Uganda - Shilling Set For Long-Term Depreciatory Trend


Tuesday, July 04, 2017 10:35 AM / BMI

BMI View: The Ugandan shilling will trade within range over the next six months, but is set to continue on its trend of long-term depreciation thereafter. This will be driven by a shortfall of inward investment and lower real interest rates.

Short-Term Outlook (three to six months)

The Ugandan shilling is likely to trade sideways over coming months as increasing flows of foreign loans and donor aid into the economy support the currency against increasing imports.

Further, the BMI Global Strategy team takes a broadly constructive view on EM FX over coming months following the defeat of Marine Le Pen in the French Presidential election, meaning the shilling is unlikely to become entangled in a global market sell-off of risk assets.

Moreover, we note bank lending will likely continue to grow slowly in coming months, given the high non-performing loan ratio (last measured at 10.5% in December) will constrain liquidity in the banking sector, and subsequently keep the money supply relatively tight, limiting imports and consumer spending by businesses and consumers.  

As such, we believe pressures will largely be balanced in the short term as sufficient foreign capital enters the country and the currency is likely to trade within a range between UGX3600/USD and UGX3700/USD in the next three to six months. 

Long-Term Outlook (six to 24 months)
Over a longer-term trajectory, we expect the shilling will continue on its gradual depreciatory trend, falling 5.4% and 5.0% to UGX3800/USD and UGX4000/USD by end-2017 and end-2018 respectively.  

The shilling's real effective exchange rate currently sits around 8% above its ten-year average, undermining its competitiveness compared to its trading partners. We also note a widening current account balance, driven by an increase in capital imports for infrastructure projects, will exert increasing pressure on the shilling.  

This will be exacerbated by the higher cost of fuel imports, driven by the increase in global Brent crude oil prices. While some of the projects – largely in the oil, power and transport sector – will be financed by foreign direct investment, other East African countries such as Tanzania, Kenya and Ethiopia are also undergoing large investment plans, meaning regional competition for investment and funding is fierce.  

This will limit the scope for Uganda's foreign investment, meaning many plans will require additional domestic funding.  

As a result, fiscal spending is also set to grow as the government ramps up funding for the projects and associated labour and administration costs, meaning domestic debt will likely rise. 

The deterioration in real interest rates is also likely to drive further weakness in the exchange rate.  

The Bank of Uganda (BoU) cut the central bank rate by 600 basis points between April 2016 and April 2017, to 11.00% from 17.00%.  

Policymakers continued with the easing cycle in February and April, despite rising inflation on the back of higher food and fuel prices.  

The fall in real yields to about 5.0% from near 10.0% in October is likely to reduce appetite for Ugandan securities, tempering inflows of foreign currency. 

We also note the BoU widened access to the primary securities market to investors through commercial banks, which will increase access to, and demand for, government bonds.  

While this is likely to prove positive in the short term, higher holdings of government securities may increase volatility in the long term, meaning the future impact of a risk asset sell-off on the currency would likely be stronger. 

Risks To Outlook
Should Uganda fail to receive the concessional loans and grants necessary to progress with the government's ambitious investment plan, the government may have to ramp up domestic borrowing even more than expected, which would lead to concerns about the country's sovereign credentials and likely damage investor sentiment. 

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