I recently received a notification from my bank increasing the prime lending rate from 23.5% to 26.5% applicable to both the existing and new borrowers.  This also implies that majority of the borrowers, who are not the prime clients; will bear much higher interest rates of near 30%. The reason highlighted is prevalent tight market conditions, which in part are reflective of Bank of Uganda's recent increase of its Central Bank Rate (CBR) to 17% in October 2015 from 16% August 2015. While, the latter is justifiable, the banks exhibit a moral hazard effect in increasing the interest rates, when on the other end; they are largely funded from the cheap customer deposits. Deposits accounted for 80.6 percent of total commercial bank liabilities in December 2014, a level that remains relatively unchanged compared to December 2013.

Also as at end of June 2015, total banking loans stood at UGX 10.5 trillion while customer deposits stood at UGX 14.5 trillion. This ideally implies that banking loan portfolio is backed up by cheap source of deposits. Despite, the high interest income for the banks, the average cost to income ratio for the banks is rather high at nearly 70%, with the bottom 15 banks operating at near 100% or above. The recent closure of the Global Trust Bank and temporary take-over of management of Imperial Bank Uganda is illustrative of the struggle at the bottom.  The cost to income ratio is way better for the top five who account for more than 80% of the total profits. The irony of persistent high interest rates in a liberalised banking sector and high cost to income ratio is indicative of fundamental structural, regulatory, and institutional weaknesses. 

These structural impediments are also traceable in other economic sectors. A 360 degrees view of Uganda's economy reveals a trend widening twin deficits: fiscal and current account (and of large magnitude), persistent cycles of inflation caused by food supply constraints, depreciating local currency, subdued private sector investment, low and stagnating levels of savings. All these factors will eventually constrain the modest economic growth; which by the way has stagnated and grown at the least rate in the East African region over the last 5 years.

The exchange rate appreciation (or shilling depreciation) has occurred over the long-term since the early 1990s and the pace has increased in recent years with the increased financial integration of Uganda’s economy with the rest of the World. The main underlying driver is the growing trade deficit with the rest of world. While a cheap shilling would ideally have spurred export growth, this has not materialised largely due the weak export competitivess and broader production and productivity challenges. The productivity challenges are also exhibited by the sporadic food inflation being the dominant cause of prices growth. It is paradoxical for a country that prides itself as a food basket for the region. To illustrate the investment gap in the agricultural sector: the October monetary policy statement intimates that inflation is expected to increase due to envisaged rains. In part, the roads will be impassable and crops will be spoilt.

In 2011, the monetary policy statements highlighted an extreme environmental challenge of drought as main cause of inflation expectations. In short inflation has largely been a case of too little supply not too much demand which lends credence to fact that over the long term, it is evident that the structural factors have had a sizeable effect on inflation trend. As a policy response, the central bank uses the hikes in CBR to constrain the aggregate demand.  This is only a temporary measure, but not sustainable in the long-term. You simply can't address supply constraints but curtaining demand growth. If anything, high interest rate subdues production (supply) in the key sectors and mitigates private sector growth whose growth has been relatively slow in recent years. The risk of crowding out the private sector has increased in recent years, with increased domestic borrowing growing. The domestic borrowing annual growth rate of 30% is higher than that of the private sector credit growth.  The depreciating shilling, the higher inflation expectations and the growing fiscal debt have led to Moody Investors service to change the credit rating for Uganda from B1 stable rating to a B1 negative.

Without addressing the fundamental structural economic challenges, Uganda shall remain in a cycle of contractionary monetary policies and high interest rates even when it is growing below potential growth.  Yet on the other side, the world has seen a cycle of unconventional expansionary policies such as quantitative easing as well as Abenomics. The lessons are indicative of fact that where the private sector has immense challenges: government should assume a more proactive role. Uganda's structural (productivity and competitiveness) challenges can largely be addressed by fiscal policy. With dwindling fiscal space however, structural shifts within execution of budgets is needed.

By Enock Nyorekwa Twinoburyo

PhD Research Fellow - University of South Africa.