 0.5-4 percent of GDP in oil-related revenue per year.

Oil Extraction: A joint venture of three international companies and a government owned oil company (Uganda National Oil Company, UNOC) will carry out upstream oil extraction. The international joint venture partners are expected to make final investment decisions by end-2017. Production could commence as early as 2020 and quickly rise to a peak of 200,000 barrels per day. The total investment cost of upstream extraction is approximately US$8 billion. The international oil companies will bring external financing, and the investment will be associated with increased imports. The government, through UNOC, has a carried interest share, and is fully involved in all commercial decisions. Additional blocks that could yield further proven reserves and thus additional revenues are set to be auctioned in the near future.

Pipeline and Refinery: There will be two outlets for extracted crude oil:

1. A pipeline to be constructed by a joint venture of the above-mentioned international companies, a subsidiary of UNOC and the government of Tanzania (costing US$4-5 billion) will transport oil from Uganda to a sea port in Tanzania, allowing crude oil to be sold on international markets.

2. A domestic oil refinery (with initial capacity of 30,000 barrels per day) will be constructed by a joint venture consisting of a UNOC subsidiary and other partners yet to be identified. Refined petroleum products are expected to be sold domestically and in the region at market prices.

Regulatory and Fiscal Regime: A Petroleum Regulatory Authority was established in 2015 to oversee the entire oil sector. The Public Financial Management (PFM) Act of 2015 requires all oil revenue to be deposited in a Petroleum Fund. Tax arrangements for upstream oil production are governed by Production Sharing Agreements (PSAs) between the government and joint venture partners that provide for: (i) royalties; (ii) distribution of ‘profit oil’ between the government and the joint venture partners according to the daily rate of production (where ‘profit oil’ is the surplus of oil over the amount needed to cover the royalty and other costs); (iii) corporate income tax (30 percent rate); and (iv) state participation, so that development costs owed by the government as a joint venture partner are initially covered by the private partners and then later repaid out of the government’s share of profits.

Outstanding Issues: Construction of the pipeline must be completed before oil production commences, and the authorities also aim to have the refinery operational in time. The tax regime for the pipeline is under negotiation between the governments of Uganda and Tanzania, while that for the refinery is also still to be determined. Public road infrastructure is required to allow access to oil fields and the government is seeking external financing to commence road construction as soon as possible. A policy on the use of oil revenue deposited in the Petroleum Fund needs to be developed, to ensure an appropriate balance between investment and saving. For now, withdrawals from the Petroleum Fund are limited to infrastructure spending. However, when the previous Oil Fund was closed, its resources were pooled in the Consolidated Fund, and the ringfencing of the saved oil revenue for infrastructure was dropped.

Policy Discussions

The 2017 Article IV consultation centered around the macroeconomic framework underpinning the authorities’ development strategy. Specifically, discussions focused on: (i) balancing infrastructure investment, social spending needs, and debt sustainability; (ii) macro-financial linkages and growth prospects; and (iii) other policies to foster inclusive growth. With fiscal policy mainly focused on the development strategy, monetary policy is the main instrument for counter-cyclical policy. In the near term, high NPLs impede credit and weigh on activity. Over the medium term, financial sector deepening is needed to promote sustained and inclusive growth.

Regional Integration

The authorities remain committed to the process of economic integration within the East African Community (EAC). EAC partner states announced that a Single Customs Territory (SCT) system will take effect on July 31. The SCT is intended to harmonize and electronically connect EAC countries’ customs clearance systems to reduce the number of customs checkpoints and clearance delays at borders, and thereby reduce the costs of doing business. The harmonization of customs systems under the SCT is likely to gradually reduce customs delays and operational disruption along transport routes, by facilitating the clearance of goods and the remittance of customs fees charged at the port of entry to the relevant country. Implementation of the SCT is also likely to reduce customs-related corruption risks, through the digitization of systems, simplified procedures, and enhanced transparency.

Work is also advancing to achieve regional harmonization objectives, in keeping with the East African Monetary Union Protocol objectives. This includes key fiscal priorities such as: harmonization of domestic taxes and the approach to international tax treaties and negotiations, to help ensure a level playing field in the EAC common market, and strengthen tax administration through efforts to reduce tax expenditures and broaden the tax base. Efforts are also ongoing to strengthen harmonization in other areas, including: regulatory and prudential frameworks, systemic risk analysis, and monetary policy implementation and operations. Also important is the adoption of common principles and rules for payments and settlements and eventual harmonization of payments and settlements systems and the harmonization of monetary and financial sector statistics, balance of payments, government finance statistics and price indices; and improved data quality. The IMF is providing extensive technical assistance in these areas.

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Selected Issues paper

Uganda’s experience under the 2013 PSI

The current PSI was approved by the IMF’s Executive Board in June 2013 with an initial duration of three years. Following a one-year extension in 2016, it was set to expire in June 2017, before being extended again through end-July 2017. The overarching objective of the 2013 PSI was to support inclusive growth through macroeconomic stability and structural reforms. Specific priorities included (i) enhancing revenue through measures to broaden and deepen the tax base and improve tax administration; (ii) improving the effectiveness of PFM; (iii) preparing the economy for oil production and management of petroleum revenues; (iv) moving from inflation targeting ‘lite’ to full-fledged inflation targeting; and (v) improving the business environment, supporting the development of the financial sector, and continuing to maintain financial sector stability.7 In practice, a critical objective was to ensure that the scaling-up of infrastructure investment was properly implemented, while safeguarding the debt sustainability low risk of distress rating.

The external environment influenced Uganda significantly, as a small open economy with a freely-floating exchange rate. In FY2014/15, the Ugandan shilling declined by 27 percent vis-à-vis the US dollar year-on-year (with the depreciation reaching nearly 40 percent in August 2015), as the economy was affected by global liquidity concerns, negative shocks in neighboring countries and trading partners, and election-related nervousness. As a commodity importer, Ugandan imports benefited from the oil price shock, even if in the medium run it represents a risk which could have delayed investment decisions in the domestic oil sector. Uganda was however also negatively affected by the commodity price decline, including for coffee, Uganda’s largest export commodity. Security concerns in the region have also impacted sentiment, and more recently, the South Sudan crisis has led to a decline in Ugandan exports and remittances, and an exponential increase in refugee arrivals. Droughts have affected the economy and triggered a spike in food prices in 2013 and more recently in 2016-17. Reduced development partners’ aid budgets as the 2013 PSI started also spurred domestic borrowing requirements.

Rebasing led to an upwards revision in GDP in November 2014. Improved methodologies and coverage showed a FY2009/10 GDP that was 17 percent larger than previously believed. Thus, some indicators experienced significant change, including the debt-to-GDP ratio, (almost 4 percentage points lower, and the tax-to GDP ratio (about 1 percentage point lower).

Growth diagnostics

External factors have been largely supportive to growth. An analysis based on IMF (2017b) showed that external factors have positively supported Uganda’s per capita GDP growth in 2000-2014, when the trend slowdown started. Three main external factors are external demand, external financing conditions, and terms of trade changes. The external financial condition has had a positive and rising impact in the last decade. The estimated impact on Uganda’s per capita GDP growth was about ¾ percentage point (ppt) in 1995-99, increasing to about 1¼ ppts in 2010-14. Second, the external demand is also estimated to have had a positive impact. The estimate was 1½ ppts in 1995-99, declined to about 1 ppt in 2000-04, and remained at about 1¾ ppts throughout 2005-14. Third, the terms of trade have had a negative but marginal impact, and the size of the negative impact has become smaller in the last five years than in 2000-04. Thus, external factors cannot explain the trend growth decline in 2010-14. The following analyses further examine what other factors could explain the slowdown of the trend growth, starting from productivity growth and then continuing with factor contributions.

Productivity Trends

Uganda’s agricultural productivity has declined since the early 2000s, while that of fast-growing peer countries continued to rise. Agriculture employed about 70 percent of the labor force, and thus it has a significant impact on overall productivity and poverty reduction. Uganda’s agricultural output per worker recorded a steady rise between 1990s and early 2000s, but then started to decline. In contrast, the average agricultural output per worker in other major EAC countries has largely continued to rise. Uganda’s Ministry of Finance, Planning and Economic Development (MoFPED) (2014) find that the dominance of small-holder farms coupled with weak agricultural extension services likely contributed to the decline in agricultural productivity.

More recent survey data also indicate productivity decline in agriculture and manufacturing sectors. A recent Bank of Uganda (BoU) analysis finds that productivity in agriculture and manufacturing sectors declined by about 2 percentage points between 2002/03 and 2012/13 even though both sectors experienced positive employment growth. In addition, the MoFPED (2014) finds that sub-sectors that experienced employment growth were those with low productivity, such as retail trade and agriculture, while high productivity sectors (e.g., manufacturing, transport and communication) had lower employment growth. Such a pattern of higher employment growth in lower productivity sectors would further reduce the economy-wide productivity. The shift of more labor to less productive sectors also undermines structural transformation as documented in some African countries. In contrast, during the high growth period of the 1990s, about 90 percent of Uganda’s growth could be attributed to productivity growth, benefiting from the initial market-liberating reforms. Therefore, productivity decline is likely a major domestic contributor to the growth slowdown.

Structural Transformation and Diversification

Drawing on cross-country evidence, IMF (2014) find that such transformation and diversification boosts growth and reduces its volatility. The following analysis benchmarks Uganda’s performance with those of the EAC peers that continue to show a strong growth momentum.

Uganda has improved export performance, although primary products still dominate. World Bank (2015) finds that Uganda’s exports have included about 60 new products, while the traditional concentration in coffee and cotton exports has declined. The share of the top five products has declined from about 86 percent in the 1990s to about 55 percent in early 2010s. Several new exports (e.g., flowers, wood, and minerals) and some manufactured products (processed leather and construction materials) have emerged, although top export products continue to be primary goods. Meanwhile, Uganda’s exports have become more diversified by some measures. The share of total export to African countries has increased from about 20 percent in 2000 to more than 50 percent in 2015, while the share of exports to Europe has declined from over 50 percent to about 30 percent. Rising exports to EAC are also found to lead to more new products.

Many indicators on export diversification and the composition of GDP still indicate scope for improvements. Despite progress in new export products and some diversification, overall export performance is below those of well-performing EAC peers. Total export of goods of Uganda has remained at about 10 percent of GDP since the mid-1990s, although service export increased. In addition, country-level market diversification has declined, indicating rising export concentration in a few countries, while, for example, Kenya recorded a steady rise in market diversification in the same period. With limited market diversification, export performance is more vulnerable to changes in a few countries, as evidenced by the recent adverse impact from South Sudan and DRC. Furthermore, while the industrial sector increased from about 15 percent of GDP in mid-1990s to about 25 percent in FY2006/07-FY2007/08, this sector’s share has since declined and leveled off at about 20 percent of GDP over the last decade, indicating limited structural transformation and risk of premature de-industrialization.

Policy implications

Accelerating business environment reforms would support productivity growth of the private sector. Enhancing Uganda’s competitiveness requires faster progress in reforms to support business creation and growth, trading across borders, and more effective fight against corruption. Improving financial market infrastructure (e.g., credit bureau and collateral registry) and liberalizing financial market to support long-term finance would help enhance credit to the private sector. Meanwhile, some targeted government interventions in key sectors could help. For example, MoFPED (2014) finds that agricultural extension services are key to boost agricultural productivity, while supports to specific firms are largely ineffective. Hausmann and others (2015) and World Bank (2016b) find that government can more actively support core infrastructure, reduce regulatory barriers, and coordinate firm clusters in labor-intensive agro-industry that fully utilize Uganda’s comparative advantages, as well as manufacturing industries around transport corridors to capitalize on the improved infrastructure. Furthermore, a strong monitoring and evaluation system is critical to learn from experiences and improve the focus and efficiency of government interventions in supporting structural transformation. Finally, the authorities’ focus on fighting corruption would also ease the burden on private business while boosting investor confidence. Policy measures include increasing public contract and regulatory transparency and establishing mechanisms for independent public scrutiny, including direct monitoring by the public or via non-government organizations. The anti-corruption hotline introduced by the Uganda Investment Authority recently is a step in the right direction.

Advancing EAC integration could further support Uganda’s export diversification and structural transformation. EAC integration can provide land-locked Uganda with a much larger market, expand Uganda’s investment and job opportunities, and offer opportunities for pooling resources in regional infrastructure and financial sector development. These opportunities in turn can further boost exports and strengthen Uganda’s growth. Potential measures include educating farmers about export standards and accelerating inter-governmental agreements on regulatory harmonization.

Financial inclusion and development

A well-developed financial sector is important for economic growth. International evidence supports the existence of strong linkages between financial development and growth and reduced inequality. Financial development can help lift a country’s growth potential by mobilizing savings, promoting a more efficient allocation of capital, facilitating economic diversification and risk management, and can reduce income inequality by easing credit constraints on the poor. Enhanced financial development initially promotes financial stability and greater economic resilience, by strengthening financial buffers and broadening the range of instruments available for responding to adverse shocks.

The introduction of mobile money technologies has helped Uganda and its regional peers achieve the twin goals of developing their financial markets efficiently and expanding financial inclusion. New cost-saving financial products include mobile money products and transactions and banking services and technologies. Although Kenya has been at the forefront of this mobile money technology, Uganda, Tanzania and Rwanda have also been successful in using this technology, with over 80 percent of all mobile money transactions in 2011 reportedly processed in East Africa. While the range of mobile money financial products continues to grow, ensuring that the supervisory framework keeps pace with financial innovation in the sector will be important.

Uganda has achieved significant gains in expanding both the number and range of financial service providers and products. It achieved among the lowest share of the population excluded from access to financial services among the SSA countries reviewed by FINSCOPE, after accounting for nonbank formal and informal credit channels. The rapid growth in utilization rates achieved between 2010 and 2015 has established Uganda as an emerging industry leader, with over 21 million registered users and mobile money transactions valued at 44 percent of GDP.

Financial Gaps

Throughout the review period, actual financial development in Uganda was below potential. Financial gaps were computed for each of the indices and sub-indices – namely, the difference between the estimated values/benchmarks based on underlying fundamentals and actual financial development indices. The data show that Uganda’s financial development gaps were positive, meaning below potential, throughout the review period, and that the gaps increased throughout much of the review period.

Uganda’s financial development gaps also exceeded those of other EAC countries and many lower middle-income peer countries. Uganda’s gaps were largely attributable to underperformance in financial institutions efficiency and depth, and financial market access.