Monday, 27 July 2015

Election cycles an Economic cost to Uganda

In various economic reports this year, one imminent risk to macro-economic stability is the 2016 election. This is in part encapsulated in the July Monetary Policy Statement (MPS), where Bank of Uganda has increased its Central bank rate for the third time this year by even a higher rate of 1.5% to 14.5%, compared to previous increases of 1% in June and another 1% in April. Before that, the central bank rate was kept at 11% since June 2014. This illustrates the heightened election related risks as Uganda draws near the election cycle.
The Monetary Policy Statement highlights that the rapid exchange rate depreciation in the last one month is driven by sentiments and speculation as opposed to market fundamentals. Two perfect candidates driving expectations are the recent intensification of election related events and the approval of the perceived expansionary budget for financial year 2015/16 of UGX 24 trillion down from UGX 15 trillion in the previous financial year. It should however be noted that the budget expected to be spent in 2015/16 is UGX 18.5 trillion and the rest largely relates to Domestic Debt Repayment which will be financed through a rollover but as required by the new 2015 Public Finance Management Act, it had to be appropriated in the budget and approved by Parliament. Even then the budget remains expansionary and 47% of the overall budget is recurrent in nature.
Overall the MPS re-emphasizes the heightened risks to inflation, growth and financial conditions. This is consistent with the present year economic developments. With the CBR at 14.5%, it implies that the bank rate (rate at which commercial banks borrow from central bank) is 18%, implying that base lending rates will increase further to range of 25% and above  given most agencies value credit risk risk between 4-5%. As of 14 July 2015, the overnight interbank borrowing was at 22%. These lending rates by and large are eventually distortive; they will slow private sector credit, crowd out private investments and could potentially heighten the prospects of non-performing loans. In the extreme case, there will be a recurrence of a 2011 situation where some banks stopped lending in Uganda shillings at the cost of the shrinking of the overall economic activity. In 2011/12, economic growth dropped to lowest in two decades owing to the contractionary monetary policy – the CBR was increased from 11% (July 2011) to 23% (Nov 2011 to Jan 2012) in response to the tehn evolving economic conditions.
An exploratory review of previous election cycles indicates that they have been economically costly to Uganda. In the election years, three possible shocks are experienced: the laxity to collect taxes, the pressure to increase overall expenditure and the amplified need to increase recurrent nature expenditure. The most recent elections in 2011 were marred with exceptional spending on fighter jets. This led to a retrospective approval of supplementary budgets to a tune of 33% of the approved budget. The 2005/06 budget year also had a supplementary budget of nearly 10% of the approved budget and these supplementary budgets are largely recurrent in nature. In addition, perceived corruption and, on the overall, money supply tends to increase during these times.
Also  traceable in 2011 was rapid depreciation of the shilling encountered in part on account of dwindling foreign direct investments, and  the election related speculation related to increased monetary expansion. As aforementioned, the Uganda shilling trend has worsened this year, reaching three record lows against the dollar; at UGX 3000 shillings in March, UGX 3300 in June and UGX 3600 in July.  This has come at a cost of foreign exchange reserves, as was noted in previous election cycles, in particular 2011. Uganda's reserves have reduced from 6 months of import value enjoyed in the mid to late 2000s to an average of 4 months of imports in recent couple of years.
Inflation tends increase during these cycles, and as noted in the monetary statement, inflation is expected to increase to 8-10% over the next year, a rate higher than national target of 5%. In 2011, inflation reached the highest at 30% in 20 years. Theoretically higher inflation tends to increase the misery index (inflation plus unemployment rate), which constrains growth and increases poverty levels.
The associated economic effects are often accompanied by corrective contractionary policies, often times the monetary policy side trying to mop out the excess liquidity largely created by the fiscal side.  The lagged effects tend to last longer, as demonstrated by subdued private sector credit growth and below potential growth rates since 2011. The recent UBOS statistics show that Uganda grew at 5% of GDP in 2014/15 compared to 4.6% in 2013/14.  These rates are in fact below our regional counterparts and way below the last 2 decades average of 6-7%. 
In conclusion, election cycles in Uganda have tended to come at the cost of macro-economic stability. And, therefore, the performance of our economy in the next few years has all to do with national politics as it does with exogenous factors like the strengthening dollar.

Wednesday, 8 July 2015

Lessons Ugandan Banks can draw from the Euro Zone

Lessons Ugandan Banks can draw from the Euro Zone
By Enock N. Twinoburyo
At the start of 2015, the Eurozone expanded its membership to 19 members when Lithuania joined. At the helm of its banking industry is the European Central Bank (ECB), which administers monetary policy of the member states - one of the largest currency areas in the world. Listed in the Treaty on European Union (TEU), the ECB is one of the world's most important central banks. The capital stock of the bank is owned by the central banks of all 29 EU member states.
In January 2015, the Eurozone inflation continued to decelerate into negatives, a ramification of prevailing aggregate demand deficiency in the currency zone. This is largely due to the financial crisis of 2008, which culminated into the Euro zone debt crisis. Referred to as the PIIGS (Portugal, Ireland, Italy, Greece and Spain), these countries had debt to GDP ratio of over 100%.
Ireland and Greece have since sought bailouts, the latter’s bailout programme hangs in balance and so is its EU zone membership. The crisis deepened the bank’s need for support from national governments. The governments on the other hand already had weakened fiscal positions. The crisis also led a threat of widespread bank failures in EU countries and near collapse of their financial systems, characterised by weak bank balance sheets and less desire by banks to lend due to depressed business confidence.
As a result, the European Commission has since proposed 28 new rules with the aim of setting up a European banking Union to better regulate, supervise, and govern the financial sector.
This was done in order to put an end to the era of massive bailouts paid for by taxpayers. It is believed that this will help restore financial stability. The measures in place include the establishment of a Single Supervisory Mechanism (SSM) effective November 2014, Single Resolution Mechanism (SRM)- expected in 2016, the European banking Authority(EBA), set up in 2012 and a future banking Union.  With the SSM and SRM, the Banks will no longer be "European in life but national in death", as they are supervised by a European mechanism and any failure will be managed by a truly European mechanism. The ECB will be stretched in trying to ensure that its monetary policy and supervision roles do not conflict. For instance it has to ensure that it does not set low interest rates to save the weaker banks.

ECB and EBA carried a year-long
comprehensive exercise to assess the state of banks and through stress tests, 25 banks failed the asset quality review (AQR) conducted by the ECB on 130 of the largest banks in the Eurozone. In the stress tests performed by the European Banking Authority on 123 of the EU’s largest banks, 24 failed. They had capital shortfalls amounting to €24.6bn(0.09 per cent of assets worth €28tn) after comparing the projected solvency ratios under the adverse stress test scenario. This was against the threshold of 5.5% tier 1 capital relative risk weighted assets. Most of these 25 banks are concentrated in (use PIIGS) crisis economies in particular Greece, Portugal, Ireland, and Italy-, which is an indication that banks, are focused on deleveraging as opposed to lending due to the low business confidence.

AQR sets a foundation for the Single Supervisory Mechanism (SSM), with ECB having direct supervisory responsibility for most of these 130 banks. It is also indirectly responsible for the rest of the banks in countries that are members of the SSM. This sets a platform for confidence building and transparency but it remains no panacea for the Euro zone banks. The bank resolution remains a responsibility of the national governments until the SRM is in place, which will also remain hybrid resolution mechanism (national and SRM framework) and the full-fledged banking Union remains to be seen. (Beck, 2014).

In addition, there has been subdued financial performance of the euro area-banking sector observed since the onset of the financial crisis, with notable cross-country differences. In particular, the profitability of the euro area-banking sector which has been mainly challenged by the on-going deterioration in asset quality, with ensuing increases in impairment charges and provisions.  Deteriorating loan quality resulted in a steady and broad-based increase in non-performing loans (NPLs) in many countries from 2008 onwards, with pronounced further increase in some cases (ECB, 2014)

The EU banking lessons indicate the need for stringent bank supervision and resolution mechanism in a bid to sustain business confidence; first at national level especially when economies are in a boom (booms are fuelled by an underestimation of risks), as well as the hit by economic hardships.  In that respect, the EAC Central Banks that are moving towards establishment of a Monetary Union do carryout joint inspections of banks and have agreed to put in place a framework for cross-border bank resolution. - Secondly, the EU banking reforms are also guided by the Basel III regulatory reforms, which require higher capital charges for systemically important institutions and better internalisation of the risks their size poses to the financial system. Fourthly, the need to repair balance sheets and beef up capital to requisite capital threshold.

Uganda has a history of  bank failures in late 1990s, early 2000s and in 2014, when Bank of Uganda revoked Global Trust bank’s license. This was in accordance to the the framework of the Financial Institutions Act (FIA), 2004, which constitutes among other minimum capital requirements and liquidity requirements and restrictions on risk taking such as limits on large loan and foreign exchange exposures. This mandates the Central Bank to protect the deposits. Uganda has also embarked on the review of both the Foreign Exchange Act 2004 and the Foreign Exchange (Forex Bureaus and Money Remittance) Regulations 2006.The process is done in consultations with other EAC central banks.
Overall, Uganda’s financial system is sound while the risks to financial stability emanating from both international and domestic sources have eased. Information from the latest Financial Stability Report from Bank of Uganda indicates that the banking system is currently well capitalized and most banks would comfortably meet the Basel III capital requirements.   
On the regional front, the EAC Central Banks are to conduct self-assessments of their compliance with Basel Core Principles for Effective Banking Supervision (BCPs) annually and conduct peer reviews every two years. In addition the EAC have adopted a standardised approach for calculating a capital charge for operational risk. As well are to finalize the process of adopting the leverage ratio, following the Basel III approach, as a supplementary measure for the analysis of capital adequacy (Bank of Uganda, 2013).

In the recent past, 2-4 years, when the Ugandan economy has slowed or least grown at less than potential, there were increased risks on the banking sector, with heightened Non-performing loans, increased credit risk and dwindling profits as well as asset quality. (See table 1).

Table 1: Uganda Banking sector Indicators March 2012- September 2014

With the limited competition in Uganda banking industry, it is likely that the lower tier banks (with a high cost to income ratio) will increase risk-taking initiatives due to moral hazard. Lessons from the Euros zone indicate that the large banks- the too big to fail, may also increase their risk taking initiatives. It is also observed, that during the economic boom days, banks over expanded and subsequently are over leveraged (European Systemic Risk Board, 2014). Uganda outlook looks positive- with the expected oil activities likely to spur the level of economic activities (including bank activity) in the coming few years; which in itself calls for prudent monitoring of the bank’s asset quality and risks. According to IMF, 2014 – there is need to strengthen the macro-prudential framework to improve risk management in systemically important banks, introduce a capital conservation buffer, and introduce counter-cyclical financial regulation will help anticipate and deal with risks.
Indeed the Bank of Uganda has taken several measures to address these concerns including data collection on and monitoring loan to value ratios for property loans.  The Bank carries out quarterly stress testing to assess the resilience of banking sector to systemic risks.
In addition to that, BoU engages small and new banks as well as systemically important ones with a view of enhancing their loan quality and liquidity. Related to that, it has brought forward implementation of Basel III capital measures to January 2014 in a bid to strengthen bank resilience.
As such, there is need to insulate the banking system from the too big to fail, in part, by enforcing measures that will create more competitive business models, as well rebalance the financial activity away from banking industry. Continued supervision indeed is a necessary action.

The writer is a PhD fellow at University of South Africa

1.    Bank of Uganda (2014), “Annual Supervision report 2013”,June
2.    Beck, T. ( 2014), “After AQR and stress tests – where next for banking in the Eurozone?”,, 10 November
3.    European Systemic Risk Board (2014), “Is Europe Overbanked?”, Advisory Scientific Committee Report 4, June.
4.    IMF (2014), “Uganda Third Review Under Policy Support Instrument”,Country Report No. 14/344, 21 November
5.    Bank of Uganda (2014), “Financial Stability Report  2014 Issue No. 6” June

Banking sector Solid but vulnerable (african executive 8th July 2015)

On the 22 June 2015, Bank of Uganda (BoU) published the annual supervision report for the year 2014 in line with its statutory provision of prudential regulation and supervision of financial institutions. This report illustrates increased accountability and serves to instill confidence in the public that the bank failures of late 1990s will not recur.  This report is comprehensive, covering the supervision of financial institutions-on-site inspection and the off-site analysis, regulatory reforms undertaken, the financial stability assessment, and risk assessment of the sector and recent developments like the mobile money service. The report also elaborates stringent supervision by BOU which led to the closure of Global Trust Bank Limited (GTBL) in July 2014, in line with the Financial Institutions Act of 2004. While the financial sector comprises of the commercial banks, credit and micro-finance deposit-taking institutions, the National Social Security Fund (NSSF), a postal bank, insurance companies, development banks, foreign exchange bureaus and the Uganda Securities Exchange, BoU only partly supervises non-banking financial institutions.

On the overall, financial outreach increased with ATMs, commercial bank branches and mobile money transactions registering sizeable growth. The number of ATMs and bank branches respectively increased to 830 and 564 in December 2014 compared to 768 and 542 in December 2013 with notable expansion outside Kampala and the metro regions of Uganda. Mobile money transactions increased to Ushs. 496.3 million with an associated value of Ushs. 24.05 trillion in December 2014, compared to 399.5 million transactions and the value of Ushs. 18.6 trillion in December 2013. The number of registered customers stood at Ushs. 18.8 million in December 2014, accounting for more than 50% of Ugandas population. Financial access however, remains low with only 20% of adults having access to formal bank accounts.

The assessment of financial stability reveals that the financial sector remains sound, well capitalized, liquid and profitable. In particular, the banking sector which represents over 95% of the financial sector assets recorded an overall improvement in performance in the year ending 2014, mainly on account of the increase in loans and advances to Ushs 9.4 trillion. Deposits remained strong at 81% of the banks total liabilities.  The stress tests carried out quarterly, with the last conducted end of December 2014, reveal that the banking sector remains resilient to adverse shocks emanating from non-performing loans, deposit withdrawals, decrease in the interest income from government securities,  and the large depreciation of the Uganda shilling.

The overall positive performance of the financial sector notwithstanding, traces of vulnerability remain. First, the size of the financial sector remains small and dominated by the commercial banking sector. The banking sector is dominated by a few players; the top three banks account for over 50% of the banking sector assets and the top two banks (Stanbic and Standard chartered bank) approximately accounted for 50% of the total banking profitability in 2014. The limited competition among the 25 commercial banks, in part, explains the obstinate prevalence of high interest rates and high spreads (lending rates minus deposit rates) despite the deposits being the largest share of bank funds at a low cost annually of 3.6%. The increasing investment in government securities by banks is likely to increase interest rates.  Deposit base and private sector credit remain low by regional standards, at about 17% and 14% of GDP respectively, which is an indication of low levels of savings and financial development.
The bank stress tests also revealed that the sector remains vulnerable to a couple of risks; in particular, credit risk emanating from large borrowers holding a large proportion of their portfolio in the top 5 banks (also referred to as systematic banks). Their loan default would have significant consequences on commercial banking sector capital exacerbating non-compliance with statutory requirements. In addition, despite the non-performing loans reducing in 2014, they remained sizeable at Ushs.390 billion or 4.1% of the total gross loans. The majority reside in trade and commerce, and building and construction sectors.

The economy became increasingly dollarized in 2014, with the foreign denominated components of the banks balance sheet growing faster than their shilling counterpart, illustrating risk aversion on the part of shilling depositors. The foreign currency deposits to total deposits increased by 4 basis points to 42.1%, while the foreign currency loans to total loans were at nearly 44% in December 2014. This is partially explained by the growing non-resident funds driven largely by the presence of regional subsidiary banks. This does not only increase foreign currency risks to the sector, but also, in part, explains the depreciation trend of the Uganda shilling.

The upward swing in interest rates noted in the first half of 2015, coupled with the economy outlook risks including election related shocks, should see the banking sector face a jagged run, in particular the bottom 10 banks whose cost to income ratio is nearly 100%. Prudent supervision alone is not a panacea and, therefore, there is need for a concerted effort to address the broader structural and regulatory weakness in the banking sector.
Also another article on banking sector being solid but vulnerable-

Wednesday, 20 May 2015

Uganda shilling on a downward spiral- In african executive 20th may 2015

On the 13 may 2015, I attended an IMF presentation on the Regional economic outlook for the Sub Saharan Africa including Uganda. The presentation indicated a very sound economic environment for Uganda with growth poised to increase to 5.4% in 2015 from the 4.9% in 2014. This compares favourably to the Sub Saharan Africa average of 4.5% and world average of 3.5% in 2015. Inflation remains below the medium term target of 5%, with annual core inflation for the year ending April 2015 at 4.6%, compared to 3.7% that was recorded in March 2015. Inflation is expected to increase in the coming months largely on account of the exchange rate depreciation, which is estimated to have a 40% pass through into inflation. The medium term inflation risks are in part demonstrated by the increase of the Central Bank Rate (CBR) to 12% in April monetary statement from 11%, the latter having remained unchanged since June 2014.  
The Uganda exchange rate to the dollar has depreciated by 20% between June 2014 and March 2015, compared to Rwanda (6%), Kenya( 10%), Ghana (30%), Angola(12%), Mauritius (18%),Cote de Ivoire (23%), Nigeria( 24%),South Africa(16%),Senegal (23%) and Zambia(13%).  As of end march, 2015, the US dollar had strengthened by 28% against the the Euro, 18% against the Japanese yen, 12% against the South African Rand, and 11% against the British pound on year on year basis. Bank of Uganda recent intervention to smoothen the exchange rate volatility has come at the cost of the dwindling foreign exchange reserves estimated at USD 2.7 Billion as of end march 2015 (or 3.5 months of next year's import ), the lowest in the last 3 years.
The strength of the dollar withstanding, there are a number of the factors that indicate the Uganda shilling may depreciate further. The guest speaker at the very conference Prof Balunywa (also a former Bank of Uganda board member)  intimated the depreciation may reach UGX 3500 to the dollar by June next year.  First the exchange rate has been on a downward spiral over the last decade, in particular depreciating from UGX/USD 1750 in January 2007 to a record low of UGX 3000 in March 2015, and has since oscillated around that bound even with the Central bank intervention.  
In 2011, there was a heightened depreciation of the shilling, in part on account of the election related fiscal slippages and increased money supply. It is projected that money supply will grow at higher rate of 17.5% in both FY 2014/15 and 2015/16 compared to 6.7% in FY 2012/13.   On account that the recent supplementary budget was largely recurrent, and funded in part by re allocations, it is arguable that the recurrent budget will account for more than 50% of the budget and a similar trend could be exhibited with the expansionary 2015/16 budget, as was in previous election years.
There is bi causality between the exchange rate and the current account (difference largely between exports and imports) - implying the shilling depreciation would spur more exports and reduce imports on account of relative respective prices. On the other hand, the widening current account deficit would have a weakening effect on the shilling. While the statistics show that Ugandan current account deficit has eased, it remains a sizeable share of GDP and susceptible to worsen, which leaves exchange rate vulnerable. The export basket remains narrow and is dominated by primary products, including coffee, fish, tobacco, gold, and flowers. The dismal growth in the Eurozone, suspension of vegetables to the Europe, conflict in South Sudan and Burundi should have a fair share impact on foreign exchange earnings through exports and remittances as well as aid transfers. The import bill will likely increase on account of the large import bill associated with large infrastructure projects.
There are a number of other factors inter alia, the increased visa fees impact on tourism, the envisaged slowdown in foreign direct investments due to the dwindling oil prices; election downward risks, and the US recovery. The periphery bound foreign exchange reserves will arguably compromise the credibility of central bank to stabilise the rate against volatility.

By and large, the increased dollarization of economy, with foreign deposits at UGX 4.578 trillion in March 2015 accounting for 36% of the total deposits from 33% in June 2014, is indicative of the increased preference of the dollar by key economic players. Against the backdrop of factors highlighted, taking a short position in dollar may be potentially lucrative. Given the exchange rate follows a random (volatile) walk; take my conclusion with a pinch of salt.