Emmanuel Tumusiime-Mutebile: The implication of the exchange rate
depreciation for inflation and monetary policy
Remarks by Mr Emmanuel Tumusiime-Mutebile, Governor of the Bank of Uganda, at the
10th Private Sector Foundation Uganda International Trade Expo, Lugogo, 25 August 2015.
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Good morning ladies and gentlemen.
I would like to begin by commending the Private Sector Foundation for organising this Trade
Expo, which performs an important role in promoting trade and industry in Uganda. In this
address I want to take the opportunity to explain the macroeconomic policies which the Bank
of Uganda is currently implementing to address the shocks facing the economy and ensure
that it remains stable.
As you all know, Uganda's exchange rate has faced repeated bouts of pressure since the
first half of 2014. On a trade weighted basis, the exchange rate has depreciated by around
23 percent since August 2014. The main reason for this depreciation is that Uganda has
suffered several external shocks which have affected exports, tourism and foreign direct
investment, while at the same time demand for imports has remained quite strong. We
suffered a wider current account deficit in the last financial year and this deficit was not fully
covered by surpluses on the financial account of the Balance of Payments.
Uganda is far from unique in facing exchange rate pressures. Many emerging markets and
developing economies around the world, including in Africa, have seen their currencies fall
sharply in value over the last year, mainly because of lower commodity prices and a reversal
of capital flows.
The depreciation of the exchange rate has implications for the macroeconomy and for the
different sectors of the economy. I will discuss the macroeconomic implications first and then
address the sectoral implications.
Before discussing the impact of the depreciation on the macroeconomy I want to emphasise
two important features of our macroeconomic framework. The first is that the primary
objective of the Bank of Uganda's monetary policy is the control of inflation. This is because
inflation is such an important variable in the economy, directly affecting the welfare of all the
population as well as the business environment for the private sector and because it is a
variable which it is feasible for monetary policy to control, at least over a medium term
horizon.
Our target for annual core inflation is 5 percent. It is not realistic to control core inflation to
5 percent in every single month - sometimes it will be lower and sometimes higher - but it is
realistic to aim for an average core inflation of 5 percent over a medium term horizon of two
to three years. Over the last three years, since August 2012, core inflation has averaged
4.7 percent.
The main tool of monetary policy is our policy interest rate which we call the Central Bank
Rate (CBR). Ceteris paribus, if we believe, on the basis of our economic forecasts, that
inflation will rise in the future, we will normally raise the CBR, and vice versa.
The second feature of our macroeconomic framework that I want to emphasise is that we
have a flexible exchange rate. We don't attempt to control the level of the exchange rate
because it is neither feasible in a small open economy subject to external shocks nor is it
desirable, as I will explain later when I discuss the sectoral effects of the depreciation.
The BOU restricts its interventions in the foreign exchange market to dampening volatility in
the exchange rate when this becomes excessive.
The exchange rate depreciation is a negative supply shock for the economy. It raises the
cost of supplying goods and services in the Ugandan economy, because many of these
goods and services are either directly imported or are produced locally but use imported
inputs in their production. Such a shock will unavoidably raise inflation, although it usually
takes up to a year for the full effect of an exchange rate depreciation to be felt on domestic
prices. The questions which macroeconomic policy makers must address are: how much
additional inflation should be tolerated? And what can be done to curb the rise in inflation?
Core inflation is still at very moderate levels; it was 5.4 percent in July. But given the
magnitude of the exchange rate depreciation over the last 12 months, and the fact that this
depreciation has not yet fed through fully into higher domestic prices, there would be a strong
danger that inflation would rise to around 15 percent if the BOU had not tightened its
monetary policy in recent months. That is why we have raised the CBR, in three steps, from
11 percent in April 2015 to 16 percent earlier this month. Core inflation will inevitably rise to
some extent over the next 12 months, but by raising the policy interest rate we aim to restrain
this rise and keep inflation within single digits. We believe that core inflation will begin to fall
back towards five percent in the second half of 2016. We are determined to avoid any repeat
of 2011 when core inflation rose to 30 percent.
The increase in the CBR is intended to influence other interest rates in the economy,
including bank lending rates; otherwise it would not work to curb inflation. We have already
seen commercial banks raise their prime lending rates.
The average prime lending rate of the commercial banks is currently just under 23 percent
compared to 21 percent in January of this year.
Higher interest rates will reduce borrowing by the private sector and thus dampen demand
for goods and services in the economy, which will help to alleviate inflationary pressures. In
addition, raising the CBR has a signalling effect which we hope will influence the
expectations of the private sector. If private sector agents expect that inflation will be kept
under control, actual increases in wages and prices are more likely to be moderate.
The increase in the CBR and consequent reduction in the growth of demand will also have a
temporary impact on the growth of real output. Hence we now expect that real growth in the
current financial year will be lower than the 5.8 percent forecast at the time of the budget in
June, and will probably be around 5.4 percent.
Unfortunately, if we want to control inflation in the face of an adverse supply price shock,
some costs in terms of lower real growth cannot be avoided. However, we expect that real
GDP growth will climb towards 6 percent over the medium term.
Let me now discuss the sectoral impacts of the exchange rate depreciation, which differ
between the traded goods and the non-traded goods sectors of the economy. The traded
goods sectors are those which produce for export or which produce goods that compete
against imports in the domestic market. What matters for the competitiveness of the traded
goods sectors is the real effective exchange rate, which is a measure of changes in the
nominal exchange rate of the Ugandan Shilling against the currencies of our trading partners
adjusted for differences in inflation rates. Over the course of 2014/15, the real effective
exchange rate depreciated by about 13 percent, thereby boosting the competitiveness of the
traded goods sectors of our economy.
This illustrates one of the most important benefits of a flexible exchange rate; it helps the
economy to adjust to external shocks. Although the real effective exchange rate is not the
only factor which affects the competitiveness of traded goods industries, the depreciation is
still important, because it strengthens the price incentives facing traded goods industries.
We need to strengthen the performance of our traded goods industries. In the six years since
the global economic crisis broke out in 2008/09, the growth of Uganda's goods exports has
been weak, averaging only 3 percent per annum in dollar terms. Services exports have done
much better, with average growth of 16 percent over the last 6 years, but this has not been
sufficient to prevent the trade deficit in goods and services from widening from $2.2 billion in
2008/09 to almost $3 billion in the last financial year.
Over the medium term the growth of Uganda's demand for imports is likely to be robust
especially because of the large requirements for capital investment. If we are to avoid our
trade deficits widening further, it is imperative to strengthen the growth of exports and of
industries which can compete with imports. I hope that the real exchange rate depreciation
that has occurred over the last 12 months will contribute to an improved performance of the
traded goods sectors.
A real depreciation of the exchange rate has the opposite impact on the non-traded goods
sectors of the economy; these are sectors which sell their output on the domestic market and
do not face competition from imports. The real depreciation will squeeze their profitability,
ceteris paribus, just as it strengthens the profitability of the traded goods sectors. From the
standpoint of the long term interests of the economy, shifting relative price incentives from
the non-traded goods sectors to the traded goods sectors is necessary if we are to achieve
lower trade deficits.
To conclude, I want to emphasise that our economy has to adjust to the external shocks that
it is facing. Adjustment of some sort is unavoidable, but policymakers have some choice over
the nature of the adjustment to the shock. Our policy responses to the shock prioritise
controlling domestic inflation because inflation has such a critical impact on everyone in
Uganda, including everyone in the business sector. We will ensure that inflation remains
firmly under control.
Thank you for listening.