Bank of Uganda Deputy Governor Speaks out on Interest Rates and Kampala Traders Strike

14-Jan-2012

Members of the Kampala City Traders Association (KACITA) have closed their shops this week in protest
against the higher interest rates that they now have to pay on their bank loans.

I have a lot of sympathy for all
Ugandan borrowers who face higher interest costs, but unfortunately higher interest rates are unavoidable given the difficulties
currently facing our economy, in particular because of the need to bring down inflation.

Last year our economy was hit by major shocks, which drove up consumer price inflation and caused the
exchange rate to depreciate (it became more expensive to purchase foreign currency).

The exchange rate depreciation also
fed back into higher consumer price inflation because of its impact on the Uganda Shilling prices of imported goods.
Inflation hurts ordinary people, because it raises the cost of living, and it usually hits the poorest people the hardest.

Inflation also makes business planning more difficult, and so persistent inflation discourages the private investment that we need to
generate employment and economic growth over the long term. For these reasons, controlling inflation is the policy priority of the Bank of Uganda.

To curb inflation, the Bank of Uganda raised its policy interest rate – the Central Bank Rate (CBR) - last year. The CBR currently stands at 23 per cent.
The Bank of Uganda does not directly control the interest rates which commercial banks charge their borrowers or offer to depositors.

These interest rates depend on the specific characteristics of individual customers. In a market economy the commercial banks must have
some freedom to set interest rates in accordance with market conditions and business costs if the financial sector is to develop and serve the
needs of its customers; high lending rates are often necessary to allow banks to extend credit to risky projects. But the CBR sets a benchmark
for other interest rates in the economy.

Normally, commercial banks will set the interest rates that they charge on their loan rates above the CBR,
because these lending rates must also cover the cost of mobilising funds, administering the loans and of possible losses from loan defaults.
When the Bank of Uganda raised its CBR last year, commercial banks followed by raising their lending rates, as was to be expected.

The Bank of Uganda’s policy of raising interest rates has started to bear dividends. Bank lending has slowed sharply since September of last year;
a slowdown which is necessary to curb overall expenditure in the economy. The exchange rate has also strengthened because of the higher interest rates.

In mid October, the US dollar cost about Shs2,850; the current rate is about Shs2,460; an appreciation of 14 per cent over the last three months.

The members of KACITA, who trade mostly in imported goods, had previously complained vociferously about the depreciation of the exchange rate and
the negative impact this had on the costs of their business. But they have been silent on the recent strengthening of the exchange rate,
which benefits them because it makes imports less costly, and which is directly attributable to the Bank of Uganda’s policy of raising interest rates.
Most important of all, we have now started to see a decline in annual inflation, which fell from a peak of
31 per cent in October to 27 per cent in December. Our policies are, therefore, having their intended impact,
and if we persevere with them, we can expect that consumer price inflation will continue to fall back throughout 2012.
This will allow interest rates to be reduced gradually during the course of 2012, once the downward momentum of inflation is irreversible.

Accepting KACITA’s demands to reduce interest rates immediately will jeopardise our prospects for bringing down inflation.
A reduction in interest rates now would risk triggering both an acceleration of credit growth and a fall in the value of the exchange rate,
which would drive up consumer prices. This would be disastrous, not just for ordinary Ugandans but also for KACITA. In the current economic circumstances,
it is not possible to curb inflation and maintain a relatively stable exchange rate without high interest rates. However, accepting some pain now,
in the form of higher interest rates, will make it more likely that interest rates will be lower in the future as inflation is brought down.

KACITA has also argued that the increased interest rates should only be applied to new loans and not to existing loans. Customers have the
option of negotiating with their banks for fixed interest rate loans or variable rate loans. Variable rate loans are not necessarily disadvantageous
for borrowers because sometimes they are cheaper than fixed rate loans. But if borrowers do not want to run the risk of having to pay higher interests
rates in future, they should insist on a fixed interest rate loan.

Dr Kasekende is Deputy Governor, Bank of Uganda