17 July 2011

Uganda: Inflation, Weak Shilling Threaten Growth Target of Seven Percent

Nairobi — Uganda, more than any other country in the region, has been hit by a wave of street protests that have raged for the better part of this year.

Triggered by the rising cost of living, the protests are a signal that worse threats to the economy lie in wait.

The Bank of Uganda's adoption of a signal lending rate earlier this month could well steer Uganda's faltering economy back to stability in coming months, but its success is heavily dependent on government actions over the next couple of months, analysts said. The economy is currently facing high inflationary pressures, a volatile exchange rate, rising interest rates and structural challenges that have set Uganda businesses on a collision course with the government. These have triggered a series of protests in recent weeks as traders demanded action on the runaway exchange rate as the shilling depreciate to unprecedented lows against the dollar.

Analysts at Stanbic Investments (East Africa) in their Quarter Two 2011 Report for Uganda see a continued rise in interest rates unless liquidity constraints and the rising inflation are resolved. BoU director of research Dr Adam Mugume said the Bank had anticipated the current turmoil in the exchange rate as early as late 2010 and provisions for intervention in the market had been made then.

"From monitoring the local and international economic climate, we had anticipated that the shilling would be trading in the region of 2,500 to the dollar at about this time. What we did not anticipate was that inflation would jump by 17 per cent in just one month between March and April 2011," Dr Mugume said, adding that the depreciation of the shilling to 2,700 against the dollar in late June was largely the result of anxieties surrounding media reports of a falling out between BoU Governor Dr Emmanuel Tumusiime Mutebile and President Yoweri Museveni.

The Bank launched Inflation Targeting, a new tool for managing price stability, in the market on July 5, under which the bank will be announcing a Central Bank Rate every month. Set at 13 per cent for July, Dr Mugume said the signals so generated should reduce the appetite for borrowing by the public, eventually restoring parity between money supply and goods in the market.

"In line with BoU's tightening monetary policy, we believe interest rates are likely to rise. The latter will impact on credit extension to the private sector, which is vital for sustained economic growth," said researchers at Stanbic.

The collateral impact on returns on government securities should also attract offshore investors and trigger positive foreign exchange inflows that should restore the exchange rate to more realistic levels.

"In circumstances like these, the biggest risk anywhere in the world is government discipline. If the government can desist from excessive spending, this policy tool should bring a degree of price stability to the market," Dr Mugume said.The shilling has lost 10 per cent of its value year on year. While this was expected to work for the export sector, prolonged drought has limited the gains there while the large community of traders has found it difficult to sustain imports, triggering protests.

Although a spike in inflation has not been limited to Uganda -- inflation is at 14.5 per cent in Kenya and 10 per cent in Tanzania, with only Rwanda managing to keep it in single digits at 6 per cent -- the Ugandan situation is the most worrying, with the region's highest inflation at 16 per cent.

"It's obvious we are giving the wrong medicine to the patient. The budget speech did not give us a direction where we are going, so this kind of inflation is very worrying," said Allan Mugisha, a tax partner at audit firm Ernst&Young.

Two weeks ago, traders closed their business premises protesting what has become an unsustainable economic climate, with the unpredictable dollar-shilling exchange rates making it hard for businesses to meet their tax obligations. But as soon as the traders returned to their shops, electricity generation firms shut down their plants over the government's failure to pay debts amounting to $81 million, further compounding the traders' misery.

Last week, the Kampala City Traders Association (Kacita) business lobby demanded that the government fix the exchange rate for tax purposes at between Ush2,000 and Ush2,200 to the dollar, or face a boycott. "For duty purposes, we need a predictable exchange rate, at least for three months. Should the government fail to fix this, we will close our shops for a week, we will stop importing and therefore we will stop clearing goods with URA," Kacita spokesman Issa Sekitto said. But Deputy Secretary to the Treasury Keith Muhakanizi said this was not possible. "Can we fix the exchange rate? That's a policy matter, decided at EAC level. I cannot answer," he told The EastAfrican.

Reacting to the traders' two-day strike, President Museveni said a weak currency was good for the country as it helped grow exports and turn around the balance of trade deficit. "The shilling will never collapse, because the economy is well-managed, the indiscipline of the various actors and their lack of foresight notwithstanding. It will simply become more expensive for those who import goods and services from outside to buy the dollar. Therefore, there should be no talk of the collapse of the shilling. There should be talk of a more expensive dollar for those who import," his July 7 statement to the media read. Museveni has also issued a directive to stop exports of unprocessed maize -- a long-term measure to take effect at the end of 2012, meant to ease food inflation locally.

Uganda's economy is heavily reliant on the services sector, which is in turn heavily reliant on imports -- companies in the telecoms sector, for instance, use imported fuel to run generators that power their base stations throughout the country. The same is true of the banking and construction sectors -- the latter this year is set to grow at a rate of 7-8 per cent, outpacing national economic growth. This means that a spike in fuel prices and other imported inputs impacts on their operations, with a braking effect on the growth rate of the whole economy.

After initially failing an IMF policy review in February, Uganda was given a clean bill of health at the end of June when the Fund said the economy was grounded on sound macroeconomic policies, which had enabled it to negotiate the global financial crisis and other shocks; but, the Fund warned, "Inflation risks, mostly related to rising food prices, have increased. Modest intervention by the central bank has mitigated the volatility of the exchange rate, and the financial sector remains sound. "The main challenge facing economic policy makers at present is to adjust fiscal and monetary policies to safeguard macroeconomic stability and rebuild policy buffers, including international reserves. Scaling up infrastructure investment will also be key to faster growth over the medium term," said the Fund's deputy managing director, Naoyuki Shinohara.

However, economists at the Ministry of Finance believe that the economy will remain resilient and grow at the projected 7 per cent rate on the back of the slackening food inflation, resumption of the Sudan export market and the return of aid from major donors -- the World Bank, IMF and bilateral donors.

Mr Muhakanizi said the Treasury is working on the assumption that with food inflation now starting to come down (it shot to 36 per cent in May but scaled back to 33 per cent in June as the harvest season kicked in) inflation will be around the 10 per cent region by the end of year.

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