On February 27th of 2018, the Daily Monitor – an independent, Ugandan daily newspaper – reported that the Ugandan government recently dropped the Central Bank Rate(CBR) to 9 percent. However, the author also noted that commercial lending rates have remained sticky within Uganda, staying at an average of 20.28 percent (Adengo). The situation is particularly interesting to explore from a developmental economic perspective, considering many reasons exist outside of neoclassical credit models for such situations to become possible. In particular, it’s interesting to observe the effects of adverse selection and moral hazard to arise within markets with asymmetric information that can lead to such credit frictions.
Before examining possibilities as to why the commercial lending rate remains sticky in Uganda, and the impact for small lenders, it’s important to understand the context and assumptions under which we are working. Uganda, for the past year, has aggressively been cutting the rate at which the Central Bank lends money to commercial banks and lenders in an attempt to improve access to credit and therefore increase economic growth. Trading Economics – a website which hosts and tracks various economic statistics across countries – reports the lending rate for Uganda has been between 18 and 26 percent since 2006(Figure 1). It is only since February 2017 the rate has been progressive cut from 17 percent down to the 9 percent we see today.
Figure 2. Uganda Lending Rate. Source: https://tradingeconomics.com/uganda/lending-interest-rate-percent-wb-data.html
Firstly, to understand how asymmetric information may introduce the credit frictions we observe in Uganda today, it’s important to understand how the market would work with perfect information. In a neoclassical model of credit, the borrower and lender both fully know all information about each other regarding project investment choice, ability to repay the loan, and the market share of borrowers. Moreover, markets are considered competitive in that lenders are unable to raise their interest rates as other lenders would continue to compete against them at the lower interest rate. In these markets, borrowers loan capital at this competitive rate and use it to invest in some entrepreneurial project which yields back profits for loan repayment and income.
In this model, the assumption is lenders charge the opportunity cost of capital – here lenders would lend out money at a rate of 9 percent per unit of capital K since lenders are only responsible for the cost owed to the Central Bank. Since all information is known, no cost is incurred for monitoring or determining borrower type. Ultimately, entrepreneurs pursuing loans should profit and contribute to overall social welfare since projects are efficient and project benefits outweigh project costs.
However, the real world is not a market of perfect information. Borrowers know things about themselves, such as risk preference, lenders cannot observe. In particular, this lack of information causes frictions – costs – the lender must incorporate into the rate at what they’re willing to lend money. In particular, lenders are faced with issues of adverse selection and moral hazard. In particular, Ugandan lenders do not know whether they’re borrowers are “safe” or “risky”, thus determining their ability to repay a loan based on project outcomes. For example, a Ugandan banker is unable to determine if a borrower will invest in the volatile market of cryptocurrency with his loan or whether he will pursue a traditionally “safe” business venture, such as a mobile phone reseller. As noted in Development Economics, “adverse selection arises… when potential borrowers differ in… default probabilities… such [that]… lenders cannot distinguish safer from riskier borrowers” (Shaffner, 641).
In particular, if Uganda bankers are unable to perceive borrower type, then they must offer an interest rate which takes into account the share of borrowers in the market who are risky, whether collateral is required, and whether safe borrowers remain in the market at such interest rates. There is a possibility that safe borrowers cannot afford to enter business ventures at a 20.28 percent rate of interest and have exited the market many time periods ago. Because risky borrowers only remain in the market, lenders must adjust accordingly to ensure the expected return on their loans is able to cover the rate at which they borrowed money from the CBR. Moreover, if projects in Uganda have become riskier or more expensive – it now costs more to invest in a riskier project or riskier projects are less likely to pay off – we would see an increase in the interest rate over time. However, we would expect since February of 2017 these rates would have dropped, since the CBR dropped significantly, which is not the case.
It is possible Uganda is facing a compound issue where moral hazard also plays a role in the credit friction. Moral hazards occur when effort and project choice remain unobservable to the lender, causing a lender to be unable to force a borrower to exert effort to select a choice of project. In particular, Ugandan borrowers faced with both ex-ante moral hazards and post-ex moral hazards. That is, they face moral hazards prior to their choice of project and after the completion of their project. Firstly, a borrower may choose to “slack” after receiving their loan and find themselves unable to pay back the lender. This would lead to increased interest rates as it becomes more difficult for lenders to break even and the increasing interest rate can even lead to incentivizing pursuit of riskier projects and causing lenders to exit the market. However, the Ugandan Banker’s Association reports the number of commercial banks branches increase from 400 in 2010 to over 500 in 2012(“History of Banks”)
Finally, Ugandan borrowers may be facing ex-post moral hazard in their choice of repayment. That is, a borrower may be successful with their project, but choose not to repay their lender in an attempt to take more money home. This is particularly true of borrowers with little personal wealth or those undergoing markets with high-interest rates. According to the OECD report commissioned by the Austrian Ministry of Foreign Affairs and Development Co-Operation titled “Microfinance in Uganda”, it’s possible that “The overall repayment rate of commercial banks continues to be extremely weak and may be a low as 55%”(Carlton et. al). Additional studies, such as “Causes of high default rate on loans in commercial banks” by Robert Kinyera find similar repayment rates(Robert). This would indicate that borrowers are unable to cope with the high-interest rates and would rather default.
Overall, while the original author of the article, Jonathan Adengo, points to interest rates coming down over time, I find it hard to believe given our understanding of developmental credit markets. The situation intuitively appears, given the evidence, that loan default rates in Uganda are high and borrowers continue to be at risk of ex-post moral hazard. Without an intervention, such as a decrease in interest rates either by government subsidy or policy change, interest rates will continue to stick at a high 20.28 percent without incentive to budge. Still, Uganda provides a real-world, tangible case study of the presence of asymmetric information in credit markets and how moral hazard projects can arise and how they influence the dynamics of a consumer credit market.