AS commercial bank interest rates continue to bite, the Crane Bank vice-chairman Sudhir Ruparelia's appeal to Ugandans to save more could not have come at a better time.

Even though inflation has continued to drop over the past nine months, bankers and economists have come out sternly, warning borrowers to brace for higher interest rates for most of the year than levels witnessed at the start of the year 2011.

Prime commercial bank interest rates, the lowest level of interest reserved for the best commercial bank clients, has fallen to an industry average of 25% from highs of 30% still far off the average 18% seen in June last year.

At the same time, the benchmark Central Bank Rate (CBR) has fallen from 23% to 17%, giving impetus for commercial banks to decrease rates largely to stimulate economic activity that had fallen in recent months.

"True the Central Bank has reduced the central banking rate but this is just one indicator. The whole equation relies on demand and supply of money in the market," Ruparelia said recently.

"The worst is over and it won't be long before we normalise. The individual banks have to sweat it out and bring in more cheap deposits and in turn translate this into cheaper credit for the public," he added.

Commercial banks have found themselves in a hard spot whereby they need to dispose of expensive credit acquired in previous months at same time having to provide cheaper credit in line with recent CBR reductions.

Faisal Bukenya, the Barclays Bank head of market making, says the borrowing rates are likely to stay high through the year as cash conditions ease following months of tightening.

"There are still hurdles to reach the 18% commercial bank interest levels. I expect the lending rates to fall within the 23% to 21% by the end of the year.

"Interbank rates are still high and economic activity is still slack," he said.

"We have been borrowing at rates of 20% or 22% on the inter-bank market for one week for the last months," he added.

Juma Kisaame, the dfcu Bank boss, says they are closely monitoring the economic situation before deciding on further prime lending rate reductions.

He adds that banks borrowed money at a time of high interest and that such contracts are still running.

"So you may not see a drastic drop in interest rates because some financial institutions borrowed during the hard economic crisis. Some may decide to first clear those contracts before lowering their rates," explained Kisaame.

He said pricing decisions are done by individual banks depending on their cost model in order to arrive at the prime lending rates.

He added that this takes into account many things which include inter-mediation and cost and source of funds.

Recent reductions of the CBR and commercial bank lending rates have seen stronger growth in new loans to the private sector, especially to the agricultural sector, at sh38b in May 2012 from sh24b in April.

Manufacturing sector loans were strong at sh80b, trade loans at sh115b, construction sh80b, services sh42b, transport and communications at sh20b and personal loans sh36b totalling sh411b, as the economy resurges.

Uganda Bureau of Statistics (UBOS) indicates that the gross domestic product (GDP) rose 2.4% to sh5.6 trillion by seasonally adjusted estimates in the year ended March 2012 underlining a healthy and strong growth.

The need for higher savings

Despite the strong economic growth, Uganda's savings culture remains low at 1.5% (sh84b) to the GDP at market price when compared to China 38%, India 34.7%, and Turkey 19.5%.

Analysts say increments in the level of savings will profoundly bring down interest rates and get the country out of poverty as it moves toward attaining middle income status.

"It is important that each economically active Ugandan starts a relationship with a formal financial institution today," Sudhir says.

"There is an estimated 20 million economically active Ugandans and if we each made an effort to save at least sh10,000 every month, this would generate an extra sh200b every month and sh2.4 trillion a year to lend out. This would significantly impact on interest rates, create thousands of jobs and fundamentally shift our poverty levels," he added.

Sudhir explains that although reducing interest rates is critical to getting the economy back on its feet in the short term, it is more important that all stakeholders address the issue of increasing savings as a more permanent solution.

Dennis Kedi, a researcher, says through savings, there will be capital accumulation, leading to investment hence economic growth and ultimate development.

"The fear of saving money has kept many Ugandans under abject poverty. While people want to borrow money, they still have a culture of fearing to save," he says.

"People with periodic income should inculcate the saving culture in order to reduce the current poverty levels. Ugandans must learn today to live within their means if we are to have a breakthrough," he adds.

The number of banked Ugandans is still low with estimates showing that the country has only four million bank accounts for a population of 34 million.

How interest rates are determined

Supply and Demand

Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.

Inflation

Inflation will also affect interest rate levels. The higher the rate of inflation, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in the purchasing power of the money they will be repaid in the future.

Government actions

The government has a say in how interest rates are affected. The Government often comes out with announcements about how monetary policy will affect interest rates on the monthly basis.

The Government also influences commercial bank interest rates through the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system. Purchases inject money into the banking system and stimulate growth while sales of securities do the opposite.

Borrower's risk profile

A borrower who is a high risk to the bank will attract a higher interest rate than one the bank considers low risk.