Ministry of Finance

Between the Sword and the Wall

Ethiopia’s Perplexing Fiscal Dilemma

 The Ethiopian government has approved a budget of ETB801 billion (USD15 billion) for the 2023-24 fiscal year, which began on July 8. The budget, equivalent to 7.1Pct of anticipated GDP for the year, prioritizes pro-poor sectors such as infrastructure development, education and health but reduces capital expenditure and freezes public sector new recruitment. The Government is seeking USD12 billion in funding based on its 2023-2027 macroeconomic and fiscal frameworks. Critics have raised concerns about debt servicing’s impact on priority spending and the potential hindrance to infrastructure development and job creation from reduced capital expenditure EBR’s Bamlak Fekadu highlights the forecast for the new fiscal year, the budget deficit, inflation, import growth, the allocation of funds for different sectors and regions, and also look into the impact of Direct Advances on the economy.

On July 6, 2023, during the 28th regular session of the FDRE House of Peoples’ Representatives (HPR), the majority vote and one abstention ratified the new budget bill after the council of ministers endorsed it the prior month. The Ethiopian new fiscal year 2023–24, with an approved budget of ETB801 billion, equivalent to USD 15 billion and 7.1Pct of the anticipated GDP for this year, began on July 8 amid fear and hope. The Federal Government’s budget considers maintaining national security, helping citizens displaced by disasters, rebuilding the infrastructure damaged due to conflicts, and achieving the directions and objectives of social and economic transformation that may occur in the future.

It is also presented based on the 2023–2027 (2016–2020 E.C.) medium-term macroeconomic and fiscal frameworks on which the federal government seeks USD12 billion worth of funding. On the closing date of the fiscal year, Prime Minister Abiy Ahmed (PhD) insisted that Ethiopia’s economy is growing at an impressive clip, boasting of the highest growth rate in East Africa this year, around 6.5Pct. This claim, however, glosses over the crucial difference between nominal and real GDP growth rates.

Addressing the parliament in the prior month, Ahmed Shide, minister of finance, asserted that the 2023–24 budget was drafted based on a growth forecast of 7.9Pct for the new fiscal year, indicating that overall spending would rise by just 1.9Pct from ETB 786.61 billion in 2022–23.

According to Ahmed, the new fiscal year’s fiscal deficit would mount by ETB 50 billion from the preceding year’s ETB 231 billion to ETB 281 billion, equivalent to 35Pct of the total budget. The previous fiscal year’s ETB49.6 billion deficit caused a big challenge for the government to execute its planned activities.

The government expects reduced inflation in this budget year to 24Pct for the 2023–24 year, while it hopes to see import growth (critical in determining trade tax performance) at 19Pct for the year.

The budget bill was presented as ETB369.6 billion for the regular expenses of the Federal Government, ETB203.9 billion for capital expenses, ETB214.07 billion for subsidies to the regional states, and ETB14 billion for the implementation of the Sustainable Development Goals (SDG) for a total of ETB801.65 billion.

Of the total subsidy and SDG, the state of Oromia takes 34Pct of the allocated budget. In contrast, the state of Amhara takes 21Pct and 22Pct for each respective funding, and Southern Nation Nationalities Region and Somalia at 13Pct and 10Pct, respectively.

The slightly increased budget prioritizes pro-poor sectors like road infrastructure (ETB 68 billion, 12Pct of the total), education (ETB 59 billion, 10Pct), and national defence (ETB 50 billion), reversing the upward trend of the past two years prompted by the war in the North, manifesting an ETB 34 billion drop from the previous year’s allocation by almost 40Pct and health ETB23 billion.

Ethiopia’s budget primarily allocates 28Pct to debt service, covering domestic payments rather than external ones. However, concerns arise that interest payments on the debt could stifle priority spending. The allocation earmarks ETB 203 billion for capital expenditure and highlights the suspension of capital projects and a freeze on public servant recruitment. Yet, with an inflation rate of 33Pct, this suggests that there will be a significant decrease in infrastructure expenditure.

The planned capital expenditure has decreased by 6.7Pct from last year, continuing a trend seen over the past five years, whereas recurrent spending has increased by 7.2Pct.

The budget shift has sparked criticism from national parliament members, including National Movement of the Amhara (NAMA) representative Desalegn Chane (PhD), who criticized the reduced budget for sectors like energy, mines, and agriculture. Tseganesh Gamato, another MP, feared capital project cuts could hinder infrastructure development in regional states.

According to the Cepheus capital macro report on the 2023/24 budget year, government expenditure is expected to decline by around 20Pct in real terms, based on 24Pct expected inflation. The relative size of Government expenditure to GDP will reach around 6Pct of GDP versus a high of 18.8Pct of GDP ten years ago, representing a marked shift in the scope and scale of Government activity relative to the economy over the past decade.

Ethiopia’s economic stability has been challenged by domestic unrest, external borrowing holdups, and ineffective revenue generation, resulting in persistent fiscal deficits and impeding sustainable economic development.

According to the African Development Bank, Ethiopia ranked 7th out of 10 African countries facing a budget deficit. Ghana ranks top with 14Pct in negative, followed by Zambia, Rwanda, and Egypt with 6.8Pct, 6.8Pct and 6Pct, respectively, in Negative.

Based on the African Development Bank (AFDB)’s financial forecast, the budget deficit expanded from 2.8Pct of GDP in 2021 to 4.2Pct in 2022, mainly attributable to escalated defence expenditures coupled with poor revenue generation.

The Ministry of Finance has forecasted a net gross budget deficit of 2.1Pct of the nation’s GDP for the current fiscal year. Nonetheless, it will be seen later if the forecast is nominal or real.

The Ministry plans to cover the ETB39.01 billion gap through external borrowing, mainly from the World Bank or China EXIM Bank, while addressing the remaining deficit through domestic borrowing.

Ethiopia secured USD400 million in support from the World Bank at the end of July to finance Human Capital Operation (HCO), a program to address Ethiopia’s poor nutrition and low learning outcomes. This programme will significantly impact the lives of 97 million Ethiopians and 800,000 refugees, a brief prepared by the World Bank reflects. With restored diplomatic relations, Ethiopia hopes to get better financial support from bilateral and multilateral arrangements.

“In the budget preparation, the ministry has only considered resources on hand rather than foreign grants and loans,” he underlined, as the Development partner budget support decreased, causing insufficient support.

Nevertheless, the assigned budget is sensible when balancing the fiscal deficit resulting from an expansive budget. Despite these measures, the present deficit remains elevated.

As was the case last fiscal year, most of the budget deficit’s financing burden will fall on domestic lenders. It will meet a mix of Treasury bills bought mainly by the state bank, pension funds, and private banks in amounts equal to 20Pct of their gross lending and Direct Advances from the central bank.

The Central Bank released Directive No. MFDA/TRBO/001/2022 in October 2022 requires all banks to buy 20Pct of the Government’s five-year Treasury bonds based on their total loan amounts at the end of each month. Bankers expressed dissatisfaction with this directive due to the below average 9pct interest rate, significantly under the sector’s usual lending rate of 14.5Pct.

Despite this, the banks have gathered ETB25.6 billion between November 1, 2022, and March 31, 2023, according to Prime.

Prime Minister Abiy Ahmed said that commercial banks’ loans in the preceding fiscal year reached ETB461 billion, indicating that the amount of money collected by the government could double in the just-ended financial year.

According to the Ministry of Finance public sector debt bullet published in June, it was stated that as of March 31, 2023, Ethiopia’s gross debt reached ETB1.7 trillion, a 14Pct increase from last year’s 1.5 trillion. The report breaks down institutions contributing to the deficit, with the Commercial Bank of Ethiopia accounting for 49Pct, the National Bank for 31Pct, the Development Bank for 3Pct, and non-bank credit sources for 17Pct.

Ethiopia’s public debt-to-GDP ratio stood at 39Pct at the end of March 2023, far below the average of 66Pct for African countries and 69Pct for emerging markets. This figure indicates that Ethiopia’s debt burden is relatively manageable.

However, the debt service to exports ratio of 77Pct versus Sub-Saharan Africa (SSA) of 20Pct and the debt service to revenue ratio (31Pct against SSA of 17Pct) are both high, given the country’s low export and revenue base.

About ETB473.4 billion in treasury bills have been put up for auction by the government since the beginning of the 2021/22 fiscal year. So far, the central bank has sold ETB277 billion worth of T-bills to banks and non-bank institutions (mainly pension agencies), with one-third of the bills maturing in less than six months and the remainder in a year. As of December 31, 2022, there were 315.4 billion in outstanding T-Bills.

According to the IMF publication on Public Debt and Household Inflation Expectations, W.P./23/66, March 2023, public debt levels have a causal effect on household inflation expectations. An increase in public debt of 10Pct of GDP leads to a rise in one-year inflation expectations of about 0.6Pct.

Despite the sale of Treasury bills, the Federal Government has been utilizing direct advances from the central bank, frequently equates to minting money amounting to ETB80 million since March 2023 to bridge last year’s budget shortfall and has also planned to do so for the current budget year.

Nevertheless, the precise funding mix from these three domestic sources has yet to be discovered. However, Cepheus Capital’s publication suggests that relying much more heavily on a combination of Treasury bills bought mainly by the state bank and pension funds and private banks in amounts equal to 20Pct of their gross lending would reduce inflation this fiscal year.

Contrary to Cepheus, Tinsae Nebiy, a financial management and investment expert, believes that only some of the three options will relieve the nation from skyrocketing inflation. In his opinion, the Government’s plan to escape a budget deficit is intended for spending, pushing the flow of money back into the market.

However, the new budget is reasonable, but it neither introduced a solution to stabilize the economy nor is appealing to the private sector.

“The government’s heavy reliance on treasury bills and direct advances from the central bank to cover deficits is worrying and could fuel deficit-induced inflation.” He says, “It is barely to expect relief from inflationary pressure while simultaneously planning to reintroduce it back into the economy.”

According To Abdulmenan Mohammed (PhD), a finance expert with over two decades of experience, treasury bills, bonds, and direct advances are the usual forms of financing budget deficit in Ethiopia.

“What matters is their proportion.” Sayed Abdulmenan

Purchasing treasury bonds is mandatory for banks based on their loan disbursements. Using more treasury bills is the better option as its primary source is the saving of the financial system, and its pricing is determined through the interaction of market forces.

Treasury bonds and bills increase debt servicing costs and the risk of debt distress. Furthermore, treasury bonds distort the credit market as they are mandatory.

Treasury bills enhance fiscal discipline as market mechanisms determine their amount and interest rate. In comparison, treasury bonds reduce budgetary discipline as the government sets their interest rate and quantity.

The central bank’s regulation does not limit government direct advances, but 1963 Proclamation No. 206, Article 13(3), allows such advances. However, outstanding advances must be at most 15Pct of the previous fiscal year’s revenues and be repayable within six months. The Ministry of Finance and the central bank should agree on an interest rate of not less than 3Pct.

However, the recent Proclamation No. 592/2008 on Article 13(1) states, “The amount of advances and credit to be extended by the National Bank to the Government for each fiscal year shall be determined in consultation with the Bank and shall be consistent with the maintenance of price and exchange rate stability.”

“Unlimited direct advances increase the risk of inflation, which is severely affecting the economy and Short-term loans owed by SOEs. Therefore, it should be scaled down by any means.” Abdulmenan remarked “Direct advance reduces fiscal discipline,” he remarked, referring to borrowing from the NBE at no interest and with no set repayment date. The more the Government relies on direct advances to finance its budget deficit, the worse the inflationary scenario becomes.

On the revenue front, an estimated ETB480 billion is equivalent to USD nine billion sourcing across 17 Categories and 163 line items, mainly from Taxes. The government plans to generate ETB188 billion, 39Pct, the highest share of the expected revenue from trade taxes, and ETB141 billion from corporate and income taxes. In contrast, 30Pct and taxes such as VAT and non-tax collections account for ETB112 billion and ETB39 billion, respectively. Domestic and foreign borrowing will cover the remaining ETB281 billion deficits.

The revenue projection for 2023/24 shows an increment of 28Pct compared to last year; the tax revenue has scaled by 27Pct. However, given the country’s economic landscape, the target of garnering ETB480 billion seems overly ambitious.

Cepheus Capital’s report stated that the total target, 85Pct or ETB 440 billion, is expected to come from tax revenues. The tax-to-GDP ratio remains very low in Ethiopia compared to other countries in sub-Saharan Africa.

Tinsae expressed his apprehension by stating, “The basis on which the forecast tax revenue estimations are being made is not transparent.” He emphasized that the requirement by offices for specific collection amounts only darkens the water further. Such obscurity sparks questions about the precision and trustworthiness of the predicted tax revenue.

Tewodros, whose middle name is withheld upon request, an investor in the agro-floral and construction sectors, has raised concerns about governmental fiscal planning, specifically the optimistic projections for tax revenue. In a statement to EBR, Tewodros explained, “Given that our economy is still reeling from the effects of both the war and COVID-19 pandemic, coupled with ongoing unrest throughout the nation impacting trade and investment, expecting an increase in revenue seems unrealistic.”

He also voiced concern that these elevated expectations may put undue pressure on the private sector.

The Government’s strategy to eliminate the current fiscal year’s budget deficit includes a reliance on domestic borrowing. Commercial banks will allocate 20Pct of their monthly loan distributions towards low-interest investments as part of this plan. This policy will increase the demand for accessible loans, increasing competition among potential borrowers.

Tewodros observed that the level of financial inclusion in Ethiopia, especially related to accessing credit, is low currently. This severe competition for fund accessibility could lead to stricter borrowing requirements and increased interest rates. This would result in a more challenging journey for individuals and businesses seeking credit. Consequently, this could unintentionally harm investments.

Abdulmenan agrees with Tewodros’s worries but believes the nature of the risk varies based on the financing type. He believes funding the budget deficit through Treasury bonds and bills significantly affects the amount of money accessible to the private sector. “The higher the budget deficits, the more money the financial system requires. In such instances, funds going to the private sector would reduce.” Abdulmenan explains

Simultaneously, suppose external funding inflows exceed the current assumptions in the budget. This scenario would notably occur with an IMF/WB programme and foreign debt service relief. In that case, this development would significantly diminish domestic lenders’ pressure. It could also usher in enhanced possibilities for an upswing in banking system credit that benefits the private sector.

Even though there are still some uncertainties and potential issues within the economic sector, the upcoming fiscal year is promising due to several key factors. These include the conclusion of the two-year conflict in the North between the Federal government and the Tigray People’s Liberation Front (TPLF), beneficial rainfall that could result in improved crop yields, and increased cooperation with foreign associates. These elements will influence a buoyant economic future significantly.

11th Year • August 2023 • No. 120 EBR


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