Traders’ protests against rising interest rates have drawn attention to the precarious position of Uganda’s economy, as global economic instability meets local inflation. In this heavily edited excerpt from the Central Bank’s Monetary Policy Report for December 2011, Governor Emmanuel Tumusiime Mutebile’s warns that the biggest danger may come from afar:
Trouble from abroad
Trade and financial ties, so critical to driving the economy forward in good times, have—ironically—become the linkages that could spread escalating economic risks. A sustained growth slowdown in advanced countries, together with continued financial market instability, will dampen demand for Uganda’s exports, inhibit private financing flows, remittances, and aid.
Pressures are already mounting on the Uganda’s capacity to finance current account deficits. Given the economy’s high dependence on foreign capital, the marked decline in private capital inflows could lead to an abrupt contraction in domestic demand and sharp adjustments in current account deficits. The potential for greater volatility in commodity markets, coupled with Uganda’s limited capacity to absorb further shocks, are of greater cause for concern if the global slowdown turns out to be more pronounced than predicted.
Policies are walking a fine line—on one hand, defending against the immediate risks from the global slowdown, while also preserving budget resources to invest in infrastructure that should help in promoting growth. Fiscal policy also needs to focus on building fiscal buffers.
Overall, Uganda’s economic activity could decelerate sharply in the event of a persistent euro debt crisis. Moreover, since growth in advanced economies is expected to remain low, it is implied that Official Development Assistance and remittances to Uganda might also decline, further curtailing growth.
Inversely, the slowdown in global activity might imply that costs of importation decline, a benefit to a net importer like Uganda. Also, the expected decline in commodity prices and global inflationary pressures might cool domestic inflation and cause reductions in domestic costs of production and interest rates.
Credit & interest rates
The weighted average lending rates on domestic currency denominated loans increased by 20 basis points to 23.5 percent observed in October 2011. Time deposit rates on the other hand fell by 160 basis points to 12.9 percent while demand and saving deposit rates remained stable at 1.2 percent and 2.4 percent respectively. Due to the rising lending rate and declining time deposit rate, the spread widened to 10.7 percentage points in October 2011 from 8.9 percentage points in September 2011. The increase in lending rates is consistent with the tight monetary policy for the month.
Lending rates on foreign currency denominated loans declined by 20 basis points to 9.5 percent from 9.7 percent in the previous month. On the other hand foreign currency demand and time deposit rates remained fairly stable at 1.0 percent and 1.5 percent, respectively in October 2011. The lower cost of foreign denominated funds is possibly linked to the appreciation of the Uganda shilling against the US dollar in the month.
The stock of private sector credit (PSC) shows a slight decline because commercial banks increased the tenor of the existing loans to forestall possible loan defaults following interest rate hikes. The extension of loan tenors implies that the value of the stock of loans increased not because of new loans but because the existing stock of loans was subjected to a higher interest rate.
Private sector credit declined by 1.5 percent in October compared to a 3.5 percent increase the previous month, on account of lower growths in foreign currency (US$) and shilling denominated loans of 1.4 percent and 1.2 percent respectively in October 2011 compared to 4.7 percent and 2.6 percent in the previous month.
The rapid exchange rate appreciation observed towards the end of October 2011 is likely to have affected monthly private sector growth as foreign currency denominated loans in shillings fell by 7.6 percent compared to an increment of 6.4 percent in the previous month.
PSC grew by 37.0 per cent in 12 months to October 2011, although notably lower than the 46.8 percent growth in September 2011. The trend of credit growth to the productive sectors is in line with that of gross private sector credit. In annual terms, commercial banks’ credit to the trade and agricultural sectors fell to 31.5 percent and 41.9 percent respectively from 36.2 percent and 53.4 percent in the preceding month.
Trade and commerce continued to lead with the highest proportion of total private sector credit at about 22 percent. The building, mortgage, construction& real estate and the personal & household sectors’ share increased slightly from 20.4 percent to 20.9 percent and 16.6 percent to 16.9 percent, between September and October 2011. Conversely, the manufacturing sector’s share declined from 13.0 percent to 12.3 percent in the same period.
The decline in credit is also evident in net monthly loan disbursements, with credit extensions declined to minus Shs 58 billion in October compared to Shs 215 billion in September. Further, both demand for and supply of credit proxied by the number of loan applications and approvals continued to fall by 675 and 611, respectively in October, due to the increased cost of credit as a result of the tight monetary policy stance by BOU.
Inflation slows
The inflation momentum, which had peaked in October 2011 to a revised annual headline inflation of 30.4 percent declined to 29.0 in November 2011. Annual core inflation also declined to 30.6 percent from 30.8 percent in October 2011. Annual food inflation dropped to 40.3 percent from 45.8 percent, in tandem with the food crops inflation, which also dropped by about 10.0 percentage points to 25.8 percent from the 35.3 percent recorded in September 2011. Annual non-food inflation remained somewhat stable.
It’s still premature to pronounce whether the decline noted this month will persist, however going forward, monetary policy remains committed to low stable inflation in the long term. Of course a sustained decline in inflationary pressures holds big implications for the economy, especially as economic agents had begun discounting heavy future inflation pressures into their allocation decisions.
The relative slowdown in the inflation momentum during November is attributed to the continued increase in food supply, as reflected by the downward trend in prices of key categories of food stuffs (staples, dry vegetables and fresh fruits) since July 2011.
The November 2011 monetary policy report indicated that inflation would remain elevated till late 2012 on account of sticky prices, persistent uncertainty and the exchange rate depreciation pressures before moderating to 5 per cent by early, 2013. The November inflation at 29 per cent was what had been projected in October 2011.
The momentum of month-on-month inflation, which decelerated for a consecutive month in November 2011, led by a sharp decrease in the momentum of food inflation, suggests that inflation has peaked. In addition, the input prices, which had surged across the board in September and October in response to the sharp currency depreciation are likely to decrease in the coming months. Inflation is also likely to drop quite meaningfully from January 2012 on account of favourable base effects, though while the base effects are large, they are also fleeting. A weak demand growth and continuing excess capacity in the economy will also tend to depress domestic inflationary pressures for some time to come.
The forecasts, however, remain unchanged. Headline inflation will remain within the 27-30 per cent range in December 2011 and gradually decline to between 16 and 20 per cent by June 2012. Core inflation will remain within the 28-30 per cent range and gradually decline to about 20 per cent in June 2012. The inflation forecasts for the second half of 2012 and first half of 2013 have been lowered, reflecting rapid deceleration in the monetary aggregates growth, the exchange rate, the revisions to the growth forecasts, lower growth in commodity prices and global inflation. The year-end rate of CPI inflation is expected to fall to about 8 per cent by end of 2012 and decline further to around 4 per cent in mid-2013, before again easing back. This general outlook for inflation is conditional to a slightly appreciated exchange rate, lower monetary aggregates, global inflation, international food prices and crude oil prices. It is also conditional on a pick-up in productivity growth as firms respond to competitive pressures and take advantage of lower prices for capital goods in international markets.
Strains in global economy and deterioration in Europe are significant downside risks to the economic outlook. Given Uganda’s strong trade links with Europe, it would be directly affected. Moreover, the slowdown in global recovery implies slower export growth for Uganda, with implications for overall economic growth. These forces combined, could lead to a widening of the external current account deficit, with implications for domestic exchange rate stability. Turbulence in financial markets could add greatly to the volatility, leading to sharp bouts of risk-aversion. Fortunately, commodity prices and overall inflationary pressures, particularly in advanced economies and some emerging markets have started to wane. This will feed through to domestic inflation, and cause costs of production to reduce as input costs decline, in turn, leading to an easing in domestic inflationary pressures in the near-term.
The projected 5 per cent GDP growth for 2011/12 could be ambitious given recent global developments, but we expect growth to linger between 4 per cent and 5 per cent, aligning with recent global developments. The slowing down in domestic demand and the fall in commodity prices over recent months are both likely to contribute to lower inflation over the period ahead. Since inflation seems to have peaked, a more neutral stance of monetary policy could be appropriate given that inflation is likely to decline and economic growth is expected to remain subdued.
Despite these concerns for growth, BoU cannot yet loosen monetary policy. The challenge of bringing down inflation to an acceptable level on a sustainable basis remains significant. BoU will therefore maintain a tight monetary policy stance in December 2011, by keeping the Central Bank Rate (CBR) at 23 percent.
In suffices to point out that BoU is not indifferent to the adverse effects increase in the interest rate can have on the economy. This is precisely the reason why the tightening of monetary policy has been gradual. In addition, the exchange rate appreciation in part as a result of tight monetary policy, is a double-edged sword; it is costing exporters since the prices of Ugandan exported products are relatively turning out to be high. At the same time it is necessary to bring down inflation. Therefore, BoU’s tight monetary stance will continue to reflect a combination of the need to stabilise the economy and the structural problems that could be aggravated by in the interest rates hike.
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