Microsoft Word - ELP-V2N1-p55 Economics, Law and Policy ISSN 2576-2060 (Print) ISSN 2576-2052 (Online) Vol. 2, No. 1, 2019 www.scholink.org/ojs/index.php/elp 55 Original Paper Inflation Thresholds, Economic Growth and Investment Planning In Uganda Rogers Matte1* 1 Macroeconomic Planning Department, National Planning Authority, Republic of Uganda * Rogers Matte, Macroeconomic Planning Department, National Planning Authority, Republic of Uganda Received: October 21, 2018 Accepted: November 7, 2018 Online Published: January 3, 2019 doi:10.22158/elp.v2n1p55 URL: http://dx.doi.org/10.22158/elp.v2n1p55 Abstract Economic Planners, monetary policy custodians and civil society in Uganda often disagree on the target for inflation when their development objectives are not harmonised. When development economists argue for increased deficit spending in support of infrastructure development and capital accumulation, they are challenged in regards how much pressure the development budget should put on likely macroeconomic stability, particularly where inflation could rise above the inflation target. This paper examined the effect of inflation on economic growth in Uganda and evaluates the equilibrium rate of inflation in the country, given the macroeconomic environment. Using the threshold model and data for the period 1991-2017 it is established that: a) below 7.3 percent inflation level, the relationship between inflation and economic growth is positive and inflation is not harmful to growth, while at levels above 7.3 percent, inflation was detrimental to economic growth and the relationship become negative; b) at economic growth rates above 7.8 percent, inflation was an incentive for further growth, yet at economic growth rates below 7.8 percent per annum, increases in inflation served as a dis-incentive to economic growth. Therefore Uganda in the current conditions is better off maintaining inflation below 7.3 percent as long as the anticipated economic growth is 7.8 percent. Keywords inflation thresholds, economic growth, investment planning www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 56 Published by SCHOLINK INC. 1. Introduction Over the last decade or so Uganda government has been seeking to develop a private led economy where private investment and export growth drive economic growth through the national development plans and poverty eradication programmes. Attaining a sustained output growth rate capable of delivering the country to middle income status in the medium to long-term was the real sector goal of the country’s national development plans (Republic of Uganda, 2015). At the same time it has pursued a monetary policy goal of macroeconomic stability with the inflation targeting framework in the recent years. Price stability is praised for creating a stable environment for decision making by the economic agents in markets. High inflation erodes the value of money and affects economic welfare of low income earners. At the same time, some moderate inflation is favourable for giving signal to market players on supply and demand situation which may affect decision making at agency level. Specific plan scenarios assume stable price levels and this makes the issue of inflation thresholds critical to economic planning, when the structure of the economy is expected to change over time. The debate regarding the management of inflation, its policies and instruments in Uganda overtime culminated in setting of a medium to long-term target of 5percent core inflation. The major policy framework for inflation in the country since 2011 is inflation targeting. The monetary policy framework uses interest rate to signal and influence macroeconomic activity: prices, inflation, output, or sometimes designated monetary aggregates. There is no direct control over these and Bank of Uganda exerts its influence over the macroeconomic magnitudes by setting the short-term interest rate (Mugume & Namanya, 2014). Despite adjustments in the central bank interest rate, there is no mention of growth based tools to address inflation. In view of the role of the East African Community integration, the country agreed to the convergence target of 8 perccent headline and 5 percent core inflation by 2021. The efforts to remain around the inflation target in some cases has been criticised for contributing to the high interest rates given a high base set by the policy rate. While the relationship between inflation and growth may been dogenous, it is important to understand the relationship in the medium to long-term to clearly visualise the impacts (Vinayagathasan, 2013). 1.1 Macroeconomic Stability and Economic Growth The primary objective of monetary policy in Uganda over the recent years has been to attain low and stable inflation. Close to a decade, the monetary policy stance in Uganda has been guided by policy persistence; the neutral nominal rate which takes into account the real interest rate and the expected inflation; inflation gap; and output gap (National Planning Authority, 2018). Monetary policy stance was contractionary in 2011 and 2015 when inflation was on the rise. The rest of the period saw a relaxation in the policy stance so as to increase money growth. When output is at its potential, and inflation and inflation expectations are at objective levels, the monetary conditions are at neutral levels and do not constrain or stimulate aggregate demand and inflation. In this case real interest rate would be at the neutral rate. www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 57 Published by SCHOLINK INC. Considering the efforts by the central bank to control inflation using interest rates, the growth effect of inflation on economic growth is more important in the economics of Uganda as a developing country. High lending rates inhibit growth in private investment and the process of value addition, yet these are primary growth objectives. This is because the cost and nature of credit has implications on the ability of the country to service the entire value chain of products prioritised in the national development plan for a country like Uganda. The national development framework expects that the growth of credit would be sufficient to support production of raw materials, value addition and marketing and logistics management along product value chains. This has however not been realised because the nature of credit available in the Ugandan market can to a greater extent serve the interests of the services sector and less the processes of value addition and production of primary inputs, which require lower cost credit because of long gestation periods. The sectors that are served more in current circumstances are more volatile in nature unlike the productive sectors which would provide tangible, stable and sustainable growth (Table 1). This process would be more supportive to the transformation process of the economy with greater bias towards industrialisation, in particular agro-processing and mineral beneficiation. In comparison with the countries in the sub-Sahara Africa over the past decade, and more so in the last four years, it is observed that interest rates have remained higher in Uganda compared to Kenya, Burundi, Nigeria, South Africa, Democratic republic of Congo and Zambia. Compared to these countries, interest rates in Uganda have remained around 20 percent since the second half of the 1990s unlike other countries where these rates have been moving in response to their economic policies. All in all, interest rates and bank credit policies remain relatively weak channels of monetary policy in Uganda, unlike the exchange rate policies, in stimulating the real sector performance especially the manufacturing sector (Nampewo, Munyambonera, & Mayanja, 2013). Generally, Ugandan interest rates have remained above the rest of the countries in Africa both those with a developed banking sector and those less developed compared to the domestic sectors. The more developed economies in this case include Kenya, South Africa and Nigeria and the less developed ones include Burundi and the Democratic republic of Congo. Further observed is that the responsiveness of the lending rates in Uganda to changes in the policy interest rates of the central bank, shows greater stickiness on the side of lending rates coming down, yet a rise attracts immediate response. This supports the view that commercial banks in Uganda are more responsive to profit motives than growing the business size, yet they respond positively to policy in a direction that is anti-private investment. In view of the above observations, the causes of high interest rates in Uganda may be characterised as on the basis of internal characteristics of the banks, and the economy wide macroeconomic environment. While the lending rates are driven by funding costs, operational costs, capital reserve costs, risk cost and bank profits (Bryony, 2012), the macroeconomic environment also presents factors that may affect lending rates. The funding cost takes care of the cost faced by banks to raise the www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 58 Published by SCHOLINK INC. necessary capital in order to lend; the operational cost presents the fixed costs faced by banks in terms of the overhead running costs; the capital reserve cost is the cost faced by banks in holding the minimum capital reserves as required by regulation; the risk cost captures the loss banks suffer from default. Macroeconomic determinants of high lending rates include: high and variable inflation, growth of output, high money market real interest rates, interest rate uncertainty (inter-bank interest rate volatility), exchange rate volatility (Nampewo, 2013), the share of commercial bank public sector loans, share of development (long-term) to commercial (short-term) assets, and public sector domestic borrowing, among others. Table 1. Ten Year Share of Total Private Sector Credit in Uganda by Sector Sector 2006/ 07 2007/ 08 2008/ 09 2009/ 10 2010/ 11 2011/ 12 2012/ 13 2013/ 14 2014/ 15 2015/ 16 2016/ 17 Agriculture 6.7 6.0 4.5 6.4 6.7 6.5 7.8 9.6 9.8 10.3 11.5 o/w Production 2.6 2.3 1.4 3.5 3.6 3.4 3.5 3.8 4.4 4.4 4.5 o/w Processing & Marketing 4.0 3.7 3.1 2.9 3.1 3.1 4.3 5.8 5.3 5.9 7.0 Mining and Quarrying 2.4 0.4 0.3 0.8 0.3 0.4 0.3 0.2 0.5 0.6 0.6 Crude Petroleum & Natural Gas 0.0 0.0 0.0 0.0 0.0 0.1 0.1 0.1 0.2 0.4 0.3 Other Mining & Quarrying 0.0 0.0 0.0 0.8 0.3 0.3 0.2 0.1 0.2 0.2 0.4 Manufacturi ng 14.1 12.4 15.2 13.2 13.7 13.4 14.0 13.2 15.4 14.0 12.8 Trade 15.6 12.2 20.6 20.4 22.5 22.6 21.1 21.6 20.4 19.0 20.1 Transport and Communica tion 6.1 6.9 5.8 7.7 7.7 6.5 5.8 5.4 5.2 7.0 6.7 Electricity 0.4 0.9 0.6 1.1 0.9 1.0 1.4 1.2 1.7 2.0 1.9 www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 59 Published by SCHOLINK INC. and Water Building, Mortgage, Constructio n and Real Estate 11.2 15.1 16.4 18.2 20.1 22.8 22.6 22.7 22.6 22.8 20.6 Business Services 0.0 0.0 0.0 3.3 4.3 3.6 5.2 4.4 4.7 3.8 4.1 o/w Working Capital 0.0 0.0 0.0 1.0 1.4 1.7 2.2 1.9 2.3 2.3 2.3 o/w Other 0.0 0.0 0.0 2.3 2.9 1.9 2.9 2.5 2.4 1.5 1.8 Community , Social & Other Services 0.0 0.0 0.0 2.9 3.3 3.5 3.1 3.3 3.3 3.4 3.3 Personal Loans and Household Loans 17.9 15.4 21.9 21.1 15.8 15.3 13.6 17.2 15.1 15.8 17.7 Other Services 25.7 30.8 14.6 4.9 4.7 4.3 5.1 1.4 1.4 1.4 0.7 Total 100 100 100 100 100 100 100 100 100 100 100 Source: Bank of Uganda. 1.2 Trends and Policy Frameworks for Inflation Since 1994, inflation in Uganda was highest in 2011 (quarter 4) at 23.6 percent when the CBR was increased to 22 percent. Through this policy there has been a drastic reduction of long term inflation to the long term target although there are episodes of high and low inflation in the short run, which are a result of shocks whose impact is largely dependent on the structure of the economy. The objective of monetary policy in Uganda has over the last decade been that of maintaining macroeconomic stability without compromising economic growth. The policy framework in place has since 2011 fostered a movement of the interbank money market interest rates in tandem with the central bank rate which in turn were expected to influence other retail interest rates in the economy, both in the short and the long-term. The target for inflation over the medium to long-term has been 5 percent per annum, and the central bank rate has been adjusted accordingly to influence demand for credit and influence the level of economic activity by managing the demand side of the economy. Over the www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 60 Published by SCHOLINK INC. medium term, inflation oscillated around the target of 5.0 percent pursued by the central bank, especially after the adoption of the inflation targeting framework. When a longer projection is made over a period of about twenty years backwards, the expected inflation raises higher taking into account the levels attained. It is accordingly noted that the country’s long run optimal level of inflation lies between 5 and 8 percent. A target of 6.5 percent has also been estimated from threshold models taking into account economic growth in the past and potential output going forward. 1.3 Sources and Effects of Inflation in Uganda Performance of the global and regional economy affects inflation. Uganda has a trade deficit and heavily imports manufactured commodities from both regional and global markets. Crises in other countries are translated into import prices for the domestic economy. International oil price fluctuations have had a key role in influencing domestic prices. Volatility in the foreign exchange market is another source, especially depreciation fuels inflation. Uganda currency has depreciated significantly in the recent past leading to secondary effects on the domestically produced commodities given a large component of imported raw materials. Large budget deficits induce increases in interest rates and high cost of private capital, with effects on inflation. There has been an increase in the domestically financed borrowing which leads to the rise in the cost of credit in the banking system, impacting on the cost of access to capital and of production. Delays in execution of public projects for which resources have been borrowed domestically exacerbate this issue and may have led to sub-optimal decisions. Uganda has underdeveloped commodity value chains and markets which provide an incentive for supply rigidities. The dependence of the food sector on natural factors and the lack of linkages with industry and under developed market institutions affect the variability in food prices in periods of boom and shortage. Further the under developed utilities sector affects production to capacity for some industries therefore affecting the cost of production. Food and Non-Alcoholic Beverages; Housing, Water, Electricity, Gas and Other Fuels; Transport and education were the major sources of inflation in the country from 2011 to 2017, contributing over 63percent of the price changes. The prices for food and non-alcoholic beverages are associated with the structural nature of agriculture production in the country, with a large percentage resulting from the shortages in supply. Addressing the key real sector factors inhibiting stable supply of food, constraints in the supply of fuel products in the transport sector and educational supplies could potentially reduce inflation from these sources. The description of inflation dynamics in Uganda during the period 2000-2012 indicated that in the long-run money supply, exchange rate, foreign inflation, terms of trade and real output, foreign prices, exchange rate, growth of domestic credit, rainfall deviation from the long-run mean, the trade and current account balances, fiscal balance, trade openness, and the international interest rate differential determine inflation in Uganda (Opolot & Kyeyune, 2012; Janine, Muellbauer, & Sebudde, 2015). In the short run, inflation is driven by changes in real output, monetary aggregates, the exchange rate, and www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 61 Published by SCHOLINK INC. foreign prices. The Central Bank of Uganda indicates that core inflation is affected by: international factors (interest rates, inflation, oil prices); exchange rates; output gap and capacity utilization; domestic demand; money supply and credit extension and expectations (Bank of Uganda, 2011). The disequilibria in the money and traded goods markets are significant but the adjustment process is slow. In spite of the fact that inflation has exogenous determinants, such as foreign inflation, there is scope for the central bank to limit the impact of such shocks on inflation by pursuing a tight monetary policy stance. The significance of the interest rate differential in the money-demand equation implies some degree of effectiveness of the monetary policy. 1.4 Effects and the Threshold of Inflation Albeit many arguments regarding inflation, there is a view that inflation is useful to economic growth if below some threshold level, and is detrimental when above that threshold level. In particular, inflation influences growth by decreasing productivity growth and investment. Uganda’s implied inflation threshold is 5 percent as set in the targeting framework by the central bank—Bank of Uganda, which is the point of variance. This threshold is unique for each economy, as indicated by the variations seen in cross-country studies, between 2 percent and 12 percent in a number of countries, and generally, developed countries have lower thresholds while those for developing countries are higher. A recent study estimated 8.5 percent as the threshold for Uganda based on data for the period 1970-2013 (Yabu & Kessy, 2015), yet the inflation target by BoU is 5 percent. What is not clear is whether this threshold is dynamic. The EAC countries under the programming for the anticipated Monetary Union target to have headline inflation at 8 percent. Whether this target would be changed and how often is not clear either. In view of the above, development planners and monetary policy custodians disagree on the target for inflation when their development objectives are not harmonised. Whereas development economists may argue for increased deficit spending in support of capital accumulation, they face a challenge in regards how much pressure the development budget should put on likely macroeconomic stability especially where inflation would rise above the inflation target. 1.5 Theoretical Review A number of theories explain the link between inflation and economic growth. There is confluence among them that in the short run, inflation induces growth, to the extent that it is positively correlated with growth but in the long run its persistence is detrimental to growth. Table 2 reviews some of the theoretical impacts of inflation. Table 2. Theoretical Economic Growth Impacts of Inflation Theory Nature Inflation and growth Criticism Emphasis Classical Supply side based A rise in inflation leads to a fall in the rate of return on High inflation inhibits financial Provide incentives for www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 62 Published by SCHOLINK INC. Theory Nature Inflation and growth Criticism Emphasis individual’s real money balances reducing wealth. People will then save more by switching to financial assets in order to accumulate the desired wealth. Higher demand for assets increases their prices, resulting in a decline in the real interest rate. Increased savings result in greater capital accumulation and hence faster output growth development by making financial intermediation more costly, hits the poor disproportionately because they do not hold financial assets that provide a hedge against it. This hinders long-term economic growth increased savings and investment so that the economy grows Keynesian AD-AS  “ “  Inflation can redistribute profits from workers with low savings propensities to entrepreneurs with high propensities to save and invest, and increases the nominal rates of return relative to the cost; hence increasing growth  During inflationary periods, money is redistributed from holders of money balances to governments (through monetary authorities – inflation tax) to expand public investment programmes, thus increasing growth High inflation rates raise the cost and risk of productive capital and may lead to misallocation of funds to less productive investments that act as a hedge against inflation … Neoclassical and endogenous growth inflation affects capital accumulation and investment; “ “ High inflation leads to speculative trade and capital … www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 63 Published by SCHOLINK INC. Theory Nature Inflation and growth Criticism Emphasis outflows affecting growth Monetarist the role played by monetary growth in determining inflation – from the quantity theory of money There is neutrality of money, with inflation rate having no effect on the growth rate as well as the level of output. In the long run, the growth rate in money mainly affects prices. This is because individuals will anticipate the rate of future inflation and incorporate its effects into their behaviour. Employment and output are not affected Provide dis-incentive for monetary growth to contain inflation. When profits decline and labour productivity remain unchanged, the prices tend to increase In view of the above theoretical frameworks, a number of models have been used to analyse the links between inflation and economic growth. These include the Philips curve, the mark-up approach, the quantity theory of money, and the dynamic panel. These are briefly reviewed below. Phillips Curve: If demand increases and the output gap becomes larger, business costs will increase, wages will increase. Companies pass on the higher costs to their customers, thus increasing prices. On the other hand, if demand falls and the output gap becomes smaller, business costs will decline thus wages will be lower. Companies then pass on the lower costs to their customers by reducing prices, hence less inflation. The Philips curve therefore underscores the link between the output gap and the inflation rate, with current inflation explained by current inflation expectations and the output gap. 1 1 e t t t t t t dP dP EP P P           (1) In the equation above, the LHS is the inflation rate ( 1 t t dP P ), the current expectation of the future inflation is the second term on the RHS ( 1 e t t dP P ), while the output gap is the third term ( tEP ). The signs of the coefficients are all positive in the equation above. The Mark-up approach: Considering Unit Labour Cost (ULC), Price of imported goods (PM), then enterprises will set domestic prices by adding a gross mark-up () to the cost per unit of output. Here www.scholink.org/ojs/index.php/elp Economics, Law and Policy Vol. 2, No. 1, 2019 64 Published by SCHOLINK INC. the CPI combines the price of domestic and imported goods. log(Pt+1)=+*log(C*U*Mt+1)+*log(PMt+1)+t+1 (2) The quantity theory of money: Considering Money supplies (M), Velocity of money (V), Real GDP (Y), then money growth is a key determinant of inflation. By assuming that Money demand remains stable, then we estimate current prices as: 1 1 1 1 (1 ) * (1 ) 1 (1 ) (1 ) t t t t t t tt t dMd dV dP Md V dYP Y             (3) The threshold model: In this model, the growth rate of real GDP is dependent on inflation, the inflation threshold variable that is exogenous and a time variant, and other explanatory factors. These explanatory factors include the past values of GDP, investment, population growth, openness, terms of trade, and the standard deviations of openness and terms of trade. The model is divided into two using a dummy variable for values of inflation below and above the threshold. This is a form of nonlinear regression presenting piecewise linear specifications and regime switching that occurs when an observed variable crosses unknown thresholds (IHS Global Inc, 2016). In this model, there are T observations and m potential thresholds (j=1, 2, … m), implying there are (m+1) regimes. For all observations in the regimes, there are two sets of regressors: those that vary (X) and those that do not vary (Z) with the regime. For the threshold variable (qt) threshold values (m) exist, such that we can identify them across the arrange j<=q<j+1, and (1<2 < …. <m). For a single threshol and two regimes, we have yt=Xt’+Zt’1+et,if–