THE WORLD BANK

Africa Region Financial Sector Division

Capital Market Integration in the East African Community

December 2002

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Currency Equivalents

Kenya Currency Unit = Shilling (Ksh)

US$1.00 = Ksh 78.7 (as at Sept., 2002)

Tanzania Currency Unit = Shilling (Tsh)

US$1.00 = Tsh 937.52 (as at Sept., 2002)

Uganda Currency Unit = Shilling (Ush)

US$1.00 = Ush 1799.14 (as at Sept., 2002)

Sector Manager : Gerard A. Byam, AFTFS

Program Manager: Marie-Francoise Marie-Nelly, AFRCE

Task Manager: Abayomi A. Alawode, AFTFS

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Abbreviations and Acronyms

ADR American Depository Receipt AIMS Alternative Investment Market Segment BAT British-American Tobacco BOAD Banque Ouest Africaine de Developpement BOT Bank of Tanzania CBK Central Bank of Kenya CIDA Canadian International Development Agency CIS Collective Investment Scheme CMA (K) Capital Market Authority (Kenya) CMA (U) Capital Market Authority (Uganda) CMDC Capital Market Development Committee CMSA Capital Market and Securities Authority (Tanzania) COMESA Common Market for Eastern and Southern Africa CSD Clearing, Settlement and Depository DFCU Development Finance Corporation of Uganda DSE Dar es Salaam Stock Exchange EAC East African Community EADB East African Development Bank EASRA East African Member States Securities Regulatory Authorities FIDP Financial Institutions Development Project FISMS Fixed Income Securities Market Segment GDP Gross Domestic Product HIV Human Immuno-Deficiency Virus IAS International Accounting Standards IFC International Finance Corporation IOSCO International Organization of Securities Commission IPO Initial Public Offering JSE Johannesburg Stock Exchange LSE London Stock Exchange MIMS Main Investment Market Segment MOF Ministry of Finance MOU Memorandum of Understanding NBAA National Board of Accountants and Auditors NBFI Non-Bank Financial Institutions NSE Nairobi Stock Exchange NSSF National Social Security Fund OECD Organization for Economic Cooperation and Development OTC Over-the-Counter PPF Parastatals Pension Fund RBA Retirement Benefits Authority SADC South African Development Community SEC Securities and Exchange Commission SIDA Swedish International Development Agency SME Small and Medium-Scale Enterprises SRO Self Regulatory Organization TBL Tanzanian Breweries Limited TCC Tanzanian Cigarette Company TOL Tanzanian Oxygen Limited UK United Kingdom USE Uganda Securities Exchange

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Table of Contents

Preface................................................................................................................................. 5

Executive Summary ............................................................................................................ 6

1. Introduction .................................................................................................................. 15

2. Overview of Capital Markets in the EAC .................................................................... 18

3. Macroeconomic and Policy Context ............................................................................ 20

4. Equity Markets ............................................................................................................. 24

5. Debt Markets ................................................................................................................ 31

6. Legal and Regulatory Framework................................................................................ 34

7. Capital Market Integration: Key Issues and the Road Ahead ...................................... 37

8. Summary of Recommendations ................................................................................... 51

List of Tables

Table 1: Kenya: Selected Macroeconomic Indicators (1997-2002).................................. 21 Table 2: Tanzania: Selected Macroeconomic Indicators (1997-2002) ............................. 21 Table 3: Uganda: Selected Macroeconomic Indicators (1997-2002)................................ 22 Table 4: Number of New Equity Issues in the EAC ......................................................... 25 Table 5: Foreign Investment Turnover on the Nairobi Stock Exchange........................... 30 Table 6: Domestic Government Debt in the EAC............................................................. 31

List of Boxes

Box 1: The Private Sector and Capital Market Development in the EAC........................ 26

List of Annexes

Annex 1: Ladder of Capital Market Interventions in the EAC ......................................... 55

Annex 2: Comparison of Stock Markets in the EAC........................................................ 56

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Preface

This study conducts an assessment of key issues relating to the establishment of a regional capital market in the East African Community (EAC), covering Kenya, Tanzania and Uganda. More specifically, the study pursued three main objectives:

• To assess the key characteristics and performance of capital markets in Kenya, Tanzania and Uganda, with a view to identifying current limitations.

• To assess the current EAC proposals for capital market integration and make recommendations for improvements.

• To identify the key issues involved in pursuing a regional approach to capital market development in the EAC and make appropriate recommendations for addressing them.

The analysis contained in this report is based primarily on data and other information collected during a March 2002 World Bank mission to Kenya, Tanzania, Uganda and South Africa as well as follow-up discussions and communications with key stakeholders in the four countries.

This study was conducted under the general oversight of Gerard A. Byam (Sector Manager, AFTFS) and Marie-Francoise Marie-Nelly (Program Manager, AFRCE). The report was prepared by a Bank team led by Abayomi A. Alawode (Senior Financial Economist, AFTFS) and including Tadashi Endo (Senior Financial Sector Specialist, OPD), Yongbeom Kim (Senior Financial Economist, OPD), and Cally Jordan (Senior Counsel, LEGCF). David Wilton (Manager, CFNOP, IFC) and Noritaka Akamatsu (Lead Financial Economist, OPD) served as Peer Reviewers.

The study team wishes to acknowledge the invaluable support provided by the following people: Rona Cook (Team Assistant, AFTPS), Jackie Omoke and Martha Simel (Team Assistants, IFC Office, Nairobi), Gloria Sindano and Anna Jacob (Team Assistants, World Bank Office, Dar-es-salaam), Vikki Taaka (Team Assistant, World Bank Office, Kampala), Diane Jeanes (Team Assistant, IFC Office, Johannesburg), as well as Alema Siddiky and Sibel Kulaksiz (Consultants, AFTP2).

We also express our gratitude for the excellent cooperation and warm hospitality received from numerous stakeholders in Kenya, Tanzania, Uganda and South Africa, including the EAC Secretariat, the EAC Capital Market Development Committee (CMDC), Capital Market Authorities in Kenya, Tanzania and Uganda, the respective Stock Exchanges in Nairobi, Dar-es-salaam, Kampala and Johannesburg, Central Bank of Kenya, Bank of Uganda, Bank of Tanzania, and the South African Financial Services Board, several brokers, insurance companies, pension funds, fund managers, investment advisors, accounting firms, rating agencies, the organized private sector, attorneys, venture capitalists and commercial bankers. They all gave their valuable time to the mission and contributed immensely to the successful completion of this report.

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Executive Summary

Introduction The member countries of the East African Community (EAC), Kenya, Tanzania and Uganda, have committed to the creation of an enabling environment within which the private sector can flourish and generate faster growth in individual countries. One of the pillars of this effort is the pursuit of financial development, with a view to maximizing the ability of financial sectors to mobilize resources and efficiently allocate them to the most productive sectors of the respective economies.

A major gap in the provision of financial services to the EAC private sector is the lack of long-term finance. Financial systems in the EAC are dominated by commercial banks, which typically have not been reliable sources of long-term capital. Non-bank sources of medium to long-term financing (e.g. leasing, mortgage, and contractual savings) are also underdeveloped. Hence, a principal component of financial sector development efforts in the EAC is the expansion of capital markets in the Community with the objective of developing long-term debt and equity capital for the private sector.

To date, capital markets in the region have not been able to provide effective support for the private sector because they are small, underdeveloped and have limited activity. Although there are ongoing efforts in individual countries to alter this situation and expand capital markets, all the EAC countries have recognized the limitations of a country-focused approach and have placed substantial emphasis on the pursuit of a regional approach1. It is expected that a regional market will ensure that capital markets fulfill their potential in providing long-term finance to support private sector activities in the EAC.

The broad objective of this study, therefore, is to assess the key issues relating to the adoption of a regional approach to capital market development in the EAC.

Main findings Macroeconomic environment. Although the macroeconomic environment in the EAC has improved substantially in recent years, there are some developments that might obstruct the orderly development of capital markets. Inflation is low and in single digits in all countries, a situation which is conducive to the holding of long-term financial assets. Also, Tanzania and Uganda have both recorded fairly robust economic expansion in recent years, with real GDP growth rates averaging 4.7% and 5.6% respectively over 1997-2002. In contrast, there has been poor output performance in Kenya, with GDP growth averaging 1.4% over the same period. This has dampened the demand for equities in the EAC’s biggest capital market and substantially limited its ability to be an engine of growth for the much smaller and much younger markets in Tanzania and Uganda.

Relatively high real short-term interest rates in the EAC have also reduced the demand for capital market instruments, although the situation has been reversed somewhat in Tanzania. Treasury bill (t-bill) rates in Kenya stood at 12.6% at end-2001, compared to 1 This commitment to a regional approach to capital market development is clearly spelt out in the 1999 EAC Treaty.

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an inflation rate of 3.9%, although provisional 2002 figures show a decline to 8.9% versus an inflation rate of 5%. T-bill rates in Uganda were at 11.4% in 2002, compared to a negative inflation rate of –1.8%. This situation has produced some crowding-out, with substantial domestic savings diverted into short-term government securities. A similar situation existed in Tanzania until 2001, when t-bill rates fell sharply to 4.1% and this fall has been accompanied by a marked increased in the demand for both equity and debt instruments.

Interest rate spreads are also very high in all countries, ranging from 12.6% in Tanzania and 13.6% in Kenya to 14.2% in Uganda. Such wide spreads discourage both domestic saving and investment, as surplus units consider deposit rates too low and deficit units consider lending rates too high. In all countries, domestic savings stand at less than 10% of GDP, which is too low to meet investment needs and insufficient to generate robust demand for equities and debt instruments.

Policy framework. The policy framework in the EAC is broadly conducive to capital market development and there is a strong commitment to the promotion of capital markets by the respective authorities. This commitment is reflected in a wide range of fiscal and other incentives put in place to encourage capital market activities. For instance, issuing costs are tax-deductible in all countries and withholding tax on dividends are relatively low at 5% in Tanzania, 7.5% in Kenya (10% for foreigners) but still relatively high at 15% in Uganda. The trend in Kenya and Tanzania is particularly welcome as withholding taxes also used to be in double digits in both countries. A recent idea introduced in Kenya is the granting of a tax amnesty, forgiving past evasions of tax for companies interested in listing on the stock exchange. In addition, all EAC governments place a high priority on achieving wider ownership through privatization of public enterprises and have therefore implemented privatization policies through the capital market. Privatization has thus turned out to be a key source of new listings for the respective stock exchanges.

Policies towards foreign investors are currently different but full harmonization is expected soon. While Uganda has no restrictions on foreign investment in her capital market, Kenya and Tanzania currently maintain restrictions on foreign investors, although the Tanzanian authorities have decided to open up the Dar es Salaam Stock Exchange to foreign investors and have also announced a June 2003 date for the full liberalization of capital flows.

Equity markets. The private sector in the EAC has not made significant use of the equity market as a source of financing. The supply of new equities into the capital market is thin and privatizations have accounted for the bulk of new issues in recent years. In Kenya, which is the oldest and most active market, there have been a total of 12 new issues since 1997, with only 3 issues recorded for 2000 and 2001 respectively. Not surprisingly, the supply situation is worse in Tanzania and Uganda where the markets are much younger with less awareness of the benefits (and costs) of issuing equity. In the two countries combined, there have been only 7 equities issued to date and most firms still rely substantially on bank financing. Major factors limiting the supply of equities include: i) the reluctance of many small, family-owned businesses to dilute ownership; ii) the tedious and costly process of making public offers; and iii) the generally underdeveloped state of the private sector in the region.

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Consequently, equity markets in the EAC are small, with capitalization-GDP ratios standing at 12%, 4.6% and 3.4% in Kenya, Tanzania and Uganda respectively. While Kenya has the biggest market with 53 companies listed, Tanzania and Uganda have listed 4 and 3 companies respectively. The markets are also illiquid as evidenced by turnover ratios of less than 5% in the three countries. Out of the 53 equities listed in Nairobi, only about 15 are regularly traded and the most actively traded stock on the Uganda Securities Exchange (USE) records an average of only 2 trades per month.

Factors accounting for the low turnover ratios include the limited floatation of shares and relatively high transaction costs. In Tanzania, only 34% of total market capitalization is available for trading and the largest company on the Dar es Salaam Stock Exchange (DSE), Tanzania Breweries, has only 7% of its shares on the market, with the rest held by controlling shareholders. The situation is similar in Kenya and Uganda where about 35% and 30% of market capitalization is available for trading respectively. In all three countries, transaction costs range from 2-4% of the consideration and fixed commissions are the norm in Tanzania and Uganda. Kenya permitted negotiable commissions from April 2002. Liquidity is also limited by the high incidence of “buy-and-hold”, especially among institutional investors who dominate the three markets.

With the demand of individuals for equities limited by low income levels, pension funds are quite dominant in the three markets. Pension reforms in Kenya, including the creation of the Retirement Benefits Authority (RBA) as the oversight body and the mandatory professional management of pension funds have boosted the demand for equities. As at March 2002, over 60% of equities in Kenya was held by pension funds. Although neither Tanzania nor Uganda has undergone pension reform, pensions also loom large in these small markets.

The insurance industry is underdeveloped and has played a relatively smaller role in the capital markets. Premium income account for less than 2% of GDP in each EAC country. In addition, insurance in the three countries is dominated by non-life companies, whose liabilities are short-term and not suitable for investment in the capital market. Most of their reserves therefore go into short-term government securities and bank deposits. In addition, the life insurance business has become unattractive due to the high rate of HIV infection in the region. The few life insurance companies that continue to be active deploy most of their reserves into real estate, treasury bills and short-term bank deposits.

Foreign investors are de facto substantial holders of equities in the three markets if we consider that a host of listed companies with relatively large market capitalization are strategically owned or controlled by foreign companies. However, only Kenya has been able to attract significant amounts of foreign portfolio investment, although this trend has been reversed in the last two years due to political and economic uncertainties.

Market infrastructure (trading, clearing, settlement and depository systems) are quite rudimentary in the three countries but efforts are underway to remedy this situation. Kenya is in the process of developing an automated trading, clearing, settlement and depository system (CSD) which will serve the entire EAC region. Both the Uganda Stock Exchange (USE) and the DSE plan to take minority stakes in the CSD system.

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Debt markets. The debt markets in the EAC are underdeveloped and dominated by government bonds. The corporate bond segment boasts only 7 issues in total (5 in Kenya and 1 each in Tanzania and Uganda). While recent efforts to restructure internal government debt has resulted in the issue of longer-term treasury bonds in both Kenya and Tanzania, the Ugandan government has no plans to issue bonds as it enjoys substantial budget support from various bilateral donors. Indeed, treasury bill issues in Uganda are mainly used for monetary policy purposes. In general, there is very little trading on the bond markets in Kenya and Tanzania, as existing government and corporate bonds are held mainly by institutional investors who exhibit a distinct buy-and-hold strategy. The Kenyan debt market has however seen an increase in turnover in the past year.

The development of a corporate bond market has been hampered by the lack of suitable benchmarks for pricing but this situation is beginning to change as more treasury bonds come onto the market. The absence of rating agencies has also been an obstacle but CMA (Kenya) recently accredited Duff and Phelps (South Africa) to offer rating services.

Legal and regulatory framework. Although EAC capital markets as well as their regulatory regimes are at different stages of development, the legal and regulatory framework in place in individual countries is reasonably sound and could serve as a basis for developing a regional market. The fact that the three countries share a common legal tradition is a bonus for the pursuit of a regional approach, as their laws and legal institutions are informed by the same basic legal concepts and are readily compatible with one another. They all have the same official legal language (English) and can easily draw on experience in other Commonwealth jurisdictions. This common heritage has helped in the ongoing process of fashioning a legal and regulatory foundation for a regional capital market.

As directed in Articles 85 and 86 of the 1999 EAC Treaty, efforts are currently underway to harmonize securities rules and regulations in the three countries. The EAC’s Capital Market Development Committee (CMDC) has now developed a comparative position on the various aspects of regulation and legislation in the three markets and has subsequently identified areas of divergence that requires harmonization. This is a difficult and time-consuming exercise. Moreover, once completed, harmonization requires constant maintenance as well, given that legal systems are dynamic and continue to change over time. As an alternative to the harmonization of regulations, this report suggests that the EAC countries consider adopting principles of mutual recognition. Mutual recognition occurs when “Jurisdiction A” recognizes compliance with the regulatory regime in “Jurisdiction B” as sufficient to constitute compliance its own territory. Although mutual recognition does require a certain degree of harmonization, the underlying regulatory regimes and institutions only need to be comparable but not necessarily identical. The EAC members should therefore assess whether they have reached a sufficient level of confidence in each other’s regulatory processes in order to recognize and rely on them in their own jurisdiction.

There is a need to streamline regulations in a few areas in order to avoid unnecessary constraints on market development. While it is welcome that the various regulators are making vigorous efforts to adhere to international regulatory standards, it should be recognized that the current stage of market development may call for a lighter touch.

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One notable example that should be reconsidered by the regulators include the current requirement for a minimum of 1000 shareholders to qualify for listing, which effectively eliminates majority of indigenous business enterprises. As a result of stringent listing requirements, most of the firms on the main board tend to be multinationals or privatized state enterprises. There is thus an urgent need to simplify and ease entry conditions into the capital market without compromising investor protection. Another area that merits reconsideration is the requirement for issuers of commercial paper to prepare a full prospectus.

Further, the interaction of old Companies’ Ordinances (a legacy of the British Colonial experience), with more modern capital market regulations is creating problems for capital market activities in the EAC. Old-fashioned UK companies law, currently in use by the three countries, is complicated, cumbersome, inconsistent and at odds with modern “enabling” regulation of corporations. In adopting modern capital market regulatory regimes, another layer of complexity and compliance is added to an already burdensome structure, leading to multiple disclosure requirements, overlap and expensive duplication.

Finally, it is also desirable to liberalize financial services and allow various market intermediaries and other financial institutions to provide cross-border services using licenses obtained from their domiciliary regulators. This will facilitate substantially the process of integrating capital market transactions across the region.

Capital market integration. There is a high level of enthusiasm and commitment among some stakeholders for a regional capital market in the EAC. However, while there is undoubtedly strong commitment and cooperation among stock exchanges and regulators, the degree of enthusiasm appears much lower among private sector-issuers, investors and capital market intermediaries, mainly due to a lack of information and inadequate efforts to educate and include them in the pursuit of this agenda.

The implications of this situation are two-fold: First, unless these key stakeholders are somewhat carried along, cross-border trading and other potential gains of integration may not materialize. Second, there is no conscious evaluation of how key intermediaries will function in an integrated regional market. Since regional integration is likely to produce “winners” as well as “losers”, there is a risk that further down the integration road, certain interest groups will oppose the initiative because they perceive the costs of integration to be higher than the potential benefits.

The realistic fact is that even a regional EAC market will continue to be small in the short-to-medium term and would benefit from linkages with other markets that are experiencing more rapid growth. Consideration could be given to leveraging a regional market further through linkages with more developed markets, both in Africa and beyond. A possibility in this regard is the Johannesburg Stock Exchange.

All the good intentions and hard efforts notwithstanding, regional integration is expected to be a relatively slow process in the foreseeable future. There are enormous challenges and obstacles facing capital market development in individual countries which might make the pursuit of integration meaningless. It should be realized at this stage that regional integration will not yield the expected benefits unless parallel steps are taken to develop markets at the country level and closely link regional market integration with national market development. Regional integration will not magically solve all the

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problems facing individual capital markets in the region and country-level interventions will still be crucial.

In going forward, the regional initiative can actually draw strength from the diversity observed in the three countries and capitalize on complementarities. Kenya has by far the largest pool of potential demand for securities and the most advanced financial services industry among the EAC countries. However, amid the economic gloom since 1997, Kenya is expected to remain weak on the supply-side until investor confidence in the country’s economy is restored. On the other hand, Tanzania and Uganda have recorded better economic performance. They are thus more likely to do better on the supply side. However, both countries have nascent financial services and have a much smaller institutional investor base than Kenya. Against this backdrop of imbalance between supply and demand at national levels, regional integration could equalize supply and demand across the region, with pension funds in Kenya providing the demand for securities issued in Tanzania and Uganda. Regional capital market activities could also make use of Kenya’s relatively more advanced financial services industry.

Finally, the EAC countries could consider the use of “variable geometry” whereby initiatives are linked in the three countries but any country that wishes to proceed more quickly on certain fronts or take a different route to reforms is welcome to do so. Member countries should however be careful not to use “variable geometry” as an excuse to undermine regional cooperation efforts. Main recommendations

Immediate Priorities

Macroeconomic environment • It is critical to maintain macroeconomic stability, especially by keeping inflation

in single digits. • There is also a need to improve fiscal discipline in order to lower interest rates

and reduce crowding out.

Policy framework • It is crucial to continue the present level of commitment to the overall integration

agenda in the EAC. This offers a vital umbrella under which the pursuit of regional capital market integration can take place.

• The commitment to privatizing state enterprises through the capital market is welcome and should be maintained, but the market should not become a dumping ground for weak and non-performing public enterprises.

• Fiscal incentives to promote the capital market should be used with careful consideration for the potential impact on government finances.

Supply of securities • Privatization of state enterprises offers the most viable source of equities in the

EAC and efforts should be made to privatize the large state owned enterprises as soon as possible.

• Efforts should also be made to remove obstacles to the listing of small and medium size enterprises (SMEs). For instance, consideration could be given to reducing the required minimum number of shareholders for listing SMEs.

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• Representatives from CMDC need to become involved in the preparation of the regional private sector strategy as one main purpose of the capital market is to meet the financing needs of business enterprises.

• As the markets develop further, consideration could be given to developing new financial instruments such as asset-backed securities.

Market development • The authorities in Tanzania and Uganda could also consider making commissions

negotiable as is the case in Kenya in order to improve market liquidity. • In the short-run, credit enhancements and guarantees could be used to make bond

issues more attractive, thus promoting the development of the debt markets.

Stakeholder involvement • There is a need to disseminate information on regional integration of capital

markets more widely among key stakeholders in order to build a broad-based support for the integration agenda.

• In this vein, the CMDC should consider enlarging its membership to include representatives of the organized private sector (chambers of commerce, manufacturing associations) as well as financial intermediaries and institutional investors.

• Consideration could also be given to establishing a web-site for the purpose of informing the public about various activities relating to capital market integration in the EAC.

Medium-Term Priorities

Macroeconomic environment • Efforts should be made to continue and sustain the ongoing program to restructure

government finances and lengthen the maturity of government debt in Kenya and Tanzania.

• The problem of wide interest spreads requires attention, particularly by addressing some of the underlying causes, such as heavy short-term government borrowing and the poor payments infrastructure.

Policy framework • Fiscal incentives should be aligned as much as possible. For instance, Uganda

could consider reducing the level of withholding taxes on dividends to match the levels in Kenya and Tanzania.

• In order to maximize the gains from cross-listing and promote cross-border trading, free flow of capital across borders is essential.

Legal and regulatory framework • Although a certain degree of harmonization of rules and regulation is necessary

for regional integration, full harmonization is not a feasible objective. An easier and more pragmatic alternative is for the regulatory authorities to adopt principles of mutual recognition, especially where full harmonization proves too costly and time-consuming.

• It is desirable to liberalize financial services and allow various market intermediaries and other financial institutions to provide cross-border services using licenses obtained from their domiciliary regulators.

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• It is important for securities regulators to ensure that the rule-making process is inclusive and transparent, in particular allowing an exposure period and inviting comments from stakeholders.

• Regulators should consider minimizing multiple prospectus filings. • There is an urgent need to modernize Companies’ law in Uganda and Kenya and

eliminate current problems of duplication and overlap with securities regulations. • The authorities should consider the creation of a “close corporation” statute as a

vehicle for establishing business enterprises.

Demand for securities • It is important to promote the development of Collective Investment Schemes

(CIS) as a means of aggregating the demand of individuals for securities • There should be efforts to consolidate current programs on investor education and

public awareness at the country level and harmonize them at a regional level • It is desirable to pursue pension reform in Tanzania and Uganda as this will be

critical in unlocking substantial amounts of domestic savings and making this available for capital market development.

• The development of the life-insurance industry should also be pursued as it is also important in generating long-term funds for investment in the capital market.

• The authorities should allow institutional and other investors to buy securities in other EAC markets. This will require that EAC investors be treated as nationals in all three countries, both in the purchase of securities and in the taxation of investment income.

Supply of securities • A viable private sector is critical to capital market development. It is therefore

important to remove current obstacles to private sector activity in the EAC. The Regional Private Sector Development Strategy presently under preparation offers an opportunity to devise a coherent approach to making the private sector viable.

• The CMDC should compile a list of potential issuers of both equity and debt in all countries and initiate contact with individual firms to educate and improve the awareness of potential issuers about the benefits and relevance of capital markets to their operations.

• Listing requirements need to be streamlined and relaxed to fit the structure and particular characteristics of business enterprises in the EAC.

• It is also important to streamline public offering procedures, disclosure obligations and limit the number of market agents involved in the issuing process.

Market development • The current stage of market development requires that authorities consider

encouraging the emergence and growth of over-the-counter markets and venture capital funds

• Bond market development deserves urgent attention. It should however be noted that developing bond markets will require continued macroeconomic stability.

• Current efforts aimed at lengthening the maturity of government debt should continue. This is desirable not only in terms of the benefits for government finances but also in terms of providing a benchmark for corporate bonds.

• Developing credit rating systems is vital to the emergence of vibrant corporate bond markets.

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• Improving liquidity on the markets will require the modernization of trading systems and reduction in transaction costs.

• There is a need to develop investment banking and underwriting in Tanzania and Uganda in order to further strengthen the institutional framework for capital market activities.

Market infrastructure • The proposed CSD system currently focuses on broker-exchange-depository

linkages but should also consider broker-customer linkages as well as a virtual communication network among the three exchanges.

• Consideration should be given to linking payment systems in the EAC to the CSD system to form an integrated payment, clearing and settlement framework.

Market linkages • Consideration should be given to leveraging the markets in East Africa by linking

a regional EAC market to more developed markets in Africa or beyond. • The African Stock Exchanges Association (ASEA) could be used as a platform

for such linkages.

The road ahead • The success of regional integration will depend on finding solutions to key

country-level problems. It is therefore important to closely link regional market integration to local efforts to develop individual capital markets.

• Consistent and assured political backing of the EAC authorities will be crucial for capital market integration to materialize.

• The observed diversity in the three countries could be a source of regional strength as they can capitalize on complementarities.

• Consideration should be given to the idea of “variable geometry” whereby reforms at the country-level are closely linked but not beholden to regional integration efforts.

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1. Introduction

Background The East African Community (EAC), covering Kenya, Tanzania and Uganda, was established under the Treaty for the Establishment of the East African Community, signed by the three member governments in November 1999. Formally launched in January 2001, the EAC succeeded the East African Cooperation, set up in 1996 to revive regional cooperation which had ended following the 1977 collapse of the original East African Community. The East African Cooperation was responsible for developing an East African Cooperation Development Strategy (1997-2000), which contained the broad policy framework for regional cooperation and integration and eventually formed the basis for the 1999 EAC Treaty.

The East African Cooperation Development Strategy (1997-2000) was followed by the Second EAC Development Strategy (2001-2005), which sets out an action plan for achieving regional integration in the EAC. The broad objective of the action plan was to propose ways and means of widening and deepening cooperation in several spheres, including political, economic, social and cultural fields, research and technology, defense, security, as well as legal and judicial affairs. The declared vision for regional integration is to create wealth and enhance competitiveness through increased production, trade and investment in the region. This is seen as an obvious response if the three countries are to sustain economic viability in an environment of rapid globalization where economies of scale is key to achieving international competitiveness.

One of the main objectives of the Second EAC Development Strategy is the promotion of faster, private sector-led growth. This approach requires the creation of an enabling environment within which the private sector can flourish, including measures to improve the access of the private sector to a broad range of financial services, such as bank credit, equity capital, payments and risk management services. The EAC member countries have therefore committed to a vigorous pursuit of financial sector development, with efforts directed towards reforming and deepening financial systems, so as to improve their ability to mobilize resources and efficiently allocate them to the most productive sectors of the economy.

A principal component of financial sector development efforts is the expansion of capital markets in the Community. Capital markets are important for mobilizing medium and long-term funds for productive investment and could significantly contribute to meeting the fixed-capital needs of the private sector in the EAC. Today, financial systems in the EAC are dominated by commercial banks, which have not been reliable sources of long-term capital. Non-bank sources of medium to long-term financing (e.g. leasing, mortgage, and contractual savings) are also still underdeveloped2. An active, efficient and effective capital market will therefore help mobilize and allocate long-term finance, widen the array of financial instruments available to savers and investors, as well as increase diversity and competition in the EAC financial systems.

2 The East African Development Bank (EADB) stands out as a key source of long-term funds in the EAC.

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Developing capital markets is also important for responsible fiscal policy in the EAC, especially with the increasing attention being paid to debt management issues in recent years. There is a growing desire to promote the development of domestic government bond markets and reduce the customary inflationary financing of government deficits through recourse to the central bank and the banking system.

Rationale for a regional approach Unfortunately, capital markets in the EAC are underdeveloped with limited activity. This has constrained their ability to contribute maximally to the mobilization and allocation of long-term financial resources. The EAC has consequently recognized the limitations of a country-focused approach to developing capital markets and has placed substantial emphasis on the pursuit of a regional approach3. The expectations are that a regional approach will: i) create the much-needed critical mass of demand and supply larger than can ever be achieved in individual countries; ii) enhance competition in the securities industry and lower transaction costs; iii) provide a framework for sharing information, expertise and experiences; and iv) provide a viable platform for linkages with more developed markets, both within Africa and beyond. Regional integration will therefore offer a better chance for the EAC capital markets to fulfill their potential as providers of long-term finance to the private sector in East Africa.

The regional capital market initiative began in 1997, with the formation of the East African Member States Securities Regulatory Authorities (EASRA), comprising of capital market regulators from the member countries. EASRA members signed a Memorandum of Understanding (MOU), adopting a regional approach to developing capital markets in East Africa and the contents of this MOU became an integral part of the 1999 EAC Treaty. Inter alia, the treaty provides for the following:

• The harmonization of capital market policies

• The harmonization of regulatory and legislative frameworks governing capital markets

• The promotion of cooperation among the three exchanges and the regulators.

• The promotion of cross-border listing and trading of securities

• The development of a regional rating system for securities.

The Second EAC Development Strategy (2001-2005) therefore includes capital market development as one of the key areas of cooperation for the member countries. The declared ultimate objective is the establishment of an East African Stock Exchange, although in the early stages, the plan is to focus attention on harmonizing capital market policies, promoting cooperation among the stock exchanges and securities regulators, promoting cross-listing of shares and developing a rating system for securities.

In August 2000, Ministers of Finance in the EAC Member states decided to establish a Capital Markets Development Committee (CMDC)4. The CMDC began operations in April 2001 and consists of the Chief Executive Officers (CEOs) of the capital market

3 There exists an historical precedent to this position. Between 1955 and 1977, the Nairobi Stock Exchange functioned as a regional market serving all three EAC countries. 4 EASRA was subsequently transformed into the EASRAF, a Forum for the EAC capital market regulators.

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regulatory authorities in the member countries, the CEOs of the stock exchanges, and the chairpersons of the respective Associations of Stockbrokers. There are also provisions for any other member that may be co-opted to represent special interests such as listed companies, shareholders/investors, and the organized private sector.

The CMDC now shoulders the responsibility of establishing a regional capital market for the EAC and under its umbrella, there are three technical sub-committees exploring various issues relating to the integration of capital markets:

• The legal issues sub-committee is charged with the harmonization of market rules and regulations in the three countries

• The disclosure, financial and accounting standards sub-committee focuses on developing regional standards of disclosure and financial reporting

• The market development sub-committee is responsible for general market development, including the development and integration of market infrastructure (trading, clearing, settlement and depository systems) as well as general policy and incentive issues.

As an EAC Sectoral Committee, the CMDC reports to the EAC Council at least once a year and makes recommendations and proposals on capital market development for the consideration of the Council. The CMDC has made satisfactory progress on several fronts in carrying forward the integration agenda:

• Legal and regulatory framework: The CMDC has developed a comparative position on the various aspects of regulation and legislation in the three markets and has identified areas of divergence that requires harmonization.

• Disclosure standards: A framework developed by the Kenyan Capital Market Authority [CMA (K)] has been recommended for adoption in the EAC with appropriate modifications in individual jurisdictions.

• Market infrastructure: Agreement has been reached on the need for a common set of parameters for trading, clearing, settlement and depository systems to facilitate remote linkages and “virtual” integration of the three markets.

• Public education and professional certification: Agreement has been reached on developing a public education campaign through the mass media and creating a certification program for market professionals.

• Credit Rating: Guidelines developed by CMA (K) for the establishment and operation of credit rating agencies have been adopted by all countries.

Objectives of the study Following from above, the general objective of this study is to conduct an assessment of key issues relating to the establishment of a regional capital market in the EAC. The study also provides a systematic analytical review of ongoing EAC/CMDC efforts towards closer collaboration among the three capital markets and the eventual establishment of a Regional Capital Market. More specifically, the study pursues the following key objectives:

• To assess the key characteristics and performance of capital markets in Kenya, Tanzania and Uganda, with a view to identifying current limitations.

• To assess the current EAC proposals for capital market integration and make recommendations for improvements.

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• To identify the key issues involved in pursuing of a regional approach to capital market development in the EAC and make appropriate recommendations for addressing them.

Plan of the Study The rest of this report is organized as follows: Section 2 provides a brief overview of capital markets in Kenya, Tanzania and Uganda, with a focus on the size, institutional structure, as well as instruments issued and traded in these markets. Section 3 establishes the macroeconomic and policy context within which these markets operate, while Sections 4 and 5 provide details of activities in the equity and debt markets respectively. Section 6 covers the legal and regulatory framework underpinning capital market operations in individual member countries while Section 7 directly addresses the subject of market integration, focusing on the key issues involved in pursuing a regional agenda. Section 8 summarizes the key recommendations.

2. Overview of Capital Markets in the EAC

Kenya The Nairobi Stock Exchange (NSE), established in 1954, is the oldest and largest capital market in the EAC. As at end-2001, the NSE had 53 equities and 64 bonds listed, including 60 Kenyan Government Treasury bonds (15 floating rate and 11 fixed rate, 4 discounted fixed coupon rate and 30 special issues), 2 bonds issued by the East African Development Bank (EADB) and 2 corporate bonds issued by Shelter Afrique and Safaricom respectively. Market capitalization stood at Ksh 86 billion, representing 12% of GDP. The market exhibits a high degree of concentration, with the top 10 companies accounting for 67% of total market capitalization.

The NSE is organized into three trading boards: i) Main Investments Market Segment (MIMS), with 43 companies listed as at end-2001; ii) the Alternative Investments Market Segment (AIMS), with 10 firms; and iii) the Fixed Income Securities Market Segment (FISMS), with 64 listings5. In 1991, the NSE introduced a floor-based “open-outcry” system for trading securities, replacing the old “call over” trading system.

Key players on the market include the Capital Markets Authority, CMA (K), established in 1990 as the regulatory and supervisory authority for the market, 18 brokers, 1 securities dealer and 29 investment advisers/fund managers. There are also 5 authorized depositories and 12 registrars6. 2 investment banks and 2 collective investments schemes were recently licensed.

Although it represents over 90% of market activity in the EAC, the NSE has entered a state of decline in recent years. The poor performance of the Kenyan economy has resulted in low corporate earnings and losses by listed companies which has in turn dampened the demand for securities. The market has also suffered from several de-listings with 4 more companies de-listed in January 2002.7 As a result of these adverse

5 Many of the listings in the fixed income market segment are preference shares 6 Many of the registrars are banks, with Barclays bank the dominant registrar. 7 Theta Group, Regent Undervalued Asset Africa Fund, Pearl Drycleaners, and Lonrho Motors E.A. Ltd.

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events, market capitalization has nose-dived from a high of 43% of GDP in 1994 to the current 12% of GDP.8 The market is also relatively illiquid, with a turnover ratio of 3%.

Tanzania The Dar es Salaam Stock Exchange (DSE) was established in 1996 but only began full operations in 1998. Its establishment was driven primarily by the need for a mechanism to implement the government’s privatization program. As at end-2001, the DSE had only 4 equities and one bond listed9. Market capitalization stood at about Tsh 365 billion, representing 4.6% of GDP. There is also a high degree of concentration with the two largest listed companies—Tanzania Breweries Ltd. (TBL) and Tanzania Cigarette Company Ltd. (TCC)—accounting for 95% of total market capitalization.

The market is organized into three components: i) the first-list market; ii) the second-list market; and iii) the over-the-counter (OTC) list. The regulatory body for the market is the Capital Market and Securities Authority (CMSA), established in 1994. The CMSA predated the DSE and was instrumental in establishing the exchange. Other key players in the Tanzanian market include 6 broker-dealers, and 7 fund managers/investment advisors. There are no investment banks/underwriters in Tanzania and Collective Investment Schemes are also absent.

Market capitalization has been increasing due to increases in the share prices of the two largest companies (TBL and TCC), whose market capitalization has more than doubled in the past year. The market is however illiquid with a turnover ratio of less than 1% and block trades account for a substantial portion of transactions.

Uganda The Uganda Securities Exchange (USE) was set up in 1997 and presently has 5 equities and one bond listed, with a market capitalization of about Ush 340 billion (3.4% of GDP). In addition, the shares of two Kenyan companies (Kenya Airways and East African Breweries) are cross-listed on the USE10. The market is divided into three segments: i) Major Investment Market Segment (MIMS) for large companies with 3 stocks listed; ii) the Alternative Investment Market Segment (AIMS) for smaller companies (no listings at present); and iii) the Fixed Income Securities Market Segment (FISMS) with one bond currently listed. The regulatory authority for the market is the Uganda Capital Markets Authority, CMA (U), established in 1996. Like in Tanzania, the CMA predated the USE and was also instrumental in establishing a capital market in Uganda. Other participants in the market include 6 broker-dealers and 12 investment advisers/fund managers. There are no investment banks/underwriters in Uganda and Collective Investment Schemes are absent11.

8 In 1994, the IFC rated the NSE as one of the best performing emerging markets. 9 Three of the companies were listed as part of the privatization exercise. The Tanzanian government is also planning to list treasury bonds on the DSE. 10 Capital controls in Tanzania currently precludes cross-listing on the DSE. 11 The CIS Law was passed in September 2002.

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3. Macroeconomic and Policy Context

Macroeconomic performance A look at the macroeconomic environment in the EAC countries reveals a mixed picture, with satisfactory performance on some indicators tempered with worrying trends in others, significant enough to obstruct the orderly development of capital markets in the region. Tables 1-3 below present the macroeconomic situation in the three countries for the period 1997-2002.

GDP growth: Output performance among the EAC countries has been uneven. While the Kenyan economy has struggled in recent years, with negative growth in 2000 and a low average growth rate of 1.4% over 1997-2002, Tanzania and Uganda have registered robust expansions in output, with real GDP growth averaging 4.7% and 5.6% respectively. The poor output performance in Kenya is traceable to a variety of factors including low investment, high real interest rates and the political uncertainties which have disrupted economic activity in recent years.

The slow growth in Kenya plus the associated losses and low profits by listed companies have had a substantial negative impact on the demand for equities. Foreign capital inflows, which were substantial in 1997 and 1998 have been rapidly reversed and many firms have cancelled investment plans, reducing the overall demand for long-term capital.

Solid growth performance in Uganda was driven by the end of civil strife and the successful implementation of structural reforms. Short-term increases in international coffee prices also helped. Tanzania’s similarly strong expansion was also driven by economic reforms, including the privatization of ailing parastatals. Reasonable price stability has also been established and there have been substantial inflows of foreign direct investment. As a result, there is healthy demand for securities in Tanzania and Uganda, which is circumscribed only by the limited availability of securities.

Inflation: The EAC countries have been remarkably successful in combating inflation and improving the operating environment for financial institutions and markets. In all three countries, inflation has been in single digits for the past three years. Uganda actually witnessed negative inflation in 1998, with the Consumer Price Index changing by –1.4% and provisional figures for 2002 also indicate negative inflation of –1.8%. High interest rates have contributed to the Ugandan success in fighting inflation. Although inflation has been somewhat higher in Tanzania (averaging 8.7% over 1997-2002), it has also fallen from a high of 16% in 1997 to stand at an estimated 4.5% in 2002. Latest figures from Kenya show an inflation rate of 5% relative to the 11.2% recorded for 1997 and it has succeeded in holding inflation below 10% for the past three years, due mainly to tight monetary policy, a stable exchange rate and the decline in international oil prices.

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Table 1: Kenya: Selected Macroeconomic Indicators (1997-2002)

1997 1998 1999 2000 2001 2002*Real GDP growth (%) 2.3 1.8 1.4 -0.3 1.2 1.8Inflation rate (%)(CPI; end of period) 11.2 6.6 3.5 6.2 3.9 5Overall fiscal balance (% of GDP) -0.8 -1.6 0.5 1 -2.1 -2.4Gross Domestic Savings (% of GDP) 10.5 9.8 10.8 7.9 4.1 4.2Gross Domestic Investment (% of GDP) 18.5 17.4 16.2 15.6 13.4 14.8Resource balance (% of GDP) -8 -7.6 -5.4 -7.7 -9.3 -10.6Treasury bill rates (%) 22.9 22.8 13.9 12.1 12.6 8.9Lending rates (%) 30.3 29.5 22.4 22.3 19.7 18.3Deposit rates (%) 16.7 18.4 9.5 8.1 6.6 4.7Spread (%) 13.6 11.1 12.9 14.2 13.1 13.6Current account balance (% of GDP) -4.4 -4.9 -2.2 -3 -3.2 -2.9International Reserves (months of imports) 3 2.8 2.6 3 3.6 3.5Average Market Exchange Rate (Ksh/$) 58.8 60.4 70.3 76.2 78.6 82.9*2002 numbers are provisionalSources: Central Bank of Kenya; IMF; and World Bank Development Indicators

Table 2: Tanzania: Selected Macroeconomic Indicators (1997-2002)

1997 1998 1999 2000 2001 2002*Real GDP growth (%) 3.3 4 4.7 4.9 5.6 5.8Inflation rate (%)(CPI; end of period) 16.1 12.8 7.9 5.9 5.2 4.5Overall fiscal balance (% of GDP) -2.8 -2.4 -4 -5.7 -4.3 -5.7Gross Domestic Savings (% of GDP) 6 5.4 3.4 9.2 6.8 6.2Gross Domestic Investment (% of GDP) 14.7 16 15.5 17.7 15.9 17.4Resource balance (% of GDP) -8.7 -10.6 -12.1 -8.5 -9.1 -11.2Treasury bill rates (%) 9.6 11.8 10.1 9.8 4.1 4.4Lending rates(%) 26.3 22.9 21.9 21.6 20.3 15.7Deposit rates (%) 7.8 7.8 7.8 7.4 4.81 3.1Spread(%) 18.5 15.1 14.1 14.2 15.49 12.6Current account balance (% of GDP) -6.2 -9.17 -5.1 -1.6 -1.6 -7.9International Reserves (months of imports) 4.1 3.3 4.4 6 5.5 8Average Market Exchange Rate (Tsh/$) 612.1 664.7 744.8 800.4 876.41 969.9*2002 numbers are provisionalSources: Bank of Tanzania; IMF; and World Bank Development Indicators

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Table 3: Uganda: Selected Macroeconomic Indicators (1997-2002)

1997 1998 1999 2000 2001 2002*Real GDP growth (%) 5.1 4.6 7.6 4.9 5.1 6.3Inflation rate (%)(CPI; end of period) 10.4 -1.4 5.3 1.9 2.4 -1.8Overall fiscal balance (% of GDP) -5.8 -5.6 -5.9 -12.1 -9.1 -11.7Overall fiscal balance (including grants) -1.4 -0.4 -1.2 -6.6 n.a. -4.2Gross Domestic Savings (% of GDP) 8 5.6 4.9 1.6 3.1 5.1Gross Domestic Investment (% of GDP) 16.3 15.1 16.4 19.6 19.9 20.1Resource balance (% of GDP) -8.3 -9.5 -11.5 -18 -16.8 -15Treasury bill rates(%) 10.6 7.8 7.4 13.2 11 11.4Lending rates(%) 21.4 20.9 21.5 22.9 22.7 n.a.Deposit rates (%) 11.8 11.4 8.7 9.8 8.5 n.a.Spread(%) 9.6 9.5 12.8 13.1 14.2 n.a.Current account balance (% of GDP) -3.9 -5.3 -9.1 -10.9 -15.3 -9.3International Reserves (months of imports) 4.5 4.8 4.9 5 4.6 5.5Average Market Exchange Rate (Tsh/$) 1083 1240.3 1454.8 1644.5 1755.7 1797.2*2002 numbers are provisionalSources: Bank of Uganda; IMF; and World Bank Development Indicators

Government finances: While Tanzania and Uganda exhibit growing fiscal deficits, government finances in Kenya recorded surpluses in 1999 and 2000 and before then, the observed deficits were small. Deficits amounting to 2.1% of GDP and 2.4% of GDP however reappeared in 2001 and 2002 respectively. Uganda has a high level of dependence on donors for budget support and this is revealed by comparing different measures of its fiscal deficits. In 2000, the fiscal deficit stood at 6.6% of GDP (including grants), but balloons to 12.1% of GDP if grants are excluded. Deficits without grants averaged 8.4% of GDP over 1997-2002, compared to an average of 3% of GDP if we factor in donor support. Fiscal deficits in Tanzania stood at 5.7% of GDP in 2002, compared to 2.8% of GDP in 1997. Tanzanian deficits averaged 4.2% over the entire period under consideration.

Interest rates: One feature that is common to both Kenya and Uganda is the high level of nominal and real treasury bill rates, which has reduced the demand for capital market instruments. In Kenya, nominal t-bill rates stood at 12.6% at end-2001, compared to an inflation rate of 3.9%. T-bill rates in Uganda were at 11%, compared to an inflation rate of 2.4%. High t-bill rates in Uganda have been attributed to the change in the monetary instrument mix in favor of treasury bills. This situation has diverted domestic savings into short-term government securities which are substantially more attractive than private securities in terms of both risk and return. The government has therefore become the principal user of domestic savings in both Kenya and Uganda. A similar situation existed in Tanzania until 2001, when t-bill rates fell sharply to 4.4%, (due to excess liquidity), leading to an increased demand for equity and other investment vehicles.

Interest rate spreads are also high in all countries, standing at 12.6% in Tanzania, 13.6% in Kenya, and 14.2% in Uganda. Such wide spreads discourage both domestic saving and investment, as savers consider deposit rates too low and borrowers consider lending rates too high. In all three countries, domestic savings stand at less than 10% of GDP, which is too low to meet investment needs.

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External developments: All the EAC countries are experiencing varying degrees of pressure on their external positions, with Uganda in the worst position. In 2001, Uganda’s current account deficit was a massive 15.3% of GDP. Comparable figures for Kenya and Tanzania were 3.2% and 1.6% respectively. Both Kenya and Uganda have suffered from recent falls in tea and coffee prices as well as the impact of drought on coffee production. Uganda’s shock has been much more severe due to the additional negative impact of the coffee wilt disease12. The three countries exhibit substantial vulnerabilities to adverse movements in terms of trade due to their dependence on primary commodities for export earnings and exposure to increases in import bills due to changes in international oil prices. They however still show reasonable levels of external reserves ranging from 3.6 months worth of imports in Kenya, to 5 months of imports in Uganda and 8 months of imports in Tanzania. All three countries experienced depreciation of their local currencies against the dollar throughout the period under consideration.

Policy framework The current policy framework in the EAC is conducive to capital market development, although there is still room for improvement. In all countries, there is a clear and strong commitment on the part of the authorities to promoting capital market development as evidenced by a range of fiscal and other incentives supportive of capital market activities.

In Tanzania, all the costs of a public listing are tax deductible and the capital gains tax and stamp duty on the transfer of listed securities have been eliminated. Also, the withholding tax on dividends was recently reduced from 15% to 5% for listed companies. A withholding tax of 15% still applies to interest income from t-bills and t-bonds, and bank deposits also carry a 15% withholding tax, withdrawn at source. In an attempt to improve the liquidity on the government bond markets, any holder of t-bonds who sells before the instrument matures is exempted from the capital gains tax.

Kenya has perhaps the most comprehensive set of incentives to promote the development of the capital market. Some of these include: • A tax amnesty, forgiving past evasions of tax for companies interested in listing on

the NSE. Beneficiaries from the amnesty will undertake to make a full disclosure of their assets and liabilities and to pay all future taxes. So far, there have been no applications to benefit from this amnesty.

• Issuing costs are tax deductible. • Expenses incurred in getting an instrument rated are also tax deductible • Newly listed companies are required to pay 25% corporate tax (30% for unlisted

companies) for 5 years post-listing, provided the firm lists a minimum of 30% of its fully issued and authorized share capital on the NSE

• Withholding tax on dividends has been reduced from 15% to 10% for foreign investors and 5% for residents.

• Maximum limit of investment by retirement benefit schemes raised from 15% to 30%

• Employee Share Ownership Schemes (ESOPs) registered with the CMA enjoy tax exemption on their income.

12 Coffee accounts for roughly 60% of Uganda’s export earnings.

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• 10-year tax holiday for registered venture capital funds. • Foreign investors allowed to acquire up to 49% of local brokerage companies and

up to 70% of local fund management companies. • No capital gains tax.

In Uganda, issuing costs are also tax deductible. There is a withholding tax of 15% on dividends (taxed at source) and a 15% tax on interest income. Capital gains are however tax free and there is no stamp duty on security transactions.

One sign of the commitment to capital market development is a series of privatizations through the capital markets in all countries. The EAC governments place a high priority on achieving wider ownership through privatization, which is in contrast to a prevailing approach in many transitional economies where there is an emphasis on attracting strategic investors.

As at July 2002, Kenya imposed a 25% minimum reserve of companies’ issued share capital for locals while the balance of 75% becomes a free float for all classes of investors. Tanzania has not permitted foreign investors except through strategic investments in listed companies although the authorities have now decided to open up the Dar es Salaam Stock Exchange to foreign investors. A June 2003 date has also been set for the full liberalization of capital flows. Uganda currently has no restrictions on foreign investment in its capital market.

4. Equity Markets

Primary market Equity markets have not been a major source of financing for the private sector in the EAC as most firms continue to rely on the banking system for debt financing. There is a clear reluctance to seek equity financing and the supply of new equities into the capital markets has been thin (Table 4). In Kenya, which has the oldest and most active market, there have been a total of 7 new issues since 1997, with only 2 issues recorded for 2001. Not surprisingly, the supply situation is worse in Tanzania and Uganda where the markets are much younger with less awareness of the benefits (and costs) of issuing equity. In both countries, there have been only 4 equities issued to date. Privatization programs account for the bulk of new issues in all countries and it is notable that outside the respective governments’ privatization programs, the pipeline of potential new issues is thin.

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Table 4: Number of New Equity Issues in the EAC

1997 1998 1999 2000 2001 Kenya 2 1 1 1 2 Tanzania* - 2 1 1 - Uganda** - - 1 1 1 * Became operational 1998 ** Became operational 1997 Sources: DSE, NSE and USE Several factors help explain the limited supply of new equity issues. First, the EAC is dominated by small and medium scale enterprises (SMEs), which are predominantly dependent on bank loans and informal sources for their financing. Many firms rely on overdrafts as a major source of finance, even for fixed capital. Although overdrafts are theoretically payable on demand, they are usually renewed every 12 months and function as a source of permanent, long-term financing as long as the borrower continues to meet the key covenants in the overdraft agreement.

Second, many firms in the EAC are family-owned or closely held and there is a clear reluctance to dilute ownership through public offers and an even stronger aversion to the disclosure and transparency requirements associated with a public listing. They therefore tend to rely on bank finance as well as a proven network of family and friends to raise additional capital when required.

Third, even when there are firms willing to attempt a public equity issue, the tedious and costly process of making public offers is a disincentive. In general, an IPO in the EAC takes over 6 months to complete, sometimes longer in Tanzania and Uganda where there is a relative lack of experience with IPOs. In all countries, the subscription period (offering period) was noticeably long (4-11 weeks), due largely to the inefficiency of communication and payments system in the three countries.

The cost of making public offers is also an issue. Although these costs are tax deductible in the three countries, many firms are simply not willing or able to make the financial commitments upfront. In Kenya, these costs range between 10-15% of capital raised. Making public offers is even more expensive in Tanzania and Uganda, with costs cited in the vicinity of 20% of total capital raised. Tanzania Tea Packers, a company listed in 1999 reported listing costs totaling 26.2% of total funds raised.

A clue to why costs are so high is the involvement of a large number of market agents in the IPO process. Public offerings normally involve the following market players: the lead financial adviser, the lead sponsoring broker, other sponsoring brokers, the reporting accountant, the legal advisor to the issuer, the lead receiving bank, other receiving banks, and transfer secretaries. The lead financial adviser has usually been a commercial bank and plays the role that a merchant bank plays in the UK market. The UK merchant bank usually acts as the underwriter, but the lead financial adviser in the EAC context does not.

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Box 1: The Private Sector and Capital Market Development in the EAC

The capital market does not exist for its own sake. One of its principal functions is to provide finance for long-term investments by enterprises. However, enterprises will demand for capital only if there are profitable investment opportunities of which they can take advantage. Without a robust economic and policy environment within which enterprises can thrive, there will be few companies willing to raise funds on the capital market. In such circumstances, the capital market will remain small and underdeveloped.

The private sectors in the three countries have evolved along distinctly different paths. While Kenya has always been a market-oriented economy, (albeit with a substantial government presence in economic activities), Tanzania adopted Socialism as early as 1968 and prohibited all forms of private ownership until recently. Uganda’s previously vibrant private sector suffered considerable damage from the misrule of the Amin regime and the long period of civil strife that followed. It is still in the early days of recovery from this traumatic era.

The EAC economies are dominated by agriculture and there is a low level of industrial development, especially in Tanzania and Uganda. Kenya has a relatively more developed manufacturing sector. Agriculture accounts for about 30% of GDP in Kenya, and 42% and 49% in Uganda and Tanzania respectively. One common feature of these economies is the large number of small and medium-scale enterprises (SMEs) in both the manufacturing and commercial sectors.

In general, the private sector in the EAC is operating under a wide range of constraints and have found it difficult to be competitive in a world of rapid globalization. Private enterprise is hampered by poor infrastructure, corruption, high levels of economic and political uncertainty, excessive bureaucracy, lack of access to finance, and the lack of access to business services. There is thus a limited demand for investment capital due to the inability to take advantage of available opportunities.

The EAC countries have recognized the importance of the private sector and have committed to crafting a common strategy to develop the private sector as an engine of economic growth. The key task confronting policy makers in the EAC is the removal of the most serious bottlenecks to private sector development in order to ensure the eventual emergence of a more diversified economic base. Key areas that require attention include: i) establishing stable macroeconomic conditions; ii) installing a supportive legal and regulatory framework; iii) improving infrastructure by allowing various forms of private participation, including the privatization of utilities; iv) improving access to financial services, especially among SMEs; and v) expanding the provision of business services to local entrepreneurs.

Re-invigorating the private sector will stimulate economic growth, create investment opportunities and raise the demand of enterprises for long-term capital. It is only then that EAC capital markets can be sure of robust growth through the regular supply of securities into the primary market and the capital market can begin to meet its potential as a source of finance for productive investment.

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Sponsoring brokers under the leadership of the lead sponsoring broker are involved in surveying large investors to evaluate interest in the issue. The lead sponsoring broker also handles listing procedures of the issue on the relevant stock exchange13. The securities laws in the three countries allow stockbrokers to play the role of the lead financial adviser.

The division of responsibilities between the lead financial adviser and the lead sponsoring broker is ambiguous, hence so are its legal implications. In the EAC, neither of them underwrites the issue and this distinction has no value added14. Thus, a large number of agents with overlapping and indistinct functions has contributed to making IPOs unnecessarily expensive.

In addition, post-IPO costs are high in the EAC environment where infrastructure is generally underdeveloped. The desire of the governments to promote widespread ownership of shares through privatization programs has also contributed. Maintaining a share register is expensive and the costs of communicating with a large number of widely dispersed shareholders is enormous. Listed firms complain about the high costs of mailing quarterly and annual reports to thousands of shareholders. A large listed firm in Tanzania estimates that it spends over Tsh 14 million annually to mail dividend warrants to its 22, 000 shareholders. It was reported that a few firms considering public issues favor a pre-sale to a few large investors in a bid to avoid the high costs of having a large number of individual investors with small holdings.

Secondary market The EAC markets exhibit relatively limited activity on their secondary markets. The Nairobi Stock Exchange (NSE) is overwhelmingly dominant, accounting for over 90% of market activity in the region. The first three decades of the NSE’s existence were lackluster and an infusion of vitality only came in the mid-1990s, especially following the introduction of foreign portfolio investors in 1995 15. Its performance has however been disappointing in the last four years as the poor performance of the Kenyan economy has resulted in low corporate earnings and losses by listed companies. Political uncertainties have also alarmed foreign investors and a massive outflow of capital was recorded in 1999 and 2000.

The NSE Index has fallen consistently for the past four years and share prices are at an all-time low. Several listed firms are trading at prices much below their IPO prices. There have also been several de-listings, resulting in a contraction of market capitalization from a high of 43% of GDP in 1994 to 12% of GDP in 2002.

Activity on the markets in Tanzania and Uganda is tiny in comparison to Kenya. This is not surprising as the Dar-es-salaam Stock Exchange (DSE) has only been operating for four years and the Uganda Securities Exchange (USE) for five years. 13 The study team gathered that the role of “sponsoring broker” was created in Uganda to help build capacity in the brokerage industry. 14 It is also not clear which agent (the lead financial adviser or the lead sponsoring broker) has a stronger incentive to conduct thorough due diligence on the issuer and the security being issued. 15Stock market activity had been hampered by the oil crisis in 1972, a 35% capital gains tax in 1975 (suspended in 1985), and a policy of nationalization and exchange controls in the late 1970s.

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One of the biggest challenges facing the EAC markets is the lack of liquidity as there is relatively little trading activity on the 3 markets. The most active market in Nairobi had a turnover ratio of only 3% in 200116. Out of the 53 equities listed in Nairobi, only about 15 are regularly traded. Tanzania reports a turnover ratio of 3.4% but this falls to less than 1% if block trades are excluded. Only two equities (TBL and TCC) are active17. Trading activity is also limited in Uganda, with the most actively traded stock on the USE (BAT Uganda), recording an average of only 2 trades per month.

One factor accounting for the low turnover ratios is the limited floatation of shares. For instance, in Tanzania, only 34% of total market capitalization is available for trading. TBL, the largest company on the DSE has only 7% of its shares available, with the rest held by controlling shareholders. In Kenya also, only about 35% of market capitalization is available for trading. In addition, liquidity is limited by poor trading infrastructure and the high degree of buy-and-hold in the EAC, especially among institutional investors who dominate the three markets (see below).

Transaction costs are relatively high in the EAC, with total costs ranging between 2-4% of transaction value in the three countries and fixed commissions are the norm in Tanzania and Uganda. Kenya has allowed negotiable commissions from April 2002. These relatively high costs of trading have contributed somewhat to the low liquidity observed in the markets.

Demand for equities There are three main sources of demand for equities in the EAC: i) individual investors; ii) institutional investors; and iii) foreign investors.

Individual investors

In value terms, individual investors are not significant in the EAC due to the generally low per capita income and the corresponding low saving rates. Nonetheless, recent privatization programs and the desire of respective EAC governments to generate broad-based ownership of privatized companies have produced a large number of individual investors, most of whom have very small holdings. However, the appetite of individual investors for equities has waned in the last two years. In Kenya, the demand from individuals has been affected by the poor performance of many listed companies and the disposal of shares by many households to meet pressing financial obligations (e.g. paying school fees). Many individual investors in Kenya took loans from banks to purchase shares but have been forced to sell as dividends dried up and share prices plunged. Many are still struggling to meet interest obligations on their bank debt.

In Tanzania, the enthusiasm of individual investors was also dampened following large losses by Tanzania Oxygen Limited (TOL). But there are now signs that individual demand might be picking up again (especially among middle-income Tanzanians) following the recent stellar performances of TBL and TCC. Both companies have reported healthy profits and declared sizable dividends in the past two years. Their share prices have now moved further away from IPO levels and during 2001, market

16 Turnover is defined as the ratio of value traded to market capitalization. 17 Trading in Tanzania is highly skewed, with TBL alone accounting for 97% of all trades by value.

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capitalization of both TBL and TCC more than doubled18. In Uganda, the demand of individuals for securities is insignificant.

Institutional investors

One notable feature of the EAC capital markets is the strong involvement of pension funds. In Kenya, demand for equities from the pension industry has increased substantially following recent pension reforms, including the creation of the Retirement Benefits Authority (RBA) as the oversight body and the mandatory professional management of pension funds. As at today, over 60% of the equity holdings in Kenya is in the hands of pension funds. Although neither Tanzania nor Uganda has undergone full-scale pension reform, pensions also loom large in these small markets. Tanzania’s initial difficulties in generating demand for its first set of privatization IPOs was mainly due to the lukewarm attitude of pension funds, a situation that has now changed dramatically as the involvement of pension funds and insurance companies has strengthened in recent years19. The Uganda National Social Security Fund (NSSF) has also been active in the market but its involvement on the USE has been far less than the involvement of pension funds in Kenya and Tanzania.

In contrast, the insurance industry in the EAC is underdeveloped and has played a relatively smaller role in the capital markets. Premium income account for less than 2% of GDP in each EAC country, a relatively low penetration rate. Also, insurance in the three countries is dominated by non-life companies, whose liabilities are short-term and not suitable for investment in the capital market. In Uganda, for example, over Ush 35 billion was collected in non-life premiums in 2001, compared to only Ush 3.5 billion in life premiums. Most of the insurance reserves are therefore invested in treasury bills and short-term deposits. The life insurance business has also become unattractive due to the high rate of HIV infection in the EAC countries. The few life insurance companies that continue to be active deploy most of their reserves into real estate, treasury bills and bank deposits.

Foreign investors

Foreign investors are de facto substantial holders of equities in the three markets if we consider that a host of listed companies with relatively large market capitalization are strategically owned or controlled by foreign companies. However, only Kenya has been able to attract significant amounts of foreign portfolio investment (Table 5). Foreign investment on the Nairobi Stock Exchange was substantial in 1997 and 1998 but has now almost disappeared due to political and economic uncertainties. As mentioned earlier, Uganda has no restrictions on foreign investment but there are still restrictions in Kenya and Tanzania.

18 Another factor stimulating demand in Tanzania is the decreasing yield on treasury bills. 19 The Tanzania Cigarette Company issue in November 2000 was fully taken up by institutional investors before it opened.

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Table 5: Foreign Investment Turnover on the Nairobi Stock Exchange

NSE Total Foreign KShs mil. KShs mil. Ratio Year a b b/a

1995 3,343 220 6.6% 1996 3,964 990 25.0% 1997 6,148 2,230 36.3% 1998 4,555 1,160 25.5% 1999 5,158 1,120 21.7% 2000 3,632 698 19.2% 2001 3,125 449 14.4% Source: The Nairobi Stock Exchange

One factor that has dampened the demand for equities (for all classes of holders) is the high rates of return on government securities, especially treasury bills20. Given the low risk associated with government paper, it is not surprising that most investors (especially banks, pension funds and insurance companies) have moved funds into government securities. This situation has been reversed somewhat in Tanzania where rates on treasury bills have dropped as low as 4% in an environment of excess liquidity, thus encouraging institutions to include more equities and bonds in their portfolios21.

Market infrastructure One factor limiting trading activity on the three markets is the rudimentary nature of their trading systems. In Kenya, trading of equities occurs Monday through Friday (10 am to noon) using a floor-based, open-outcry system. Trade execution is entirely paper-based and although a transfer certificate is issued 5 days after the transaction (T+5), the final exchange of shares and money occurs in 14 days (T+14)22. Using the so-called “letter of hold”, a buyer may resell in 5 days before the ownership is finally transferred at the registrar level. However, this practice is problematic in terms of investor protection and may increase settlement risk in the market. Kenya is in the process of developing an automated trading, clearing, settlement and depository system which will serve the entire EAC region. Both the USE and the DSE will be taking 2.5% stakes in the CSD.

In Tanzania, a simple settlement system has been created with trades conducted on a T+5 basis. Both shares to be sold and cash must be on deposit before a bid or offer is made. The DSE has been able to create a central depository system to immobilize or dematerialize securities and place them in safe custody.

The trading system in Uganda is manual, operating via T+5, with registrar verification required for both stocks and bonds. The USE acts as a central clearing-house; buyers and sellers are required to deliver transfer forms to the exchange within 3 days (T+3).

20 See the discussion in Section 3. 21 Tanzanian treasury bill rates were at 13% as recently as 2000 22 In addition, it takes 12 days to obtain a share certificate.

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5. Debt Markets

Primary markets

Government bonds

The debt markets in the EAC are underdeveloped and dominated by government bonds. Kenya again has the largest market with government debt representing 27% of GDP. Government debt in Tanzania and Uganda represent 10% and 7% of GDP respectively.

Table 6: Domestic Government Debt in the EAC

Kenya Tanzania Uganda (In KShs bil.) (In TShs bil.) (In UShs bil.)Treasury Bills 96.8 162.5 733.3 Government Bonds 80.3 383.8 Government Stocks 1.5 227.8 Non-interest bearing TBs & Bonds 36.9 Others 6.5 30.5 Total Domestic Govt Debt* 222.0 804.6 733.3 GDP for 2001 824.9 7,981.3 10,200.0 Domestic Govt Debt/GDP 26.9% 10.1% 7.2% * Domestic government debt amounts were as of December 31, 2001 for Kenya, as of January 13,

2002 for Tanzania, and as of May 27, 2002 for Uganda. Sources: CBK, BOU, BOT

The Kenyan debt market has become more active, mainly due to the fillip received from the restructuring of short-term government debt into long-term treasury bonds in 2001. These bonds were subsequently listed on the Nairobi Stock Exchange. As at end-2001, there were a total of 28 government bonds listed.

Treasury bonds in Kenya are floating and fixed rate instruments, issued monthly by the Central Bank of Kenya (CBK) with a maturity ranging from one to six years. The market is however dominated by 1-3 year bonds. The coupon rate is pegged to the 91-day treasury bill average rate, plus a premium of 0.25%, 0.5% and 0.625% on the one, two and three-year bonds respectively. Minimum investment is Ksh 50, 000 and applications are received in multiples of Ksh 50, 000. Applications are submitted either directly to CBK or to authorized selling agents, including commercial banks, licensed stock brokers and licensed investment advisors. There is no primary dealer system. These bonds are re-discountable and since they are listed, could also be sold through the Nairobi Stock Exchange.

T-bonds are dematerialized and investors are required to open a Central Depository System (CDS) account with the National Debt Registry at the CBK. Investors receive statements of account after a new issue as well as after transactions on the secondary market.

The introduction of the t-bonds has enabled CBK to increase the proportion of longer-dated treasury bonds (1-6 years) from only 1% of total debt in 1999 to 43% in 2002. The

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study team was informed that the government’s objective is to shift 70% of its debt into long-term bonds by June 2003.

Tanzania began issuing 2-year government bonds in 1997 and 5-year bonds were introduced in 2002. There are plans to list the 2-year and 5-year bonds on the DSE23. Many of the bonds are being issued to replace old, long-term, development stocks that the BOT has been carrying on its books. These old government stocks were issued mainly on a placement basis and are currently non-traded. The ultimate aim is to restructure the debt stock by issuing newer, lower rate, tradable bonds to replace old, higher rate, non-tradable stocks24.

So far, over Tshs 64 billion worth of old stocks have been converted into 2-year marketable bonds, carrying market-determined yields. With about Tshs 145 billion worth of government stocks still outstanding, there are plans to convert some of these into 5-year bonds and there is thus quite a rich pipeline for the supply of long-term government securities into the market.

The government debt market in Uganda consists solely of treasury bills and the so-called bank restructuring bonds, as the government has indicated it has no need to borrow long term. The government budget is comfortably supported by donor inflows and there are no real pressures to borrow on the domestic market25. There are however moves to have the government issue bonds as a way to develop the debt side of the capital market. The Ugandan government has committed in principle to issuing two, three and five-year bonds but has put this on hold for now for two reasons: i) it does not really need the money and cannot presently justify the cost of issuing long term bonds; and ii) there are worries about crowding out effects on the private sector.

Corporate bonds

The corporate bond market in the EAC is very thin. Kenya boasts only 4 corporate bonds: a 3-year fixed rate Shelter Afrique bond, a 5-year floating rate Safaricom bond, and 2 floating rate bonds issued by the EADB, with a coupon based on the prevailing 91-day t-bill moving average rate plus a premium of 0.75%. The Safaricom bond was credit enhanced, with a 75% bank guarantee and was pre-placed among large banks.

Uganda has the PTA Bank bond and arrangements are underway to list a recently issued medium-term note from MTN, a telephone company26. Bonds in Uganda are priced based on t-bill rates plus a 2% premium. Tanzania has one bond listed, issued by the EADB at 0.75% above the 182-day t-bill rate. However, a combination of low t-bill rates, high bank loan rates and excess liquidity has stimulated interest in corporate bonds both from potential issuers and potential investors in Tanzania. It is notable that the recent EADB Tsh 20 million bond issue was oversubscribed by 36% and all the successful subscribers were institutions, mainly banks, pension funds and insurance companies.

23 The first tranche of the 5-year bonds (worth Tsh 2.5 billion) was listed on the DSE in March 2002. All outstanding 2-year bonds are slated for listing. 24 Many of these stocks were issued when inflation was high (around 30%) and in some cases carry yields as high as 25%. 25 Treasury bills in Uganda are issued mainly for monetary policy purposes. 26 A previous bond issued by the EADB was recently redeemed.

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A major factor impeding the development of corporate bond markets is the underdevelopment of the credit rating industry. Kenya has made provisions for rating agencies to register with the Capital Market Authority (CMA) under its Guidelines on the Approval and Registration of Credit Rating Agencies. Only East African Research Associates Ltd., which has a contractual arrangement with Global Credit Rating Co. in South Africa, has so far been registered as a credit rating agency in Kenya. However, no debt issues, including the East African Development Bank issues, have ever been rated, and the credit rating business in Kenya is practically dormant.

Secondary market Secondary market activity is limited in all markets. Tanzania operates a primary dealer system and holds these dealers responsible for creating a secondary market in government bonds. However, BOT has no support facilities for broker-dealers to enable them build inventories and make a market in government securities. Rediscounting of bills at the BOT is being discouraged in order to encourage the development of a secondary market. Trading could also be encouraged by the fact that in Tanzania, treasury bills and bonds are no longer eligible assets for meeting official reserve requirements. It is expected that trading would occur both on the DSE and on the over-the-counter (OTC) markets. In an attempt to improve the liquidity on the government bond markets, any holder of t-bonds who sells before the instrument matures is exempted from the capital gains tax.

Kenyan bonds are listed on the NSE and trading is done through brokers as there are no OTC arrangements. The government pays listing fees to both the NSE and CMA. There are however considerations for starting a primary dealership system. Banks are the principal holders of treasury bonds and efforts are underway to attract other financial institutions into the market and further diversify the investor base.

Liquidity In 2001, bond market turnover in Kenya was Ksh 9.4 billion, three-times the turnover for the equity market (Ksh 3.1 billion). However, its turnover ratio for 2001 stood at only 4.2%27. Actively traded bonds include Kenyan government t-bonds (both fixed and floating rate), EADB bonds and Shelter Afrique bonds. Notably, bond turnover in the first quarter of 2002 stood at Kshs 7.9 billion, compared with Kshs 9.4 billion for the entire year 2001. Despite these gains, liquidity is still hampered by a prevailing culture of buy-and-hold among many bond holders. The irregular issuing of government bonds on the primary market has also limited the volume of trading. Kenya is planning to license securities dealers in 2002 as a means of enhancing trading and improving liquidity.

Overall, the prospect for developing active and liquid government debt markets seem to be brighter in Kenya and Tanzania where there is an ongoing program of converting existing debt into tradable, long-term bonds. Uganda’s situation is not expected to change in the near term. However, it is expected that short-term instruments will continue to account for a substantial proportion of government debt in the EAC, especially as treasury bills have become more prominent as instruments of monetary policy.

27 The turnover ratio is calculated as the traded value in 2001 divided by the outstanding amount at the end of 2001.

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6. Legal and Regulatory Framework

As a heritage of their British colonial past, Kenya, Tanzania and Uganda share a common legal tradition, including the common law, the doctrines of equity and statutes of general application under British rule. With respect to the securities markets, the legal and regulatory frameworks in Tanzania and Uganda were largely designed with the objective of minimizing deviations from the Kenya securities law. This was expected to facilitate the regional integration agenda. Under the auspices of the CMDC, considerable effort has gone into further harmonizing the legal and regulatory frameworks in the three countries.

Kenya The Kenya Capital Markets Authority CMA (K) was created in 1990 as the overall regulatory and supervisory agency for the capital market28. Unlike in Tanzania and Uganda, the Stock Exchange in Kenya predated the regulatory authority by over 40 years and until the establishment of CMA (K), oversight responsibilities for capital market activities resided with the NSE, which functioned as a Self Regulatory Organization (SRO). Since its inception, CMA (K) has been steadily consolidating its role as the primary market regulator and was instrumental in changing the organizational form of the NSE from a “club” with no trading floor, to a company limited by guarantee. It also restructured the NSE Board, and championed the appointment of a non-broker as Chairman29. It was also responsible for introducing the current three-board structure for the exchange. Nonetheless, under the present regulatory framework, the NSE continues to serve as an SRO with a set of rules and regulations governing the conduct of its members.

CMA (K)’s oversight of the market is backed by an array of laws, regulations and guidelines. The main bodies of legislation include: i) the Capital Market Authority Act of 1989; ii) Capital Markets Authority (Amendment) Act of 1994; iii) Capital Markets Authority (Amendment) Act of 2000; and iv) the Central Depositories Act of 2000.

These pieces of legislation are made operational by CMA (K) through various regulations and guidelines. Key regulations include: i) the Collective Investment Schemes Regulations; ii) Public Offer of Securities, Listing and Disclosure Regulations; and iii) the Licensing and General Regulations. Regulations are in turn supplemented with guidelines including: i) Guideline on Corporate Governance Practices for Public Listed Companies; and ii) Guidelines on the Approval and Registration of Credit Rating Agencies.

The Capital Markets Authority (Amendment) Act of 2000 invested CMA(K) with extensive rule-making authority and powers, most of which were formerly vested in the Minister of Finance. CMA (K) now has a wider range of powers including powers to regulate the listing requirements of the NSE and to impose fines on brokers for non-compliance with information reporting requirements.

28 CMA (K) was preceded by the Capital Issues Committee of the Ministry of Finance 29 An early objective of CMA (K) was to break the perceived brokers’ cartel on the NSE.

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Another important piece of legislation relevant to the Kenyan capital market is the Companies Act, which is largely based on the UK Companies Act of 1948 and contains prospectus provisions and registration requirements. As in the UK until relatively recently, the regulation of capital market activity in Kenya was accomplished through the interaction of the Companies Act with the NSE listing rules. Although the Companies Act is somewhat outdated, CMA (K) considers it largely irrelevant in light of its own extensive rule-making powers.

The shift in regulatory nexus from a self-regulating exchange to a statutory regulatory agency and the attendant transfer of regulatory functions has inevitably generated resistance on the part of the NSE and the various interests associated with it. In addition, there are several transitional and institutional difficulties arising from this fundamental change in regulatory structure, including: i) regulatory overlap; ii) inconsistency of various regulatory requirements and their application; iii) duplication of requirements; and iv) possibly, regulatory arbitrage. For example, Kenya currently has two separate investor protections schemes, one established by CMA (K) and another one at the NSE. Also, companies have to make prospectus filings to multiple entities (the CMA, Companies Registrar, and NSE) under three different sets of rules. The result is increased costs of compliance, or outright non-compliance in the face of multiple and sometimes conflicting demands.

In a deliberate effort to adhere to “international standards”, CMA (K) has been following closely regulatory developments in many other jurisdictions (UK, Malaysia, Singapore, South Africa). The proposed collective investment scheme legislation is modeled on that of the UK and the capital markets legislation took inspiration from the Malaysian and Singaporean legislations. CMA (K) is also taking the lead in the EAC in formulating corporate governance guidelines and is considering a consolidated financial markets regulator (as in the UK and, closer to home, South Africa). There is now a Market Tribunal with high court powers which serves the appellate function [from CMA(K) decisions] formerly residing in the Minister of Finance.

However, the Kenyan regulatory structure has attracted criticism from various market participants. “Over-regulation” was a consistent complaint and the CMA has been accused of imposing too many involved and complicated regulations unsuitable for a thin market plus interference in otherwise routine transactions. Particular references were made to the current CMA (K) restrictions on off-exchange trades and the requirement of a full prospectus for issuing commercial paper. There was also dissatisfaction expressed with the complexity of certain regulations which are considered inappropriate for the Kenyan market. An example relates to the proposed collective investment scheme legislation, which many market participants consider too sophisticated for a developing environment like Kenya’s30. It is the study team’s opinion that while a sound regulatory foundation is important to orderly market development, it is desirable that regulators and the regulated maintain continuous and amicable dialog in order to ensure that regulations do not stifle market development.

30 The CIS Bill requires the calculation of daily Net Asset Value, which may not be feasible in a market like Kenya’s

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By virtue of the RBA Act of 1997 (as amended in 1998), the Retirement Benefits Authority is another regulatory body for certain segments of the capital market. It supervises pension funds31 and while CMA (K) licenses asset managers, they must also register with the RBA in order to operate in the Kenyan market. The RBA is under Ministry of Finance oversight and all its regulations must be signed by the Minister and become effective through a Gazette Notice.

Tanzania The Capital Market and Securities Authority (CMSA) was established under the Capital Markets and Securities Act of 1994 as the overall regulator and supervisor for the Tanzanian capital market. It thus predated the establishment of the DSE. The 1994 Securities Act was inspired by the Singaporean Capital Market Act and is supported by a number of regulations on licensing, prospectus requirements, codes of conduct, as well as financial and accounting provisions to enable the CMSA carry out its oversight functions. Another relevant body of legislation is the Companies Ordinance of 1929, which contains prospectus provisions for companies interested in making public offers. The Securities Act contains several references to the Companies Ordinance, a feature which helps to prevent potential conflict between these two key bodies of legislation32.

The CMSA has powers to approve stock exchanges and stock exchange rules, license market intermediaries and punish infringements of securities regulations. The DSE functions as an SRO and has been operating since 1997 under a “Blueprint” which includes listing rules, guidelines, additional prospectus requirements and a model code for directors addressing insider dealing. The Blueprint is not legislation but its guidance and flexibility appear to have been useful. The DSE is supervised by the CMSA and its rules are subject to approval by the CMSA.

Given its long history of socialism and the fact that Tanzania is in the early stages of re-building a market economy, the regulatory environment is markedly different from Kenya’s, despite initial attempts to minimize deviations. As in Kenya, there is a need to establish dialog between the regulator and the regulated in order to ensure that regulations facilitate and not impede market development.

According to a CMSA report, all brokers have violated its regulations at one point or another, some of them serious violations. But this has not been due to lax oversight or regulatory gaps, but rather due to a struggling industry not yet financially viable. The brokerage industry has been struggling in the face of very little trading. Float is relatively small and recent figures indicate that block trades account for over 90% of turnover in the market.

However, there are some encouraging developments. Various restrictions on foreign participation in the market and capital account controls are scheduled to disappear soon. The authorities have decided to open the DSE to foreign investors and capital controls are scheduled for removal in June 2003. The creation of the commercial court and the use of mediation has also been seen by market players as significant improvements in the legal environment for commercial transactions.

31 The NSSF operates under the 1973 NSSF Act and is currently not regulated by the RBA. 32 The Companies Ordinance is currently being revised by the Registrar of Companies.

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Uganda The Ugandan capital market is regulated by the Capital Markets Authority of Uganda [CMA (U)], established by a 1996 statute. This statute provides for CMA (U) powers regarding the approval of stock exchanges and stock exchange rules, powers to license market intermediaries and punish infringements of securities regulations.

CMA (U) also has rule-making powers and can unilaterally amend USE listing rules although the USE does appear to have certain latitude as a self-regulatory organization. For example, continuous reporting obligations are monitored by the USE and while CMA (U) approves public issues, the USE is responsible for approving listing.

However, listing requirements currently discourage most companies from considering listing. As in the other EAC countries, the regulatory framework and formal efforts at developing a capital market are very “exchange-centered” with a high level of regulatory oversight. Commercial paper, as in Kenya and Tanzania requires full prospectus disclosure and regulatory clearance. If it is not listed on the exchange, a commercial paper must be backed by a bank guarantee. The rationale for this is the absence of rating agencies; however, there are other means of addressing concerns about the creditworthiness of the issuer without undue regulations and restrictions being imposed on issuers (see Section 7).

As in Tanzania, a fairly comprehensive regulatory system has been established, inspired by the UK and Malaysian frameworks. The Companies Act is based on the 1948 UK companies law, and as in Kenya and Tanzania, it is out-of-date. The superimposition of a more modern capital markets regulatory structure on old UK-style companies law produces the same difficulties found elsewhere: duplication, overlap and inconsistencies. Compliance with three sets of rules, for example, with respect to public offering procedures and disclosure obligations [Companies Act and Companies Registrar, CMA (U) and USE].

In general, the current framework for capital market regulation in the EAC is adequate although there is a need to streamline regulations in a few areas in order to avoid unnecessary constraints on market development. While it is welcome that the various regulators are making vigorous efforts to adhere to international standards, it should be recognized that the current stage of market development may call for a lighter touch in some areas (e.g. listing requirements). Notable examples that should be reconsidered by the regulators include the current requirement for 1000 shareholders to qualify for listing and the requirement for issuers of commercial paper to prepare a full prospectus. As a result of stringent listing requirements, most of the firms on the main board tend to be multinationals or privatized state enterprises. There is thus an urgent need to simplify and ease entry conditions into the capital market without compromising investor protection.

7. Capital Market Integration: Key Issues and the Road Ahead

In the EAC, there is a frank recognition of the limitations to capital market development in individual countries. The integration of these markets is therefore seen as a meaningful way to overcome country-level limitations and ensure the long-term survival and development of capital markets in the sub-region. However, as attractive as the prospects

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of a regional market appear, there are significant issues that need to be addressed if the dream of a viable regional market is to be realized.

Macroeconomic and Policy Environment Efficient and effective capital markets require macroeconomic stability. The EAC governments should therefore make vigorous efforts to sustain current gains in the area of price stability. Also, there is a need to improve fiscal discipline in order to lower interest rates and reduce crowding out. Current efforts aimed at lengthening the maturity of government debt in Kenya and Tanzania should continue as this promises to give a boost to the development of the bond market. This will also help to combat the current inverted yield curve, (especially in Kenya and Uganda), which has discouraged demand for capital market instruments. Efforts should also be made to address the underlying causes of wide spreads, including the poor financial infrastructure in the EAC (e.g. poor payment systems, difficulties in contract enforcement and inadequacies in the accounting and financial reporting environment). Due to risks associated with enforcing contracts and obtaining reliable financial information on borrowers, banks either refuse to lend or only lend at very high rates to compensate for credit risks.

Legal and Regulatory Issues Although EAC capital markets and their regulatory regimes are at different stages of development, the legal and regulatory framework in place in individual countries is reasonably sound and could serve as a basis for developing a regional market. The fact that the three countries share a common legal tradition is a bonus for the pursuit of a regional approach, as their laws and legal institutions are informed by the same basic legal concepts and are readily compatible with one another33. In addition, they all have the same official legal language (English) and can easily draw on experience in other Commonwealth jurisdictions.

This common heritage has helped in the ongoing process of fashioning a legal and regulatory foundation for a regional capital market. The vision of a regional legal and regulatory framework was spelt out by the 1999 EAC Treaty, particularly in articles 85 and 86:

Article. 85 (c) Harmonize capital market policies on cross border listing, foreign portfolio

investors, taxation of capital markets transactions, accounting, auditing and financial reporting standards, procedures for setting commissions and other charges;

(d) Harmonize the regulatory and legislative frameworks and structures; (e) Harmonize and implement common standards of market conduct; (f) Harmonize policies impacting on capital markets, particularly the granting of

incentives for the development of capital markets within the region; (g) Promote cooperation among the stock exchanges and capital markets and securities

regulators within the region through mutual assistance and the exchange of information and training;

33 It should however be noted that despite the common heritage, the legal and regulatory regimes in each country exhibit considerable differences in detail.

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(h) Promote the establishment of a regional stock exchange within the Community with trading floors in each of the Partner States.

Article. 86 “…ensure that the citizens of and persons resident in a Partner State are allowed to acquire stocks, shares and other securities or to invest in enterprises in the other Partner States and encourage cross border trade in financial investments”.

The Legal Issues sub-committee of the CMDC is charged with implementing the regulatory provisions contained in the treaty and it reports regularly to the EAC Consultative Committee on progress made in implementing these provisions.

The EAC Treaty explicitly espouses harmonization of the underlying legal frameworks in the three countries as well as the creation of supra-national institutions. Despite the similarities and compatibility of the three legal systems, full “harmonization” of legislation and regulatory structures as well as the creation of supra-regional capital markets institutions (such as a regional investor compensation fund and a regional stock exchange) may prove difficult in the short to medium run. The countries are still at quite different stages in the development of their capital markets and are each dealing with different, if related, issues. This is not surprising nor unusual; similar difficulties were encountered in the European Union where there has been a long process of change and accommodation that is still ongoing. Nonetheless, the substantial amount of work carried out by the CMDC’s Legal Issues sub-Committee has been a fruitful exercise in addressing relevant regulatory issues and suggesting solutions.

A certain degree of harmonization is very useful, and as markets integrate, inevitable, but full harmonization may not be a feasible goal to pursue in the EAC. This is because harmonization, once completed (as difficult as that process is), requires constant maintenance as well, given that legal systems are dynamic and continue to change over time. In addition, there is a body of academic literature which suggests that harmonization of legal systems can in fact stifle innovation and lead to sub-optimal solutions34.

As a relatively easier and more pragmatic alternative to the full harmonization of regulations, the EAC countries could consider adopting principles of mutual recognition. Mutual recognition occurs when “Jurisdiction A” recognizes compliance with the regulatory regime in “Jurisdiction B” as sufficient to constitute compliance in its own territory. An example of mutual recognition at work is the European Union’s “single passport” for financial intermediaries which allows the provision of financial services across borders. Another example is the Multi-jurisdictional Disclosure System between the United States and Canada with respect to public offerings of securities.

Although mutual recognition does require a certain degree of harmonization, the underlying regulatory regimes and institutions need to be comparable but not necessarily identical. The only desirable requirement is for regulatory regimes to be of acceptable standards. The EAC members should therefore assess whether they have reached a sufficient level of confidence in each other’s regulatory processes in order to 34 See Hal Scott, “Internationalization of Primary Securities Markets”, Law & Contemporary Problems, No. 71, 2000.

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recognize and rely on them in their own jurisdiction. Although mutual recognition sometimes raises issues of political sovereignty, the benefits in terms of lower costs and regulatory efficiency can be significant and ultimately persuasive.

In considering the principle of mutual recognition, the EAC countries should be aware that certain conditions need to be in place to ensure its maximum effectiveness. For mutual recognition to work properly, “second guessing” and multiple approvals and filings should be limited. It is also important to promote continuous coordination and cooperation among regulators in order to avoid regulatory arbitrage. Local stakeholders, including the brokerage community and the stock exchange should be encouraged to embrace the operation of mutual recognition principles. This could be achieved by allowing capital market intermediaries to be recognized across borders and permitting financial services to flow freely among the EAC member countries. For instance, a broker would be allowed to provide cross-border services with a license from its domiciliary regulator. Foreign ownership restrictions should also be relaxed to allow entry by market intermediaries located in other EAC countries. In the long run, this could turn out to be one of the most important driving forces behind capital market integration in East Africa.

There is a need to streamline regulations in a few areas in order to avoid unnecessary constraints on market development. While it is welcome that the various regulators are making vigorous efforts to adhere to international standards, it should be recognized that the current stage of market development may call for a lighter touch. Notable examples that should be reconsidered by the regulators include the current requirement for 1000 shareholders to qualify for listing and the requirement for issuers of commercial paper to prepare a full prospectus. As a result of stringent listing requirements, most of the firms on the main board tend to be multinationals or privatized state enterprises. There is thus an urgent need to simplify and ease entry conditions into the capital market without compromising investor protection.

The increased importance of international capital markets in the 1990s has disseminated widely sophisticated regulatory techniques, (mostly drawn from the United States), around the world. Participation in fora such as the International Organization of Securities Commissions (IOSCO) and training offered by the US Securities and Exchange Commission (SEC) have enabled EAC regulators to familiarize themselves with the state of the art in developed markets. In an attempt to adhere to international standards, the regulators run the risk of implementing changes that are unsuitable to the underdeveloped state of capital markets in the EAC and counterproductive to the development of a viable regional market.

It is therefore important for securities regulators to ensure that the rule-making process is inclusive and transparent, in particular allowing an exposure period and detailed comments from stakeholders. At the national level, the regulation of commercial paper offerings and the requirement for a full prospectus and review should be reconsidered. The rationale is the absence of rating agencies to rate commercial papers, but the regulatory authorities could provide some investor protection (while lightening the regulatory burden) through other means such as requiring high denominations or restricting purchasers to institutions. The regulatory resistance, especially in Kenya, to OTC markets is another example. These markets already exist in some form and will

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continue to do so even in the face of regulatory obstacles. Requiring trades over the exchange in all circumstances for listed securities may be too restrictive. It is desirable to nurture and acknowledge OTC markets in the interests of the longer term development of the market.

Around the world, there are niche, regional markets which are more or less unregulated [e.g. the Eurobond market and American Depository Receipts (ADRs)]. It is significant that these markets, making use of interstices in the national regulatory regimes, have thrived. This is not to say EAC capital markets should be unregulated at a regional level, but that a lighter touch may be warranted. It is notable that the recent EADB bond offering in Tanzania, was done successfully, using a simple offering memorandum.

In sum, it is important that the regulators find ways to provide effective oversight without interfering with market development. They could revisit current regulations in order to change complicated restrictions into tailored regulation, such as the introduction of private placement rules and the explicit recognition of OTC markets35.

The decrepit state of Companies Law in the EAC is an obstacle to the development of both national and regional capital markets. Old companies laws have been a source of duplication, confusion and expense and in some ways, creating a modern companies law is a greater challenge than creating a capital markets regulatory regime36. As a first step, the authorities might consider enacting a “close corporation” statute. Companies established under this statute would not be listed, nor their shares traded, but they could provide the desperately needed business vehicle for entrepreneurial activity. The close corporation would therefore provide a simple, inexpensive vehicle for businesses involving a small number of people and might be useful in transforming a wide range of activities from the informal to the formal sector37. Such legislation could be put in place relatively quickly and would not require the difficult decisions associated with modernizing the old company laws. In addition, there is a successful, modern, African precedent in the 1984 South African Close Corporation Act, which the EAC countries could find relevant and useful.

As for the old companies laws, the UK recently completed a three year review of its companies law, the first major review in 140 years. New, modern companies law should be appearing in the UK in the near future and this could also prove useful as a guide to the EAC countries.

One regulatory issue that is currently being discussed in the EAC relates to the feasibility of creating integrated regulatory frameworks for financial markets within individual countries as well as an integrated regulator for capital markets at the regional level. The study team was informed that deliberations have already reached an advanced stage in Kenya on the possibility of having a single regulator for insurance, pensions and capital markets. It is however the study team’s view that this requires careful and in-depth study as any move in this direction would entail substantial institutional and political changes. 35 Tanzania already recognizes an OTC market. 36 Tanzania recently enacted a new Companies’ Act which could be useful to Kenya and Uganda. 37 The typical close corporation will have no board of directors, no shareholders, between one and ten members and incorporation is effected by the registration of a single document. One person “corporations” are therefore possible.

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Demand for securities A fundamental constraint to increasing the demand for securities is the low levels of savings in the EAC. As noted earlier, domestic saving rates stand at less than 10% of GDP in the three countries. This is however not surprising in countries with low per capita incomes and significant portions of the population living below the poverty line.

Even in Kenya, the most industrialized country in the EAC, over 75% of the population still live in rural areas, with the agricultural sector contributing about 30% of GDP.38 Given the poor transportation and communication infrastructure, this low urbanization suggests that, in the near term, potential investors in the securities markets amount to a quarter or one-fifth of the total EAC population of 82 million39. In this sense, these three countries would have a much smaller pool of effective demand for securities than the overall GDP and population numbers suggest.

Faster progress will therefore be required on establishing viable and simple Collective Investment Schemes which will be important in ensuring sustainable demand for securities. Such schemes are useful in aggregating the demand of numerous individuals for securities and creating a sizeable pool of resources for investment in the capital market40. It will also be useful to consolidate ongoing efforts in the area of investor education, both at the country and regional levels41.

However, available evidence suggests that institutional investors (especially pension funds) may hold the key to generating sustainable demand for securities in the EAC. It is therefore important to consciously promote a sound institutional investor base. Pension reform is going to be critical in the EAC if capital markets are to really take off. While Kenya has achieved a substantial degree of liberalization and reform of the pension industry, this is not yet the case in Tanzania and Uganda.

The major contractual savings institutions in Kenya include the National Social Security Fund (NSSF), with assets estimated at Kshs 50 billion, 1,300 occupational pension schemes (Kshs 70 billion), and life insurance companies (Kshs 27 billion). The combined assets of contractual savings (Kshs 147 billion) is equivalent to 28% of GDP or 200% of market capitalization on the NSE42.

In terms of investment portfolios, the NSSF has invested predominantly in government securities (56 %) and real estate (25 %), with little in equities (2%). Occupational pension funds, managed by professional investment managers, show more balanced portfolios. The market leader, Barclays Trust Investment Service, managing Ksh 20 billion for 140 pension funds, had the following portfolio in 2000: government securities (55%), fixed- 38 Agriculture accounts for 56% and 44% of GDP in Tanzania and Uganda, respectively. 39 For example, it is estimated that only 2 million of the 33 million Tanzanians have bank accounts or post office savings account (see Tanzania: Wider Share Ownership Through Collective Investment, GMA Capital Markets Ltd., 2001). 40 Uganda passed the CIS Law in 2002 and the other two countries are currently working towards the same goal. 41 This should cover the basics of capital market operations, securities available, issuing and trading practices, etc. 42 In terms of market capitalization of the free float, estimated at one-third of total market capitalization, it jumps to 606%.

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income (15%), NSE equities (15%), and offshore investment (15%). As for life insurance companies, government securities (42%) and real estate (31%) were dominant investment channels, while equities (11%), loans (7%), and bank deposits (7%) were moderately represented.

Tanzania has two major pension funds: the National Social Security Fund (NSSF, Tshs 130 billion) and the Parastatal Pension Fund (PPF, Tshs 73 billion). In addition, there are two newly established state-sponsored pension schemes: Government Employees Pension Fund and Local Government Employees Pension Fund. Total assets of the four pension funds were estimated to be as high as Tshs 250 billion4 % of GDP or 50 % of DSE’s market capitalization43. Each year an additional Tshs 40 billion of new contribution is made to the NSSF. As for the life insurance industry, overall assets amounted to Tshs 20 billion by end-2000.

On investment portfolios, both NSSF and PPF exhibit a clear preference for real estate (NSSF 37.4%; PPF 45.0%) and government securities (NSSF 53.6%; PPF 11.2%), with little exposure to equities (NSSF 2.7%; PPF 1.8%) in 1999. Between 1999 and 2000, however, the share of equities in the NSSF portfolio increased from 2.7% to 5.45%, a sign of growing appetite for equity investment. For life insurance companies, the majority of funds was invested in government securities (77%), with the remaining in deposits (10%), long-term investments (8% ) and equities (5%).

The National Social Security Fund (NSSF) in Uganda is a monopoly with over Ush 145 billion in assets. Short-term bank deposits account for 53% of the portfolio with real estate coming next with 35%44. Only 12% of the portfolio is in any kind of long-term financial instrument (equities, bonds, and long-term bank deposits).

The size and current portfolio structure of pension funds in Kenya and Tanzania therefore suggest that there is a considerable pool of contractual savings available for investment in equities and bonds. This pool of investible funds would be larger still if both Tanzania and Uganda can successfully carry out planned reforms of the pension industry.

In order to take full advantage of the available savings, the EAC authorities should allow institutional and other investors to buy securities in other EAC markets. This step will require that EAC investors be treated as nationals in all three countries, especially in the taxation of investment income.

Supply of Securities The lack of a regular supply of new securities (especially equities) is perhaps the biggest obstacle to capital market development in East Africa, both at the country and regional levels. With substantial potential demand available from institutional investors, the ensuing question is whether there would be a consistent supply of quality securities in the capital markets that could capitalize on potential demand from institutional investors. A look at basic business profiles in East Africa does not yield much encouragement:

43 143% of the market capitalization of the free float. 44 Most of the real estate investment is in uncompleted properties.

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i) the industrial base is small in all three countries and even in Kenya, the most industrialized EAC country, the manufacturing sector accounts for only 13% of GDP.

ii) the informal sector accounts for a substantial proportion of business activities

iii) closely-held foreign companies have significant market shares in both the manufacturing and service sectors.

In terms of number and to some extent economic vibrancy, small, family-owned businesses are dominant in East Africa. These businesses are tightly privately-owned and mobilize most of their financing from private savings as well as from friends and family members. Also, if a business is reasonably well managed, loans are available from banks, usually in the form of overdrafts.

Firms of this type have shown little interest in going public because of the fear of losing control and a desire to avoid the disclosure and tax burdens. A recent study in Kenya reports that 25% of firms surveyed cited loss of control as the main reason for not listing, while 17.9% feared heavy taxation and exposure to strict government regulations45. They prefer to keep a low profile so as not to attract the attention of the tax authorities or any other form of public scrutiny. As explained earlier, both the Kenyan and Tanzanian governments have installed fiscal incentives for listed companies, including a tax amnesty in the case of Kenya. However, with tax administration in the jurisdictions being generally characterized by weak enforcement, prevalent evasion and corruption, many firms still believe they can pay much less tax (or none at all) by remaining private.

Foreign companies have also shown little interest in equity financing through the local stock markets. They can mobilize needed capital through their home offices where funds can be raised cheaper and faster than in local markets. In case they are interested in going public, they have the option of doing so on the international capital markets.

Thus, few private firms are interested in the local capital markets in the near term. Against this background, privatization appears to be the most reliable source of supply for EAC capital markets in the near to medium term. Indeed, state-owned or public enterprises still account for a sizeable portion of the national economy in all three countries.

In 1994, Kenya began the implementation of a Parastatal Reform Project, including the privatization of state-owned enterprises (SOEs). Since then, some 160 non-strategic public enterprises have been either divested or closed through various methods, including public flotation of 10 enterprises on the NSE.46 However, progress has been slow on the reform and privatization of big and strategic parastatals, as highlighted by the stalled privatization of Telcom Kenya. In addition to Telcom Kenya, major outstanding privatization candidates include: Kenya Ports Authority, Kenya Railways Corporation, Kenya Power and Lighting Company, Kenya Commercial Bank, Kenya Reinsurance Company, and East African Portland Cement Company.

45 Mbui Wagacha, To list or not to list. Discussion Paper No. 028, 2001, Institute of Policy Analysis & Research, Kenya. 46 See Privatization in Kenya: Country Fact Sheet, World Bank, Africa Region, August 2001.

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The privatization program in Tanzania, begun in 1993, has so far shown a positive track record of linking privatization with capital market development. Starting with the privatization of manufacturing, agricultural and trade enterprises in the early 1990s, the Tanzanian government decided to include utility and infrastructure parastatals in the privatization program in 1996. One of the main objectives of the privatization program involves the greatest possible participation of citizens in the ownership of privatized companies. As a result, the government has tried to earmark shares of attractive enterprises for transfer into broad private ownership. SOEs slated for divestiture include: Tanzania Telecommunication Company Limited, Tanzania Harbors Authority, Dar es Salaam Water Supply Authority, Tanzania Electricity Company, Tanzania Railways Corporation, Air Tanzania, National Insurance Corporation, and the National Micro Finance Bank.

In Uganda, a policy of privatization was adopted for about 142 government-owned parastatals in the industrial, commercial, agricultural and hotel sectors. Although by the middle of 1999 approximately two thirds of SOEs had been privatized, the process has been bedeviled by a lack of transparency and widespread allegations of corruption, poor management and supervision. As of February 2002, the privatization of the main utilities companies, Uganda Electricity Board, the National Water and Sewerage Corporation and the Uganda Railways corporation are still ongoing.

Overall, many big enterprises in the EAC are still in the public sector’s hands and are scheduled for privatization in all three countries. Thus, if carefully designed, the privatization program alone may provide a sizable pool of shares to the capital markets. What is needed is a strong commitment and strategy to link the privatization program to the promotion of local capital markets.

In trying to strengthen this linkage, it is important to make the best public enterprises available for public flotation. A common mistake observed in many African countries is that governments have a tendency to reserve blue-chip parastatals for strategic sales, while floating less attractive state enterprises on the stock markets47. There have also been accusations of corruption, with valuable state enterprises being allegedly purchased at cheap prices by those in power or their close friends. Listing weak and highly indebted state enterprises will only serve to damage confidence in the capital market as evidenced by the case of Tanzania Oxygen Limited.

We cannot ignore the fact that a vibrant capital market needs a vibrant private sector. Privatization is a finite exercise and will not go on for ever. Developing the regional capital market will therefore require removing existing bottlenecks impeding private sector development in the EAC (see Box 1). In this regard, the Regional Private Sector Strategy being developed under the auspices of the EAC will be relevant as it offers an opportunity to devise a coherent approach to making the private sector viable in the Community. We recommend that the CMDC get involved in the preparation of this strategy and engage in a dialog with other stakeholders on ways in which to improve the access of business enterprises to the capital market.

47 Strategic investors are expected to bring new investment, management skills, and/or technologies

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Further, there is a need to streamline and simplify prospectus requirements and procedures for issuing securities, in order to make it less onerous for potential issuers. For instance, it is desirable to keep the number of market agents involved in a public offer to a minimum in order to lower issuing costs. The tax-deductibility of issuing costs is helpful but as mentioned earlier, most firms balk at incurring all the expenses upfront.

Finally, there is a need to continue the existing programs on educating the private sector about the benefits of listing and raising funds on the market. It is welcome that the various stock exchanges are already involved in various initiatives to sensitize companies to stock market opportunities and the procedures for listing. It may be desirable to go one step further and tailor the listing requirements to the peculiar characteristics of firms in the region. In this regard, particular attention should be paid to the features of SMEs. As a first step in trying to attract more firms, the CMDC should compile a list of companies in the EAC that may be qualified for listing but are not listed at present. This will help make the educational program more targeted.

Market Development A well-developed capital market would consist of different segments, including an organized exchange as well as over-the-counter (OTC) markets. Given the current underdeveloped state of capital markets in the EAC, there is a need to consider the conscious development of OTC and venture capital arrangements (alongside the exchanges) in order to better meet the needs of the private sector. It is reported that a large number of indigenous companies (mostly cooperatives) are already traded outside the exchanges at significantly high transaction costs. With virtually no market information available, investors often search for potential buyers on their own. In this sense, the initiative to improve OTC trades by the Association of Kenya Stockbrokers merits positive consideration and we recommend that regulators in all countries consider these forms of market arrangements.

The cross-listing of equities looks promising. In March 2001, the NSE-listed East African Breweries Limited (EABL) made history by pioneering cross-listing of its shares on the USE. Kenya Airways followed suit in March 2002. Because of capital controls in Tanzania, cross-listing has only been possible between the NSE and USE. EABL intends to apply for a cross- listing on the DSE when the Tanzanian government ends current restrictions on foreign investors.

A glaring gap in the EAC capital markets is the underdevelopment of bond markets. This is an area that needs urgent attention in order to create a more rounded capital market to support private sector activity. Government debt is dominant and a promising development is the recent emergence of long-term government bonds due to the debt restructuring taking place in Kenya and Tanzania. Uganda’s access to donor funding has made issuing bonds unnecessary. However, it should be noted that dependence on aid for budget support is not sustainable and there is a need to develop alternative sources of financing the government budget in Uganda. On the corporate bond side, a possibility is for non-bank financial institutions involved in long-term finance, such as leasing companies, mortgage firms and development banks to issue bonds to finance their lending activities. The EADB is already an active bond issuer in the three markets. In Uganda, Development Finance Company of Uganda (DFCU) has

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also indicated plans to issue bonds to fund leasing operations. Such bond issues could target institutional investors such as pension funds and insurance companies. Pensions and insurance are particularly relevant to bond market development by virtue of their long-term liabilities.

A bond market needs competent credit rating agencies to evolve. Conversely, a credit rating industry needs an active bond market to be commercially viable. This is a “chicken-and-egg” situation, and is a common problem in many developing capital markets. The experience of the International Finance Corporation (IFC) indicates that it is difficult to make even a single credit rating agency in a developing country commercially viable without a critical mass of bond issues48. To alleviate the problem, credit rating agencies are often allowed to cross-subsidize credit rating operations49. In Turkey and the Philippines, local credit rating agencies provide local banks with ratings in order for them to establish correspondent or credit-line relationships with foreign banks. Other revenue sources include non-rating activities such as financial information services. The integration of the capital markets in East Africa will no doubt create a bigger mass than a single market and this is expected to ease the “chicken-and-egg” problem to a certain extent.

The recent licensing of Duff and Phelps to provide rating services in the region is a step in the right direction. Regional development institutions like the East African Development Bank can then take the lead in getting their bonds rated, a move which will have a significant demonstration effect and help promote the rating industry50. In addition, the entire capital market will benefit from the development of investment banks and underwriters, particularly in Tanzania and Uganda.

Market Infrastructure In terms of market architecture, the CMDC envisages a “virtual” integration of the three exchanges, with blue chip stocks cross-listed. To this end, the three exchanges are engaged in close consultation toward the joint-development of a central depository system (CDS) which will include an automated common trading system. In August 2002, the Nairobi Stock Exchange, the Capital Markets Authority of Kenya, the Association of Kenya Stockbrokers, the CMA Investor Compensation Fund, and 9 institutional investors came together through the Capital Markets Challenge Fund as investors in the Central Depository and Settlement Corporation (CDSC). The CDSC will serve as the legal entity that will own and operate the automated clearing, settlement, depository and registry system of the capital markets.

Out of the Kshs 100 million initial funding obtained for the project, the Nairobi Stock Exchange has committed Kshs 25 million, with the other investors collectively

48 Since 1994, the IFC has invested in eight rating agencies in developing countries and has several projects to invest in rating agencies in the pipeline. 49 Cross-subsidizing operations should be run so as not to cause conflicts of interest and not to compromise the independence of credit-rating opinions. 50 An alternative while the credit rating industry is developing is to obtain credit enhancements for bond issues from banks.

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contributing the balance of Kshs 75 million51. The Nairobi Stock Exchange is also holding 2.5% of the shareholding in the CDSC in trust for the USE and another 2.5% for the DSE, to be transferred at a future date yet to be determined.

The Central Depository and Settlement Corporation Board has been mandated to commence negotiations with the technology supplier of the automated system. The same vendor is also providing the Nairobi Stock Exchange with an automated trading solution. The CSD project has the potential to move the integration agenda to the next level. Apart from the CSD project that will develop the broker-exchange-depository leg of clearing and settlement, an initiative to improve a broker-customer leg is equally critical. This could be incorporated into the current proposal for the CSD system52.

It is welcome that there is a sense of realism pervading ongoing discussions within the CMDC on regional integration. The current strategy of pursuing the establishment of a “virtual” regional market is based on a realistic assumption that the establishment of a single regional stock exchange may not be politically possible in the medium term. In fact, given little public awareness about capital markets in Tanzania and Uganda, the creation of stock exchanges in both countries was a deliberate effort aimed at using stock exchanges as tools of public education and awareness. However, from the start, regional integration was clearly in mind. Thus, in designing both the regulatory framework and market infrastructure for the DSE and USE, policymakers put a high priority on compatibility and harmonization. This sense of realism also appears in the design of the common CDS. Rather than envisioning a large and technically complex system, they have developed a CDS proposal that is compatible with the projected pace of market development and fits within the available financial resources.

Stakeholder Involvement There is clearly a high level of enthusiasm and commitment shown by various stakeholders for a regional capital market in the EAC. However, the study team detected a need for wider consultation and inclusion in moving forward with the integration agenda. While there is undoubtedly strong commitment and cooperation among stock exchanges and regulators, the degree of enthusiasm was much lower among private sector-issuers, investors and market intermediaries, perhaps due to a lack of information and their limited involvement in the initiative. While regional integration was initiated by regulators, it is important to now involve a much wider range of stakeholders in carrying the agenda forward. There is therefore an urgent need to disseminate information on the integration initiative more widely among key stakeholders. The CMDC could consider establishing a web-site for the purpose of informing the public about its various activities.

Unless all relevant stakeholders are carried along, the expected gains of integration may not materialize. There is also the risk of having to confront interest groups opposed to a regional market if the costs of integration are perceived to be higher than the benefits. It is therefore important to ensure broader and active private sector representation as soon

51 The 9 partners are: Apollo Insurance, Jubilee Insurance, Kenya Commercial Bank, Old Mutual Insurance, CFC Bank, East African Breweries Ltd., East African Development Bank and the ICDC Investment Company. 52 Developing the customer-broker leg will depend crucially on the adequacy of telecommunication facilities.

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as possible. Although CMDC’s constitution allows for outside membership, this has yet to materialize. We therefore urge the CMDC to make more vigorous efforts to enlarge its membership to include representatives of the organized private sector (chambers of commerce, manufacturers associations, private sector foundations, etc) as well as issuers, financial intermediaries, and institutional investors.

Linkages with other markets The EAC should consider leveraging a regional market further through linkages with more developed markets, both in Africa and beyond. Exploring such linkages could be done under the auspices of the African Stock Exchanges Association (ASEA). The realistic fact is that even a regional EAC market will continue to be relatively small in the medium term and would benefit from linkages with other markets that are experiencing more rapid growth. A natural candidate is the Johannesburg Stock Exchange, which is the largest in Africa. The capital market in Mauritius is another possibility. These markets offer a good doorway for EAC markets to establish linkages with international capital markets.

Some market participants raised concerns about Tanzania’s membership in both the EAC and the Southern Africa Development Community (SADC) against the background of her withdrawal from the Common Market for Eastern and Southern Africa (COMESA)53. The fact that Tanzania participates in a parallel SADC initiative to integrate capital markets in Southern Africa has also raised misgivings54. It is our view that this configuration should be seen in a positive light, in terms of Tanzania serving as the link between the EAC and SADC in an effort towards the ultimate integration of capital markets in East and Southern Africa.

The Road Ahead Despite the wave of good intentions and the hard work of various stakeholders (especially the CMDC) towards making integration a reality, it is appropriate to caution that regional integration will be a slow and difficult process. There are enormous challenges facing capital market development in individual countries which still require attention. Annex 1 gives an indication of some interventions that are relevant at the country level relative to regional interventions. Failure to address these country-level challenges (such as fiscal indiscipline and obstacles to private sector development) might make the pursuit of integration meaningless. Regional integration will not succeed if key country-level problems persist and country-level interventions will still be crucial in moving ahead with regional integration.

It will therefore be important to closely link the regional market integration initiative to national market development. Except for highly integrated economies, a well-functioning domestic market still matters even in a post-integration era. Even in the ideal case of the European Union, a typical market integration modality was either alliance or a holding company structure with national exchanges continuing to operate. Even under a single currency with converging economies, cross-border trading has been significantly restricted by persistent home bias. In the East African context, regional capital market

53 Kenya and Uganda are still members of COMESA but not members of SADC. 54 South Africa plays a leading role in the SADC initiatives towards capital market integration.

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integration would bear fruit only when it is pursued with a close reference to promoting individual capital markets. If regulators and policy makers neglect to address local developmental issues, thereby failing to develop deep and liquid individual capital markets, regional market integration by itself would not magically transform a set of poor individual markets into a good integrated market. Thus, it is recommended that stakeholders strike a balance between the pursuit of regional integration and efforts aimed at developing individual markets.

In going forward, the regional initiative should draw strength from the diversity observed in the three markets. Presently, Kenya has by far the largest pool of demand and the most advanced financial services industry among the EAC countries. However, amid the economic gloom since 1997, Kenya is expected to remain weak on the supply-side until investor confidence in the country’s economy is restored. On the other hand, Tanzania and Uganda have recorded better economic performance and have made sound progress in the area of privatization. However, both countries have nascent financial services and have a much smaller institutional investor base than Kenya. Against this backdrop of imbalance between supply and demand at the national level, regional integration has the potential to equalize supply and demand across the region. With poor growth in Kenya, institutional demand for securities may switch to available securities in Tanzania and Uganda. It may therefore be advisable in the short run to capitalize on complementarities and not attempt to turn the three countries into “identical triplets” in terms of capital market development.

A recent study by the OECD examined the process of regional integration in East Africa from a wider perspective, and makes an interesting suggestion on the possible use of “variable geometry” in advancing integration efforts55. The use of “variable geometry” could link initiatives in the three countries but not lock in a country that wished to proceed more quickly or take a different route to reforms. The Community members however need to be careful and avoid a situation where “variable geometry” is used as an excuse to undermine regional cooperation efforts.

Finally, it is crucial that the capital market integration initiative continue to receive the backing of key political authorities in the EAC. While the input and involvement of the private sector in capital market integration has been important, the EAC political umbrella has provided a conducive and appropriate forum for the initiative to gather momentum. Therefore, if the goal of capital market integration is to be eventually realized, it is vital that the current level of support and commitment from respective EAC governments continue. There will be a need to draw on this commitment at various rocky points on the road to integration.

Possible Areas for World Bank and other Donor Support

The EAC integration agenda is a laudable one and the efforts of the CMDC so far are commendable. The initiative could however benefit from the involvement of a broad range of donor agencies who are in a position to provide both financial and technical support.

55 Goldstein, A. and Ndung’u, N. Regional Integration Experience in the Eastern African Region, OECD Development Centre, Technical Paper No. 171, March 2001.

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The World Bank Group could provide technical and financial support on several of the issues listed in Annex 1, including inter alia, developing government bond markets, capacity building for capital market regulators and the strengthening of regulatory frameworks, design of mutual recognition arrangements, further development of market infrastructure, design and implementation of pension reform, modernizing company laws, as well as the design of public awareness campaigns. The Bank is currently working with the EAC Secretariat in the preparation of a Regional Private Sector Strategy which also has relevance to the development of financial markets.

8. Summary of Recommendations

This section summarizes the key recommendations contained in this report, highlighting various actions (policy and institutional) that need to receive immediate attention as well as those actions that could be implemented in the medium to long-term.

Immediate Priorities

Macroeconomic environment • It is critical to maintain macroeconomic stability, especially by keeping inflation

in single digits. • There is also a need to improve fiscal discipline in order to lower interest rates

and reduce crowding out.

Policy framework • It is crucial to continue the present level of commitment to the overall integration

agenda in the EAC. This offers a vital umbrella under which the pursuit of regional capital market integration can take place.

• The commitment to privatizing state enterprises through the capital market is welcome and should be maintained, but the market should not become a dumping ground for weak and non-performing public enterprises.

• Fiscal incentives to promote the capital market should be used with careful consideration for the potential impact on government finances.

Supply of securities • Privatization of state enterprises offers the most viable source of equities in the

EAC and efforts should be made to privatize the large state owned enterprises as soon as possible.

• Efforts should also be made to remove obstacles to the listing of small and medium size enterprises (SMEs). For instance, consideration should be given to reducing the required minimum number of shareholders for listing SMEs.

• As the markets develop further, consideration could be given to developing new financial instruments such as asset-backed securities.

Market development • The authorities in Tanzania and Uganda could also consider making commissions

negotiable as is the case in Kenya in order to improve market liquidity. • In the short-run, credit enhancements and guarantees could be used to make bond

issues more attractive, thus promoting the development of the debt markets.

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Stakeholder involvement • There is a need to disseminate information on regional integration of capital

markets more widely among key stakeholders in order to build a broad-based support for the integration agenda.

• In this vein, the CMDC should consider enlarging its membership to include representatives of the organized private sector (chambers of commerce, manufacturing associations) as well as financial intermediaries and institutional investors.

• Consideration could also be given to establishing a web-site for the purpose of informing the public about various activities relating to capital market integration in the EAC.

Medium-Term Priorities

Macroeconomic environment • Efforts should be made to continue and sustain the ongoing program to restructure

government finances and lengthen the maturity of government debt in Kenya and Tanzania.

• The problem of wide interest spreads requires attention, particularly by addressing some of the underlying causes, such as heavy short-term government borrowing and poor payment systems.

Policy framework

• Fiscal incentives should be aligned as much as possible. For instance, Tanzania could consider reducing the level of withholding taxes to match the levels in Kenya and Uganda.

• In order to maximize the gains from cross-listing and promote cross-border trading, free flow of capital across borders is essential.

Legal and regulatory framework • Although a certain degree of harmonization of rules and regulation is necessary

for regional integration, full harmonization is not a feasible objective. An easier and more pragmatic alternative is for the regulatory authorities to adopt principles of mutual recognition, especially where full harmonization proves too costly and time-consuming.

• It is desirable to liberalize financial services and allow various market intermediaries and other financial institutions to provide cross-border services using licenses obtained from their domiciliary regulators.

• It is important for securities regulators to ensure that the rule-making process is inclusive and transparent, in particular allowing an exposure period and inviting comments from stakeholders.

• Regulators should consider minimizing multiple prospectus filings. • There is an urgent need to modernize Companies’ law in Uganda and Kenya and

eliminate current problems of duplication and overlap with securities regulations. • The authorities should consider the creation of a “close corporation” statute as a

vehicle for establishing business enterprises.

Demand for securities • It is important to promote the development of Collective Investment Schemes

(CIS) as a means of aggregating the demand of individuals for securities

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• There should be efforts to consolidate current programs on investor education and public awareness at the country level and harmonize them at a regional level

• It is desirable to pursue pension reform in Tanzania and Uganda as this will be critical in unlocking substantial amounts of domestic savings and making this available for capital market development.

• The development of the life-insurance industry should also be pursued as it is also important in generating long-term funds for investment in the capital market.

• The authorities should allow institutional and other investors to buy securities in other EAC markets. This will require that EAC investors be treated as nationals in all three countries, both in the purchase of securities and in the taxation of investment income.

Supply of securities • A viable private sector is critical to capital market development. It is therefore

important to remove current obstacles to private sector activity in the EAC. The Regional Private Sector Development Strategy presently under preparation offers an opportunity to devise a coherent approach to making the private sector viable.

• The CMDC should compile a list of potential issuers of both equity and debt in all countries and initiate contact with individual firms to educate and improve the awareness of potential issuers about the benefits and relevance of capital markets to their operations.

• Listing requirements need to be streamlined and relaxed to fit the structure and particular characteristics of business enterprises in the EAC.

• It is also important to streamline public offering procedures, disclosure obligations and limit the number of market agents involved in the issuing process.

Market development

• The current stage of market development requires that authorities consider encouraging the emergence and growth of over-the-counter markets and venture capital funds

• Bond market development deserves urgent attention. It should however be noted that developing bond markets will require continued macroeconomic stability.

• Current efforts aimed at lengthening the maturity of government debt should continue. This is desirable not only in terms of the benefits for government finances but also in terms of providing a benchmark for corporate bonds.

• Developing credit rating systems is vital to the emergence of vibrant corporate bond markets.

• Improving liquidity on the markets will require the modernization of trading systems and reduction in transaction costs.

• There is a need to develop investment banking and underwriting in Tanzania and Uganda in order to further strengthen the institutional framework for capital market activities.

Market infrastructure • The proposed CSD system currently focuses on broker-exchange-depository

linkages but should also consider broker-customer linkages as well as a virtual communication network among the three exchanges.

• Consideration should be given to linking payment systems in the EAC to the CSD system to form an integrated payment, clearing and settlement framework.

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Market linkages • Consideration should be given to leveraging the markets in East Africa by linking

a regional EAC market to more developed markets in Africa or beyond. • The African Stock Exchanges Association (ASEA) could be used as a platform

for such linkages.

The road ahead • The success of regional integration will depend on finding solutions to key

country-level problems. It is therefore important to closely link regional market integration to local efforts to develop individual capital markets.

• Consistent and assured political backing of the EAC authorities will be crucial for capital market integration to materialize.

• The observed diversity in the three countries could be a source of regional strength as they can capitalize on complementarities.

• Consideration should be given to the idea of “variable geometry” whereby reforms at the country-level are closely linked but not beholden to regional integration efforts.

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Annex 1: Indicative Ladder of Capital Market Interventions in the EAC

Country level

• Maintaining fiscal discipline and restructuring government debt • Creating an enabling policy environment for capital market development (e.g.

fiscal incentives) • Developing government bond markets, especially improving auction procedures,

settlement infrastructure and primary dealer network to improve liquidity. • Addressing wide interest rate spreads through improvements in financial

infrastructure (payment systems, contract enforcement, etc) • Continued privatization through the stock market • Modernization of companies’ laws • Accounting and auditing reforms • Streamlining listing requirements and public offering procedures • Capacity building for regulatory agencies, including comprehensive review of

regulations, staff training and information systems • Capacity building for other market players, including brokers, dealers and

exchanges • Developing collective investment schemes, including appropriate legal and

regulatory frameworks • Pension reform and development of life insurance • Removing obstacles to private sector development (regulations, infrastructure,

etc) • Development of over-the-counter markets and venture capital funds • Development of capital market skills, especially by developing certification

programs for capital market professionals Regional level

• Cross listing • Market infrastructure (trading, clearing, settlement and depository) • Harmonization of regulations and guidelines for mutual recognition. • Harmonization of reporting and disclosure requirements • Liberalization of financial services and creation of “national investor” status. • Linkages with other markets to provide leverage and greater mass of supply and

demand • Linking capital market development with the EAC Regional strategy for private

sector development • Continued political commitment to integration

Overlapping areas (actions at both country and regional levels) • Public awareness campaign, including investor education and strengthening

stakeholder involvement in regional integration • Enhancing the awareness of potential issuers on the costs and benefits of raising

capital in the market • Private sector development efforts, including regulatory reform and business

development services • Developing the credit rating industry

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Annex 2: Comparison of Stock Markets in the EAC

Kenya Tanzania Uganda Official name Nairobi Stock Exchange

Limited Dar es Salaam Stock Exchange Limited

Uganda Securities Ex-change Ltd.

Legal form A company limited by guarantee without a share capital

A company limited by guarantee without a share capital

A private company lim-ited by guarantee

Regulator The Capital Markets Authority (set up in 1990)

The Capital Markets and Securities Authority

The Capital Markets Authority

Governing law Capital Markets Author-ity Act (Amendment), 2000, Act No. 3 of 2000

The Capital Markets and Securities Act 1994 (as amended)

The Capital Markets Authority Statute in 1996

Established 1954 Sep-96 Jun-97 Became operational 1954 Apr-98 Jan-98 Ownership Brokers Broker/dealers, listed

companies, banks, pension funds, etc.

Broker/dealers and in-vestment advisors

The number of listed securities

Common shares 50 4 4

Preferred shares 3 0 0 Bonds 30 3 1 Cross-listed 2 0 2 The number of market segments

3 (The Main Investments, Alternative Investments and Fixed Income Securities Market Segments)

3 (First, Second Tiers, & fixed income)

3 (The Main Investments, Alternative Investments and Fixed Income Securities Market Segments)

Key listing requirements (1)

The First tier Min. float of 25% and min. number of share-holders of 1000

Min. float of 25% and min. number of share-holders of 1000

Min. float of 25% and min. number of shareholders of 1000

The Second tier Min. float of 10%, and min. number of share-holders of 300

Min. float of 10% and min. number of share-holders of 300

Min. float of 10% and min. number of shareholders of 300

Trading hours 10:00 am - 12:00 pm on Mondays through Fridays (5 days a week)

10:00 am - 12:00 pm on Tuesdays, Wednesdays & Thursdays (3 days a week)

10:00 am - 12:00 pm on Tuesdays & Thursdays (2 days a week)

Trading system Continuous Open Outcry System

Continuous Open Outcry System

Continuous Open Outcry System

Main market index NSE 20-share Index Not constructed yet Not constructed yet

Market capitalization Kshs. 81,890 mil. (US$1,043 mil) (3/31/02)

TShs. 365.03 bil. (US$371 mil.) (12/31/01)

Ushs. 345.8billion (US$ 193m) (3/31/02)

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Kenya Tanzania Uganda Market cap/GDP ratio (for 2001)

9.9% 4.6% 3.4%

Turnover ratio (for 2001) 3.3% 2.4% 0.3%

Clearing, settlement and depository

Physical via the NSE Manual book-entry (Manual Central De-pository & Settlement)

Physical via the USE

Settlement cycle T+5 T+5 T+5 Active intermediaries Broker/dealers 18 6 7

Investment advis-ers / fund managers

23 7 6

Net capitals of Broker/dealers (12/31/2001)

N.A US$22, 000 – 215, 000 US$5, 000 – 22, 000(2)

Compensation fund In place In place In place Trading costs

Commission rates Negotiable under ceiling rates

Negotiable under ceiling rates

Negotiable under ceiling rates

For equities 1.1 - 2.0% (3) 1.1 - 2.0% (4) 1.1 - 2.0% (5) For bonds 0.15% N.A. 0.0625% Foreign investment re-strictions

The ceiling on foreign investment: 40% for institutions and 5% for individuals (Approx. 20 listed companies)

Restricted No restriction

Foreign ownership ratio 49% 75% N.A. (1) The listing requirements also include other criteria such as years of operation, company size, and profitability.

(2)Uganda Commercial Bank Ltd. is out of this range. It is the only broker/dealer in Uganda that is a commercial bank. Its net capital is Ushs. 6.06 billion (US$3.4 million). (3) Brokerage commission, NSE transaction fee (0.14%), CMA transaction fee (0.14%), NSE compensation levy (0.01%), and CMA compensation levy (0.01%).

(4) Brokerage commission, DSE transaction fee (0.14%), CMSA transaction fee (0.14%), Fidelity fee (0.02%), and CDS fee (TShs 100).

(5) Brokerage commission, USE transaction fee (0.14%), CMA transaction fee (0.14%), and Compensation fund fee (0.02%).

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