* Offshore investors held 13 pct of local debt at end 2014
* President Museveni widely expected to seek to extend rule
* Investors fear repeat of 2011 pre-election spending
* Government scrapped debt auction as rates surged
By Elias Biryabarema
KAMPALA, Jan 13 (Reuters) - Expectations that Uganda will spend more than planned in the run up to an election due in early 2016, pose risks for investors who are demanding higher returns to hold government debt.
President Yoweri Museveni, 70, who has overseen rapid economic expansion during his almost three decades in power but has a weaker record on fiscal discipline, is widely expected to run for re-election in 2016, though he has yet to declare his candidacy.
Investors worry about a repeat of the 2011 presidential election campaign, when government spending surged, helping drive inflation to an 18-year high of 30 percent and sent the Ugandan shilling plunging to an all-time low of 2,901 in September 2011.
In response, the central bank jacked up lending rates to 23 percent in November 2011, angering businesses and triggering public protests about the rising cost of living.
For now, indicators are fairly benign, with inflation at just 1.8 percent in December, helped by falling food prices, but the shilling, like other emerging market currencies, has been weakened by a resurgent dollar and has fallen 12 percent in the past 12 months to around 2,865.
Yields on Ugandan debt are starting to price in what investors see as growing risk. The yield on one-year paper was 14.2 percent at a Jan. 7 sale, compared to 11.9 percent in June.
Faisal Bukenya, head of market making at Barclays Bank, said investors were demanding higher yields “as they anticipate inflation to rise into 2016 as the election spending takes off.”
The government overshot its borrowing target by 67 percent in the fiscal year ended June 2014, partly because of a row over an anti-gay law that led some donors to hold back aid, which has now largely resumed.
Finance Minister Maria Kiwanuka, in her budget speech in June, said the government would borrow 1.4 trillion shillings in 2014/15, down from 1.7 trillion shillings in 2013/14, but spending would rise to 15.1 trillion shillings, from 13.2 trillion. Financial markets doubt the government will keep to that target.
“Considerable fiscal slippage is likely ahead of the 2016 polls,” said Clare Allenson, Africa analyst at Eurasia Group.
The Finance Ministry says it has made provisions for borrowing this year. “We don’t want to speculate on what may happen to the yields,” said spokesman Jim Mugunga.
But the authorities are already baulking at rising borrowing costs. The central bank scrapped a sale of two- and five-year notes worth a total of 180 billion shillings ($63 million) on Dec. 31, citing “unacceptably” high offers.
It did not give figures but the yield on two-year paper at a Dec. 3 auction was 14.3 percent, up from 12.8 percent in June.
Yields on 10-year local debt have also spiked, to 14.770 percent when last offered on Nov. 5, from 13.954 percent in January 2014.
The government is investing heavily in infrastructure needed to start oil production, scheduled for 2018, supported by foreign investment and loans including from China. While investment is helping the economy grow by around 5 percent annually, analysts have questioned whether the government can afford to take on so much debt, which Fitch forecast would total 35 percent of GDP in fiscal year 2014, up from 21 percent two years earlier.
An official at the International Monetary Fund has urged Uganda to stagger planned energy and transport projects to avoid fuelling inflation and hogging bank credit.
Offshore investors held about 1.17 trillion shillings, or 13 percent of total domestic debt as of December 2014, central bank data shows.
While investors demand higher returns, though, rising yields could tempt back some foreign investors, who have lost interest in Ugandan sales as prospects for a U.S. interest rate rise have sapped appetite for emerging market debt.
Yields on Ugandan short-term debt are now higher than for those of much bigger neighbour Kenya, which has been hit by a series of attacks by militant groups. One-year bills in Kenya yielded 10.679 percent in January, roughly the same level they were in June, and 10-year paper yields around 12 percent.
“As yields rise we could start to see them (offshore investors) come back,” said Kenneth Owera, analyst at Stanlib Uganda Limited, a fund manager and investment advisory firm. (Editing by Edmund Blair and Susan Fenton)