Economic Reform in Uganda: Lessons for Africa 3 December Prof. E. Tumusiime-Mutebile, Governor

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1 Economic Reform in Uganda: Lessons for Africa 3 December 2009 Prof. E. Tumusiime-Mutebile, Governor

2 Introduction If I was asked what the one theme of this book is, I would say that the these is the relevance of economic policy to economic outcomes. My message is that policy matters. It is of crucial importance to Africa because the economies of that continent, despite improvements in the 2000s, remain very poor and underdeveloped and because the question of what policies are best suited to promote sustained growth, development and poverty reduction in Africa remains highly controversial. The relevance of Uganda s experience to the policy debate arises, in particular, because it has implemented a coherent set of economic policy reforms, in a consistent manner, for nearly two decades. While there have been revisions to policies in this period, there have been no policy reversals and the basic thrust of the reforms have emphasised maintaining macroeconomic stability, an open trade regime and liberalising markets. That the Ugandan economy has improved dramatically during the period in which these reforms have been implemented is beyond dispute. In the 18 years since Uganda began to implement economic reforms in earnest, real GDP growth has averaged 7.3 percent per annum. Real output is now three and half times greater than it was at the start of the 1990s. Private investment, in real terms, rose six fold in this period, while 1

3 exports of goods and services, in dollar terms, are now sixteen times larger. Economic growth in Uganda has also been pro-poor. The incidence of poverty, measured in terms of household expenditure, has been reduced from 56 percent of the population in 1992 to 31 percent in 2005, the time of the most recent household survey. The lessons of Uganda s economic reforms are especially pertinent because the country s strong economic performance has been sustained for nearly two decades; it does not simply reflect the bouncing back of the economy from the collapse it suffered in the 1970s and 1980s, nor is it just a cyclical response to a temporary improvement in the external environment. Growth spurts in developing countries are relatively common, but sustaining rapid growth for nearly 20 years is less so. Many different reforms were implemented in Uganda in the last two decades. Unfortunately I don t have time to do justice to them all. Instead I want to focus for the rest of this talk on what I believe were the economic reforms that were most crucial in contributing to the strength of Uganda s economic performance and to explain why these reforms were so important. 2

4 Macroeconomic management The foundation for Uganda s economic success was a strong commitment to sound macroeconomic management. As a result, macroeconomic stability was quickly restored in the early 1990s and has been maintained ever since. By macroeconomic stability I am referring to low inflation, a sustainable balance of payments position and the avoidance of boom bust cycles of real output growth. Two aspects of macroeconomic management have been crucial to macroeconomic stability. The first is fiscal discipline. When the reforms began in the 1990s the emphasis of fiscal policy was on avoiding government borrowing from the domestic banking system, so that deficit financing would not fuel monetary growth and inflation. This was successful in quickly bringing down inflation to single digit levels by 1993, from over 40 percent at the start of the 1990s. Fiscal policy has continued to emphasise macroeconomic stability but the fiscal policy anchor has become more sophisticated. The focus is now mainly on the fiscal deficit before grants, so as to take account of the overall impact of the budget on aggregate demand in the economy as well as the need to avoid crowding out the private sector from credit markets. The government sets limits on the 3

5 extent to which it can absorb donor aid through higher spending, because translating external resources into domestic spending has consequences for the wider economy in terms of the real exchange rate and the need to sterilise the monetary impact of domestic spending, financed by external aid. Of crucial importance for the credibility of macroeconomic management in Uganda has been the consistency of fiscal policy over a long period; since 1992 there have been no episodes in which control over public spending and fiscal deficits has been lost, even in response to exogenous shocks or the exigencies of the political cycle. Since it was brought under control in the early 1990s, inflation has only risen above single digit levels as a result of the global fuel and food price shocks in In the current fiscal year, the projected fiscal deficit before grants is 5 percent of GDP, while the fiscal deficit after grants, which is equivalent to the government borrowing requirement, is only 2.5 percent of GDP. The second key component of macroeconomic management was exchange rate reform. The official exchange rate in the 1980s was highly overvalued. In 1990, the exchange rate was devalued and then floated, with the parallel foreign exchange market being legalised. At the time, there was considerable opposition within Uganda to using the exchange rate as a tool to reduce external imbalances, because of a belief that devaluation would fuel inflation 4

6 and scepticism that relative prices have much of an influence on exports and imports. These doubts proved unfounded. The devaluation of the exchange rate provided a large boost to traditional exports such as coffee. Moreover, the flexible exchange rate has allowed the external accounts to balance avoiding balance of payments deficits - even when faced with major negative terms of trade shocks, such as the fall in the price of coffee (a Ugandan export) in the late 1990s and the rise in imported fuel prices in 2007 and Since the exchange rate reforms were implemented at the start of the 1990s, the Ugandan economy has not suffered any shortages of foreign exchange; foreign exchange has always been available at the prevailing, market determined, exchange rate. A flexible exchange rate serves a country which suffers from real external shocks, such as terms of trade shocks, better than a fixed exchange rate, because it helps to insulate the real economy from the full impact of these shocks. As such, real GDP growth has been less volatile in the face of large terms of trade shocks than would have been the case had the exchange rate regime been less flexible. The combination of fiscal discipline and the floating of the exchange rate meant that the central bank was able to control the money supply, which in turn was essential for the control of inflation. In addition, the operational independence of the central bank the 5

7 Bank of Uganda - which is guaranteed in the 1995 Constitution of Uganda, has been vitally important. This has ensured that the Bank of Uganda s focus on its primary policy objectives of controlling inflation and maintaining financial stability has not been undermined by political pressures to meet conflicting objectives, such as the provision of subsidised credit or regulatory forbearance for distressed banks. Structural Reforms Much of the initial impetus for growth arose from structural reforms which were intended to improve the allocation of resources within the economy, and hence raise total factor productivity, by removing large policy induced distortions. These reforms included the exchange rate reforms already mentioned and trade liberalisation. Trade liberalisation included the removal, in the early 1990s, of export taxes on coffee and what had been extensive non tariff barriers to imports, followed by a progressive lowering of import tariffs during the 1990s, combined with a reduction in import duty exemptions. Interest rates were deregulated, coffee marketing was liberalised and public enterprises, most of which were loss making, were privatised or closed down. Structural reforms helped promote, inter alia, the recovery of export crop agriculture and the banking sector and the growth of non traditional exports and telecommunications. 6

8 The effectiveness of structural reforms in boosting output depends upon their ability to convey clear price signals to guide resource allocation by the private sector. However, clear price signals are only possible if the macroeconomic environment is stable, not least because inflation makes relative prices both difficult to interpret and very uncertain. Hence without the foundation provided by macroeconomic stability it is unlikely that the structural reforms would have been so successful. Budget Reforms Alongside its role in macroeconomic management, fiscal policy reform has aimed to improve the efficiency of public services in Uganda. The recovery of the tax base, together with external debt relief and donor aid, provided the budget resources for a strong expansion of public expenditure in the 1990s. This placed the onus on the government to ensure that increased budget resources were used efficiently, to meet the needs of the population. The most important tool for achieving this is the Medium Term Expenditure Framework (MTEF). This is essentially a tool for medium term budget planning, designed to improve the allocative efficiency of expenditure. It aims to force budget planners, at both central and sectoral levels, to prioritise their expenditures within the hard 7

9 budget constraints of expenditure ceilings, taking a medium term perspective. The MTEF in Uganda made a crucial contribution to the shift in expenditure allocations within the overall government budget towards programs designed to directly benefit the poor, such as primary health care and primary education. Budget planning also benefited from a marked strengthening of technical capacity to identify sector policy objectives, analyse spending priorities and cost spending programs at the sector level, especially in key sectors such as health, education and roads. The contribution of fiscal policy reforms to both sound macroeconomic management and improved allocative efficiency of public expenditures would not have been possible without the strong centralised control which the Finance Ministry was able to exert over all aspects of fiscal and budget policies. In 1992, the separate planning and finance ministries were merged into a single ministry (now called) the Ministry of Finance, Planning and Economic Development. This was crucial for two reasons. It enabled the recurrent and development budgets to be unified in a single budget process, thereby allowing a coherent budget to be prepared consistent with the overall fiscal policy and spending priorities of government. Secondly, it ensured that the planning process, which in a market oriented economy focuses mainly on the strategic 8

10 planning of public expenditures, was fully consistent with the objectives and constraints of fiscal policy. In countries where the finance ministry is separate from the planning ministry or planning agency, plans are often drawn up which are far too ambitious in terms of budget resource requirements to be consistent with the realities of fiscal and macroeconomic constraints. Hence these plans serve little practical purpose as tools for guiding public expenditure. A pertinent lesson for Africa is, therefore, the need to avoid fragmenting responsibility for all aspects of fiscal policy among multiple institutions and instead to centralise it within a strong Finance Ministry. What other lessons are worth highlighting for Africa? As I have noted, the sustained growth which Uganda has achieved since the early 1990s was made possible by a combination of sound macroeconomic management and structural reforms to remove the major policy induced distortions in the economy. In general, policymakers in Uganda have promoted free markets in most sectors of the economy. This is not because they are ignorant of market failures, but because of the recognition that government itself faces major constraints, both technical and political, in trying to correct market failures in ways which are not counterproductive and at times highly costly. Efforts to overcome market failures in the provision of credit by setting up government owned banks to direct credit to priority borrowers are a prime example of this. As such, policymakers in Uganda have generally taken the view that 9

11 government should concentrate its own resources on sectors where market provision of goods and service is clearly deficient, such as the traditional public goods of roads, security, health and education. The obvious exception to this is the need for prudential regulation of the financial sector, because the negative externalities associated with bank failures are large. Accordingly the Bank of Uganda, which has responsibility for bank regulation, has prioritised both the reform of the banking laws, bringing them into line with international standards, and the strengthening of its capacity for supervision and regulation of banks. Uganda has also eschewed the big push approach to public spending that is advocated by those who believe that only a massive program of public investment in infrastructure and other services can break the alleged binding structural constraints to growth in Africa. The danger of such an approach is that it ignores the reality of the resource constraints facing the budget and the economy. It thereby risks destabilising the macroeconomy and crowding out private sector activities long before the benefits of the investments are actually realised. Instead Uganda has adopted a more holistic approach, balancing the requirements for public investment with the need to provide space for private sector growth, while at the same time maintaining macroeconomic stability. 10

12 Looking forward, the biggest challenge facing Uganda will be how we manage the arrival of substantial revenues. There are many examples in Africa where the discovery of oil has been a bane of people s lives not a boon; oil revenues have turned into a curse for ordinary citizens. Just as Uganda has become a model of how to manage scarce resources effectively, we must be a model of how to manage oil resources in a responsible, sustainable manner. We must be Africa s Norway. We must manage our oil resources in the stellar manner in which Botswana has managed its wealth from diamonds. Conclusion To conclude I want to briefly summarise the main lessons for Africa. Primacy should be accorded to macroeconomic stability. This is essential for stimulating higher rates of private investment and to realise the benefits of structural reforms. The bedrock of macroeconomic stability is a sound fiscal policy. Also of crucial importance is a central bank which is operationally independent, with a clear mandate to focus on the primary policy objectives of controlling inflation and maintaining financial stability. 11

13 Government resources, both financial and human, are scarce, and should be allocated to sectors of the economy where market provision of goods and services is clearly deficient. To improve the efficiency of public expenditures, they must be planned within a unified budget, taking a medium term planning horizon which links expenditure allocations to clearly defined policy objectives. The vast majority of commercial activities should be left to the private sector, not because markets are perfect, but because the government has neither the resources or appropriate incentives to engage in commercial activities efficiently. BANK OF UGANDA KAMPALA 12

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