Kampala, March 9, 2001

Mr. Horst Köhler
Managing Director
International Monetary Fund
700 19th Street NW
Washington, D.C. 20431
U.S.A.

Dear Mr. Köhler:

1. We recently held discussions with the Fund staff on the 2001 Article IV consultation and second review of the third annual arrangement under the Poverty Reduction and Growth Facility (PRGF) that was approved by the Executive Board on December 10, 1999. This letter reviews progress in implementing the 2000/01 program and sets out the policies to be pursued during the remainder of the fiscal year.

2. Almost all the quantitative performance criteria and benchmarks for end-September 2000 and end-December 2000 under the third annual arrangement under the PRGF were observed, except for the accumulation of unfunded outstanding commitments against nonwage recurrent expenditures (attached Table 1). This was primarily on account of the failure of two ministries (State House and the Judiciary) to control commitments.¹ In addition, all the structural performance criteria for end-September 2000 were met. However, the benchmark relating to the study of the special protection accorded to the sugar and textile industries was missed. The study was undertaken in December 2000 and a report produced in January 2001. The end-December structural performance criterion on verification of nonwage expenditure arrears accumulated in 1999/2000 (July-June fiscal year) and the structural benchmark on removal of special protection for sugar and textile industries were not observed. Verification by the Auditor General of the nonwage recurrent expenditure arrears accumulated in 1999/2000 will be completed by end-April 2001. The protection accorded to the textile industry was removed in January 2001. However, as explained in paragraph 24 below, the removal of the protection accorded to the sugar industry has been delayed. The budget of the Uganda Revenue Authority (URA) will be augmented in the fourth quarter of 2001 following the appointment of a new Commissioner General. In addition, presentation to parliament of the new Financial Institutions Bill is now expected to take place by end-June 2001. Taking into account the nature of the nonobservance of the budgetary arrears performance criterion and the measures described in this letter, the government requests waivers for the end-September 2000 and end-December 2000 performance criteria that were missed.

I. Developments in the first quarter of 2000/01

3. Implementation of the 2000/01 program has been taking place against a background of insecurity in some parts of the country and the subregion, the continued sharp drop in Uganda's terms of trade, and the presidential and parliamentary elections scheduled for March 2001 and June 2001, respectively. These factors have contributed to increased budgetary pressures and a drop in exports, thereby complicating economic management.

4 Real GDP is now projected to grow by 5.0 percent in 2000/01 compared with the 6.0 percent growth envisaged under the program, owing in large part to the effects of the sharp deterioration in the external terms of trade, which are projected to fall by a further 15.3 percent in 2000/01 in addition to the 14.0 percent drop sustained last year. Coffee export prices have dropped by 36 percent during the first half of 2000/01 compared with a year earlier, while oil prices have risen by about 9 percent during the same period. Mainly in response to the increase in petroleum import prices and the depreciation of the shilling, consumer price inflation has picked up, with headline and underlying inflation rising to 4.2 percent and 4.7 percent, respectively in the year to December 2000 from 1.9 percent and 2.9 percent, respectively in June 2000. Notwithstanding these developments, the government's financial program remained on track during the first half of the year.

5. Overall fiscal performance in the first half of 2000/01 was broadly as foreseen under the program. The overall fiscal deficit, before grants, amounted to 4.3 percent of GDP, with revenue totaling 5.6 percent of GDP and expenditure and net lending of 9.9 percent of GDP. The deficit was more than offset by inflows of donor budgetary support that resulted in a net repayment to the banking system of U Sh 98 billion. Bank financing was considerably lower than the December 2000 adjusted ceiling under the program.

6. In the six months to December 2000, total revenue was slightly below program expectations. Lower-than-expected collection of corporate tax, as well as excise and value-added tax (VAT) receipts from locally produced goods, was offset by higher-than-expected receipts of pay-as-you-earn (PAYE) tax, withholding tax, non-oil import duties, and VAT on locally produced services. Non-oil import duty collections benefited from the more depreciated Uganda shilling. Tax receipts from locally produced goods appear to have been dampened by the negative effects of the terms of trade shock and the exchange rate depreciation on domestic demand-based industry. Revenue from petroleum product taxes was also lower than the program projection, reflecting the negative influence on fuel consumption of the increase in prices of petroleum products. During the first six months of the fiscal year, retail prices of oil products rose by 9-12 percent.

7. Implementation of the measures envisaged for the first half of the year designed to strengthen revenue performance was mixed (attached Table 2). While a new Acting Commissioner General of the Uganda Revenue Authority (URA) was appointed in September and a draft operation plan was produced, the 2000/01 budget for the URA will not be augmented until the fourth quarter of the fiscal year, following the appointment of a Commissioner General; this action will lay the groundwork for a more aggressive revenue mobilization endeavor in 2001/02. The scheme for rewarding the authority a percentage of all revenue above the official target will be instituted in 2001/02. The amendments to the Customs Law to remove the provision for the granting of exemptions by the Minister of Finance and to introduce tougher penalties for smuggling, misdeclaration, and false documentation were not effected. Although the amendments were incorporated in the 2000 Finance Bill, parliament directed that the proposed amendments be effected in the context of a separate bill, which is now expected to be placed before parliament by end-June 2001.

8. In the six months ended December 2000, total expenditure and net lending amounted to U Sh 939 billion, with domestic outlays (recurrent expenditure plus locally funded development expenditure) of U Sh 644 billion and externally funded outlays of U Sh 302.8 billion. The government succeeded in containing domestic expenditure within the projected level through, among other measures, the implementation of the Commitment Control System (CCS), which has been extended to the development budget since October 2000. Notwithstanding the remarkable success of the CCS in reducing new nonwage recurrent expenditure arrears in 2000/01 when compared to previous years, overcommitments by ministries above cash releases amounted to U Sh 3.7 billion in the six months ended December 2000.

9. Reflecting the increased emphasis on the implementation of the Poverty Eradication Action Plan (PEAP), in the first half of 2000/01, budgetary releases under the Poverty Action Fund (PAF) were considerably higher than in the same period last year. Programs designed to improve the incomes of the poor accounted for about 11.2 percent of the PAF releases, with rural roads representing about 7 percent of total PAF releases. Expenditure on agriculture extension services was not substantial, owing to delays in phasing in the programs associated with the Plan for the Modernization of Agriculture (PMA). Expenditures on programs designed to improve the quality of life of the poor (primary health, water and sanitation, and primary education) more than doubled compared with the corresponding period last year, with releases for education accounting for about 62 percent of total PAF outlays. Releases for monitoring and accountability purposes represented about 4 percent of the total.

10. Broad money (M3) grew by 18 percent in the year to December 2000. M3 includes foreign currency-denominated deposits, which expanded by 26.1 percent, reflecting primarily hedging by the nonbank sector.² The shift in the composition of monetary aggregates, as well as some instability in these aggregates has complicated the management of monetary policy, as the reliability of these aggregates as indicators of the stance of monetary conditions has weakened. Meanwhile, the monthly average interest rate on 91-day treasury bills fell from 18.4 percent in June 2000 to 13.4 percent in December 2000. Credit to the private sector rose by 19.8 percent in the 12 months to December 2000.

11. Although the underlying position of the banking sector has strengthened somewhat compared with a year earlier, the performance of a few banks remains weak. The liquidation of the four banks that were closed in 1998/99 is proceeding smoothly. However, problems have been encountered in recovering assets from three of the four banks, in part because the enforcement of the sale of mortgaged properties through the courts has moved slowly and because insider loans have been difficult to realize in the absence of collateral. In addition, liquidation costs have been very high. Following the successful resolution, under international arbitration, of the government of Uganda's claims against the previous owners of Uganda Commercial Bank Ltd. (UCBL), the government recently regained full possession of the UCBL. The financial position of the bank has strengthened as a result of the conservative credit policies followed by the Bank of Uganda (BOU) appointed management.

12. As noted above, the external sector has remained under substantial pressure in 2001/01 owing to the wilt disease, which has destroyed some coffee trees, and the sharp deterioration in the terms of trade. In the six months to December 2000, coffee export earnings dropped by 53 percent compared with the corresponding period last year. Imports have also been somewhat weaker than envisaged, reflecting in part the effects of the 7.8 percent depreciation of the shilling in nominal effective terms in the year to December 2000, as well as the lower real incomes arising from the decline in the terms of trade. In the first half of 2000/01, donor import support was about US$92 million higher than programmed, resulting in a buildup in net international reserves of the BOU of about US$87 million. When the adjustors built into the program are taken into account, foreign reserves were about US$30 million above the floor established under the program for end-December 2000.

II. Policies for the Remainder of the 2000/01 Fiscal Year

13. The main challenges facing the government during the remainder of the fiscal year are the need to do the following:

• strengthen institutional and implementation capacity, particularly at the local government level, to facilitate the achievement of the output and outcome targets under the PEAP set for the fiscal year;

• minimize the crowding out of essential developmental expenditures in the face of weaker-than-budgeted revenue performance and increased expenditure pressures for general administrative services arising from the scheduled 2001 presidential and parliamentary elections, the increase in petroleum prices, and the depreciation of the exchange rate;

• in the face of the sharp fall in the terms of trade during the past 18 months, conduct monetary policy in a manner consistent with the inflation objective under the program; and

• maintain vigilance and take strong action to forestall a significant deterioration in the balance sheet positions of some of the banks.

14. The overall fiscal deficit (excluding grants) is now projected to exceed the program projection for fiscal year 2000/01 as a whole by 1.0 percent of GDP, primarily on account of the effects of depreciation of the shilling on foreign-financed expenditure. The budgetary pressures arising from the shortfalls in revenue, higher-than-budgeted interest payments, and supplementary appropriations, including the elections, would be accommodated through the use of the contingency reserve and cuts in nonessential outlays. The deficit would be fully financed by external resources equivalent to 14.2 percent of GDP (including grants), permitting a buildup of government deposits with the central bank equivalent to 1.1 percent of GDP and a reduction of domestic nonbank claims on government of 1.7 percent of GDP.

15. On the basis of the current tax system, revenue is projected to total U Sh 1,093.4 billion (11.6 percent of GDP) in 2000/01, reflecting an increase of about 8 percent compared with 1999/2000. However, to help ensure the attainment of the revenue targets, the government has been implementing measures to strengthen tax administration. To reduce smuggling, the URA is securing the petrol transit corridor more effectively, sealing pumps, and auditing oil companies more frequently; also, it has introduced the biocoding of petroleum products. Moreover, surveillance over Lake Victoria has been intensified. In addition, the URA has closed bonded warehouses not complying with regulations and is auctioning goods that have been stored and for which no duties have been paid. In the period ahead, the URA is concentrating on implementing an information technology (IT) strategy, and on improving VAT collections by targeting individual enterprises and individuals, so as to prevent evasion by companies attempting to change themselves to remain below the VAT threshold. In the area of tax policy, the Ministry of Finance has formed a working group, which has been charged with the development of a medium-term strategy to strengthen the revenue effort. This group will also consider ways of raising nontax revenue collections, including appropriations-in-aid. In addition, it will consider the introduction of excise taxes on cellular airtime and taxes on interest income from treasury bills. Moreover, it has been decided to allow banks other than the UCB to collect taxes, thus improving revenue collection.

16. Total expenditure and net lending in 2000/01, at the equivalent of 23.0 percent of GDP, would exceed the original program projection, reflecting mainly the effects of the more depreciated exchange rate on foreign-financed development expenditure and foreign interest payments The government is keenly aware that the utilization of the contingency reserve in the manner indicated above will expose important locally funded development expenditures to potential cuts in the event of shortfalls in revenue. Moreover, the resulting expenditure structure will differ somewhat from the PEAP objectives. The government views this development to be temporary, largely reflecting the need to fund the constitutionally mandated elections. The government intends to take steps, beginning in the next fiscal year, to ensure that essential development outlays are protected, including the placement of limits on the proportion of the contingency reserve that could be used to fund unanticipated nondevelopmental outlays.

17. The budget management system has been strengthened considerably in recent years, in part through the introduction of the CCS. Nevertheless, recurrent budget overcommitments remain. To enhance the operation of the CCS, the inspectorate department will be strengthened as soon as possible to facilitate the monthly audits of overcommitments, while arrears will be verified on a biannual basis by an independent body. In addition, the Minister of Finance will propose to the cabinet by end-June 2001 that the stiff penalties, already in place, for incorrect or misleading monthly returns, actually be applied following the verification of end-1999/2000 arrears. With regard to the inclusion under the CCS of the development budget, supplementary expenditures and lower-than-budgeted revenues will likely lead to cuts in expenditure releases relative to the budget. Strong action to prevent any further supplementary expenditures will be required to ensure that at least 70 percent of the budgeted amount is released, as announced in the context of the CCS.

18. As indicated above, on the basis of the performance during the first half of 2000/01, it will be difficult for Uganda to achieve some of the output and outcome indicators established under the PEAP for the fiscal year. In response to this situation, the government has already instituted several actions to address some of the constraints. Efforts to develop more effective feedback mechanisms to communicate with local authorities in the event of unsatisfactory performance or reports will be undertaken. To partially overcome the shortage of qualified teachers, the government has modified the entry requirements to the teaching services to permit secondary school graduates to join. In addition, the procedures for newly recruited government employees to access the payroll is being rationalized. Furthermore, in light of the experience to date in the implementation of the PEAP, a review of the feasibility of the targets in relation to the identified constraints is under consideration in the context of the PRSP Progress Report—poverty status report (PSR). The PSR is also reviewing the appropriateness of the current balance between programs designed to improve the living conditions of the poor and those aimed at raising their incomes. In addition, the criteria used to determine the eligibility of programs to be included in the PAF is under review.

19. In the context of the decentralization of government services, local governments are becoming the main providers of social services. However, the tracking of these activities, as well as the systematic accounting of funds extended to local authorities, have been problematic, in large part because local governments have not yet complied with the government's requirement to submit to the Ministry of Finance, Planning and Economic Development and Ministry of Local Government monthly accounts. Steps to sensitize districts with respect to the importance of strengthening accountability by local governments are under way, based on the recognition that a successful decentralization and an effective implementation of the PEAP will need to be supported by the development of an efficient mechanism to account for budgetary resources. In particular, workshops on the preparation of monthly accounts will be taken by accountants at the district and subcounty levels; the workshops will benefit from the PMA and Local Government Development Program (LGDP) funds. These workshops will include the participation of stakeholders, the Inspector General of Government, and the Accountant General. PMA and LGDP funds will not be released to subcounties until the backlog of monthly accounts are received. Future releases of these funds will depend on the receipt of monthly accounts, and the sanctions will include publication of noncompliant districts in the media. The Ministry of Finance has also initiated discussions with local governments and the donor community on the need to consolidate and reduce the multiplicity of bank accounts operated by the districts.

20. The main objective of monetary policy will remain the containment of underlying inflation (excluding food crop prices) at 5 percent. Broad money (M3) is projected to expand by 14 percent in 2000/01, and credit to the private sector is forecast to increase by 16 percent, an implicit 8 percent increase in the second half of the fiscal year. The BOU will continue to monitor a broad range of monetary aggregates to gauge liquidity conditions, and, if necessary, will stand ready to tighten monetary policy to achieve the inflation target. Present indications are that the pass-through of the higher-than-expected world petroleum prices to domestic retail fuel prices would not result in measured inflation in excess of 5 percent.

21. With regard to the financial sector, the BOU remains firmly committed to enforcing rigorously existing banking regulations and law. To this end, the BOU will endeavor to build up a multidisciplinary cadre of experts in bank supervision through the training of existing staff, partly with donor technical assistance, the recruitment of high-caliber experts, and implementation of a results-based human resource management policy. In this connection, the government has requested the IMF to provide a long-term resident advisor. The BOU will also work toward improving the governance of banks and ensuring their compliance with prudential regulations through (a) annual on-site inspections of all banks, with closer scrutiny and more frequent on-site follow-up examinations of problem banks; (b) strict enforcement of prudential regulations through the timely and effective implementation of sanctions on delinquent banks with a view to protecting BOU's credibility; (c) more rigorous and substantive vetting of banks on the occasion of the annual renewal of licenses, with continuous "fit-and-proper" testing of senior managers; and (d) promotion of the computerization of the banking industry. The BOU policy of providing liquidity support on a fully secured basis only to solvent banks has been reaffirmed: a bank in receipt of liquidity advances from the BOU that is subsequently discovered to be insolvent will have its operating license suspended. Presentation of the new Financial Institutions Bill to parliament will be postponed until the second half of 2001 to take account of the recommendations of the Commission of Enquiry on the failed banks and the final discussions with commercial banks. The government is committed to fully privatizing the UCBL in a transparent fashion.

22. Uganda's balance of payments outlook continues to be dominated by the sharp decline in the terms of trade. Reflecting the worse-than-envisaged external environment the current account deficit (excluding grants) would, at 13.1 percent of GDP, be 2.2 percentage points of GDP wider than programmed. Exports are projected to fall by about 13.3 percent (as against the 10.1 percent increase envisaged under the program), largely on account of smaller coffee volumes and lower coffee prices. Total payments for imports are expected to remain at about the 1999/2000 level, as against the 6 percent growth projected under the program. In this connection, the increase in petroleum import prices is expected to be partially offset by smaller oil import volumes. Transfers, both private and official, are expected to be larger than programmed. As a result, the overall balance of payments would turn to a surplus, as against the deficit that was expected under the program.

23. The exchange rate will continue to be market determined. The BOU, in its role as the institution responsible for intermediating donor funds to the nongovernmental sectors, will not counter movements in the exchange rate that reflect changes in economic fundamentals, but remain committed to maintaining orderly conditions in the foreign exchange market. In this regard, the government has requested Fund technical assistance to review the conduct of monetary and exchange rate policy.

24. The government will continue its efforts to liberalize, simplify, and streamline its trade regime. Accordingly, it will eliminate the surcharge on beer by March 2001, and those on cigarettes and other tobacco products by June 2001. The existing discriminatory excises on selected imports will be phased out consistent with the framework for trade liberalization to be undertaken in the context of the East African Community (EAC). The government has already removed the special protection accorded to textiles. As regards sugar, the report on the study of the effects of protection underscores the significant social benefits provided by the industry. Eliminating the protection without putting in place mechanisms to ensure continuation of these benefits will entail considerable hardship for a significant portion of the population. The government, therefore, reaffirms its commitment to eliminate this protection at an early date, after adequate measures have been put in place to safeguard the social benefits provided by the industry.

25. On September 12, 2000, the Paris Club creditors agreed on the delivery of debt relief to Uganda, in the context of the Enhanced Initiative for Heavily Indebted Poor Countries (HIPC Initiative), by canceling 100 percent of pre-cutoff-date debt and 18 percent of post-cutoff-date debt. Debt-data reconciliation with five Paris Club creditors has already been finalized, and one bilateral agreement has been signed. Therefore, the government is requesting that the Paris Club extend the end-March 2001 deadline for the signing of all bilateral agreements. Moreover, the government has informed all non-Paris Club bilateral creditors of its commitment, in the context of the Paris Club framework, to secure debt relief on terms at least comparable to those provided by the Paris Club by writing to the representatives of these creditors in Uganda, as well as their Ministers of Finance and their representatives at the IMF Board. Among these creditors, an agreement has been reached with China only. With regard to multilateral creditors, apart from the IMF and the World Bank, which are already providing debt relief, final agreements with the Arab Bank for Economic Development in Africa and the African Development Bank have been reached. Negotiations with other multilateral creditors are ongoing. In line with its prudent debt- management strategy, the government will strictly adhere to its commitment not to contract any new nonconcessional external liabilities.

26. The government believes that the policies and measures described above are adequate for achieving the objectives of the program. Nevertheless, it stands ready to take any further measures that may be necessary for this purpose. Taking into account the nature of the nonobservance of the budgetary performance arrears and the policies and measures described in this letter, the government requests waivers for the nonobservance of the end-September and end-December 2000 performance criteria on the accumulation of new domestic budgetary arrears and the structural performance criterion on the verification of government arrears outstanding as of June 2000.

Yours sincerely,
/ s /

Gerald M. Ssendaula
Minister of Finance