How commentators misunderstood the 2015/16 budget proposals

By Dr. Louis A. Kasekende

Dr. Louis A. Kasekende, the Deputy Governor, of the Bank of Uganda, on Friday, June 19 addressed the  2015 annual general meeting (AGM) of the Uganda Institute of Banking and Financial Services (UIBFS) at the Bank of Uganda Gardens in Kampala.

Below are his remarks.I would like to thank the Institute Council and Board for giving me the honour to address its AGM this evening.

I hope that this AGM has in some way helped us as players realise key efforts we can undertake to improve the Institute and grow it to serve us better. You all realise that this Institute is our common asset whose activities must be continually reinvigorated to achieve better operational efficiency and also meet the changing knowledge and skills’ needs of the economy. On our end as a Central Bank, our commitment to the institute remains strong.

We value professionalism and every year we commit resources to the support the Institute and for our staff to undertake programmes at the Institute. I have been made aware that some of you have also taken this as company policy. I commend you for this strategic decision to bridge the skills gap in the industry. As observed in the board report, the institute has attained a number of achievements, ranging from an improved financial position, the adoption of a new strategic plan, to the election of a new Board, chaired by Herman Kasekende. I congratulate you all on these milestones.

Having said that, I would like to focus tonight on how I see the prospects for the economy in the year ahead, especially in view of the 2015/16 Government budget presented to Parliament last week and the decision by the Bank of Uganda (BOU) to raise the policy interest rate – the Central Bank Rate (CBR) – by one percentage point to 13% at its Monetary Policy Committee meeting on Tuesday.

I will start with the budget for the next fiscal year. From a macroeconomic perspective, the budget presented last week does not represent a radical change in fiscal policy. The overall fiscal deficit is projected at 7% of GDP. While it is larger than the forecast outturn for this fiscal year, of 4.5% of GDP, it is only slightly higher than the fiscal deficit of 6.8% of GDP which was originally budgeted for this year. In the current fiscal year, delays in implementing the two hydropower projects (HPPs) meant that capital spending has underperformed and hence the fiscal deficit will be smaller than budgeted.

Next year’s budget incorporates an increase in total Government spending, compared to the forecast outturn of the current fiscal year, of about 3% of GDP. This increase comprises higher development expenditures, including higher spending on the two HPPs, and is financed mainly by higher external borrowing along with a stronger tax effort.

There are two facets of the 2015/16 budget which I believe will be most important in terms of its impact on the macroeconomy. The first is the extent to which the budget will add to aggregate demand in the economy; that is demand for goods and services produced in Uganda. If we strip out the foreign components of the budget – donor grants, foreign interest payments, Government imports, etc, we can estimate the domestic fiscal deficit, which is the most pertinent measure of the impact of the budget on aggregate demand. The domestic deficit will rise from an estimated 2.2% of GDP in the current fiscal year to 3.8% of GDP in the next fiscal year. The increase of less than 2% of GDP, which represents a fiscal stimulus to aggregate demand, is relatively modest and will not, by itself, generate significant inflationary pressures in the economy.

The second aspect of the budget which is important for the macroeconomy is the Government’s domestic borrowing requirement. In the next fiscal year, the Government has a domestic net borrowing requirement of 2 percent of GDP and this will be fully funded through the issuance of Government securities – Treasury Bills and Treasury Bonds – in the primary securities markets. On a net basis – issuances minus redemptions of maturing securities – the Government intends to raise sh 1.4 trillion from the market in 2015/16 through the primary auctions. This is exactly the same nominal amount of net financing from the market that has been raised in the current fiscal year. Next year’s budget will not require any more financing from the domestic markets than is the case in the current fiscal year.

Unfortunately, some commentators misunderstood the presentation of the 2015/16 budget appropriations to Parliament, which included an appropriation to cover the maturing Government securities in 2015/16, in line with the requirements of the recently enacted Public Finance Management Act. These commentators appear to think that the Government has dramatically increased the size of its budget and will fund this with a huge increase in domestic borrowing. This is not true. As I have already noted, all of the increased borrowing to finance the fiscal deficit in the next fiscal year will be met from external sources; either concessional or commercial lending specifically for infrastructure projects.

It should be possible to accommodate the Government’s net domestic borrowing requirement of sh 1.4 trillion in 2015/16 without forcing up interest rates and crowding out private sector borrowers. A borrowing requirement of this magnitude entails a nominal increase in the holdings of Government securities by all investors combined of about 14%.

In the light of both the estimated modest fiscal stimulus to aggregate demand and the Government’s domestic borrowing requirement, I don’t envisage that the budget, if implemented as planned, will undermine macroeconomic stability in 2015/16.

Alongside the fiscal stance, the other component of domestic demand emanates from the private sector. Private sector demand, for consumption and investment, depends on various factors including bank lending to the private sector. After several years of relatively slow growth, private sector credit (PSC) has accelerated over the past 12 months, expanding by 17%. At the same time, there has been a reduction in non-performing loans from 6.2% of total loans in March 2014 to 4.3% in March 2015. These trends suggest both more buoyant private sector demand for loans and stronger private sector balance sheets. Looking ahead over the next 12 months, the increase in the CBR should dampen credit growth somewhat but we still forecast PSC growth of around 15% in 2015/16.

The main source of macroeconomic volatility in the current period is the external sector through its impact on the exchange rate. On a trade weighted basis, the nominal exchange rate has depreciated by 14.2% since the start of the current fiscal year in July 2014. The depreciation against the US dollar has been even greater, at 23.5%, because the dollar has itself strengthened against many currencies around the world. As we have made clear on several occasions over the past year, the depreciation of the Shilling reflects a weakening of our balance of payments position. Problems in the regional markets, especially South Sudan, together with lower global commodity prices, have negatively affected merchandise exports. Revenues from services exports, especially tourism, have fallen sharply. Despite the fall in the price of oil, import demand has been robust. We have also recorded a fall in foreign direct investment (FDI) in the current fiscal year, which is likely to be linked to the lower global oil prices given that FDI in the oil sector comprises approximately half of total FDI inflows to Uganda.

In the face of a widening current account deficit and lower FDI Inflows, a real depreciation of the exchange rate is unavoidable to support the adjustments, such as lower import demand, which are needed to ensure a sustainable balance of payments. While the BOU will intervene when necessary, if the pace of depreciation becomes too disruptive, as we did today, it is not realistic or optimal for the economy for the BOU to try and prevent the depreciation of the exchange rate when this is necessary to support a sustainable external balance.

We forecast real GDP growth to rise to 5.8% in 2015/16, which is 0.5 percentage points higher than the forecast for the current fiscal year. The main factor pushing up growth in the next fiscal year will be stronger aggregate demand.

Our current estimate of the economy’s potential output growth, which is determined by supply side factors such as the growth of the labour force, the capital stock and productivity, is between 5% and 6% per annum. Hence real growth in the next fiscal year should be in line with the economy’s potential rate of growth.

Monetary policy does not affect the economy’s potential rate of growth but it does affect aggregate demand. The aim of monetary policy is to ensure that aggregate demand grows at a rate which is sufficient to allow the economy to grow at its potential rate without causing the economy to overheat and cause inflationary pressures.

Finally I would like to assess the prospects for inflation, which, as I am sure you all know, is the primary policy objective of the BOU. Our monetary policy target is to hold annual core inflation to 5% on average over the medium term, which we define as a period of two to three years. It is not feasible to hold inflation to 5% continuously in every month because there are too many shocks to prices which make inflation volatile, but it should be possible to achieve a target for average inflation over the medium term, if monetary policy is implemented well. Over the last three years, annual core inflation has averaged 5.4%, hence after the inflationary spike in 2011/12, we have been quite successful in achieving our target for inflation.

Annual core inflation has been rising since the start of the year and was 4.8% in May. The main factor behind the rise in core inflation is the exchange rate depreciation. Because Uganda is an open economy, with imports of goods and services accounting for around 30% of GDP, the pass through from the exchange rate to domestic prices is quite high; we estimate that the pass through is around 50%. The pass through from exchange rate depreciation to inflation takes up to one year to occur in full. As such, the full impact of the exchange rate depreciation which has already taken place has yet to be felt on prices. That is one of the main reasons why we expect further rises in core inflation over the next 12 months.

In the Monetary Policy Statement presented by the Governor on Tuesday, we forecast that annual core inflation would be between 8% and 10% in 12 months’ time before falling back to 5% during the course of 2016/17. This forecast is in line with most published private sector forecasts.

The monetary policy actions we have taken in April and June of this year, which together increased the CBR by 2 percentage points to 13%, are intended to ensure that, although core inflation will unavoidably increase further during the next fiscal year, it will be brought back to our target level well within the medium term horizon. Our inflation forecast is conditional on our assumptions for the economy over the forecast horizon, including those pertaining to the Government budget, the strength of domestic demand and food prices as well as the exchange rate. If we have to revise these assumptions as new information becomes available and this leads to a revision of our inflation forecast, we will adjust monetary policy accordingly. As the Governor made clear in the Monetary Policy Statement, if the inflation forecast deteriorates, we will tighten monetary policy further. We are determined to ensure that we deliver our medium term target for inflation.

To conclude, our macroeconomy is undoubtedly facing difficult challenges, especially those emanating from the external sector. We share many of these challenges with other frontier and emerging markets, including our neighbours in east Africa, which also face a much less propitious external environment. Nevertheless, I am confident that, with sound macroeconomic management, we can maintain macroeconomic stability and achieve robust economic growth over the medium term.