By Enock Twinoburyo
Uganda’s Central Bank may soon face a challenge in its conduct of monetary policy
In recent times, the media has been awash with digital migration, a term that has cascaded into politics, with digital and analogue presidential candidates. Kampala waved good bye to the analogue signal in June and since then, there have been massive adverts for digital migration.
As a recent recruit to DSTV in recent months, I have noticed that the pricing for the different packages has been on an upward swing largely pegged on the dollar exchange rate. Another classic example of business pegged to the foreign currency is the Electricity Regulatory Authority pricing of electricity units. This has sparked debate among economic practitioners regarding the use of exchange rate as a variable for adjusting electricity tariffs when it is already captured in the core inflation computation. Pegging of business pricing to the exchange rate is essentially used by investors to cover the exchange rate risk, often time known as covered interest rate arbitrage.
In the extreme case, a country with a perpetually weak currency will face a situation where its citizens officially or unofficially use a foreign country’s currency as legal tender for conducting transactions. Increasingly the major shopping malls around Kampala charge rental space in the US dollars as do many other business entities like hotels, schools, and land dealers.
Even in the media, the reporting of corruption cases involving large sums surface in dollar terms because, understandably, those who offer bribes transact in the dollar. The statistics also indicate that there has been growing trend of foreign deposits as a share of the total deposits, also referred to as dollarisation. By June 2015, dollarization, stood at 43%. This makes Uganda one of the most dollarized economies in the world.
Increasingly also the commercial banks hold significant assets in particular loans in foreign currency; foreign currency loans account for 45% of the total loans. The trend has been growing like cockroaches, which are never alone but in droves.
The private sector reliance on dollars has been triggered with the trend likely to continue to grow as foreign currency is seen as the currency for the future.
Dollarisation in part reflects a growing inflationary and volatile outlook, in particular among holders of non-monetary assets priced in foreign currency but are not invested abroad. Zimbabwe is one recent example. As a result of hyperinflation and associated depreciated currency value of ZW$10 billion to 0.33 US$ in July 2008, Zimbabwe was forced to adopt the use of foreign currencies, mainly the U.S. dollar but also the EURO and South African Rand as official currencies. This is what is regarded as official dollarisation.
In African history, 24 other African economies have practiced official dollarisation, some as a result of colonisation while others as result of economic, social and political disturbances. Uganda’s previous dollarisation was between 1906 and 1920, when the East African Rupee was used.
Uganda today grapples with de facto dollarisation, where there has been a gradual adoption of the dollar by the general public without deliberate support from government legislation. If the trend is not reversed, it could have far reaching effects on economy through various transmission mechanisms.
The most obvious and direct channel being compromising the effectiveness of the Bank of Uganda (BoU) monetary policy conduct. The increased dollarisation literally means strength of the dollar against the shilling, implying it would first and foremost keep the central bank on its toes in trying to ensure stability of the exchange rate. In the extreme lies the peril of drawdown of its reserves. The BoU reserves have since 2008 deteriorated from 6 months of import value to the current 4 months of import, in part owing to the stabilisation efforts of the exchange rate by BoU as well as fiscal slippages. In addition, the exchange rate depreciation exacerbates inflation expectations, as highlighted in the July monetary policy statement; it is expected to be between 8-10% over the next year. Management of the rapid depreciation of the exchange rate and the associated upward swings in inflation presents any central bank with a nightmare scenario bearing in mind the other supplementary objectives of creating a favourable environment for investment and growth as well as ensuring financial stability. In the end, the central bank’s independence may be compromised.
By definition, broad money supply encompasses currency in circulation, local currency deposits (demand and savings) and the foreign currency deposits. If the latter grows sizeably, it implies the central bank’s control of the money supply will be compromised as most of its instruments are tailored to controlling currency in circulation and the local currency deposits. The commercial banks, the main holders of the foreign currency deposits face a heightened foreign exchange risk exposure, mainly due to fact that foreign exchange deposits are responsive to the interest rate differentials (difference between local interest rates and regional or international rates).
In a nutshell, dollarisation is a sign of investors diversifying their asset portfolios in response to economic instability including persistent depreciation of the local currency and high inflation. In the long run, the store of value, unit of value and the medium of exchange functions of the Uganda shilling will be compromised.
Against this backdrop, everything needs to be done to addressing economic instability. This will require a concerted effort to address institutional, regulatory and structural bottlenecks to Uganda’s competiveness. In absence of the addressing these, direct de-dollarisation measures are essential. Nigeria for example has put an embargo on importation of foreign currencies as well as the acceptance of foreign currency deposits by commercial banks into the country to stem the dollarisation of the economy.
Enock Nyorekwa Twinoburyo is an economist PhD Research Fellow at the University of South Africa. Twitter: @Etwinoenoq