Delaying Devaluation Burdens Economy

Foreign exchange shortage has remained a recurring problem within the Ethiopian economy. There never had been a time, except for a relatively unprecedented build-up in 2010/11, that shortage was not felt. No one could better describe the situation than Sufian Ahmed, former Minister of Finance & Economic Development (MoFED) and now advisor to the Prime Minister, who famously once said, That the foreign currency shortage was not going to be resolved in his lifetime.

To the monetary authorities stationed off Yared Street, the foreign exchange shortage in the economy is largely one of the structural issues they struggle with each day. Controlling foreign exchange usage, tracking international exchanges and settlements, managing interbank transactions, and overseeing the national reserve are their day-to-day activities. If anything, these are inherent precedents of a managed foreign exchange rate constrained by relatively inelastic exports.

Lately, though, the challenge faced by the contingent of monetary gurus, led by Governor of the central bank, Teklewold Atnafu, an old hand in the job, has grown beyond maintaining reserves. The incessant negative trade balance the economy witnesses, coupled with growing demand for foreign currency, has continued to expand the gap in the exchange rate of the local currency, Birr, between the formal and parallel markets. As it stands, the parallel market, often named black market, is experiencing an average of 12.4pc more value than the formal market.

Overvaluation of the Birr is one of the latest monetary developments Teklewold and his compatriots at the National Bank of Ethiopia (NBE) ought to address. By the accounts of the International Monetary Fund (IMF) and the World Bank, the Birr is overvalued by an average of 15pc. Some accounts even take the figure up to 25pc.

Research by the Bretton Woods institutions shows that overvaluation is hurting exports. Imports might have been cheaper as a result of overvaluation, but it is all coming as a result of a worsening trade balance position. Not least, the imbalance is affecting the foreign exchange reserve of the nation.

There seems to be no disagreement over the fact that the Birr is overvalued. Both monetary and fiscal authorities of the nation admit that the exchange rate of Birr against major currencies is being maintained at its current state with huge cost. The difference of opinion seems to lie in the policy response.

The official line from the authorities has been that the overvaluation ought to be reduced through continuous depreciation of the currency’s value. This line takes much of its rationale from cautiousness to avoid market turbulence. Studies conducted back in 2009/10 by Access Capital, a research firm now inactive, shows that the monthly depreciation of the local currency by that time was in less than four per cent. Considering the difference in the global economic situation, it is obvious that the slump will be lower than the case in 2009/10.

Independent experts and international financial institutions, however, do not agree with the policy line. They argue that a one-off aggregate devaluation is better than a rolling depreciation as it will reduce the pain of uncertainty felt within the markets. They even exemplify the case as the difference in uncertainty of pain between a higher dose injection conducted once and a lower dose conducted multiple times.

Simulation research conducted by the World Bank in 2014 shows that a five percentage point devaluation of Birr would result in 0.5pc growth in gross domestic product (GDP). This means, at 15pc overvaluation, the currency holds a key to an instant GDP growth of 1.5pc. The simulation exercise, nonetheless, admits that the process would have a cost in the form of a raise in import costs. Yet, the resultant outcome stands positive, for devaluation benefits exports and growth.

From all appearances, the market and macroeconomic winds seem to be in favour of devaluation. Not only is the action supported by the higher benefits it brings, but also the historically low cost it takes to conduct this exercise.

The global commodity cycle stands at its historically low end. Oil, a major import for Ethiopia, is being sold at lower than 40 dollars per barrel. Underpinned by lower Chinese growth, the price of capital goods, which constitutes close to 80pc of Ethiopia’s imports, has also declined considerably. Even with a raise in interest rate by the US Federal Reserve last week, the global economic situation is more doom and gloom.

On the demand side, such a global situation will suppress exports for Ethiopia. As nation with an export mainstay of agricultural produce, the only way to boost exports will be to diversify destinations and push more in the side of volume. Even for this though, the exchange rate will play a huge part.

The case with the supply side is, however, positive. The marginal increment in cost of imports to be endured by the economy would be historically low at this point in time. Hence, the change for a higher positive balance will is considerable.

Whether it is 12.4pc, as the market indicates, or 15pc, as the research by the Bretton Woods institutions shows, it is obvious that the local currency is overvalued. And the economy is paying a huge cost to maintain the formal exchange rate at the current state. Complemented with a faltering export sector, which has been falling behind the state’s plan for a fifth year consecutively, the situation will remain costly to the economy.

There seems to be little left for the monetary authorities to choose from. They would either conduct the injection is smaller doses with prolonged uncertainty in the market, as they have been doing it for the past five years, or they would go for a thoughtful one-off injection in the form of devaluation.

It takes no genius to see that the foreign exchange shortage in the country will be experienced for some time. The ongoing drought that is affecting close to 10 million people around the country will most likely add to the pain. After all, challenges in the agricultural sector will have a multiplied impact on the economy.

If one looks at the gamut of factors that ought to be analyzed in making an exchange rate policy – from cost of imports to competitiveness of exports – the time seems to be favourable for devaluation. Thus, the monetary authorities ought to have the courage to respond to the signals of the market. Prolonging devaluation will only be painful for the economy as it will be left to shoulder unnecessary costs embedded in the overvaluation of the currency.

Surely, the action may not be plausible in a political sense. It may be translated as a sign of weakness to the state and to the monetary authorities. Nonetheless, no critic would be stronger than the voices of the market.

Fortunately, even the one stronger case for the opponents of devaluation – a rise in cost of imports – would not justify inaction as the global commodity cycle is at its lowest. This means, the marginal increment in cost of imports is at its lowest level.

On the benefit side, as the World Bank research rightly shows, devaluation pays in the form of exports and GDP growth. It will also narrow the gap between the formal and parallel exchange market, infusing inertia to the formal market. Formal remittances will also be enhanced through devaluation. With remittances contributing hugely to the foreign exchange generation of the nation, positive development in this respect will have a significant role in the build-up of national foreign reserves.

So much as the challenge is to build reserves, the policy action to be taken by monetary authorities ought to be one that plays in the positive. At this time, there is no better alternative than thoughtful devaluation.

Published on Dec 21,2015 [ Vol 16 ,No 816]



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