Balancing between inflation control and investment growth
In order to strike a healthy balance between controlling inflation and maintaining investment, it may be necessary to modify the Central Bank’s intervention. However, and because of the credit and horizon risk differences, the measures taken to regulate short-term borrowing and its effects should be different from those measures taken to regulate long-term borrowing and its effects.
Apart from the correlation between foreign exchange and interest rates in the current policy interventions, there are other effects in the financial markets and in the economy. The high cost of borrowing, which the business community, including KACITA, has complained about lately, results in an increased rate of loan default and a corresponding increase in the non-performing loans (NPL). NPL is a measure of credit risk; an increase in NPLs directly increases interest rates charged by the banks. The high cost of borrowing also results in an increase in book profits for the Commercial Banks in the short term but may result in lower profits or losses in the medium to long term due to higher provisioning charges.
In addition to these effects in the commercial banks, the Central Bank’s response in raising CBR makes investment in Treasuries very attractive. As a result, investments in equities and other instruments decline. For example, during the period since June 2011, the USE All Share Index has lost over 30 per cent of its value, in part because Treasuries attracted liquidity away from the equity market, and in part because the listed firms are operating in a higher interest cost environment. Higher cost of funds reduces the viability of firms, stifles their growth, and by extension the value of their shares leading to competition for scarce resources between private sector and the public sector.
High interest rates have other indirect effects. These derivative effects tend to be more intractable than the direct effects, with the ability to adversely impact economic performance of the country for long even after the CBR policy is reversed.
For instance, it is now evident that mortgage defaults are increasing. Given the long-term nature of mortgages, some contracted in a significantly different interest rate environment, defaults in this sector will have the effect of reducing the gross tenure of bank assets. A high default rate will also increase the risk of lending on a long-term basis and compel banks to revert to short-term lending, which would tend to negate a major goal of the current CBR policy to reduce short-term bank assets.
To put one of the effects of the ruling monetary policy in perspective, one needs to track the direction of flow of financial gains resulting from the policy. When the CBR was pegged at 25 per cent, yields on Treasury bonds rose close to the CBR. These yields attracted speculative foreign capital, which came into Uganda at an exchange rate of about Shs3,000 per US dollar. The shillings acquired were then invested in the treasury market for a yield of about 25 per cent per annum. In the meantime, over the ensuing weeks the foreign exchange rate dropped to Shs. 2,400. This means that if one started with US$ 100,000, they would exchange that for Shs 300,000,000 to invest in treasuries.
After three months one could earn Shs18 million from investment in Treasuries and buy back US$ 100,000 for Shs 240,000,000. In other words within three months the investor would gain Shs78m, i.e. a neat rate of return of 26 per cent per quarter or 104 per cent per annum in shillings and 130 per cent per annum return in dollars. In this simple analysis it is quite easy to see the direction of the gains. It is therefore not difficult to see why foreign investors would come in droves to invest in our treasury market. While the entry of foreign portfolio investors is usually a positive sign for the economy, their exit after attaining the desired returns is the cause of unhealthy volatility of the currency, leading to the debilitating impact on foreign currency reserves and price increases. There is likely no market currently around the globe that offers such returns.
As result of the gains available due to the monetary policy stance and the paired movement of the interest rate and the foreign exchange rate, there is room to modify the policy. However, this modification would need to take the shape of a combination of interest rates and tax rates. Using interest rates and tax rates in tandem effectively modifies the cost paid by the borrower, enables the banks collect close to what is due to them and the government to absorb the amount of Uganda shillings it needs to curb inflation. The alterations would also enable the Central Bank to decouple interest rate from foreign exchange movements.
Two possible measures the Central Bank and Government could take would lighten the load and make the process of inflation management less stressful. The first is for the Central Bank to create another rate to reflect long-term inflation projections and to regulate long-term lending. Let us say that rate would be called CBR2.
While acknowledging the Central bank does not usually provide long-term funds on which it can charge CBR2, a careful analysis of the metrics that form an interest rate should enable the Central bank arrive at a CBR2 that would then be used by the banks to guide interest rate adjustments on long-term assets. CBR would be left to impact short-term assets. Since CBR and CBR2 would necessarily derive from different metrics and analyses, they should result in different policies during a typical monetary policy cycle.
The other possible measure would include tax policy modifications designed to make certain types of long-term lending products tax deductible. Tax deductibility means that before a tax liability is computed on an income, allowable deductions would have to be made first. In the case of a tax deductible mortgage, tax liability would be computed after reducing the incomes by interest due on the mortgage. Effectively this would reduce the cost of the mortgage, while enabling CBR to tighten on the short end of the interest rate spectrum.
Any combination of the multiple CBR policy above and tax policy innovation would help deliver the fight against inflation, while assisting to maintain the required rate of investment in the economy.
Secondly, the proposed introduction of CBR2 and tax deductibility would begin the process to decouple, even partially, the movement of exchange rates from interest rates. Today, given the paired movements, where a change in interest rate determines the exchange rate market, decoupling would enable the Central Bank acquire the flexibility in dealing with interest rates independently of the exchange rate.
In order to advance the decoupling process and to control inflation more directly, rather than through an exchange rate-linked mechanism, the Central Bank would need to attract Uganda Shillings holders to invest in the Treasuries market. Alongside, the Central bank would foster a potentially separate policy on the Uganda shilling in the foreign exchange market.
In order to attract holders of Uganda shillings to the Treasury market, it is vital that access to debt securities is broadened. Currently government debt securities are traded in a primary and secondary market operated by the Central Bank. Steps have been made to have Treasury Bills and Bonds traded on the Uganda Securities Exchange, where the number of investors is substantially higher and the reach of the securities broker community substantially further than the current configuration.
These steps are expected to bear fruit soon. By attracting Uganda shillings into this market independent of foreign portfolio flows that affect the exchange rate, Uganda will be able to achieve (i) a true inflation targeting policy that relies on Uganda shilling interest rate management, (ii) a foreign exchange rate regime that reflects Uganda’s true international trade performance and (iii) the creation of a foreign exchange market into which the Central Bank can intervene with other motivations independent of interest rate policy.
If the above modifications to policy were in place the treasury securities market would offer a beneficial alternative, while delivering less stress to the various economic actors across the country.
The writer is the CEO of Uganda Securities Exchange (Mr.Kitamirike)
