Uganda shilling not world’s worst performer

Tuesday, 9th August, 2011

Sunday Monitor claimed, in its front page article on August 7, that the “Uganda shilling is now the worst performing currency in the world”.

The basis of this claim was that the shilling has depreciated against the US dollar by 10% over the last two months, which the article implied was a larger depreciation against the dollar than that of any other currency in the world.

Even if that were true, it would not justify the claim that the Uganda shilling is the world’s worst performer.

It is grossly simplistic to judge the performance of the exchange rate solely on the basis of how much it depreciated over a given arbitrary period, without considering the context, both domestic and international, in which this takes place.

Exchange rates are inherently volatile. This is as true for the Uganda shilling as is for most other currencies. The South African rand, for example, is a very volatile currency.

Moreover, exchange rate depreciation per se is not inherently bad or a sign of poor performance. Sometimes, it is necessary and desirable for exchange rates to depreciate to allow economies to adjust to external shocks. Uganda’s exchange rate has come under strong pressure to depreciate for two reasons.

First, our balance of payments has weakened. This is because most of the major sources of foreign exchange for Uganda - exports, workers’ remittances and foreign direct investment – are growing at a slow rate because of the stagnation in the industrialised economies of the world.

In contrast, Uganda’s demand for imports has grown at a robust rate, reflecting the strong growth of the domestic economy.

The only way in which we can bridge the gap between demand and supply of foreign exchange is by a depreciation of the exchange rate. This will make the production of Ugandan exports more profitable and encourage Ugandan consumers to economise on their use of imports and instead consume local products to the extent that this is possible.

Second, as everyone who has been following the international news will understand, the world economy and financial markets have suffered tremendous turbulence in the last few weeks, with large falls on stock markets.

In periods of global market volatility, international investors tend to flee from assets which they perceive as being risky and instead invest in safe assets like, for example, US treasury bonds or gold.

As a result, countries such as Uganda which attract modest amounts of short term portfolio capital from abroad have suffered capital outflows, which has put further pressure on the exchange rate to depreciate. Uganda is part of a globalised economy.

The global economy performed well in the decade or so, which led to the global financial crisis in 2008 and, as a result, export markets boomed and capital flowed into developing countries like Uganda.

The outlook for the global economy has deteriorated dramatically since 2008. Large parts of the industrialised world are again facing economic slowdown. Inevitably this has an adverse impact on Uganda, which is felt primarily through the balance of payments.

The Ugandan economy has to adjust to living in a more difficult global economic environment – an environment in which major export markets grow very slowly and from which it is more difficult to attract private investment.

Exchange rate depreciation provides one tool for facilitating the adjustments, which the Ugandan economy must make to prosper in a more challenging and volatile global economic environment. As I have already mentioned, this will help to narrow the trade deficit by making Uganda’s exports more competitive and encouraging Ugandans to consume fewer imports.

There are many countries around the world which peg their exchange rates, usually to the dollar or the euro. Because they peg their exchange rates, these countries have not experienced a depreciation of their exchange rate over the last two months, unlike Uganda. But that does not mean that they have performed better than Uganda.

Pegging exchange rates in the face of balance of payments shocks entails costs for an economy. This is because foreign reserves have to be depleted to defend the exchange rate against depreciation. But the rigidity of the exchange rate impedes the adjustments of the economy, which are essential for the long-term prosperity of the economy.

Uganda has not followed this path. Instead, it has chosen to pursue a flexible exchange rate policy, allowing market forces – the supply and demand for foreign currency – to determine the level of the exchange rate. Although there are sometimes costs in the short-term, a flexible exchange rate is better for the long-term health of the economy. This is due to the fact that it provides a mechanism for allowing the economy to adjust to macro-economic shocks, which affect the balance of payments.

The Ugandan economy faces major challenges in the years ahead if it is to sustain its strong record of growth and stability in a much less benign global economic environment.

The country will need to make difficult economic policy decisions. As such, we need a serious and informed public debate about the policies, which are best for the long-term development of our economy.

Unfortunately, flippant comments about the shilling being “the worst performing in the world”, without taking any account of the context or reasons for the depreciation of the unit, do not help to promote public understanding of the challenges facing our economy.

By Dr. Louis Kasekende : The New Vision Newspaper
The writer is the deputy governor Bank of Uganda