Uganda: Economic Consequences of Credit Market Failure - Case Study Example

Running head: Uganda: economic consequences of credit market failure Uganda: economic consequences of credit market failure [Institution’s name] Contents Foreword---------------------------------------------------03 1. Executive Summary----------------------------------------04 2. Credit Market Failure------------------------------------06 3. Introduction of Ugandan Economy-----------------------06 4. Role of Credit in development------------------------- 5. Credit Market Restructuring--------------------------- 6. The pro keynesian perspective------------------------- 7. The neo-classical perspective------------------------- 8. The structuralist perspective------------------------- 9. Factors resulted in the Failure of Ugandan Credit Market-10 a. Competitive advantage---------------------------------10 b. Change in Economic structure--------------------------11 c. Technological factors---------------------------------12 d. Social and Cultural factors---------------------------13 10. Proposed Initiatives----------------------------------14 11. Summary of proposed initiatives and actions-----------14 12. References--------------------------------------------16 Foreword: This report is a blueprint for consequences of the failure of credit market failure on the growth of the Ugandan Economy. It contains practical and suitable recommendations for the stabilisation of the Ugandan credit market according to the Economic, Regional and Social set-up of Uganda. The report will also pinpoint the importance of credit market for increasing the sustainable growth and competitiveness of the economy and its contribution to regional and universal prosperity. It is expected that the implementation of these initiatives and recommendations will lead to prosperous growth of credit markets in Uganda. On behalf of the PK consulting Company’s development Committee, I present this report to the respected government of Uganda. Executive Summary: Perhaps the foremost social responsibility levied upon private and public credit providing organisation in recent decades is the adoption of fair and just supply of credit to the consumers. This responsibility is being increasingly codified in law and various governmental orders. Its influence is becoming increasingly pervasive through a constant series of federal court decisions as well as steady enlargement in the size and scope of administering agencies. “The failure of formal credit institutions to serve the poor is due to a combination of high risks, high costs and consequently low returns associated with such business.” (Orkut et al. 2004:5) Despite the pressure from the International agencies and Governments of the developed nations it will neither fruitful for the economy of the developing countries nor for the consumers of these countries to implement terms and conditions of lending and borrowing as applied in the developed countries. Factors contributing to this argument are many and varied, which include: Difference in economic conditions. Difference in technology and skills. Dependence economies of both the countries on Labour intensive industries. Loss of competitive advantage in international trade. The economy of Uganda is considered as one of the fastest growing economy in the African countries. The growth in the Gross domestic Product of Uganda has reached to 6.9%per year from 2.9% in the era of 1980s according to World Bank. (World Bank 2004:183) As a consequence of this growth,Appleton (2001:4)has estimated,based on household surveys,that the poverty headcount (defined relative to a poverty line close to the widely used dollar a day)has declined substantially:From 56%in 1992 to 34%in 1999/2000 – mainly because mean consumption per adult equivalent rose by 4.7%%per annum over this period (its distribution worsened slightly).Wider measures of poverty (the poverty gap ratio P1 and the poverty severity ratio P2)declined even more tha n the poverty headcount ratio (P0),thus indicating that the poorest gained much from this growth (Appleton 2001:27,Table 2).This decline in poverty is confirmed by panel data that show similar declines in the poverty headcount ratio over the same period (Lawson et al.2003:6).Nevertheless,this is a relatively strict poverty definition,and poverty is still widespread,particularly in the Northern region,where the panel data also seems to indicate most poverty persistence (Lawson et al.2003:7).Uganda is still a very poor country,as judged by the fact that its per capita income of $240 in 2002 is scarcely above half the average level for all African countries ($450)and for all low income countries ($430)(World Bank 2004:16).Admittedly,exchange rates exaggerate Uganda ’s poverty,and converting using PPP dollars gives a somewhat better picture. But even then,at $1360 versus Africa ’s $1 700 and the average for low income countries of $2 110,Uganda is still amongst the world ’s very poorest countries,despite its more recent commendable growth performance,and it needs much more growth to reduce poverty (World Bank 2004:16). It is against this context of poverty that the issue of credit in Uganda should be seen.In an impoverished country,albeit one experiencing rapid economic growth,opportunities of individuals and therefore indeed opportunities for macro-economic growth are likely to be constrained by lack of access to resources to invest.It is in this way that micro- finance builds a bridge between micro-economic opportunities for individuals and macro-economic performance of the economy.Moreover,another micro-macro-linkage is also of relevance:where macro-economic reforms have been introduced,including macro-economic financial reforms,it is important to ask whether they have contributed towards improving access of the poor to formal credit,and if not,what role informal credit plays. This paper focuses on identifying the factors that influence credit demand and also those that result in the poor being credit rationed by lenders.An understanding of both these sets of determinants could assist policy formulation to enhance the welfare of the poor through improved credit access.In this respect we were fortunate in having a dataset that contains questions not only on actual credit given,but also on loans applied for. This allows us to investigate both credit demand and credit supply,and to model these using observed household and individual characteristics. The paper is organised as follows:The next section investigates the role of credit in the development process,as it has become evident from the relevant literature.We then look at credit in Uganda and turn to formally modelling both credit demand and credit supply,with the latter in particular dealing with the important.Finally,our concluding remarks draw some inferences from the models and speculate as to what this may imply for the role of formal and informal credit institutions in the context of a very poor country. The role of credit in development In a developing country context,credit is an important instrument for improving the welfare of the poor directly (consumption smoothing that reduces their vulnerability to short term income shocks)(Binswanger and Khandker 1995;Heidhues 1995;Nwanna 1995)and for enhancing productive capacity through financing investment by the poor in their human and physical capital.An investigation of household credit thus has implications that link together micro-level analysis with factors that determine long term macro-economic performance. In Uganda,mainly macro-level policies were implemented from the early 1990s to improve the efficiency of the financial sector.These included liberalisation of interest and foreign exchange rates,as well as government divesting from the management of public sector banks.However,as has also often been experienced in other developing countries,deregulation of the formal financial sector has not increased access to formal finance for the Ugandan poor.This failure of the formal financial sector to serve the poor has forced the m to rely on informal finance (Musinguzi and Smith 2000),as is often the case in developing countries. The demand for credit for productive investments usually comes from those poor who are less risk-averse and enables them to overcome liquidity constraints,making it possible to undertake investment that can boost production,employment and income. Credit for consumption purposes can have a long term positive impact on household produc tivity,allowing acquisition of skills or improvement in health status if such loans are used for education or health care.These may enhance or at least preserve the productivity of the labour force.The credit market is also,at least potentially,an important instrument for consumption smoothing. Commercial banks constitute the formal lenders in Uganda and access to them is restricted to a small proportion of the population who can meet their stringent requirements,which include high minimum balances for account opening,onerous collateral requirements for loans,and long and costly bureaucratic processes.Banks are, furthermore,mainly urban based,thereby adding the burden of transport costs if the predominantly rural population wishes to use bank facilities.As a result of constrained access to formal credit,the poor rely almost exclusively on the informal financial sector. Informal lenders innovatively seek to solve the problems of high risk,high cost and low returns that banks face when serving the poor. In practice households apply for credit,but lenders determine how much credit is allocated to them,based on their perception of the households creditworthiness.This often results in credit rationing, that reflects the lenders perception of the household risk profile. Understanding which factors influence credit rationing highlights specific interventions that may raise the creditworthiness of households, to the advantage of both lenders and households. From the lender ’s perspective, improved creditworthiness of borrowers will reduce risk of default and improve profitability and financial sustainability. From the household side, increased creditworthiness means increased access to credit, which may provide a possible escape route from poverty. Factors to be considered for the implementation of: a. Competitive advantage: For the labour intensive economies like Uganda the competitive advantage heavily relies on the low cost of labour. In the countries like Uganda where most of the population of the country is leading their life below the poverty line it sometimes become inevitable for the consumers to make their child work so that they can get the basic necessities of life i.e. food, shelter and clothing. In these economies higher education is regarded as luxury which is only affordable by the upper classes. If in these countries the child labour becomes restricted, how these people will get the basic necessities. Even UNICEF has said that child labour is not necessarily harmful, that recent dismissals of Bangladeshi children under LS pressure from the US has caused a lot of social problems and that elimination of such practices would not be feasible in the foreseeable future (ICDA 18:14). Hansson (1983:94 ff) has suggested that a ban on child labour would only be practicable in manufacturing and would almost certainly only force migration to uncontrolled rural, backyard and service activities, while impoverishing many low-income families. b. Change in Economic Structure: “The economic transformation since 1970 shows that the share of the agricultural sector declined from 30.8% in 1970 to 9.3% in 1999 while the share of the manufacturing sector increased steadily from 13.4% to 30% during the same period. The share of the services sector also increased from 41.9% in 1970 to reach 54.2% in 1999.” (World Employment Report 2001) The economy of Uganda is still labour intensive. Increase in wages will lead to overall increase in the production cost in manufacturing sector. c. Technological factors: While implementing the uniform labour standards, it should also be taken into consideration that most of the developing countries are not technologically advanced as those of the developed countries. Their production methods are still labour intensive rather than technology intensive. The increase in the labour cost will lead to the high cost of production lowering the profit margins from the export of the different goods. It will also be unfair to provide the labour with low technical skills with the same wages as those having high technical skills. d. Social and Cultural factors: It is not possible to implement the labour standards at universal level like other human rights. As there is a big difference in the economic circumstances and culture-specific standards. (Khor M 1994 and 1996; LeQuesne 1995). Proposed Initiatives: Summary of proposed initiatives and actions: Some times some steps taken for the benefit of a group can be harmful for other people at greater level. The increase in wages to international level will lead to production costs, these would tend to distort labour or other markets in the affected countries, thus distorting development, discouraging investment, fostering labour-displacing technologies, forcing workers out of the formal economy into the informal sector (where conditions are even worse) and so forth. The result may be the opposite of what was intended (e.g. Lawrence, 1994; Anderson, 1995). Although the principles of ILO will lead to the betterment of the labour all over the world but it should be kept in mind that the advanced countries which are demanding the implementation have different employment conditions and are very advance in technology and education. The Government of Uganda should demand for the provision of the technological assistance and support in the educational and technical skill development programs from the advanced countries. The Governments of these countries should provide loans and financial assistance to the developing countries in order to make the position of labour in these countries better rather than worsening their conditions by imposing sanctions. According to the proposal in a World Bank sponsored study by Thillairajah (1995), there should be three types of institutions in a properly functioning financial market, which would ideally play the roles of, wholesaler, intermediary, and retailer, of financial services to the ultimate customers at the grassroots, with the following advantages in the linkage chain: 1. The retailers would cope with the rurality of the small scattered customers and minimize the cost of collecting information on credit-worthiness, as well as loan recovery and savings mobilization. 2. The intermediary role of the semi-formal sector would enable the informal and semi-formal customers to earn interest by depositing their savings in the formal sector. This would assist the mobilization of savings and help the formal sector to create more money. The intermediaries would also save the formal sector the extra cost of dealing with small deposit and loan accounts. The same intermediaries would pass on loanable funds to the retailers, relieving the excess demand for credit at the grassroots. 3. The wholesaler formal sector intermediaries would be able to meet cash shortages and utilize idle funds. These operations would be crucial in meeting the problems of seasonality. and mitigating co variant risk. Unfortunately, the AERC sponsored studies concluded that the linkages are either extremely weak or indirect on both the credit and deposit side, or practically non-existent. The neoclassical logical argument would run that once the returns on assets in rural institutions are positive, the entire financial sector would integrate itself for funds to flow to the most profitable enterprises, urban and rural. This is yet to be seen, given the perceived prejudices of urban-based banks against the more humble organizational set-ups required to keep costs to the minimum in micro-enterprise banking, and the unorthodox clientele served without collateral. Read More