Why currency appreciation matters

 Due to the global financial system and trade, the continuous international transactions cause the exchange rate to rise or fall, depending on supply, demand and geopolitical events.

By way of definition, appreciation of the currency is the increase in value of the currency compared to others, whereas depreciation, is the decrease in value of that particular currency.

Currency appreciation tends to make imports cheaper because the same amount of local currency can buy more foreign products. Appreciation might also cause domestic production to lose competitiveness in the international market because local products are worth more in foreign currency. Therefore, exports tend to decrease. More imports and fewer exports expand the trade deficit. 

Shilling’s appreciation

Explaining what has contributed to Shilling’s strength this year, the deputy governor Bank of Uganda, Dr Michael Atingi-Ego explained in an interview that while the exchange rate has been relatively stable, it has exhibited some appreciation pressures (strength) due to budget support inflows, including highly concessional term loans from the International Monetary Fund and World Bank, personal remittances and Non-Governmental Organisation transfers.

Dr Ating-Ego added that relatively high portfolio investment inflows reflecting offshore investor appetite for government securities, and rebound in exports.

In addition, low private sector demand for imports and the weakening of the US dollar against other major currencies have also contributed to strengthening the shilling.

So how does the strong shilling impact Ugandans and the economy?

Importers benefit from a strong shilling, which makes their goods cheaper, but exporters suffer a reduction in their income as they receive less shillings per unit sold.

Dr Atingi-Ego said: “The relative appreciation pressures exhibited by the shilling have somewhat reduced upward pressures on domestic prices, especially that of imported goods, thereby translating into low and stable inflation. Indeed, inflation in Uganda has remained low and stable for most of this year with core inflation averaging 3 per cent in the seven months to July 2021, which is below the BoU target of 5 per cent.”

Dr Atingi-Ego technically explained that as the Shilling stabilises, it could lower the shilling-denominated prices of imports, which translates into low inflation. Since imports become relatively cheaper, this increases their domestic demand which deteriorates the external trade balance because import values will grow faster than export values.

In addition, a strong shilling would stabilise the shilling value of a given level of foreign currency-denominated debt; and if domestic output is growing, this leads to improvements in the debt to Gross Domestic Product (GDP) ratios.

However, Dr Atingi-Ego said a strong shilling reduces the competitive advantage of local exporters/suppliers in that locally produced goods become more expensive for foreigners, which reduces exports.

Breakdown

In breaking this down further, Dr Atingi-Ego said: “Assume the average exchange rate in year one was Shs4,000 per US$ and in year 2 it is Shs2,000 per  US$. If a kilogramme of coffee produced in Uganda is Shs4,000 in year one and remains at Shs4,000 in year 2, it means the importers of Ugandan coffee will pay twice the coffee price in year two  compared to year one, which would discourage demand for Ugandan coffee by foreigners, thus reducing Ugandan coffee exports.”

 “Similarly, a strong shilling may cause less tourism activities as the country will be more expensive for foreigners which in turn could reduce Uganda’s foreign exchange earnings,” Dr Ating-Ego added.

Despite the recent appreciation of the shilling, the exchange rate has remained stable because it reflects the prevailing economic conditions.

Outlook

On whether there is hope that the shilling could depreciate against the US dollar and other currencies before the end of the year, Dr Atingi-Ego said in the near term, the Uganda Shilling is expected to remain relatively stable.

“However, in the medium-term, the shilling is expected to depreciate on account of a pick-up in import demand by both the private sector and government, a possible slowdown in portfolio inflows as government reduces its domestic financing needs and the interest rate differentials between Uganda and those in advanced economies begin to narrow,” he said.

Discussing the current risks in Uganda’s exchange rate; Dr Atingi-Ego said the outlook for the exchange rate is highly uncertain and is subject to both downside and upside risks. On the downside, a stronger-than-expected pick-up in domestic economic activity would increase demand for imports, exerting stronger depreciation pressures on the shilling.

In addition, Dr Atingi-Ego said the firming up of economic activity and rising inflationary pressures in advanced economies may cause their central banks to increase interest rates earlier than expected, leading to reversals in portfolio inflows from emerging markets and frontier economies such as Uganda, which in turn would generate depreciation pressures on the shilling.

“The possible resurgent of virus infections would hinder economic recovery. This coupled with continued budget support inflows, personal remittances inflows and portfolio inflows, will exert appreciation pressures on the shilling,” he said.