Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 14828

PROJECT COMPLETION REPORT

TANZANIA

FINANCIAL SECTOR ADJUSTMENT CREDIT(CREDIT 2308-TA)

JULY 3, 1995

Public and Private Enterprise DivisionEastern Africa DepartmentAfrica Region

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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Glossary of Abbreviations

BFIA Banking and Financial Institutions Act (1991)BOT Bank of TanzaniaCRDB Cooperative and Rural Development BankERP Economic Recovery ProgramESAF Enhanced Structural Adjustnment FacilityESAP Economic and Social Action ProgramFSAC Financial Sector Adjustment CreditICB International Competitive BiddingIDA International Development AssociationIFC International Finance CorporationIMF International Monetary FundIRAC Industrial Restructuring Adjustment CreditIRTAC Industrial Rehabilitation and Trade Adjustment CreditLART Loans and Advances Realization TrustMRC Multisector Rehabilitation CreditNBAA National Board of Accountants and AuditorsNBC National Bank of CommerceOGL Open General License FacilityPBZ People's Bank of ZanzibarPFP Policy Framework PaperTANAA Tanzania Agricultural Adjustment ProgramTDFL Tanganyika Development Finance LimitedTHB Tanzania Housing BankTIB Tanzania Investment BankTPOSB Tanzanian Postal Office Savings BankTsh Tanzanian Shilling

FOR OFFICIAL USE ONLYThe World Bank

Washington, D.C. 20433U.SA.

OTrice of the Director-GeneralOperations Evaluation July 3, 1995

MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT

Subject: Project Completion Report on TanzaniaFinancial Sector Adjustment Credit (CR 2308-TA)

Attached is the Project Completion Report (PCR) for the Tanzania Financial Sector AdjustmentCredit (FSAC, Credit 2308, approved FY92), prepared by the Africa Regional Office. This PCR does notcontain a Part Il prepared by the Borrower.

The FSAC was one of a series of quick disbursing operations in support of the EconomicRecovery Program of Tanzania (ERP). The Government introduced the ERP in 1986. Funds availableunder the FSAC were augmented by IDA reflows in FY93, raising the total financing to SDR 158.4million. Other quick disbursing operations supporting the ERP include four Multisector RehabilitationCredits (US$152.2 million), three Industrial Rehabilitation and Trade Adjustment Credits (US$157.8million) and three Agricultural Adjustment Credits (US$227.4 million). The primary objective of the FSACwas to create a financial system in Tanzania that would operate on the basis of market-oriented principles.

The PCR concludes that the Borrower attained partial success at introducing some of the policyreforms required by the credit agreement. Thus, the Government instituted licenses for private banks tooperate, but did not restructure the insolvent, government-owned, National Bank of Commerce (NBC)which still accounts for about 90 percent of deposits in the sector. The PCR also finds that the projectdesign was questionable because tranche release conditions were linked to achieving agreement on plansand enacting legislation, rather than to implementing these plans and legislation; and the Governmentinitiated a program to capitalize banks, but did not link capitalization to performance. In addition, a slowpace of reforms in the real sector and a deterioration of macroeconomic management in 1992-93 affectednegatively the outcome of the project. As a consequence, most of the banking system is still in the publicsector, insolvent and continues to have significant losses.

Based on the above, the project outcome is rated as unsatisfactory and the institutionaldevelopment as negligible. The Government and the financial community have recently reached consensuson the basic objectives of financial reform. But the PCR does not assess the probability of such consensusto be maintained in the foreseeable future. Therefore, sustainability is rated as uncertain.

The PCR is of good quality. It provides a good analysis of project design, implementationexperience and results. A lesson derived from the PCR is that ambitious policy statements and enactmentof legislation are often insufficient unless complemented by detailed implementation programs andconditions. This would be particularly prudent in countries with weak implementation capacity. Moreover,if policy statements and approval of legislation are deemed essential to the success of the project, theyshould take place prior to approval.

An audit is planned.

Attachment

This document has a restricted distribution and may be used by recipients only in the performance of their officialduties. Its contents may not otherwise be disclosed without World Bank authorization.

I

FOR OFFICIAL USE ONLY

TANZANIA

FINANCIAL SECTOR ADJUSTMENT CREDIT

(Credit 2308-TA)

PROJECT COMPLETION REPORT

Table of Contents

Preface ...................................................................... (i)Evaluation Summary ..................................................................... (iii)

PART I: Credit Review from the Bank's Perspective ........................................................ 1

Project Identity ..................................................................... 1Background ..................................................................... 1Reform Objectives and Credit Description ..................................................................... 3Credit Design ...................................................................... 4Credit Implementation .............................. ................................................ 6Borrower Performance .............................. ................................................ 10Bank Performance ..................................................................... 10Achievements under FSAC ............................................................................... 10Lessons Learned .............................................................................. 11

PART II: Project Review From the Borrower's Perspective ................................................ 13

PART III: Project Profile . .............................................................................. 15

This document has a restricted distribution and may be used by recipients only in the performance of their| official duties. Its contents may not otherwise be disclosed without World Bank authorization. l

TANZANIA

FINANCIAL SECTOR ADJUSTMENT CREDIT

(Credit 2308-TA)

PROJECT COMPLETION REPORT

PREFACE

This is the Project Completion Report (PRC) for the Financial Sector Adjustment Credit forTanzania. The Credit, amounting to SDR 150.2 million, was approved by the Board on November14, 1991 and became effective on November 20, 1991. Funds available under the Credit wereaugmented by IDA reflows in FY93 of SDR 8.17 million, raising the total financing to SDR158.37 million. Switzerland and United Kingdom also cofinanced the equivalent of USD 6.6million and USD 16.8 million, respectively.

This Credit was first appraised by the Southern Africa Departtment and was transferred tothe Eastern Africa Departrnent in July, 1992. The PCR was prepared by the Public and PrivateEnterprise Division, Eastern Africa Department (Parts I and 111).

The preparation of this PCR was based on the President's Report, Supervision Reports,correspondence between the Bank and the Borrower, and internal Bank documents.

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TANZANIAFINANCIAL SECTOR ADJUSTMENT CREDIT

(CREDIT 2038-TA)

PROJECT COMPLETION REPORT

EVALUATION SUMMARY

1. Introduction. The Financial Sector Adjustment Credit (FSAC) was one of a series of quick-disbursing operations to support structural adjustment in Tanzania under the Government'sEconomic Recovery Program (ERP). In 1986, the Government introduced ERP to improvemacroeconomic management, to tackle underlying structural weaknesses, and also to encouragemore active private sector participation. The program was a comprehensive package of policiesdesigned to reduce the budget deficit and improve the balance of payments. The measures alsoincluded sector specific reforms in agriculture, industry, transport infrastructure, and the financialsector.

2. Sector Background. The Arusha Declaration of 1967 effectively transferred ownership offinancial institutions to the Government. Since then, the sector performed poorly on all accounts,due to lack of competition, a directed credit policy, excessive interest rate controls, and weaknessin bank supervision. The directed credit policy led to the financing of non-bankable activities, amisallocation of resources to the parastatals and agricultural cooperatives, and resulted in a largeaccumulation of non-performing loans (around two thirds of the total). By 1988, the bankingsystem was insolvent.

3. Faced with a crisis in the financial sector in 1988, the Government established a Commission ofEnquiry into the Monetary and Banking system to examine the sector and make recommendationson how to improve its overall performance. The Commission submitted its report to theGovernment in July 1990. The broad recommendations of the Commission's report, whichincluded measures to stimulate competition by encouraging foreign banks and joint ventures, wereendorsed by the Government and formed the basis of the financial sector reform program.

4. Credit Objectives and Rationale. The primary objective of the financial reform in Tanzaniawas to create a system that would operate on the basis of market-oriented principles. Conceptually,the program was intended to: (i) support a stable, market oriented macroeconomic framework; (ii)address the overall strengthening of the financial infrastructure, including banking and associatedlegislation; (iii) create a competitive environment and introduce private participation in the bankingsector; and (iv) address institutional strengthening of the existing banks. It was recognized,however, that the reforms needed to achieve the objective could not be speedily implemented,given the precarious situation of the financial institutions. The short to medium-term objective was,therefore, to create an appropriate policy and regulatory environment conducive to private sector

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entry of both domestic and foreign banks while increasing private sector participation in existingfinancial institutions.

5. Credit Description. FSAC, amounting to SDR 150.2 million, had two main components: (i) aquick-disbursing component for financing foreign expenditures (SDR 146.4 million in two equaltranches) of eligible imports under the Official General License (OGL); and (ii) technical assistanceand consultant services (SDR 3.8 million). The Credit was approved on November 14, 1991, andbecame effective on November 20, 1991. It was augmented by SDR 8.17 million of IDA Reflowsin FY93, raising the total financing to SDR 158.37 million. Switzerland and United Kingdomcofinanced the equivalent of USD 6.6 million and USD 16.8 million, respectively.

6. Credit Design. The reform program supported by the credit was based on therecommendations of the Presidential Banking Commission Report. The broad conceptualframework appeared to be appropriate for the intended financial sector reform. Nevertheless, therewere recognized risks which were not properly factored into the program's design. The largestrisk stemmed from the pace of reform in the real, or nonfinancial, sectors. The pace wasinadequate for the creation of a bankable client base and therefore for sustaining financial sectorreforms especially as it pertains to the restructuring of the existing commercial banks. Also, anattempt should have been made to explicitly link the recapitalization of the banks to theirperformance. Another risk stemmed from the extent of the Government's commitment to thereforn effort, especially to the restructuring of the banks. Second tranche release conditions calledtoo often for agreement on restructuring plans as opposed to their implementation. The implicationis that the adjustment component of the credit may have been premature or, alternatively, thattranche release conditions may have been inappropriate given the status of preparation of therelevant restructuring plans. Finally, a more aggressive strategy for reducing the dominance of theNational Bank of Commerce was required to boost competition in the sector.

8. Credit Implementation. The Credit was approved on November 14, 1991, and it becameeffective on November 20, 1991. The Government was required to take action on a number ofimportant policy measures prior to presentation of the program to IDA's Board. Accordingly,there were few up-front actions required from the Government for the release of the first tranche.The release of the second tranche was targeted for November, 1992 and was contingent uponsatisfactory macroeconomic performance and the attainment of sector specific targets. However,the release was delayed until July 1993 due to unsatisfactory performance on both fronts.Macroeconomic performance deteriorated mainly due to an increased budget deficit and anaccomodating monetary policy. At the time of the release of the second tranche, there was arecognition that the macroeconomic program was very fragile and that continued, and close,monitoring of fiscal and monetary developments was necessary. Concerning sector specificreforms, the main problem area was the restructuring of CRDB which was delayed, in part,because of a disagreement between the Government and IDA over the scope of the terms ofreference for preparation of the restructuring plan. Following the release of the second tranchedisbursements were slow as the Government found it difficult to implement new procedures for theallocation of donor import support through the newly unified foreign exchange system.

9. Borrower Performance. The Borrower was successful in introducing major policy reformsand bank regulations. As a result, the financial sector was deregulated and liberalized, and privatebanks were licensed. The Borrower was less successful, however, in changing the behaviour ofmanagers of the financial institutions. The management of the banks often did not implementpolicies which were consistent with the overall strategy for the financial sector. Changes inmanagement, as a result of their failure to implement Government policy, occured only whendonors applied pressure to do so.

10. Bank Perfonnance. The Bank played an active role at various stages of the reform programand provided the Borrower with advice on policy reforms and institutional measures. Nevertheless,the Bank's effectiveness, especially in terms of the dialogue with the Borrower and cofinanciers,was undermined by frequent changes in Task Managers and mission teams.

11. Achievements. Measured against the expected achievements of the reform strategy, FSACenjoyed limited success. FSAC introduced indirect methods of monetary policy control withinwhich financial institutions would be able to operate commercially. The program strengthened thefinancial infrastructure by revising banking and associated legislation and enhancing banksupervision. The program encouraged the emergence of a competitive environment through theintroduction of private sector participation in the banking sector. However, weak fiscalperformance coupled with an accomodating monetary policy, and reversals in the restructuring ofNBC undermined the accomplishments in this area. Also, the combination of these factors in aderegulated environment contributed to high interest rates (both nominal and real). Although theGovernment owned financial institutions were recapitalized and significant portions of their non-performing assets were transferred to LART, the banks are still insolvent and incurring substantiallosses.

12. Lessons Learned. IDA recognized that the deregulation of Tanzania's banking system wouldbe a difficult process and major risks were identified. These included the adverse impact ofdelayed implementation of reforms in the real sector and, specifically, parastatal reform. Also,there was likely to be substantial resistance to reform by the management of the banks. These riskswere not factored into the design of the program. As a result, the lack of meaningful restructuringof the financial institutions was the most disappointing aspect of FSAC.

TANZANIA

FINANCIAL SECTOR ADJUSTMENT CREDIT(Credit 2308-TA)

Project Completion Report

PART I: PROJECT REVIEW FROM THE BANK'S PERSPECTIVE

1. Project Identity

Name Financial Sector Adjustment CreditCredit No. Credit 2308RVP Unit Africa RegionCountry Tanzania

2. Background

2.01 Country Background. In the second-half of the 1970's, the Tanzanian economy entered aperiod of economic decline caused by a combination of factors, including external shocks in theform of successive droughts, the rapid increase in oil prices, the collapse of the East AfricanCommunity, the war in Uganda, and the declining prices of its major commodity exports. Theeffects of these external shocks were exacerbated by underlying weaknesses in the management ofthe economy, including inadequate incentives and resources for the agricultural sector, a poorlyconceived and implemented industrialization strategy, excessive administrative controls overeconomic activities and a proliferation of public sector institutions. Consequently, GDP growthdeclined from 5.5 per cent per annum between 1973 to 1978 to 0.4 per cent per annum between1978 and 1982; this was accompanied by accelerating inflation, a deteriorating fiscal situation, andan increasingly unsustainable balance of payments position.

2.02 In an effort to reverse the protracted economic decline, the Government first launched"Economic Survival Plans" in 1980 and 1981, which were followed by a "Structural AdjustmentProgram" (SAP). Though measures adopted under SAP had some positive economic effects, theywere not comprehensive enough to stimulate a major economic recovery.

2.03 In 1986, following a review of the experience of SAP, the Government introduced anEconomic Recovery Program (ERP) to improve macroeconomic management, to tackle underlyingstructural weaknesses, and also to encourage more active private sector participation. Themacroeconomic program was a comprehensive package of policies designed to reduce the budgetdeficit and improve the balance of payments. Economic measures included a substantialdepreciation of the overvalued exchange rate, trade liberalization, the removal of most pricecontrols, and the easing of restrictions on the marketing of food crops. The Government alsoundertook adjustment programs in agriculture, industry, transport infrastructure, and the financial

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sector. The economy responded positively to the reform measures and the result wasimprovements in the availability of external resources, food production, and traditional andnontraditional exports. This was reflected in the overall GDP growth rate of 4% per year during1986 - 1991.

2.04 The Government's reform program was supported by the Bank, the International MonetaryFund (IMF), and other donors.

2.05 Sector Background. Since the Arusha Declaration of 1967, the Tanzanian financial sectorwas mainly Government-owned and comprised of: (i) The Bank of Tanzania (the Central Bank),(ii) three commercial banks--the National Bank of Commerce (NBC), the Cooperative and RuralDevelopment Bank (CRDB) and the People's Bank of Zanzibar (PBZ), (iii) two developmentbanks--the Tanzania Investment Bank (TIB) and the Tanzania Development Finance Limited(TDFL), (iv) an assortment of smaller special-purpose non-bank financial institutions--the TanzaniaPost Office Savings Bank (TPOSB), the Tanzania Housing Bank (THB), the National InsuranceCorporation (NIC), the National Provident Fund (NPF) and a hire purchase company; and (v) theDiamond Jubilee Investment Trust (DJIT). Tanzania also had roughly 400 savings and creditsocieties, mainly located in urban areas and over 200 cooperatives involved in financialintermediation in rural areas. There were no capital or money markets, other than Governmentbonds and Treasury Bills issued primarily to the insurance company, pension funds and savingsbank. However, the informal financial markets were well developed, and were active in foreignexchange dealings, fund transfers and debt financing.

2.06 By 1988, the financial sector was in a state of crisis. This was due mainly to the pervasiveinterference of the Government in the financial system. Credit was directed on the basis ofGovernment priorities without regard to creditworthiness, and banks were convenient agents offiscal policy. The lack of separation between fiscal and financial activities, combined with anunfavorable economic environment and an inadequate regulatory frarnework, led to a significantmisallocation of credit to banking system clientele who were bankrupt and mostly in arrears; anineffective monetary policy and an unstable macroeconomic framework characterized by theunchecked growth in the money supply; and a lack of competition. Weak bank supervision alsocontributed to the crisis in the sector.

2.07 In August 1988, a Commission of Enquiry into the Monetary and Banking system wasestablished by the Government. Its mission was to examine the sector and make recommendationson how to improve its overall performance and support economic growth. The Commissionpresented its recommendations to the President in July 1990. These recommendations mainlyfocussed on: (i) stimulating competition by encouraging foreign banks and joint ventures; (ii)strengthening the existing financial institutions; (iii) developing management accountability; and(iv) the recovery of non-performing loans.

2.08 Building on the findings of the Banking Commission, the Government implemented a seriesof measures in 1991. The Government issued a Policy Statement on financial sector reform which

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acknowledged the perverse impact on the sector caused by a lack of competition and Governmentinterference. In an important reversal of policy, the Government recognized the need to licensenew private sector banks and enacted the Banking and Financial Institutions Act which permittedthe entry of private banks and vested BOT with up-to-date supervisory and regulatory controls.Also, interest rates were liberalized and banks were allowed to set lending rates below anannounced maximum and to set deposit rates freely, subject to the twelve month deposit rate beingpositive in real terms. The Government also enacted the Loans and Advances Realization TrustAct to create an expeditious machinery for the recovery of overdue debts. Finally, bankingsupervision in BOT was expanded and strengthened.

3. Reform Objectives and Credit Description.

3.01 Reform objectives: The primary objective of financial sector reform in Tanzania was tocreate a system that would operate on the basis of market-oriented principles, was efficient inmobilizing and allocating resources, and effective in fostering long-term economic growth. Theshort to medium-term objective was to develop an appropriate regulatory environment conducive toprivate sector entry of both domestic and foreign banks as well as to increased private sectorparticipation in existing financial institutions. This was to be achieved through restructuring andrecapitalization of the existing government owned banks, encouraging joint ventures with theprivate sector, and allowing wholly-owned private banks to commence operations.

3.02 Credit Description: The Financial Sector Adjustment Credit (FSAC) was the fourth in aseries of quick disbursing operations to support structural adjustment in Tanzania under theGovernment's Economic Recovery Program and Enhanced Structural Adjustment Program(ESAP). The previous Bank operations were the Multisector Rehabilitation Credit (MRC) inFY86, the Industrial Rehabilitation and Trade Credit (IRTAC) in FY88, and the TanzaniaAgricultural Adjustment Credit (TANAA) in FY90. FSAC, amounting to SDR 150.2 million, hadtwo main components: (i) a quick-disbursing component (SDR 146.4 million) to finance eligibleimports under the Official General License (OGL); and (ii) technical assistance and consultantservices (SDR 3.8 million). The balance of payments component was scheduled to be released intwo equal tranches, the first becoming available upon effectiveness and the second upon fulfillmentof specific conditions for tranche release. The credit was increased by SDR 8.17 million of IDAReflows in FY93. The Credit was also cofinanced by Switzerland with a non-reimbursablecontribution of ten million Swiss Francs (US$ 6.6 million) and the United Kingdom with a grantequivalent to ten million Pounds Sterling (US$ 16.8 million).

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4. Credit Design.

4.01 The reform program supported by the credit was based on the recommendations of thePresidential Banking Commission Report. The program adopted a four pronged approach tosupport financial sector adjustment. The first component aimed to support a stable macroeconomicframework, including indirect methods of monetary policy control, within which financialinstitutions would be able to operate autonomously. The second component of the programsupported the strengthening of the financial infrastructure including a revision and streamlining ofbanking and associated legislation, the introduction of banking supervision and regulation functionsat the Bank of Tanzania and a review of the accounting and auditing franework. The thirdcomponent supported the creation of a competitive environment and the introduction of privateparticipation in the banking sector. The fourth component addressed institutional strengthening ofthe existing banks, including financial, organizational and managerial restructuring; recapitalizationbased upon both public and private participation; and the establishment of a Loans and AdvancesRecovery Trust (LART) for the transfer of non-performing assets from the banking system and fortheir collection and liquidation where necessary.

4.02 This broad conceptual framework appeared to be appropriate for the intended financialsector reform. Nevertheless, in retrospect there were flaws in the program's design. Thesestemmed from risks which, though considered, were not properly factored into the design of theprogram. One recognized risk was the pace of reform in the real, or nonfinancial, sectors. Hence,the financial sector reforms were timed to follow a restructuring program in the agricultural sectorand to coincide with the implementation of an industrial sector restructuring adjustment operation.The latter, which was to include a comprehensive program of parastatal reform, was delayed andthe former did not include cooperatives who were major borrowers. As a result, the creation of abankable clientele, which was essential to the sustainability of the reforms as it pertained to therestructuring of the existing commercial banks, never occurred.

4.03 An attempt should have been made to explicitly link the recapitalization of the banks to theirperformance. The banks would then have been encouraged to take forceful actions to sell orliquidate those parastatals with non-performing loans and therefore rely less on LART. A by-product would have been the acceleration of the pace of parastatal reform. Also, this would havehad the additional advantage of reducing the recapitalization requirements. Admittedly, in anenvironment where the banks were not used to allocating credit on the basis of profitability criteria,this would have been difficult. However, the need to create a banking culture in an environmentwhere one did not exist suggests that more emphasis should have been placed on the incentivesrequired to create this culture. This was an approach apparently discussed during the credit'sdesign, but viewed as unworkable by the Bank.

4.04 It might also be argued that the method of recapitalization proposed in the credit did notprovide sufficient incentive to the Treasury to adequately monitor the restructuring of NBC.Recapitalization was in the form of bond issues and the only costs to the budget in the short runwere those associated with interest payments, which were based on below market rates. A part of

the recapitalization could have been in cash (or alternatively, the interest payments should havebeen based on market rates). A higher and more immediate impact on the budget might haveforced the Treasury to be more concerned with the budgetary impact of additional recapitalizationsand to pay more attention to the restructuring of the banks.

4.05 The credit acknowledged the difficulty of restructuring institutions from within. As aresult, it included technical assistance for the restructuring of the banks. With regards to NBC,there was some discussion during the design of the program of placing the experts in line positionsand holding them contractually responsible for elements of the bank's restructuring plan. Thisoption was ruled out as politically undesirable. As a result, the experts were given advisory roles.With hindsight, given their increasingly marginal role in the bank's restructuring, the other optionwas preferrable.

4.06 Another risk, which was recognized, stemmed from the extent of Government commitmentto the reforms - especially the restructuring of the banks - and to the sustainability of the reformeffort. The Government was required to take action on a number of important policy measuresprior to presentation of the program to IDA's Board (see para 2.08), and there were few up-frontactions required from the Government for the release of the first tranche. However, the actionsrequired for the release of the second tranche did not test the Government's commitment in thatthey called in many cases for agreements on plans rather than for the plans' implementation (forexample, in the cases of CRDB and TIB, the conditions entailed agreement on restructuring plansand in the case of NBC the conditions included agreement on a plan for the transformation ofbranches into profitable units or their closure). These agreements should have been required up-front, and the second tranche release conditions should have focussed more on theirimplementation. The implication is that the adjustment component of the credit may have beenpremature or that tranche release conditions may have been inappropriate given the status ofpreparation of the relevant restructuring plans.

4.07 During the preparation of FSAC, there was considerable discussion of the best means forencouraging competition in banking. In addition to allowing private entry, the Presidential BankingCommission had proposed splitting NBC into two or more manageable units thereby creatingcompeting Government owned banks. The option eventually adopted was to focus the scarcefinancial and human resources on rebuilding NBC into a commercially viable instituiton; theexpectation was that new banks would provide the competition required to increase efficiency in thesystem. However, the expected pace of entry of new banks, and therefore their impact oncompetition, was overestimated. Todate, only two new banks have been established and theirimpact on NBC's deposit base so far has been marginal.

4.08 The apparently contradictory objectives of strengthening NBC, which essentially was amonopoly, and encouraging competition in the sector were to be reconciled through the downsizingof NBC. This was to be accomplished through the closure of loss making branches, retrenchmentof staff, and a natural erosion of the bank's deposit base as new and more efficient banks enteredthe market. However, the credit also entailed the explicit recapitalization of NBC through an

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injection of capital by the Government, and an implied recapitalization through the technicalassistance provided under the credit. It is not clear how a combination of these events could haveresulted in any significant reduction of NBC's market share. In retrospect, a more aggressivestrategy for downsizing NBC would have required the bank to meet some of its recapitalizationrequirements through the sale of some of its assets.

4.09 Finally, the credit did not cater sufficiently for the involvement of BOT, and specifically itsBank Supervision Directorate, in the restructuring of the banks. Granted, BOT's capacity to playan active role was very limited. Nevertheless, the very act of reviewing progress in this areawould have been an invaluable learning experience for the staff of the directorate, and could haveserved to enhance the image of the directorate in the eyes of the staff of the banks.

5. Credit Implementation

5.01 The Credit was approved on November 14, 1991, and it became effective on November20, 1991. The Interministerial Committee of Principal Secretaries, chaired by the Chief Secretary,was responsible for regularly reviewing implementation of the Enhanced Structural AdjustmentProgram, including financial sector reform. This Committee also advised the working levelcommittee of the Cabinet, chaired by the Prime Minister. The Bank of Tanzania was entrustedwith the lead role in the implementation of FSAC. The program also provided adequate technicalassistance for restructuring of the banks. Much of the initial technical and capacity building was tobe focussed on the Bank of Tanzania and the key financial institutions. A monetary policy advisor,with IMF assistance, was to be placed with BOT to provide policy advice to the Governor and theBoard. Moreover, BOT was to be assisted by a Coordinator who was to play a key role incoordinating the various activities of the program.

5.02 The release of the second tranche was targeted for November, 1992 and was contingentupon satisfactory macroeconomic performance and the attainment of sector specific targets.However, the release was delayed until July 1993 due to unsatisfactory performance on both fronts.Following the release of the second tranche disbursements were slow as the Government found it

difficult to implement new procedures for the allocation of donor import support through the newlyunified foreign exchange system.

A. Macroeconomic Framework

5.03 Macroeconomic Performance. During the reform period, the macroeconomic situationdeteriorated mainly due to an increased budget deficit and an accomodating monetary policy. Thefiscal deficit (including grants) amounted to 8.1 % of GDP in 1992/93 after a surplus of 2.3% in1991/92 due to a sharp decline in indirect tax revenues. As a result of these and other sources ofmonetary expansion by BOT, the money supply increased by 40%, and inflation remained over20% in 1992/93, against a projection of 7%. In an effort to improve the fiscal situation, the

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Government passed a supplementary finance bill in January 1993 which increased tax rates anduser charges, reduced tax exemptions, and strengthened tax enforcement. The Government alsotook steps to rein in the growth of the money supply.

5.04. These measures were augmented by the 1993/94 budget which called for substantial taxincreases, including increases in customs sales taxes, introduction of a real estate tax, increases invarious fees and user charges for Government services, inclusion of excise taxes on imports in thebase used to calculate sales taxes, and further strengthening of tax administration. Increases inrecurrent expenditure also were limited.

5.05 Concerns remained about whether these measures were sufficient to reverse thedeterioration in macroeconomic performance. Nevertheless, to avoid destabilizing themacroeconomic program, IDA concluded that: (i) on the basis of the measures implemented inJanuary and the proposals in the 1993/94 budget, the macroeconomic context for financial sectorreform was appropriate; but (ii) the macroeconomic program remained in danger and thatcontinued, and close, monitoring of fiscal and monetary developments was necessary.

5.06 Interest Rate and Discount Policy The new policy eliminated subsidized credit and allowedbanks to set their own deposit rates. However, BOT continued to set the maximum rates of interestfor each type of deposit. BOT further introduced a discount policy that would not provideautomatic refinancing except to meet temporary liquidity needs of banks. BOT had set the discountrate at 27 percent, which was above the average deposit rate to discourage banks from demandingfunds at the discount window.

5.07 Directed Credit Policy In the past, directed credit policy and Government interference inday-to-day operations of the financial system had resulted in the financing of many publicenterprises without a proper assessment of risks and profitability of the enterprises. Under thereform program, however, all financial institutions in Tanzania were allowed to operate on acommercial basis without government intervention. Implementation of this policy was hamperedby the absence of a comprehensive program of parastatal reform and the absence of an appropriateincentive framework for improving the management of the banks.

B. Strengthening the Banking Infrastructure

5.08 Competitive Environment. Since the enactment of the Banking and Financial InstitutionsAct in 1991, which opened up the sector to foreign competition, two banks were licensed in 1993and became operational. In both cases their openings were delayed partly because of difficulty insecuring premises. Overall, the banking environmnent is still uncompetitive because of the quasi-monopoly status of NBC (see paras 4.07 amd 4.08).

5.09 Regulatory and Supervisory Framework. The Bank of Tanzania Act was approved byParliament in April 1991 to create a more favorable environment for the financial sector. Further,

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BOT undertook a comprehensive review of its structure in order to play a more effective regulatoryand supervisory function. A study was also undertaken to review the role of the National Board ofAccountants and Auditors, and to assess the demand and supply of accountants and their levels ofskills, standards of accountancy training and review laws and regulations pertaining to accountingand auditing in the country.

5.10 BOT established a Directorate for Bank Supervision, appointed a new Director andincreased staffing to meet its expanded responsibilities. A better and a regular reporting systemwas put in place for the use of the banks. The strengthening of the directorate was especiallyimportant given the anticipated entry of new private banks and the underlying restructuring of theexisting financial institutions. BOT also introduced several regulations, including, bankinglicensing, provisioning, capital adequacy and loan limit to a single borrower. The introduction ofthese regulations provided an adequate regulatory framework for the operation of the financialsystem and implementation of the Banking and Financial Institutions Act (BFIA). Despite thesemeasures, bank supervision remained ineffective due to the absence of an effective off-sitesurveillance system and lack of compliance with promulgated regulations by the financialinstitutions. Consequently, significant improvements are required in the area of methodologydevelopment and staff training, as well as the development of restructuring and internal controlexpertise.

C. Strengthening the Banking System

5.11 The Loans and Advances Realization Trust (LART) Although LART was created in June1991, it became fully operational only in early 1993. The appointments of the Administrator,Board and Tribunal members were finalized in June, 1992. Also, Memoranda of Understanding(MOU), which specified the responsibilities and obligations of the banks and the Governmentpertaining to the transfers of non-performing assets, were signed in June, 1992. Following thecompletion of portfolio reviews and loans classification by BOT, the non-performing assets ofNBC, CRDB and TIB were transferred to LART for recapitalization of banks. These transfers didnot occur until 1993. The first partial recapitalization of Tsh 108.7 billion worth of bonds to NBC,CRDB and TIB and interest payments of Tsh 12.4 billion took place in 1992/93. The finalrecapitalization of Tsh 92.3 billion of bonds for NBC and CRDB was completed in 1993/94. As ofFebruary, 1994, total recoveries by LART amounted to only Tshl.O billion.

5.12 Restructuring the National Bank of Commerce. NBC's restructuring was on scheduleduring the initial stage of the reform program. Major accomplishments included adoption of a aplan for the closure of unprofitable branches; formulation of a retrenchment plan as well as animplementation plan for a pilot compensation and employee incentive program; a reduction, bymid-1993, of the proportion of loans outstanding to higher risk borrowers; and the rationalizationof the branch network by downgrading 21 branches into mobile agencies. Implementation of thepilot compensation and employee incentive plan was delayed until completion of the retrenchmentprogram.

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5.13 Following the release of the second tranche in July, 1993, there was a substantial reversalin NBC's performance which appears to have been due, in part, to a change in the seniormanagement of the bank. There was very little implementation of the restructuring plan especiallyin terms of branch closings, staff retrenchment, and credit policies. As a result, in February, 1994the Government agreed to implement an action plan aimed at arresting the deteriorating financialposition of the bank and at taking the first steps towards privatization.

5.14 Restructuring of Cooperative and Rural Development Bank. Implementation of arestructuring plan for CRDB was slow because of delays in securing funding for technicalassistance. The restructuring team was to be funded by DANIDA. However, Danish support wasconditioned upon certain undertakings by the Government. These included changes in managementand the appointment of external auditors from the private sector. There also was a delay whichstemmed from disagreement between the Government and IDA over the scope of the terms ofreference for preparation of the restructuring plan. The Government eventually reached agreementwith IDA to consider all options regarding the future of CRDB, including liquidation, and tochoose the least cost option. An advisory team from DANIDA was appointed in October 1992 anda detailed restructuring plan was finalized. BOT sold its shares of CRDB to the Treasury in March1993.

5.15 In July, 1993 there was a change of management of CRDB. Since then there has been asignificant improvement in performance as the management moved aggressively to implement therestructuring plan. The plan calls for the privatization of CRDB through the sale of shares tocooperatives and private individuals. Upto 30% of the shares will be held by a Trust, capitalizedby DANIDA, pending their sale to the public. A new organizational structure for headquarters,zonal and branch offices was prepared and, as a result, a total of 600 staff members wereretrenched. However, CRDB's losses continued to grow and the bank's viability remainedquestionable. Furthermore, in recapitalizing CRDB, some donor financed lines of credits wereerroneously omitted from te bank's balance sheet. The result was that CRDB remainedundercapitalized even after the last capital injection by the Government in October, 1993. Todate,the sale of shares to the public and the cooperatives has been slow. If CRDB's recapitalization planis unsuccessful, the bank will be in violation of BOT's capital adequacy requirements and its licensewill have to be withdrawn.

5.16 Restructuring of Tanzania Investment Bank. Prior to FSAC, TIB mainly lent to industrialparastatals and over 90 per cent of its portfolio was in arrears of one year or more. The bank alsowas illiquid. An advisory team was appointed in October 1992 and a restructuring plan wasfinalized and agreed with IDA. Major elements of the plan included a redefinition of TIB's roleand its transformation into a merchant bank; and its privatization through sale of a majority of itsshares to a foreign partner. TIB has ceased all lending pending its transformation and privatization.

5.17 Restructuring of Other Banks A restructuring plan for TDFL was finalized in 1992 and theinstitution was recapitalized by its shareholders. A restructuring plan for the Tanzania Housing

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Bank was finalized in April, 1994. The People's Bank of Zanzibar remained undercapitalized formost of the program period. Although PBZ's non-performing assets were transferred to LART inNovember, 1993 and the bank was recapitalized, a restructuring plan was not finalized.Preparation of the restructuring plan did not begin until February 1994.

6. Borrower Performance

6.01 The Borrower was successful in introducing major policy reforms and bank regulations. Asa result, the financial sector was deregulated and liberalized, and private banks were licensed.Government bonds were also issued for recapitalization of the major Government-owned financialinstitutions. The Borrower also made a concerted effort to end Government interference in the dayto day operations of the banks and to ensure that the banks operated according to commercialprinciples. Success, however, depended on the commitment of the management of the banks to thesame principles. In NBC, it seems that a change in management in July 1993 was followed almostimmediately by deteriorating performance and increased insolvency. A change in the managementof CRDB had the opposite effect although the bank remains insolvent. The Borrower did notensure that the banks' managements were implementing policies consistent with the overall strategyfor the financial sector. Changes in management, as a result of their failure to implementGovernment policy, occured only when donors applied pressure to do so.

7. Bank Performance

7.01 The Bank played an active role at various stages of the reform program. The Bank providedthe Borrower with advice on policy reforms and institutional measures, and also played a role indesigning the program and coordinating the donors, as well as supporting the program throughtechnical assistance and guidance. Nevertheless, the Bank's effectiveness was undermined byfrequent changes in Task Managers and mission teams. As a result, a sustained dialogue neveremerged and the frequent changes in advice offered by different Bank staff were frustrating to theTanzanians and eroded Tanzanian ownership of the program. This was especially unfortunate sincethe Banking Commission's report created a good foundation for dialogue between the Borrowerand the Bank. The frequent changes in Task Managers also disrupted the dialogue between theBank and the credit's cofinanciers and led to some confusion over the status of cofinancingarrangements.

8. Achievements Under FSAC

8.01 Measured against the expected achievements of the four prongs of the reform strategy,FSAC enjoyed some success in three of the prongs, but failed in the fourth. First, FSAC aimed tosupport a stable market oriented macroeconomic framework, including indirect methods of

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monetary policy control within which financial institutions would be able to operate commercially.Also, the program aimed to support a more deregulated and liberalized banking system. Progress

in this area was mixed. The banking system was deregulated and liberalized, and a treasury billauction was introduced as part of BOT's efforts to use indirect methods of monetary control.However, weak fiscal performance coupled with an accomodating monetary policy, and reversalsin the restructuring of NBC undermined the accomplishments in this area. Also, the combinationof these factors in a deregulated environment contributed to high interest rates (both nominal andreal).

8.02 Second, the program entailed the strengthening of the financial infrastructure includingrevisions to banking and associated legislation and the strengthening of bank supervision. A newBanking and Financial Institutions Act and an amendment to the Bank of Tanzania Act wereapproved by Parliament in April, 1991 and a more comprehensive review of the BOT Act isongoing. Bank supervision has evolved as a result of a new series of banking laws and prudentialregulations. BOT has begun to develop most of the basic skills necessary to conduct bankingexaminations and has conducted a series of on-site examinations. However, professional skills andtraining amongst the existing staff are still weak; off-site monitoring is yet to be fully developed;and BOT has not yet exercised its enforcement powers, including the ability to impose monetarypenalties and issue cease and desist orders as well as the ability to remove bank management whenit continues to ignore directives.

8.03 Third, the programn encouraged the emergence of a competitive environment through theintroduction of private sector participation in the banking sector. Participation was envisagedthrough the entry of new banks and the restructuring and privatization of existing banks. Two newbanks began operations in late 1993 and two other banks have been licensed. However, it isarguable that the existing restructuring plan for NBC would enhance competition.

8.04 Fourth, FSAC supported the institutional strengthening of the existing banks, includingrestructuring and recapitalization. Progress in this area was disappointing. Although theGovernment owned financial institutions were recapitalized and significant portions of their non-performing assets were transferred to LART, the banks are still insolvent and incurring substantiallosses.

9. Lessons Learned

9.01 IDA recognized that the deregulation of Tanzania's banking system would be a difficultprocess and major risks were identified. These included the adverse impact of delayedimplementation of reforms in the real sector and, specifically, parastatal reforms; the reversal ofpolitical support especially as indirect subsidies previously passed through the banking systembecame more transparent and had to be either funded by the budget or terminated; and the limitedcapacity of the Government to implement the programn and to create a new culture of banking in theexisting institutions.

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9.02 The lack of meaningful restructuring of the existing financial institutions was the mostdisappointing aspect of FSAC. One risk which was not sufficiently considered was the likelihoodof resistance to reform by the management of the banks. Many of the senior managers resistedchanges in the bank. Ideally, the banks' Board of Directors should have ensured implementation ofGovernment policy for the restructuring of the banks. However, the technical capacity of themembers of the Board was weak. A more effective strategy might have been to place externaladvisors in senior line positions, and to provide assistance for strengthening the Board of Directors.The high probability of management resistance is also an argument for the faster privatization of

the bank.

9.03 More attention also should have been paid to the capacity to implement reform. Thereshould have been an attempt to strengthen Bank Supervision's involvement in overseeing therestructuring of the commercial banks; the very act of reviewing progress in this area would havebeen an invaluable learning experience for the staff of the Directorate. Also, there appeared tohave been no attempt to strengthen Treasury's ability to monitor adherence to the program. As thesole shareholder of NBC's shares, it was in the Treasury's interest to ensure that therecapitalization of the bank was followed by its turnaround.

9.04 Finally, FSAC, as well as similar programs in other countries, demonstrated theimportance of paying more attention to competition policy and to the likely structure of the sectorat the end of the program. A major objective of FSAC was to create competition in the sectormainly through the entry of new banks. FSAC also aimed to improve the performance of NBC sothat it would be able to compete with the new private banks. Since NBC accounted for over 90%of the deposit base, these two apparently conflicting objectives could be reconciled only bysignificantly downsizing NBC. However, the plan for downsizing NBC focussed on the closure ofloss making branches. It is not clear how the closure of loss making branches coupled with aninjection of capital equal to its full recapitalization requirements would have resulted in a reductionof NBC's market share. In fact, the successful restructuring of NBC, without any attempt toaggressively reduce its market share, is likely to suppress competition and to stifle the emergenceof an indigenous banking sector.

9.05 These lessons are being incorporated into the designs of a follow-up technical assistancecredit and a Structural Adjustment Credit.

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PART II

Project Review From the Borrower's Perspective

No comments were received from the Borrower.

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PART IIIPROJECT COMPLETION REPORT

TANZANIA

TANZANIA FINANCIAL SECTOR ADJUSTMENT CREDIT(CREDIT 2308-TA)

1. PROJECT TIMETABLE

Item Date Planned Date Actual

Appraisal Mission 07/17/91 07/22/91

President's Report 09/17/91 10/17/91

Loan Negotiation 09/30/91 09/30/91

Board Approval 11/14/91 11/14/91

Loan Signature 11/18/91 11/18/91

Loan Effectiveness 11/20/91 11/20/91

Loan Closing 06/30/94 12/31/94

2. CREDIT DISBURSEMENT(US$ million)

IDA Fiscal Appraisal Estimate Actual Cumulative asYear . percent of

Annual Cumulative Annual Cumulative AppraisalEstimate

1991/92 N/A N/A 81.68 81.68 N/A

1992/93 N/A N/A 16.33 98.01 N/A

1993/94 N/A 211.00 99.59 197.60 93.7

1994/95 N/A N/A 13.40 211.00 N/A

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3. USE OF BANK RESOURCES(Sws)

A. Staff Inputs

Stage of 1990/91 1991/92 1992/93 1993/94 TotalProject Cycle

Preparation 109.5 5.4 114.9

Appraisal | 34.1 34.1

Negotiations ___ 9.3 9.3

Supervision | 27.1 43.3 20.3 90.7

PCR 7.0 7.0

Total 109.5 75.9 43.3 27.3 256.0

B. SUPERVISION MISSIONS SCHEDULE AND STAFFING

Iterns. ::Month/: Total No. of : S/W ini Date of Specialization: Perform-Yeart SW Persons Field Reports Represented. ance

RatingStatus

Supervision I 2/92 2.8 5 0 3/16/92 5 2

Supervision II 5/92 27.1 5 13.5 6/4/92 5 2

Supervision III 11/92 26.8 4 4.2 11/18/92 4 2

Supervision IV 3/93 6.5 3 3.0 4/5/93 3 2

TOTAL 63.2 20.7

Specialization1. Finance2. Commercial Banking3. Economist4. Macro Economist5. Insurance6. Training

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