Beyond Policy Rates: Unpacking hidden factors that inflate lending costs

by Christopher Kiiza
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According to Bank of Uganda, in the first half of this year, (January to June, 2023), both demand for credit and supply, either remained stagnant or declined. Interest rates slightly edged up, and by June 2023, weighted lending interest rate was around 21%.

That means that there was a combination of low demand credit, low supply for credit, but also slightly rising lending interest rate picking around 21% in June.

Bank of Uganda started reviewing monetary policy in August by 0.5 percentage points.

The Central Bank’s Executive Director, Research, Dr Adam Mugume says, “since then and today, we see that lending weighted interest rates have averaged around 18.8%,” indicating a noticeable impact of the monetary policy action on lending interest rates.

“We have started seeing a slight recovery of demand and supply for credit. We are reporting a growth in terms of both demand for supply of credit. However, we still see nervousness into credit extension, we still see a bit of risks being elevated and certainties also in lending behavior,” says Dr Mugume.

On December 6, 2023, the Monetary Policy Committee (MPC) of Bank of Uganda announced that it was maintaining the Central Bank Rate (CBR) at 9.5%.

The 9.5% rate, however, does not align with market lending rates. While the CBR serves as a benchmark for commercial banks to set their lending rates, there remains a persistent query about why market lending rates consistently exceed the CBR, often more than doubling it.

There are many factors beyond policy rates that explain the inflating lending rates.

The Bank of Uganda Deputy Governor, Michael Ating-Ego explains: “The government appetite to borrow from the same market. If you are issuing government securities to finance a government budget deficit, and let’s say a one-year treasury bill is 13%, it is very unlikely that commercial banks or financial institutions are going to lend [an ordinary borrower] at 12%. Because you cannot be any less risky than government. If anything, they are going to give you a risk premium that if I can lend government at 13%, the ordinary borrower, maybe I will give you a premium of about 7% [making it 20% interest] since I don’t know much about you,” says Deputy Governor.

However, there are also factors beyond the government appetite to borrow money.

Ating-Ego says, “if you look at for example, the non-performing loans that banks have had to provide for especially in post COVID-19 era, where a number of loans became non performing, they have to provide for those non-performing loans, and that is a cost to them. So, how do they recover some of this? They recover by adjusting their lending rates to account for that, because capitalism is very expensive. So, the aspect of non-performing loans has to be addressed.”

He adds: “You also have some borrowers who go to supervised financial institutions for credit, and then they have issues of repaying. Then they run to court to seek a court injunction. The court puts an injunction which means that the capacity of the banks to recover their money is now constrained. And you [the borrower] don’t want to hear the amount of money locked on account of injunction. It is running into trillions of shillings, and these are depositors’ monies. Remember that you the depositor cannot go to the bank to withdraw your money, and the bank tells you there is no money, because some borrower has not paid us. The bank has to pay your money if you demand for your deposits. They [bank] have to look for it.”

 It is noteworthy that there are also incidents where borrowers get loans from the banks to serve goods and services to government, and the repayment date falls due before government pays the supplier for the services provided, so they could clear their loans.

This situation may lead to financial strain. Therefore, commercial banks consider these challenges when setting lending rates, taking into account the timing of repayments in relation to expected inflows from government payments. 

The Deputy Governor says, “we may produce the policy rate, but as long as you don’t address structural factors, the lending rates will not come down at the same pace as policy rates.”

Why Bank Of Uganda Maintained December Lending Rate At 9.5%

On 6 December 2023, Bank of Uganda announced that it was maintaining the Central Bank Rate (CBR) at 9.5%.

The Central Bank’s Monetary Policy Committee (MPC) statement reads that the decision to keep the CBR unchanged reflects the MPC’s assessment of the inflation outlook in light of the incoming economic data.

Headline inflation increased slightly in November 2023, to 2.6% from 2.4% in October 2023, while core inflation remained unchanged at 2.0%.

The medium-term inflation forecast for December 2023 shows that the inflation outlook remains unchanged compared to the October 2023 round of forecasts. 

“Inflation is projected to remain below 5% in the near term but return to the target in the medium term. Core inflation is projected to average 2.5 to 3.5% in FY2023/24, up from 2 to 3% in the October 2023 forecast round. The upward revision for FY 2023/24 reflects a higher path for energy prices in the short term,” reads the monetary policy statement.

Atingi-Ego, said that although the outlook for both inflation and economic growth is good, the Monetary Policy Committee (MPC) noted that inflation has bottomed out, with significant uncertainties on the horizon.

“Therefore, keeping the CBR unchanged is necessary to anchor inflation around the target in the medium term, while at the same time supporting growth in the private sector investment and socio-economic transformation,” Atingi-Ego said.

The inflation outlook is, however, subject to elevated risks. On the upside, the current geopolitical conflicts could escalate and feed into higher international oil prices passing through to domestic pump prices and renewing supply chain disruptions.

Furthermore, volatility in global financial markets could increase, triggering an increased outflow of capital and exacerbating the depreciation of the shilling. On the downside, global inflation could decline faster leading to much lower imported inflation.

In addition, current rains could result in bumper harvests, pushing down further food crop prices.

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