Monetary policy may be sound but risks futility

trueBy Enock Nyorekwa Twinoburyo

Since independence, Uganda has recorded at least as many shifts in policy as, there have been regime changes including the shift from direct controls (on interest rates and credit) pre 1993, to indirect monetary policy control as part of the financial sector liberalization process undertaken under the IMF Structural Adjustment Programmes.

Prudent macroeconomic management helped by economic reforms, particularly better monetary policies, have contributed to an improvement in macroeconomic performance in Uganda since the early 1990s, manifested in higher real GDP growth rates and lower inflation.

In 1993, when BOU assumed its primary responsibility as the formulation and implementation of monetary policy, the Bank adopted the Reserve Money Programme (RMP) as the operating framework to facilitate indirect monetary control.

This RMP remained the guiding framework until June 2011 and was premised on monetarism school of economic thought, which maintains that the money supply (the total amount of money in an economy) is the chief determinant of current GDP in the short run and the price level over longer periods.

In July 2011, the base money targeting was replaced by “inflation targeting lite”. The most important consequence of the change in monetary policy regime is that the operating instrument for monetary policy became an interest rate dubbed the central bank rate (CBR), rather than the monetary base.

Under the new regime, the CBR is the operating target of monetary policy, which is set monthly and announced through published monthly monetary policy statements.

Monetary policy is typically the first line of defence against a number of internal and external shocks that a country faces or is exposed to, so it is important to get it right. While inflation targeting has been successful at reducing inflation from double to single digit(s), the designing of monetary policy frameworks in a bid to achieve its objectives of low inflation and full employment output as well maintain that financial stability faces a number of challenges.

One of the greatest threats to monetary policy regime in developing countries like Uganda is the lack of central bank independence. Over the last few years, monetary policy costs have grown to account for 30% of bank’s total operating expenditure.

In fact over the last two or three financial years, the bank has had operational deficits (where the income is less than the operating expense). Given the still low returns on BoU reserves, the bank’s capital is at risk of being eroded which will undermines the credibility of monetary policy. Some of the monetary costs relate to the fiscal policy (government budget) operations.

Arguably, there is disharmony between the fiscal policy and the monetary policy. While the CBR has been kept at 11.5% for the last six months to boost private sector credit, the increased government presence on the domestic debt would defeat this objective as the associated yields on the government risk free paper (e.g. Treasury bills) would make attract banks to invest in government securities rather than lend to private sector a phenomenon known as crowding out effect.

The Bank of Uganda Governor in his speech at the annual dinner of Uganda’s Bankers’ Association indicated that the primary auctions of government securities are now used to fund the government domestic borrowing requirement and to refinance the existing stock of securities as they mature rather than as instrument of monetary policy.

As matter of fact, between 2007 and 2012, Uganda’s domestic debt stock picked up from 9% to 13.1% of GDP and it is by no surprise that the interest payments on debt as share of the budget accounts for over 8% of the budget (more than twice the agricultural budget).

The concerns about the path and volatility of the exchange rate still playing a dominant role amongst private actors is a challenge for monetary policy. With an open capital account, it is not possible to have independent monetary policy when the central bank is also trying to manage the exchange rate a phenomenon known as “the impossible trinity”.

This is because the central bank lose control over money supply.  On price and output objectives, the governor too has been on record saying that in the circumstances when the economy is faced with supply shock as was the case in 2011, there was an unavoidable conflict between achieving both inflation and output targets.

In that particular circumstance, the inflation target takes precedence even at cost of private sector growth, an issue which private actors need to comprehend.

There are a number of other factors that constrain the conduct of monetary policy in Uganda including but not limited to; the low levels of financial development for example limited access to formal financial services (thanks to the growing level of financial innovation e.g. mobile money), and low levels of trading on the secondary securities markets , increased dollarization (ratio of foreign currency deposits to the total deposits at 33.8% of total deposits as at December 2013),  global shocks (including fuel and food prices) and the transition to the East African Monetary Union.

Without addressing the challenges head on, especially institutional reforms at BoU to strengthen its independence, the transition to a modern monetary policy may be futile.

The writer is a PhD student( Economics) at University of South Africa