Thursday May 15 2014

Whose interest do interest rates serve in Uganda?

By Fred K. Muhumuza

Interest rates are one of the most important variables for management of an economy. Management here means making short-term operational and long-term strategic decisions for economic stability, growth and jobs creation. Practically, low interest rates are preferred by both government and the private sector since they allow borrowing to bridge the gap between low savings and the investment needs.

However, there is a problem! If interest rates are too low then scarce finances can be wasted on projects with low returns/benefits. Besides, too much borrowing due to low interest rates can trigger unnecessary (excess) demand for goods and services leading to inflation. Question One: “What level of interest rate is too low and at what level does demand become excess?”

While the interest of the private sector is best served by low interest rates that make it easy to borrow, this sector has no enforceable right to determine the level of interest rates. The formal and informal lenders normally decide the rate of interest. Conclusion One: Interest rates cannot serve the interest of the borrowing private sector!

The lending private sector too, is not fully in charge of setting interest rates. While high interest rates would be preferred by this group, it is not the best for genuine lenders who wish to maximise profits.

To begin with, high interest rates restrict borrowing to an extent that the ‘big returns’ on few borrowers fail to compensate for the losses due to less borrowing. Furthermore, high interest rates reduce the number of good or less risky projects, leaving a basket full of ‘bad apples’.

The resultant adverse selection problem (high likelihood of selecting a bad project) increases bank losses due to poor loan repayments and write-offs hence lowering bank profits. Conclusion Two: High interest rates cannot serve the interest of the genuine lending private sector.

Though public sector borrowing is not necessarily constrained by high interest rates, this is only in the short run. Overtime, the high interest payments, Uganda is to pay over one trillion in 2014/15, affect regular budget operations, lower economic growth due to ‘death’ of the borrowing private sector, reduce local revenues used to pay the debt – all leading to a possible debt overhang. This is the tale of an economy going to the dogs!
Why then would a government allow high interest rates? We have to consider the argument of excess demand and the need to reduce borrowed money, which is alleged to fuel inflation. I deliberately use “alleged” because inflation can also result from a “reduction in supply” implying that genuine demand can be treated as “excess demand”. I belong to the school that believes the major cause of inflation in Uganda is structural rigidities to supply, and that the long-term solution is to lower interest rates, stimulate private investments and increase supply. It is not a case of auto pilot – set a low rate and sleep – but real effective economic management using both short and long-term perspective to address other constraints.

The current economic management model uses high interest rates in a reactive mode to curb inflation rather than proactive stimulation of private sector growth. The Central Bank Rate is determined a few days following the inflation rate.

It may sound good short-term management of the economy, but when done for nearly two decades, high interest rates defeat the logic of good economic management for growth and jobs, which are the interest of the public sector. For example, high interest rates attract foreign speculative inflows that lower the exchange rate, which promotes imports at the expense of local production and jobs.

Conclusion Three: Interest rates do not serve the strategic interest of government. Could it be that interest rates in Uganda only serve the interest of taking the economy to the dogs? My dear reader, conclude. Question Two: “Who let the dogs out?”

Dr Muhumuza is a Development Economist.