Joseph Mubiru Lecture by Dr. Ngozi Okonjo-Iweala
Board Chair, Gavi Alliance; Minister of Finance, Nigeria (2003-2006, 2011-2015); Managing Director, World Bank (2007-2011)
at The 50th Anniversary of the Bank of Uganda

Let me start by offering my warm congratulations to the Bank of Uganda on its 50th Anniversary! This auspicious occasion is a good time to take stock of how far we have come and the challenges we confront as the journey continues. We meet even as global macroeconomic uncertainty is extremely high and politics is growing increasingly insular and populist, as witnessed by the recent Brexit vote and the divisive presidential election campaign in the USA.

In our ever more connected world, the African continent has not been without its travails. The most tangible factor has been the big drop in commodity prices starting in 2014. A combination of slowing growth, a big fall in the terms of trade for commodity exporters and large fiscal and current account deficits has tarnished the Africa Rising narrative: was it simply a product of a large windfall driven by China’s almost insatiable appetite for commodities until 2014? We know that this is not the whole story. That policies, institutions and governance have greatly improved in Africa over the last decade.

Yet, we must heed the warnings signs. The most recent forecast, from the IMF’s July Update of the World Economic Outlook, has drastically cut the growth projection for 2016 from 3% in April to just 1.6%, with a forecast of 3% for 2017. These would be the worst growth outcomes in 15 years, with oil exporters hit particularly hard. The shocks include slowing growth in China, a major trading and investment partner of Africa and prime driver of the commodity super cycle; a massive loss in income for commodity exporters, energy and non-energy; tightening financial conditions reflected in higher commercial borrowing costs; and severe drought in Ethiopia, Malawi and Zimbabwe. Angola, Mozambique, the Republic of Congo and Zambia have suffered credit downgrades.

The point I wish to stress is that slowing growth and falling terms of trade may not be just a temporary rough patch. The consequences could linger especially in countries where public and private sector balance sheets have been overextended in terms of rising debt levels, worsening dynamics and currency mismatches. This is the environment in which African central banks need to define their strategy in conjunction with fiscal policy and structural reform as they seek to control inflation and help promote inclusive growth.

But we now live in an age of unconventional monetary policy. This raises a fundamental question for African central banks. Do we need a change in paradigm, or should African central banks stay the course established over the last decade, when have been focusing on price stability? Recall that, in earlier decades, they had a much broader remit that included being a source of fiscal deficit and development finance. This is the question I will be addressing in this Memorial Lecture honoring the memory of the brilliant Joseph Mubiru, whose life was tragically cut short, but whose legacy of excellence endures.

In answering the question, I shall draw lessons for African central banks from recent central banking developments in the advanced countries, or developed markets, as well as in major emerging markets. The weight of the experience points to being highly circumspect about unconventional monetary policy. Indeed, the overwhelming priority for African central banks is to pursue low and stable inflation in order to make their currencies credible stores of value, thus promoting financial deepening and long run growth. In the last section, I shall focus on the situation in Uganda.

DM Central Banks: Adapting to Crisis
Just a decade ago, the Great Moderation held sway. Inflation targeting was viewed as the ultimate stage in the evolution of monetary policy. It was the logical destination for responsible, mature central banks. Monetary policy would be conducted in an idyllic setting: the capital account is open, the currency floats with little or no intervention and central bank independence is the cornerstone of credibility and good macroeconomic management. With long run growth assured, central banks would operate counter-cyclically to minimize fluctuations around the trend, ensuring low inflation and full-employment growth. Monetary policy had arrived.

Ten years later, the situation could not be more different as consequence of the Global Financial Crisis of 2008-9, which I shall refer to as the GFC. The US Federal Reserve Board has completed three rounds of Quantitative Easing, with QE3 brought to a close at the end of October 2014. By then, the balance sheet of the Federal Reserve System had swelled by 400%, from USD 0.9 trillion in August 2008 to $4.5 trillion. But last December, the normalization of US monetary policy began, with the Fed hiking the policy rate, the Fed Funds Rate, by 25 basis points, lifting off above the zero lower bound where it had stayed for seven years.

Meanwhile, “unconventional monetary policy” has become the order of the day in DMs. Massive ongoing QE is being carried out by two major central banks, the Bank of Japan (BoJ) and the European Central Bank (ECB). Negative nominal policy rates have been adopted by the ECB, BoJ, Swiss National Bank (SNB), and central banks of Denmark and Sweden; the “zero lower bound” has been breached. And sovereign bond yields are below or close to zero out to ten years for Japan, Germany and Switzerland. Citi estimated in early July 2016 that more than 50% of the outstanding government debt in 10 countries, including France, Germany and Japan, was trading at negative nominal yields.

In the Eurozone, Mario Draghi took over as President of the ECB in November 2011, when fallout from the burgeoning Greek debt crisis included fears of a sovereign debt crisis in the Eurozone periphery, which includes big countries like Italy. Draghi has risen to the occasion and acted not merely to save the euro, but also to prevent a government solvency crisis in the Eurozone periphery by keeping long-term interest rates low.

Yet, in spite of the prompt and massive unconventional action by DM central banks, growth remains anemic and inflation is well below targets! As Mario Draghi has repeatedly stressed, monetary policy cannot do it alone. This is a lesson for Africa: if monetary policy is to deliver the goods, it must be formulated in concert with fiscal and structural policy and improved governance and institutions.

Why not Unconventional Monetary Policy in Africa?
The unconventional steps taken by DM central banks after the GFC begs the question: why can’t central bankers in Africa adopt unorthodox measures to lower long-term interest rates and spur growth? Let me now illustrate why unconventional monetary policy should be viewed with caution by Africa by citing significant examples from prominent emerging markets, including Brazil, China and India.

Brazil
Between 2001 and 2008, Brazil painstakingly rebuilt its macroeconomic credibility by sustained adherence to old-fashioned policies, such as ramping up primary fiscal surpluses to improve debt dynamics. It created a good climate for private investment and promoted social inclusion and poverty alleviation. By the time the GFC occurred, macroeconomic volatility and high inflation appeared relics of the past.

But after the GFC, Brazil took unorthodox steps to shore up growth. In addition to cutting the SELIC, the central bank’s policy rate, by a huge 525 basis points between Aug 2011 and Oct 2012, a much bigger role was carved out for Brazil’s National Bank for Economic and Social Development, BNDES, and other public sector banks, whose market share increased from 34% to 45% of total credit between Dec 2007 and July 2012. Various targeted tax breaks were also implemented as part of so-called rules-based industrial policy. There was obvious merit to some measures, such as some loosening of fiscal policy for a country which had earned an investment grade credit rating in 2008, and a push to increase private investment in infrastructure. But something clearly went wrong.

Brazil’s potential growth has dropped considerably with private sector confidence taking a beating. Actual growth came in at minus 3.6% in 2015 with minus 3.3% expected for 2016. The SELIC has been hiked to 14.25%, by far the highest policy rate among the world’s large economies, at a time when most central banks are cutting rates. 2015 inflation came in at over 10%, well above the upper end of the target inflation range of 4.5% ± 2% with a similar inflation outcome expected this year. According to the IMF, subsidized lending by the public banks has diminished the impact of the central bank’s rate hikes. The 2014 Article IV consultation notes: “The widespread use of subsidized lending weakens monetary policy transmission and distorts credit markets. Introducing a direct link between the policy rate (SELIC) and the subsidized lending rate (TJLP) would increase the effectiveness of monetary policy. Reducing the gap between the SELIC and the TJLP…..would also lower the recurrent fiscal cost arising from the cumulative stock of policy lending by government.”

Brazil’s credit rating has been slashed substantially below investment grade and its proudest accomplishments, taming inflation and restoring sustainability to public debt dynamics, have been compromised. The country is now embroiled in a serious political crisis and corruption scandal involving Petrobras, with the President suspended in May amidst impeachment proceedings.

b. China
I shall next discuss China, a major trading partner and an important source of infrastructure loans for Africa. Big challenges have arisen for China after the GFC as the result of a massive increase in leverage and related financial vulnerability as the growth drivers switched from investment and exports to social housing, real estate and public investments in infrastructure. Let me give three examples of rising financial vulnerability: First, trust funds, which are part of the so-called “wealth management products” now account for some 20% of GDP and constitute the core of the “shadow banking” system. Some 50% of trust fund proceeds are invested in real estate, infrastructure, energy and mining, with companies in these sectors taking a big hit. Wealth management products had their genesis in financial repression: with household deposits in banks severely taxed via financial repression, wealth management products with their much higher guaranteed returns, became a natural, albeit much more risky, alternative. Second, local governments, which account for 80% of public infrastructure investments, have seen their debt skyrocket. Some 50% of local government revenues come from land sales. Third, the real estate sector, which has become a major engine of growth post GFC, is described by the IMF in China’s 2014 Article IV consultation, as being at the center of a “web of vulnerabilities”.

In this environment, the approach of the central bank, the Peoples’ Bank of China, PBoC, has been to support the financial sector through rate cuts, liquidity injections and regulatory forbearance. Various measures have also been taken to support the Shanghai and Shenzhen stock exchanges in view of last summer’s equity market rout. And the seeming lack of will to confront the problem of non-performing loans in commercial banks has fueled concern that PBoC may be supporting growth at the expense of rising financial vulnerability. While there is no doubt about China’s headline-making historic economic accomplishments over the past three decades, and I am a great fan of that, the indecisiveness about addressing rising vulnerability in the domestic financial system after the GFC has become a major concern and potential headwind to growth.

c. India
I come now to the case of India, which has clearly been doing things right while sticking to orthodoxy. Indian economic growth is one of the few bright spots in the global economy. India formally adopted an inflation targeting regime in March 2015, setting a target for CPI-based inflation of 4% with a band of plus or minus 2% beginning in the 2016/17 financial year. But this was preceded by meticulous preparation to build credibility under the Reserve Bank of India’s Governor, Raghuram Rajan. Rajan took the helm of India’s monetary policy in 2013, a year which saw the county bracketed together with Brazil, Indonesia, Turkey and South Africa as the Fragile Five.

The first challenge was to exit the Fragile Five by lowering the current account deficit, bolstering foreign exchange reserves by attracting dollar deposits from the Indian diaspora overseas and establishing RBI’s seriousness about lowering consumer price index- or CPI-based inflation, which was in double digits, by hiking rates; with wage awards being based on the CPI, India was rapidly losing competitiveness relative to China and other emerging markets. Rajan’s goal was simple: make the Indian Rupee a credible store of value, thus dulling the seduction of gold, and raise interest rates above CPI inflation, making rupee-denominated assets attractive. Intermediate targets were also set for inflation: less than 6% by January 2016, which was met, and less than 5% by January 2017.

Rajan reminds us of the reasons why low inflation is important in a speech made only a few weeks ago on June 20. First, low and predictable inflation makes the currency a credible store of value. Second, the ones who benefit from negative real interest rates are rich industrialists and the Government, with the inflation tax hurting the middle class savers and the poor. Inflation is a tax that hurts the poor. But what struck me most is Rajan’s call for staying the course and adopting tried-and-tested orthodoxy—because it works. It enables sustained growth and lowers volatility. To quote him—and recall that he is a former IMF chief economist—“Decades of studying macroeconomic policy tells me to be very wary of economists who say you can have it all if only you try something out of the box. Argentina, Brazil, and Venezuela tried unorthodox policies with depressingly orthodox consequences."

Summary of lessons from Emerging Markets
Now let me distil a few lessons. Brazil’s experience point to the risks and costs of letting central banks and public banks become fiscal agents and trying to promote growth through large amounts of subsidized lending. This is not to say that some amount of subsidized lending targeted at SMEs and managed fiscally through the budget is not important. As a carefully crafted and targeted instrument to lift up the small enterprises, it can work. At the same time, it is vitally important to avoid domestic corruption and political shocks of the type that have befallen Brazil.

China offers several lessons. Let me focus on three. First, a prolonged and excessive reliance on financial repression can lead to undesired and risky responses such as the rise of shadow banking and unregulated financial instruments promising high returns as people try to escape the financial repression tax. Second, the massive forex reserves China has built up may have to be used to absorb potential losses in the clean up of the domestic financial sector. Already, some US$775 billion have been used up to support the Renminbi in the six months August 2015 to January 2016. Building up forex reserves is not enough. Central banks have to be proactive in anticipating potential sources of vulnerability and heading them off, through macro-prudential tools, for example. Third, China is held up as a stellar example of cleverly used industrial policy to grow rapidly. But remember: China is not your standard small, open economy, a description that would apply to much, if not all, of Africa. No multinational could ignore its domestic market of over one billion. China could exploit its bargaining power to transfer technology as a quid pro quo for access to its market. The lesson for Africa: create a good climate for private investment and FDI in manufacturing and agri-business. Couple this with structural reform to spur competition and innovation.

India’s experience is a wake-up call for getting the basics right and resisting opportunistic and costly experimentation. We cannot let monetary and exchange rate policy be captured by economic and political elites for their limited goals of personal enrichment.

Let me complement this with lessons from Russia and Turkey. Russia tried in the late 1990s to achieve inflation targets while fiscal deficits and public debt dynamics were out of control. This was a futile quest that eventually backfired. With regard to Turkey, lack of transparency in the conduct of monetary policy as well as its politicization lowered credibility and served to fuel costly procrastination, de-anchoring inflationary expectations and then forcing a massive tightening in January 2014.

Financial Sector Challenges

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