VII Uganda
Author:
Mr. Shekhar Aiyar
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Language:
English
Print Publication Date:
23 Mar 2007
Keywords:
OP; nominal exchange rate; depreciation; deficit; terms-of-trade movement; aid inflow; terms-of-trade shock; net effect; world coffee price; Exchange rates; Real effective exchange rates; Foreign exchange sales; Treasury bills and bonds; Monetary base
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Abstract

In the early years of the new millennium, Uganda represented the paradigm of a poor but well-governed country receiving high levels of aid inflows. After attaining political stability in the late 1980s, the government committed itself to a strong program of economic reform and prudent macroeconomic management, with commensurately strong involvement by the donor community. Aid inflows were high throughout the 1990s, but there was a sharp increase in aid in 2000/01. This makes the country an interesting case study both in terms of the general macroeconomic management of high levels of aid inflows, and in terms of policies to deal with a sudden spurt in aid.

In the early years of the new millennium, Uganda represented the paradigm of a poor but well-governed country receiving high levels of aid inflows. After attaining political stability in the late 1980s, the government committed itself to a strong program of economic reform and prudent macroeconomic management, with commensurately strong involvement by the donor community. Aid inflows were high throughout the 1990s, but there was a sharp increase in aid in 2000/01. This makes the country an interesting case study both in terms of the general macroeconomic management of high levels of aid inflows, and in terms of policies to deal with a sudden spurt in aid.

This chapter examines the period from 1997/98 through 2002/03.1 Uganda’s macroeconomic policies were supported by Enhanced Structural Adjustment Facility (ESAF) and Poverty Reduction and Growth Facility (PRGF) programs through much of this period. Social expenditures increased significantly, with a corresponding improvement in education, health, and poverty indicators.2 The inflows did not lead to appreciation in the real effective exchange rate (REER), which depreciated steadily, at least partly because of collapsing world coffee prices. A rapid rate of growth of both GDP and noncoffee exports was maintained.

External debt burden indictors improved over the period. The main policy concern was that spending out of aid exceeded aid absorption, resulting in a substantial injection of domestic liquidity over the period as a whole. Inflationary pressures were countered with sterilization through treasury bill sales, leading to rising interest rates and potential crowding out of private sector investment, as well as to a rapid accumulation of domestic debt.

Pattern of Aid Inflows

Gross aid inflows were already high from 1997 to mid-2000 at about 9 to 11 percent of GDP. This was followed by a sharp increase, with inflows reaching almost 14 percent of GDP during the following two years.3 This pattern was not generated by project aid (which remained quite stable), but by program assistance, which rose sharply from 3 to 4 percent of GDP in 1998–2000 to 6 to 9 percent in 2001–03 (Table 7.1).

Table 7.1.

Uganda: Aid and Other Inflows

(In percent of GDP)

article image
Note: Figures in bold represent the aid-surge period. The pre-aid-surge period is from 1999–2000 and the aid-surge period is from 2001–03. Errors and omissions included in the capital account.

Net aid inflows were lower than gross aid inflows in most years but still very high, and they followed the same pattern, rising from 8 to 10 percent of GDP in 1998–2000 to 12 to 15 percent over 2001–03.

Private sector inflows remained relatively stable at about 3 percent of GDP throughout the period. This stability, and the small size of private relative to public sector inflows, enables a focus on the latter when considering macroeconomic management.

Real Exchange Rate and Terms of Trade

Despite the surge in aid inflows from 2000/01 onward, the real and nominal effective exchange rates depreciated considerably over the period (Table 7.2). In general, a real depreciation in the face of surging aid inflows may be indicative of three factors: (1) real features of the economy, such as a rapid supply response to aid expenditures or high import propensities, although this would tend to mitigate the appreciation rather than cause a depreciation; (2) a policy stance that leans against real appreciation through some combination of fiscal and monetary policy; or (3) other exogenous events, most notably a terms-of-trade shock that adversely impacts the country’s primary export commodity. The first two factors will be examined in the subsequent sections.

Table 7.2.

Uganda: Exchange Rate Movements and the Terms of Trade

(In millions of U.S. dollars, unless specified otherwise)

article image
Notes: f.o.b. = free on board. Figures in bold represent the aid-surge period.

In 1997/98, coffee comprised 59 percent of Uganda’s exports. After a period of rising prices in the mid-1990s, world coffee prices began to fall precipitously during the period studied here.4 This fall was mirrored by the terms of trade, which declined by 34 percent between 1997/98 and 2002/03. Box 7.1 attempts to disentangle the effects of this decline in coffee prices from the surge in aid.

The falling REER probably helped cushion the effect of the decline in world coffee prices. Apart from tempering the decline in local currency earnings in the coffee sector, it may have helped nontraditional exports, which more than doubled over the period, and accounted for a much larger share of exports than coffee by 2002/03. Since the REER fell substantially over the aid-surge period, there is no ex-post evidence of Dutch disease.

Aid Absorption

Despite substantially higher aid inflows in the surge period, the non-aid current account deteriorated by only 1.3 percent of GDP (Table 7.3). Much of the incremental aid appears to have escaped through the capital account. In addition, the authorities’ concern over the exchange rate translated into a reluctance to sell foreign exchange, resulting in gross international reserves rising substantially over the period.5

Table 7.3.

Uganda: Was Aid Absorbed?

(In percent of GDP)

article image
Note: The pre-aid-surge period is from 1999–2000 and the aid-surge period is from 2001–03. Errors and omissions included in the capital account.

Uganda: Terms-of-Trade Shocks and Aid Inflows

Because high levels of aid inflows in Uganda coincided with a terms-of-trade shock, including during the period of sharply elevated aid levels, it is useful to compare the effect of these separate factors on the net inflow of dollars into the economy. The table below measures the change in dollar inflows into the economy compared to the previous year, both as a result of changes in aid and as a result of terms-of-trade movements. The net changes in dollar inflows are then compared with movements in the real and nominal exchange rate.

Until 1999/2000, the terms-of-trade shock combined with a fall in annual aid inflows, causing both the nominal and real exchange rates to depreciate. In 2000/01, however, a steep increase in aid inflows dominated the adverse effect of price movements, leading to a net increase in dollar inflows to the economy. The continuing sharp depreciation of the nominal and real exchange rates partly indicates a policy stance that leaned against nominal appreciation and curbed inflation through sterilization. The same trend is apparent in an average of the post-aid surge period (2000–03)—despite the fact that incremental aid dominated the loss in dollar inflows from the terms-of-trade shock, the real and nominal effective rates depreciated substantially.

Uganda: Terms-of-Trade Shocks and Aid Inflows: Net Effect on Dollar Inflows From Trade and Aid

article image
Note: f.o.b. = free on board; c.i.f. = cost, insurance, and freight. Figures in bold represent the aid-surge period.

Current year export and import volumes multiplied by export and import price indices of the previous year.

Counterfactual net exports minus actual net exports.

Net aid inflows in the current year minus net aid inflows in the previous year.

Spending Out of Aid

As shown in Table 7.4, most of the incremental aid was spent, in the sense that the aid-surge period was characterized by a deterioration in the fiscal balance before aid. Almost 80 percent of the additional aid was spent, even though only about a quarter of incremental aid was absorbed. Thus, over the period as a whole, Uganda’s aid expenditure greatly exceeded its aid absorption. This implied an injection of liquidity into the domestic economy and determined the challenge for monetary policy, as discussed in the next section.

Table 7.4.

Uganda: Was Aid Spent?

(In percent of GDP)

article image
Note: The pre-aid-surge period is from 1999–2000 and the aid-surge period is from 2001–03.

Most of the aid-surge dollars were sold by the central bank, but went into capital outflows rather than a current account deficit. There are subtle questions about how to interpret policy in this context (see Box 2.3 in Chapter II), but it remains the case that a given aid dollar can be used either to accommodate a capital outflow or to finance government spending, but not both. Thus, the spending in excess of absorption still shapes the monetary policy challenge.

How well was the aid spent? On the face of it, the aid was a success. In general, governance in Uganda was relatively good, with the authorities firmly committed to economic reforms. Real GDP grew at between 5.5 and 7.5 percent annually over the period under consideration. Given Uganda’s low (albeit rising) revenue mobilization, official inflows were important in enabling the government to spend on areas such as health, education, and other poverty-reduction programs. The Poverty Action Fund (PAF), an accounting mechanism within the government budget, linked donor assistance to poverty-reduction spending and allowed for better monitoring. Between 1997/98 and 2001/02, budgetary expenditures on education and health increased by 1.5 percentage points and 0.8 percentage points of GDP, respectively, along with substantially increased spending on roads, water supply, and agricultural support services. The share of expenditures on poverty-related programs increased from 39 percent in 1997/98 to 46 percent in 2001/02.

Increased social spending appears to have laid the foundation for sustained growth in Uganda, particularly by enhancing human capital.6 Educational outcomes have improved, and the adult prevalence rate of HIV/AIDS declined from 30 percent in 1992 to 6.5 percent in 2001. However, Kappel, Lay, and Steiner (2005) argue that in recent years growth ceased to be pro-poor. Household surveys show that while the poverty headcount fell from 55.7 percent in 1992/03 to 33.8 percent in 1999/2000, it increased to 37.7 percent by 2002/03. Moreover, income inequality increased throughout, with the Gini coefficient rising from 0.36 over 1992–2003 to 0.39 in 1999–2000, and to 0.43 in 2003/04. The steep fall in world coffee prices could be partly responsible for the recent increase in poverty.

Table 7.5 shows that despite the substantial aid inflows, and despite the rising share of grants as a percentage of GDP, it seems that the government did not succumb to potential adverse incentives on the revenue generation front. Revenue as a percentage of GDP rose from 11.6 percent in 1997/98 to 13.2 percent in 2002/03, albeit with some volatility in the interim.

Table 7.5.

Uganda: Central Government Budgetary Operations

(In percent of GDP, unless specified otherwise)

article image
Note: Figures in bold represent the aid-surge period. The pre-aid-surge period is from 1999–2000 and the aid-surge period is from 2001–03.

There is little indication that the debt situation worsened significantly. The debt-to-GDP ratio fell from the high level of 43.1 percent in 1999 to 34 percent in 2001. Debt service decreased substantially, with the debt service-to-exports ratio declining from 27 percent in 1997/98 to under 10 percent by 2000/01. This reflected both a brisk growth rate of GDP and debt relief granted to Uganda under the Heavily Indebted Poor Countries (HIPC) and enhanced HIPC frameworks.7

Monetary Policy Response

Throughout the period, and especially from 2000 onward with the sharp increase in aid, policymakers were concerned with keeping the exchange rate from appreciating. This concern was driven by collapsing world coffee prices and the consequent shrinking of the important coffee sector. The other main objective of policy was to keep inflation low and stable.

Put together, these policy objectives implied that the target was a stable REER. Although this target was indeed reached, it is debatable whether it represented an optimal policy response (Figure 7.1). In particular, the REER depreciation may have been too high during the period of sharply increased inflows, when the net effects of terms-of-trade shocks and aid inflows are taken into account.

Figure 7.1.
Figure 7.1.

Uganda: Exchange Rates and Monetary Indicators

Sources: IMF staff reports, and country authorities.Note: REER = real effective exchange rate; ER = exchange rate; CPI = consumer price index. The data cover the period from June 1999 to June 2003.

The main instruments at the disposal of policymakers were transactions in treasury bills, transactions in the foreign exchange market, and the rate of spending of aid inflows. It is instructive to look more closely at the way these instruments were deployed to meet the twin policy objectives when aid inflows surged in mid-2000.

June 2000 to December 2000

Net foreign assets (NFA) increased sharply in response to greater aid inflows starting around the middle of 2000 (Table 7.6). The central bank, concerned with the exchange rate, set net interventions in the foreign exchange market to prevent nominal appreciation. At the same time, to temper the injection of domestic liquidity that this exchange rate policy entailed, the authorities sterilized by means of selling treasury bills. Table 7.6 shows the combined effect of these policies on reserve money, inflation, and interest rates. Although there was a spurt in the growth of reserve money, underlying inflation (excluding food prices) remained relatively low at 4.7 percent in December 2000. The rate of interest on treasury bills jumped to 15 percent, and the lending rate of commercial banks followed suit, climbing to over 24 percent.

Table 7.6.

Uganda: Policy Instruments and Outcomes

(In billions of Ugandan shillings)

article image

There were apparently two main reasons for the pattern of foreign exchange intervention, which aimed at preventing nominal appreciation, rather than at sterilizing government spending out of aid. First, an appreciating nominal exchange rate may have had adverse effects on poverty by compounding the effect of falling world coffee prices. A lower local currency price for coffee may have lowered farmgate prices correspondingly, thus squeezing rural incomes. Second, the central bank maintains that attempts to sterilize government spending through sales of foreign exchange would have been quickly limited by the commercial banks’ limited appetite for foreign exchange assets. The argument is that commercial banks could not buy much foreign exchange without facing a currency mismatch between assets and liabilities.8 For these reasons, treasury bill sales were the only instrument used to attempt to sterilize government expenditures.

It is interesting to compare this policy response to the IMF stance implicit in program targets and in the short-term macroeconomic framework. Table 7.7 shows quantitative targets and programmed growth in reserve money for June, September, and December 2000, and compares them to the outcome. All quantitative targets were met over this period. In particular, net domestic assets (NDA) remained well under the program ceiling. On the other hand, reserve money grew much faster than programmed. This implies that the increase in reserve money was due to the rapid increase in NFA, which in turn was partly due to the pattern of central bank net interventions in the foreign exchange market to prevent nominal appreciation. Given the level of net foreign exchange intervention, the sterilization through treasury bill sales was actually insufficient to keep reserve money under the programmed level.

Table 7.7.

Uganda: Macroeconomic Performance Against Poverty Reduction and Growth Facility Targets

article image

Not a program target. The Poverty Reduction and Growth Facility program expired in March 2001.

The IMF’s program implied much greater net sales of foreign exchange by the central bank, which would have allowed the nominal exchange rate to appreciate (or moderated the nominal depreciation). From June through December, the increase in the central bank’s net international reserves remained well above the program floor. The authorities’ aggressive stance was fueled by concerns over export earnings in the face of the shock to coffee prices. Who was correct? On balance, it seems fair to conclude that the central bank had ample room for more net sales of foreign exchange. There were two opposite influences on the REER during this period: reduced export earnings due to the coffee price shock, and increased aid inflows. But the net effect of the two appears to have been an increase in dollar inflows (Box 7.1). So the fact that there was a sharp depreciation in the REER and in the nominal effective exchange rate (NEER) over the period indicates that net foreign exchange sales by the central bank were too low—so low as to reverse the expected direction of the REER.

Although reserve money growth was far more rapid than programmed, consumer price index (CPI) inflation remained broadly in line with the program forecast. This implies that the IMF’s program framework was perhaps unnecessarily restrictive. In fact, given the level of foreign exchange interventions, keeping reserve money at the programmed level would have required even more sterilization through treasury bill sales than actually transpired and would have almost certainly been counterproductive, raising interest rates to unacceptably high levels.

Taken together, these points imply that a more appropriate response would have been to increase net sales of foreign exchange, allowing some nominal appreciation to occur (or moderating the rate of depreciation). This would have helped to keep interest rates lower through two channels. First, it would have reduced the need for sterilization through treasury bills, especially because faster reserve money growth was clearly compatible with maintaining low and stable inflation. Second, the expected erosion of the Ugandan shilling compared with the dollar meant that higher nominal interest rates needed to be offered on domestic borrowing and lending. This effect would have been moderated by more sales of foreign exchange.

December 2000 to June 2001

With the successful containment of inflation in the previous period, and the sharp rise in interest rates, sterilization through the sale of treasury bills was curtailed. NFA over the period declined slightly, probably due to a combination of lower aid inflows and larger net sales of foreign exchange. This policy led to a fall in treasury bill rates, and the rapid growth of reserve money in the preceding period was curtailed. Although underlying inflation increased to almost 8 percent, this largely reflected a rise in electricity tariffs by the state-owned utility.

The PRGF arrangement expired in March 2001, and it was not until September 2002 that a new arrangement was put in place. Hence it is not possible to compare the authorities’ macroeconomic performance over this period against program benchmarks or performance criteria. However, it seems clear that IMF staff shared the authorities’ concerns about the rise of reserve money and inflation; the general goal was to keep inflation at or under about 5 percent. Again, it seems that better results may have been achieved through higher net sales of foreign exchange. More nominal appreciation could have been allowed to counter the sharp depreciation of the previous period. This would have moderated the inflationary impact via the exchange rate as well as further reduced the need for treasury bill sterilization. Such a policy may have led to moderating the decline in the REER compared with the actual outcome, in line with net dollar inflows over 2000–01.

June 2001 to June 2002

Aid inflows remained high in 2001–02, and government expenditures increased.9 A greater willingness to engage in net sales of foreign exchange led to a mild appreciation of the NEER. Treasury bill sales continued to be used as a sterilization instrument, as indicated by the fall in NDA over the period. Overall reserve money growth fell from 24 percent the previous year to about 14 percent, and inflation fell sharply.

Why did treasury bill sales not lead to a spike in interest rates as they did in the preceding year? Greater net sales of foreign exchange allowed the nominal exchange rate to appreciate mildly. This in turn probably helped lower inflation. Both the fall in inflation and the reduced need for treasury bill sterilization may explain the lack of an interest rate response.

June 2002 to June 2003

The mild NEER appreciation over the previous year appears to have sparked renewed concern about international competitiveness over 2002/03. It is evident from Table 7.6 that NFA climbed sharply, as aid inflows went into reserve accumulation, with low net sales of foreign exchange. In June 2003, the PRGF floor on net international reserves was exceeded by over $20 million.10

Again in 2002/03, there was much sterilization through treasury bill sales to keep inflation low. This kept the central bank’s NDA well below the program ceiling, and resulted in zero growth in reserve money over the year.11 Consequently, underlying inflation remained very low, but at the cost of another spike in the treasury bill rate, which jumped up to over 18 percent by June 2003.

Conclusions

Despite some policy variations from year to year, government expenditure out of incremental aid generally exceeded absorption over the aid-surge period. The central motive for this appears to have been a desire on the authorities’ part to preserve international competitiveness. Foreign exchange sales by the central bank were limited to a level consistent with a stable or depreciating nominal exchange rate.12 This response avoided exacerbating the effects of the terms-of-trade shock on the coffee sector, and allowed nontraditional exports to continue their healthy rate of growth. However, the policy also entailed a rapid increase in domestic liquidity. This led to episodes of heavy sterilization through treasury bill sales.

The spend-but-don’t-absorb strategy followed by Uganda, coupled with treasury bill sterilization, had at least two negative consequences. First, interest rates rose significantly as a result of treasury bill sales. This potentially crowded out private sector investment.13 Second, the treasury bill sales led to a rapid accumulation of domestic debt, which rose as a percentage of GDP from an average of 2.9 percent in 1999–2000 to 6.9 percent during the aid-surge period, and a corresponding rise in debt service.

It seems likely that greater net sales of foreign exchange, and therefore a greater degree of exchange rate adjustment, might have alleviated some of the macroeconomic imbalances that arose, while not unduly compressing exports. Real and nominal exchange rate stability, as opposed to the depreciation that occurred, would have curtailed domestic liquidity to some extent and reduced the need for treasury bill sterilization. In turn, this would have further spurred private sector activity and reduced the build-up of domestic debt. Hence the optimal response would have been to absorb and spend, with sales of foreign exchange by the central bank enabling absorption through increased imports. Implicitly, this is the outcome that was targeted by the PRGF program.

1

The Ugandan fiscal year begins in July.

2

There is some evidence, however, that in recent years the decline in poverty may have been arrested or even reversed (Kappel, Lay, and Steiner, 2005).

3

From 2000/01 onward, official data include off-budget donor inflows of about $80 million annually. This tends to bias upward the amount of the aid increase. However, even if these inflows are excluded, there is still a substantial aid surge, and the analysis remains fundamentally unchanged.

4

This was the second prolonged shock to world coffee prices since the Museveni government came to power. The first began around 1986 and reached its trough in 1992, after which prices climbed for a few years. Prior to the first shock, Ugandan coffee exports were even more important to the country’s economy, comprising 95 percent of all exports in 1986.

5

However, in terms of months of imports, reserves fell slightly, from an average of 6.2 months from 1998/99 to 1999/2000 to 5.9 months from 2000/01 to 2002/03.

6

For example, Deninger and Okidi (2001) calculate that over the last decade, a rise in the education level of the head of the household by one year was associated with a statistically significant increase of about 0.6 percentage points in the growth rate of household income in Uganda.

7

Uganda reached its completion point under the HIPC Initiative in April 1998. The resulting debt relief was followed by a further debt stock operation in May 2000, when the country reached its completion point under the enhanced HIPC Initiative.

8

This argument is perhaps unlikely to hold for countries with relatively open capital accounts like Uganda, where the ultimate counterparty to the central bank’s foreign exchange sales would be the nonbank public and foreign investors.

9

As noted in Table 7.5, government expenditures increased substantially from about 23 percent of GDP to about 27 percent, and the share of poverty-related expenditure rose from 39 percent in 1997/98 to 46 percent in 2001/02.

10

A new PRGF arrangement commenced in 2002/03.

11

The new PRGF program explicitly targeted reserve money rather than NDA. The NDA target referred to here was therefore only an indicative component of the macroeconomic framework.

12

Some of this depreciation may also be attributable to the capital outflow over the period.

13

It is difficult to ascertain how much crowding out actually occurred due to the absence of a counterfactual. This is especially true in low-income countries where the private sector is often small and dependant on government patronage. The private investment-to-GDP ratio improved from an average of 11.2 percent in the pre-surge period to 13.9 percent during the aid surge, but given that interest rates rose substantially during the sterilization episodes, it is possible that more improvement may have occurred in the absence of treasury bill sterilization.

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Cover The Macroeconomics of Scaling Up Aid
The Macroeconomics of Scaling Up Aid
Lessons from Recent Experience
ISBN:
9781589065918
ISSN:
0251-6365
Publication Date:
23 Mar 2007
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589065918.084
Pages:
114
Figure 7.1.

Uganda: Exchange Rates and Monetary Indicators

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