A striking Similarity

The 1997 Asian Financial Crisis vs. Ethiopia’s Foreign Exchange Problem

The 1997 financial crisis in Asia occurred after several decades of outstanding economic performance. Annual gross domestic product (GDP) growth in the ASEAN-5 (Indonesia, Malaysia, the Philippines, Singapore, and Thailand) averaged close to eight percent over the decade before 1997. This is similar to the official growth rate registered by Ethiopia in the past decade. Then, in 1997, these economies witnessed a major financial crisis. In general, economic growth in the region suffered a dramatic decline. Equity prices fell by 10 to 45Pct while exchange rates declined by 12 to 68Pct. Exports suffered as well: the median annual growth of exports, which was about 23Pct before the crisis, declined to 4Pct.

The Origins of the Crisis
The origins of the 1997 Asian financial crisis were the subject of heated debate on a world scale. For instance the famous American economist Stanley Fisher and the Nobel laureate Paul Krugman argued that the key domestic factors that led to the crisis were the failure to dampen overheating of the economies, whichresulted in large external deficits as well as property and stock market bubbles.

Secondly, it was the maintenance of prolonged fixed exchange rate regimes that encouraged external borrowing and led to excessive exposure to foreign exchange risk. Thirdly, Fisher and Krugman argued that the crisis was due tolax prudential rules and financial oversight, which led to a sharp deterioration in the quality of banks’ loan portfolios.

As the crises unfolded, political uncertainties and doubts about the authorities’ commitment and ability to implement the necessary adjustments and reforms exacerbated pressures on currencies and stock markets. Reluctance to tighten monetary conditions and to close insolvent financial institutions also added to the turbulence in financial markets. A good number of these signs are apparent in Ethiopia today as described in the table below.

In contrast to this view, another Nobel laureate American economist Joseph Stieglitz, who at the time was vice president and chief economist of the World Bank, noted that the aforementioned opinions went further than is justified by the fundamentals. In his view, no other economic system had delivered so muchin such a short span of time. He further notedthat financial and currency crises have occurred elsewhere in the world. Although the lack of transparency in the East Asian economies contributed to the problems, it is probably not responsible for the crisis itself. East Asian countries have high national saving rates.

The East Asian governments had all run budget surpluses or minimal budget deficits at the time. Also, macroeconomic policy has been relatively stable, as evidenced by their low inflation rates. Thus, he argued, the financial crisis in East Asia can be understood as the result of a number of factors that have made these economies especially vulnerable to a sudden withdrawal of confidence.

The problems –including misallocation of investments, unhedged short-term borrowing and, in Korea, very high debt-to-equity ratios – were rooted in private-sector financial decisions. This is not to absolve governments of responsibility, Stieglitz argued. Insufficient financial regulation and implicit or explicit government guarantees, as well as misguided exchange-rate and monetary policies, each played an important role in creating the incentives that led to the particular size and character of external financing and internal misallocation of resources.

Many of the problems these countries face today arise not because governments did too much, but because they did too little – and because they themselves had deviated from the policies that had proved so successful over preceding decades. In several countries, for instance, poorly managed financial liberalization lifted some restrictions, including restrictions on bank lending to real estate, before putting in place a sound regulatory framework.

Here, I’d like to acknowledge a number of similarities between these Asian economies prior to 1997 and the condition in Ethiopia today. In addition, the following features of the Asian economies then are very similar to conditions in today’s Ethiopia – each of which was major factors behind the crisis
Financial Sector Weakness

The first is the credit boom, especially growth of both bank and non-bank credit to the private sector, which exceed the high level of real GDP growth. A good part of this credit is also concentrated in the speculative (property) sector. The pressure to maintain exchange rates (with high interest rates) led to falling property prices and hence non-performing bank loans. Moreover, loanswere very lax and there was too much ‘connected lending’ (lending to bank directors, mangers and their related businesses).

Government ownership of banks also was turning banks into quasi-fiscal agents by providing government (off-budget) assistance to ailing industries. On top of this, the quality of public disclosure and transparency was poor. In general, the lack of prudent regulation of the financial sector was one of the major problems.These are features quite apparent in Ethiopia today as indicated in the table below.

External Sector Problems
First, these countries suffered significant current account deficits. Second, the exchange rate in much of these economies led to appreciation of their (trade-weighted) exchange rate, which leads to low competitiveness.Third, 1996 was a year where many Asian countries experienced a significant decline in merchandise exports, which was attributed to slow down in world trade growth. As indicated in the table below for Ethiopia shows, this pattern is observable today and in much more serious way than East Asia in 1997.

As can be read from Table 1 and in general, if a country investsmore than its saves,the country can do one of two things: either run down its financial foreign assets (if there are enough) or borrow from the rest of the world.

In either case, the excess of investment over saving leads to a trade or current account deficit (-19.1Pct of GDP trade deficit; -10.7Pct of GDP current account deficit in Ethiopia; Table 2). If such current account deficits continue year after year, as has been the case in Ethiopia for the last decade, net foreign assets will fall to zero and the country will become indebted (Tables 1 and 2).

Since a country’s ability to service its external debt in the future depends on its ability to generate foreign currency receipts, the size of its exports as a share of GDP is another important indicator of sustainability. For Ethiopia this is just about 5Pct (just compare this to 60Pct for South Korea’s more than USD500 billion in exports per year).

Most episodes of unsustainable current account imbalances that have led to a crisis have occurred when the account deficit was large relative to GDP, as is the case in Ethiopia today. Lawrence Summers, the U.S. deputy Treasury secretary, wrote in The Economistthat “close attention should be paid to any current-account deficit in excess of 5Pct of GDP, particularly if it is financed in a way that could lead to rapid reversals.”Thus, Ethiopia’s deficit level of 10.7Pct is twice the amount of the warning zone suggested by Summers.

In sum, there is a striking similarity between the 1997 Asian crisis and the condition in Ethiopia today. This is because there is a booming construction sector invariably financed by bank and connected lending and there is an alarming level of trade balance deficit, shortage of foreign exchange and a rising level of debt as shown in the tables above.

Additionally, planned projects both in the finalization of the Growth and Transformation Plan (GTP) and its second phase, theGTP II, are foreign exchangeintensive despite a rudimentary export sector; there is a significant gap between saving and investment and a rising external debt too.

There seems also a missing foreign exchange planning in designing these plans. This is complicated by structural problems of food supply. The only fundamental differences are first the Ethiopian capital account is closed: which means one can’t take dollar freely out and in to the country and the major external finance in Ethiopia is coming from China and not from diversified sources as in East Asia.

To finalize, when Stieglitz concluded his observation about the 1997 Asian crisis he concluded, and with the benefits of hindsight he is proved right – that some of the most important features of East Asia’s development were sound macroeconomic fundamentals: high savings, a commitment to education, technologically advanced factories, a relatively egalitarian distribution of income, and an aggressive pursuit of foreign exports. “All of these elements, he said, were still present, suggesting that East Asia’s economic prospects continue to be bright. And these elements of the East Asian success continue to provide a model for successful development throughout the world”.

We have to ask here whether Ethiopian growth so far has been based on such fundamentals. If not, even reviving back is impossible. What is the solution for Ethiopia? This is a million dollar question and, hopefully, learning the lessons of the 1997 Asian fiscal crisisispart of the solution.


6th Year . June 16 – July 15 2018 . No.63

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