Effects of fiscal deficits on long term interest rates in Uganda (1993-2022)

Abstract

Over the past years, Uganda has faced fiscal challenges, including persistent fiscal deficits averaging 4% of GDP over the last 30 years and coupled with rising public debt levels reaching 48.4% of GDP as at end June 2022. This has led concerted efforts to pursue fiscal consolidation in the medium to long term to ensure deficits which usually translates to accumulated debt do not get out of hand. Despite these efforts, Uganda has still faced a high and increasing cost of debt service with interest payments as a proportion of GDP being on the rise over the years, from 2.3% in June 2019 to 3.1% as at June 2022. The proportion of domestic debt interest payment taking a higher and growing share despite domestic debt constituting less of total debt stock. This accentuates the age old question of whether there is a linkage between fiscal deficits and interest rates. The objective of this study was to investigate the effects of fiscal deficits on long term interest rates in Uganda while controlling for short term interest rates, inflation, GDP growth, and Debt using secondary data over the period between 1993 and 2022. The study investigates the relationship between fiscal deficits and long-term interest rates using an Autoregressive Distributed Lag (ARDL) modeling approach. The study aims to provide a comprehensive analysis of the impact of fiscal deficits on the long-term interest rates, with a particular focus on understanding both the short and the long-term dynamics as well as potential causality between these variables. The results of the study indicated that in both the short and long run deficit have a positive and significant relationship with long term interest rate. The results showed that a 1% increase in fiscal deficits as a percentage of GDP will likely increase long term interest rates by about 9 basis points (0.09%) taking into account inflation, short term interest rates, GDP growth and debt as a percentage of GDP. The result of granger causality test indicated that there is a unidirectional causality from deficits to Long term interest rates. The strong, significant relationship lends credence to the Neoclassical proposition that rising government deficit reduces the stock of loanable funds and consequently crowds out private sector investment in the long run hence raising interest rates.