Central Bank governor Emmanuel Tumusiime Mutebile has said Bank of Uganda will no longer inject dollars in the currency markets because it is not sustainable
Many people in the business community are concerned about the developments in the exchange rate. Over the course of the 2014/15 fiscal year, the Ugandan Shilling depreciated against the US dollar by 27 per cent. Uganda is, however, not alone in this respect. Many emerging and frontier markets have suffered similar problems to Uganda over the last 12 months because export commodity prices have fallen, demand in key export markets has weakened and it has become more difficult to mobilise capital on international markets.
For Ugandan importers and exporters, the most relevant measure of the exchange rate is the trade weighted exchange rate index, which is based on a basket of currencies from the countries with which Uganda conducts international trade. The trade weighted exchange rate index depreciated by 17.5 per cent in 2014/15.
Why did the Shilling depreciate?
Uganda has a market determined exchange rate. As such the strength of the supply of, and demand for, foreign exchange are the main factors which determine the exchange rate. Developments in the balance of payments (BOP) determine the supply of, and demand for, foreign exchange. In the 2014/15 fiscal year, Uganda’s BOP deteriorated as a consequence of several factors.
First, Uganda’s current account deficit widened in 2014/15 by an estimated $700m, to almost $2.9b. This was mainly because our exports of goods and services fell in the last fiscal year. Despite the fall in the price of oil, which enabled Uganda to reduce its fuel import bill, imports of goods and services increased, partly because of higher government spending on imports related to infrastructure projects but also because of stronger demand from the private sector for non-oil imports.
As a result, our trade deficit in goods and services was larger by $582 million in 2014/15. In addition to the larger trade deficit, dividend payments by foreign owned companies were higher by almost $250 million, which reflects a recovery in corporate profits in 2014/15, and this also contributed to the widening of the current account deficit.
Our current account deficits have to be financed by surpluses on the financial account. While the current account deficit widened in 2014/15, the surplus on the financial account failed to keep pace. This was mainly because of a fall of almost $240 million, or about 20 per cent, in inflows of foreign direct investment (FDI). The fall in FDI in the last fiscal year was mainly because of lower foreign investment in the oil industry.
Because the financial account surplus was not large enough to fully finance the current account deficit, Uganda incurred an overall BOP deficit in 2014/15, and hence a fall in foreign exchange reserves, which is estimated at $535 million.
What are the prospects?
Unfortunately, there is little prospect for substantial improvement in the external economic environment in 2015/16. Global economic growth is forecast to remain weak. Nevertheless, I expect a modest improvement in the BOP in this fiscal year for two reasons.
First, the exchange rate depreciation which has taken place over the last l6 months should have strengthened the competitiveness of our traded goods industries and boosted demand for our exports. For example, it will be cheaper for tourists to visit Uganda.
Secondly, we are forecasting a rebound in FDI, especially related to the oil industry, and financial inflows for the large energy projects of Karuma and Isimba, which will contribute to a larger financial account surplus. Consequently, I hope that we will be able to achieve an overall BOP surplus in 2015/16 and thus accumulate foreign exchange reserves. Our target is to increase foreign exchange reserves by just over $250 million in the current fiscal year.
How does the depreciation of the exchange rate affect manufacturing industry?
Manufacturing firms are among the largest users of foreign exchange in Uganda. Depreciation will make these inputs more expensive. However, most manufactured goods are what economists call “traded goods’, which means potentially they can be traded across international borders. Traded goods are either exported or are sold in the domestic market but face competition from imports. As such, the real exchange rate matters for the competitiveness of traded goods.
A real depreciation of the Ugandan exchange rate makes Uganda’s traded goods cheaper relative to their foreign produced competitors and, therefore, should boost demand for the Ugandan goods, whether in the domestic market or in export markets.
Uganda adopted a flexible, market determined exchange rate in the early 1990s, because it offered two crucial advantages over a fixed, or pegged, exchange rate. First, exchange rate flexibility helps the economy to adjust to external shocks, for example by improving the competitiveness of traded goods industries when there is a negative shock. Second, it provides a mechanism for maintaining BOP sustainability, and thereby avoiding the risk of BOP crises. Exchange rate flexibility has contributed to the sustained growth of the Ugandan economy over more than 20 years.
In the face of the worsening external economic environment, exchange rate depreciation is unavoidable. It is not sustainable for the Bank of Uganda to try and prop up the exchange rate, at levels which are not consistent with supply and demand in the foreign exchange market, by intervening and selling foreign currency. The BOU would simply deplete its foreign exchange reserves if it attempted to do this.
Furthermore, depreciation can help the Ugandan economy adjust to a more challenging external environment, by boosting the competitiveness of traded goods industries, including manufacturing industries, and by encouraging Ugandans to purchase domestically produced goods rather than imports.
Mr Tumusiime-Mutebile is the Governor, Bank of Uganda. This is an abridged version of a statement he issued on the weakening Shilling