Exchange Rate Depreciations Indicate Weak Economic Fundamentals

Joseph Mawejje, Research Analyst EPRC

The Uganda shilling has steadily lost value against the dollar over the last year. By the second week of March 2015 the dollar equivalent in Uganda shillings had hit the 3,000 mark up from about 2,500 Uganda shillings only a year earlier, signifying 20 percent depreciation. This trend can be explained by the strengthening of the dollar globally and weak economic fundamentals domestically. While we cannot control the global exchange rate movements, we can surely influence domestic policy. For this reason therefore, I will focus on the domestic economic fundamentals in the discussion that follows.

Uganda liberalised the exchange rate market in the early 1990’s as part of wider economic reforms. Since then exchange rates are determined by purely demand and supply forces. The central bank only occasionally intervenes to smoothen out volatile movements.  On the supply side, foreign exchange inflows are determined through exports, official development assistance (aid), remittances and other capital inflows. On the demand side, foreign exchange is used to finance the import bill, and to pay foreign denominated debt, among others.  

Reducing Inflows

Uganda majorly exports primary agricultural commodities such as coffee, tobacco and tea. These are not only of low value but also their prices are volatile. Indeed, Uganda’s export performance has been poor over the last few years. Statistics from the Bank of Uganda indicate that Uganda’s exports have been declining in value terms over the last year. For example total Uganda exports declined from USD millions 2,828.71 in 2013 to USD millions 2,659.29 in 2014, signifying a 6 percent fall in one year. Instability in South Sudan, Uganda’s leading export market, has played its part. More tellingly, the decline in the performance of the export sector has coincided with a manufacturing sector whose contribution to GDP has contracted. Going by the recently rebased figures the contribution of industry to GDP has declined from 26.3 percent to 18.1 percent. This decrease, coupled with instability in South Sudan, could explain the poor export performance over the last few years.

At the same time official development assistance or aid inflows have scaled down. Indeed remittances have overtaken aid as one of the important sources of foreign exchange inflows.  Remittances are useful but they have not been mobilised in such a way as to contribute to investment in a broader sense. Our remittances have majorly facilitated domestic household consumption, even though, if well guided, they could enhance and enable investments in Uganda.  In the recent past however, the weak global economy especially in the Euro zone has led to decreased inflows of remittances.

Increasing Import Bill

While all this happens, Uganda’s import bill continues to rise resulting into a widening trade deficit.  Data from Bank of Uganda indicates that Uganda’s import bill increased from USD millions 4,512.10 in 2013 to USD millions 4,714.48 representing more than 4 percent increment.  Here is the problem: while Ugandans import more, our export and manufacturing sectors are declining.

Another point to note is the performance of foreign investment inflows, particularly in the oil and gas sector, which have recently contributed to some foreign exchange inflows.  I suspect the falling oil prices have resulted into a waning investment appetite in the sector, and this too could have played its part.

Another important factor is the structure of the private sector. Uganda’s private sector dominates the services sector. Here you have big businesses such as the banks, telecoms and oil importing and distribution companies. The majority of these big businesses are foreign owned. Participation of domestic business is limited. The problem here is that these big companies will collect the money in Uganda shilling and expatriate the profits or dividends in foreign currency, further piling pressure on the shilling. The rest of the private sector is either engaged in import business, or in activities that cannot be traded to earn foreign currency.   This structure is not sustainable. What we need is the participation of Ugandan-grown businesses in sectors that earn foreign exchange. Target sectors to be promoted include tourism, agro-processing and manufacturing.

Dollarization of the Economy

Finally, the dollarization of the economy has aggravated the situation. It is now common knowledge that some property rents and other bills are paid in dollars. The dollarization of the economy signals a growing lack of faith in the local currency and results in unhealthy speculations and distortions in the foreign exchange markets. It also signals weak policy framework for exchange rate management.

A depreciating shilling has negative implications for the performance of the economy as a whole. One of the likely channels through which exchange rates affect the economy is through the rising costs of imports which could feed into inflation in the coming months. Rising inflation, up to a certain level, is not desirable as it erodes the purchasing power, exacerbates income inequality, and could even haven implications for food security especially for those households that are net buyers of food. Moreover, inflation hurts growth and poverty reduction efforts because it affects investment decisions. Inflation could also have implications for credit markets if interest rates are raised in response to inflationary pressures.

Possible Solutions

In conclusion, the weakening Uganda shilling is a reflection of both global dynamics but also weak economic fundamentals domestically. Constraints in domestic investment and export sectors should be examined and addressed. In addition Diaspora remittances should be mobilised to spur domestic investment.

The article was first published in the Daily Monitor of March 17, 2015:

http://www.monitor.co.ug/Business/Prosper/Weak-economic-fundamentals-explain-shillings-troubles/-/688616/2655142/-/fhokp0z/-/index.html