Poorly diversified export portfolio, the vagaries of global commodity markets and weak logistic services are pointed out as the culprits for the current foreign currency shortages. The role of the Central Bank’s rigid exchange rate policy has been a factor, writes Fiseha Haile (firstname.lastname@example.org), an economist at the World Bank. The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the views of the World Bank.
Ethiopia has recently witnessed an unparalleled economic growth, as measured by its Gross Domestic Product (GDP), which has surged from an average of four per cent between 1994 and 2003, to 10.7pc between 2004 and 2017, according to official government figures. Though some scholars cast doubt on the accuracy of the growth figures and official statistics in general, only a few people question Ethiopia’s growth spurt.
Growth is propped up by massive public spending on roads, electricity, railways, and education, largely financed by loans from external and domestic sources. Ethiopia maintains one of the highest public investment rates in the world, according to a recent World Bank report. Poverty has also declined, mainly propelled by growth in the agricultural sector.
However, the story is not all rosy. The double-digit growth, the buzzword of the last decade, did not translate into jobs growth. With the private sector still lagging behind, tens of thousands of graduates remain unemployed or underemployed.
The government’s pro-cyclical fiscal policy has supported infrastructure investment leading to a rapidly growing public debt, which spiked to over 55pc of GDP in 2016/17, from just 46pc in 2013/14. Rising debt may not be unique to Ethiopia, but what sets the country apart from other African economies is the chronic foreign currency shortages that hamperes debt servicing, an uphill battle.
Foreign reserves have hit rock bottom with less than two months’ worth of imports. Last month, Ethiopia received some relief when the United Arab Emirates (UAE) agreed to deposit one billion dollars with the National Bank of Ethiopia (NBE).
Acute forex shortage, currency rationing and a flourishing parallel currency market have long been the Achilles’ heel of the Ethiopian economy. This was partly due to lacklustre export performances as a result of falling global commodity prices, and weak domestic supply and poor quality. Debt servicing difficulties may also signify wasteful spending and inherent inefficiencies of public investment projects.
In a bid to correct currency misalignments and improve export competitiveness, the Central Bank devalued the Birr by 15pc in October 2017. This was combined with an increase in interest rate floors on savings and time deposits from five to seven per cent, which was meant to arrest inflationary pressures. The devaluation helped reduce the currency overvaluation, according to recent IMF estimates.
Overvaluation means that the Birr is too expensive in terms of the United States dollars, making the dollar much cheaper than market forces indicate, leading to increases in Ethiopia’s exports prices and undermining its competitiveness. It is no wonder then that coffee exporters and foreign manufacturers have recently reoriented their sales to the local markets as the domestic prices have surpassed global markets.
Ethiopia may be the only country that aspires to industrialise while maintaining an overvalued currency. Harvard professor and economist Dani Rodrik, prominent figure in debates about economic development, showed that historically fastest-growing Asian economies pursued the well-trodden path of systematic currency undervaluation during their growth heydays, which was strongly linked with rapid export growths.
Indeed, the exchange rate is a strong determinant to Ethiopia’s manufacturing sector. As a second-best policy intervention, undervaluation, or at least establishing a competitive exchange rates may mitigate the key culprits of manufacturing growth – market distortions and institutional constraints – and help stimulate a virtuous process of structural change in the country.
No doubt, the Ethiopian government had benefited from the overvaluation because it lowered the cost of capital-goods imported for public investments. This is especially true given the fact that government and SOEs have preferential access to foreign currency. On the other hand, the private sector has borne the brunt of the foreign currency shortage.
Why has Ethiopia been facing recurrent currency overvaluation and foreign currency shortages, in both good and bad times?
The former Finance Minister, Sufian Ahmed, is reported to have said that foreign currency shortages would not be solved in his lifetime. The new Prime Minister has also recently opined that the problem could last for two decades. Some of the factors responsible for this situation, as expressed by both experts and laypersons alike, include poorly diversified export portfolio, the vagaries of global commodity markets and weak logistics services.
The role of the exchange rate policy has been much less appreciated, however. The Central Bank categorises the exchange rate regime as a managed float. This means that the exchange rate has no predetermined path, and thus it fluctuates from day to day with only occasional interventions by NBE.
In reality, the Birr has been allowed to depreciate only at a fixed pace – around five per cent in nominal terms. It seemed as if the fixed rate of depreciation is too sacrosanct to be changed. This ER policy aimed at keeping the country’s effective (trade-weighted) exchange rate stable is predicated on the assumption that the dollar is stable relative to the currencies of Ethiopia’s trading partners, and that the inflation differential with the trading partners remains at five to six percentage points.
The NBE’s exchange rate arrangement is classified as “crawl-like,” by IMF’s standard categorisation.
Although the Birr is tightly managed against the dollar, the exchange rate has been mostly unresponsive to changes in the external environment, including the value of the United States’ currency against others and inflation differentials.
That the dollar appreciated by double digits against all major currencies between 2014 and 2016, and that no significant adjustment was made to the value of the Birr by NBE is a good indicator. During this time, when other African economies were grappling with sharply depreciating currencies, the Birr was markedly appreciating.
In a similar vein, during the 2008/09 fiscal year, despite marked changes in macroeconomic fundamentals, notably skyrocketing domestic inflation rates, it was business-as-usual at the Central Bank in terms of exchange rate policy-making.
The NBE did not take timely and deft reactive measures and come to grips with deviations from its assumptions. It is noteworthy, however, that managed exchange rate regimes can only be sustained if substantial adjustments are made for substantial changes in the exchange rate and inflation rates of the anchor currency country – the United States, in the case of Ethiopia.
For the future, it is crucial to maintain a flexible exchange rate to bolster competitiveness and to jump-start export diversification. An overly rigid exchange rate regime should be shunned and a more responsive system should be put in place.
The NBE may want to live up to its stated managed floating exchange rate system similar to what Rwanda adopted, or implement appropriate form of floating as Kenya, Tanzania, and Uganda carried out. Though Ethiopia uses the dollar as an exchange rate anchor, its exports destined for the United States account for under eight per cent of the total, according to the first six months data of this year provided by the Ministry of Trade (MoT).
In the medium-term, an alternative policy may be to peg the Birr to a basket of currencies, or a trade-weighted average of currencies, which would help stabilise movements in the effective exchange and increase competitiveness. A basket peg though might be harder to administer and may be more challenging in terms of foreign reserve management.
Needless to say, Ethiopia should continue to improve logistics services, which would lower transactions costs; and cut back red tape and improve the business environment, which would attract new investment and unleash existing ones. It is also imperative to diversify (vertically and horizontally) into higher value-added products; and tap into foreign capital, including by gradually opening up the capital account over the medium to long-term.
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