Sticky Loan Rates in Uganda

Introduction

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

Neoclassical Model

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.

Asymmetric Information

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.

Conclusion

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.

 

 

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Insurance – How Uganda Will Quadruple Its Coffee Industry

An analysis explaining how an innovative style of insurance policy can lead to farmers’ confidence in coffee to rise.

LA REVANCHA: FAIR TRADE CERTIFIED COFFEE ESTATE - NICARAGUA

The government of Uganda is promoting growth of its coffee industry by nearly 400%. Aiming to increase production of coffee from four million bags to twenty million bags, the government is investing in irrigation and subsidizing coffee seedlings to increase interest in growing coffee, a crop often seen risky by farmers because of the unpredictable nature of rainfall in Uganda. NUCAFE, the National Union of Coffee Agribusiness and Farm Enterprises, is promoting crop insurance as a tool to increase interest in growing coffee. Justus Lyatuu of The Observer, writes of NUCAFE’s foray into crop insurance.

Coffee is extremely reliant on moisture and rainfall to successfully grow and mature to a  crop fit for harvest. A slight decrease in rainfall could cause mass coffee crop failure, leading farmers to stray from growing the risky crop. Nearly 65% of crop losses in Uganda are due to drought, and the farmers’ inability to accurately predict weather and effectively mitigate the risks associated with weather leads farmers to devote their resources to growing less risky and less valuable crops.

NUCAFE is encouraging farmers to grow coffee through the offering of crop insurance, which will function to reduce the risk carried by farmers from investing in the production of coffee. Farmers will pay 5% of their expected yield of harvest in the beginning of the grow, and in the event of crop failure due to weather events such as drought, the insurance policies will pay out to farmers near the expected yield of the harvest. Not only does this promote the growth of coffee by mitigating many of the risks of doing so, NUCAFE also will offer education and access to weather information from NASA to allow farmers to more accurately predict weather and mitigate losses from drought.

Index Insurance, How Can It Promote Increased Confidence in Risky Crops?

Index insurance is an emerging form of insurance beginning to become available to those in the agriculture industry, that offers policies to farmers based on weather indexes. Farmers will pay premiums to the insurer, who will in turn, pay out to the farmer in the event of weather conditions suitable for crop failure are met. For example, if the agreed upon conditions for the weather index insurance policy state that if below 15 inches of rain falls in the grow period, then the insurance policy will pay out to the farmer.

Pre-existing forms of crop insurance were structured so the farmer pays premiums to the insurer, and if the crop fails, then the insurance policy pays out near equal to the crop loss.

Index insurance has many advantages over standard crop insurance policies. Because index insurance uses publicly available data to determine if conditions for crop failure are met, transaction costs for index insurance are significantly lower than standard insurance, where claims often result in the insurer needing to inspect the farm themselves, increasing transaction costs. Lowered transaction costs are essential for financial products, and create suitable conditions for private insurers to exist in the marketplace as well as allowing small farmers to afford insurance. When transaction costs are minimized, the cost associated with the financial product is as close as possible to the cost to the insurer of paying out to policyholders. Not only does this increase potential profit margins for insurers, it keeps the cost of insurance low for farmers. Index insurance’s low transaction costs mean the product’s adoption might be possible without governmental and NGO financial support, which otherwise would be required to supplement insurers operating at a loss.

Index insurance protects insurers from moral hazard. With standard crop insurance, the policy may provide a better outcome to the farmer if the crop fails, tempting the farmer to intentionally sabotage their crop. They may have a policy that pays out more than the expected yield of their harvest, or they may be able to make the same amount of money with a failed harvest without having to put in effort to grow the crops. Because index insurance pays out when uncontrollable weather conditions are met, farmers don’t benefit from a failed harvest, it actually still serves the farmers best when they always strive for a successful harvest, since payouts aren’t determined with the outcome of the crop, but instead based on growing conditions.

Because index insurance determines if payout conditions are met based on weather data, it isn’t always effective in protecting the farmer from risk. If the farmer’s crop fails even when there has been 15 inches of rainfall in the grow season, the farmer has a failed crop and no payout from his insurance policy. If somehow the farmer’s crop succeeds when there has been less than 15 inches of rainfall in the grow season, he receives a payout even when his crop succeeded. So, while index insurance protects insurers from moral hazard, it often can result in ineffective risk mitigation for the farmers.

Index Insurance in Uganda

With the implementation of weather index insurance in Uganda for coffee farmers, coffee farmers can invest their resources to growing coffee without having to bear the risk of crop failure. Policies aimed to protect farmers from drought would pay out to farmers when drought conditions have been met. Since drought is the leading cause of crop loss in coffee agriculture, insurance policies that pay out when drought conditions occur mitigates the risk of low rainfall to coffee farmers, the largest drawback to growing coffee instead of safer crops.

Works Cited

Lyatuu, Justus. “Coffee Farmers Urged to Embrace Insurance.” The Observer. N.p., 10 Mar. 2017. Web. 11 Apr. 2017. <http://www.observer.ug/business/51694-coffee-farmers-urged-to-embrace-insurance.html&gt;.

Hellmuth M.E., Osgood D.E., Hess U., Moorhead A. and Bhojwani H. (eds) 2009. Index insurance and climate risk: Prospects for development and disaster management. Climate and Society No. 2. International Research. Institute for Climate and Society (IRI), Columbia University, New York, USA.

Leiva, Oscar. Hands of María Del Socorro López López. Digital image. Coffeelands. Catholic Relief Services, 9 Nov. 2015. Web. 17 Apr. 2017.