BANKS IN FOR A ROUGH RIDE AND WHY WE SHOULD CARE

Last week the Bank of Uganda announced the fourth increase of the Central Bank Rate(CBR) in as many months to 10% in a bid to beat back inflation, which rose in September into the double-digit range for the first time in more than a decade.

In July 2012 inflation stood at 14.3% working its way down from a high of 30% in October of the previous year.

Inflation or a general rise in prices, is caused by too much money chasing few goods. This may arise because there are general shortages of goods or because there is more money in circulation than necessary.

The most recent inflation has been driven by external shortages, a hangover from the covid-19 lockdown and accelerated by the war between Russia and Ukraine. Another major driver was the increases in global oil prices earlier in the year.

The short-term way to fight inflation is to decrease money supply, which is what the Bank of Uganda is attempting to do by increasing the CBR. In determining lending rates banks take a cue from the CBR, when it goes up they raise rates when it goes down they follow suit. A raising of rates tends to lead to a slow down in borrowing but even more worringly an increase in loan defaults..

Predictably we have seen increases in lending rates to keep up with the Bank of Uganda’s recent actions. This has the effect of dampening the demand for credit.

"Whereas the borrowing public may grit their teeth at the banks’ speed to respond, which they have little choice as the cost of their money is pegged to the CBR, banks are bracing themselves for hard times ahead....

According to a Uganda Bankers’ Association (UBA) report released earlier this year, in 2021 lending to the private sector grew by eight percent but this growth was down from 12% the previous year. This was on account of low economic activity through the worst of the Covid-19 lockdown last year.

An increase in lending rates, apart from the bad press, invariably leads to a rise in bad loans. Bad loans not only affect banks’ profitability but also their appetite to lend.

The full effect of the higher lending rates will be felt in 2023 as the BOU’s anti-inflationary actions have come in the second half of the year. We can reasonably expect that rate of growth in lending will slow down or fall off altogether.

Other instruments at the central banks disposal to check the growth rate of money supply are treasury bills and bonds.

In 2021 bank investments in these and other tradable securities grew by 10%, much higher than the rate of increase of lending to the public.

That maybe where the danger is for the borrowing public, this more than the higher lending rates. That given a choice between lending to government and lending to the riskier private sector and individuals that banks will shift their attention more towards government paper.

Sadly, this has been a trend in the making with the ratio of how much of customer deposits do they lend out falling to 61% last year from 71% in 2015.

In case anyone needed any convincing, the overall health of the banking sector is key to whether growth continues at acceptable levels or not in this economy. A stressed banking will hamper its ability to support the private sector. While the investing in government paper is critical to stabilizing the macroeconomy, that is not supposed to be the core activity of the sector.

The truth of the matter is that while the central bank has the sole right to print money, it’s the banking sector that actually determines money in circulation through its lending practices. The ability to execute this function depends on the health of the sector.

The knee jerk reaction would be to blame the banks. This would be wrong.

The central bank’s major mandate is to ensure there are no dramatic increases or decreases in prices, they do this with the limited tools at their disposal, designed to reduce money in circulation. The more sustainable thing in the inflation equation is to increase production to balance the money in circulation. The nature of this jump in prices is a function of things happening outside out borders and therefore the central bank cannot control.

“Unfortunately, restoring inflation to low and stable levels involves taking medicine with some temporary side effects. The fight against inflation is not a painless battle,” wrote deputy bank of Uganda governor Michael Atingi-Ego in the press last week...

The hope is that the banking industry comes out the other side intact as it will be needed to reignite the economy.