Beyond Devaluation

Strategies for a Stronger Ethiopian Economy

Devaluating a currency, which makes one’s currency cheaper and foreign currencies dearer, is a crucial policy intervention in the forex market with severe economic consequences. Of course, the type and degree of these effects depend on the magnitude of devaluation, the level of economic development a country is at and the perception of stakeholders about a currency’s future value.

The Ethiopian currency, the Birr, has undergone devaluation many times. For instance, a 17 % devaluation in August 2010 (roughly from 13.5 birr/$ to 16.5 birr/$). Similarly, a 15 % devaluation was implemented in October 2017 (from 23.9 birr/$ to a little above 27 birr/$). There is no evidence that these measures achieved their target- to reduce the trade deficit in the subsequent quarters, if not years.

Reports show that there is also an ongoing negotiation between the Ethiopian Government and the International Monetary Fund (IMF)) for the Fund to provide a 3.5billion dollars that the Ethiopian economy critically needs to address food security, humanitarian needs, post-conflict reconstruction, and combatting high inflation that has engulfed the Ethiopian economy because of supply-side constraints.

However, some news has surfaced unconfirmed information that the IMF is putting pressure on Ethiopia to devalue the Birr by a significant percentage (60%) to commit 3.5 billion dollars in loans and assistance. Although no official confirmation has been given yet, the Government has agreed to devalue the Birr by 15% right away and a gradual daily devaluation to see the Birr devalued by 35%. However, as the IMF is still pushing for an outright 60% devaluation before releasing the financing, which the Ethiopian Government didn’t accept, the deal with the Monetary Fund has yet to materialize.

Why do countries devaluate their currency? And what are the potential consequences of devaluation?
An exchange rate is the value of a country’s currency in relation to the currencies of other countries. Because exchange rates impact international trade and global financial flows, they are central to any national economic policy framework.

There are two main types of exchange rate regimes with some variations within them. The first one is the Fixed (or Pegged) Exchange Rate Regimes. In this regime, a government sets its currency’s value at a fixed rate against another currency (like the US dollar) or a basket of currencies. This means the Government intervenes in the foreign exchange market to buy or sell its currency as needed to maintain the peg. Of course, there are some variations, where, in some scenarios, countries establish a Currency Board, which handles exchange rate issues in the strictest form. The country’s entire money supply is backed by reserves in another currency, and monetary policy is surrendered. Examples are Saudi Arabia, Kuwait, Hong Kong, and Bulgaria. The exchange rate is fixed in these countries, and the Government determines it.

Floating (or Flexible) Exchange Rate Regimes: In countries that use this regime, the currency’s value is determined by supply and demand in the foreign exchange market. Governments may still influence the exchange rate indirectly through tools like interest rates and intervening occasionally to smooth out fluctuations, but they don’t fix actual rates.

The literature on managed floating sometimes mentions a third category: a flexible regime with more frequent government interventions to influence the exchange rate’s movement within a target range. This regime offers some stability but allows for more flexibility than a fixed peg.

In a fixed or managed floating exchange rate regime, countries devalue their currencies to improve their competitiveness in international trade (making exports cheaper), reduce their trade deficit (making imports more expensive and more affordable), or meet conditions imposed by lenders and donors. For example, the IMF presses Ethiopia to devalue its currency to approve the much-sought 3.5 billion dollars.

To put it simply, countries engage in or are pressured to weaken the purchasing power of their local currency when the demand for foreign currency far exceeds the supply of foreign currency, resulting in a significant exchange rate premium between the official and the parallel markets. One notes that there is no parallel forex market in free-market economies such as Japan, the US, the Euro Zone, and the UK, Where the supply of foreign currency is within the demand.

However, the theoretical arguments and empirical evidence show that devaluation negatively impacts developing economies and positively affects industrialized countries. One justification is that poor countries cannot increase the volume of their exports to benefit from the rise in foreigners’ demand for their cheaper goods and services following the weakening of the domestic currency.

In the Ethiopian context, we cannot dramatically increase production, for example, the export of coffee after devaluation, as coffee growth takes time (inelastic supply). The second reason is that the export of goods and services from developing countries are primary commodities whose prices in the are either stable or declining in many cases. And international buyers spend a tiny fraction of their income on commodities coming from developing countries. Thus, attempts to devalue a currency to attract foreign buyers will get less response in terms of the volume of exports than the percentage by which the currency is weakened (exchange rate increased)-this is called inelastic demand for export.

The opposite is true for industrialized economies. If China, for example, devalues the Yuan, Chinese products will be cheaper and more competitive in the international market. Other industrialized countries such as Germany and Japan will find it difficult to compete with China and, at the same time, cannot devalue their currencies directly since their forex markets are freely floating. (But, they can still use monetary policy instruments such as interest rates).

What about the imports sector?
When it comes to the import of goods and services, devaluation of a currency makes them more expensive (an Ethiopian importer requires more Birr now than before to get the same amount of forex, and subsequently, the same quantity and quality of foreign goods). Since developing countries imports manufactured goods and are less likely to succeed in import substitution- at least in a short period- this expensiveness will have an insignificant effect on reducing import demand (import demand inelasticity).

In the case of industrialized countries, import expensiveness leads to a quick shift into domestic production. However, for countries like Ethiopia, devaluation is less likely to increase export volumes to a degree that compensates for the fall in price (Birr weakening). Similarly, imports will stay strong because most Ethiopian imports are strategic commodities whose consumption can’t easily be replaced or reduced. Hence, if the objective of devaluation is to reduce the trade deficit, it will not materialize until the economy passes through a successful structural transformation where the industry sector- especially manufacturing- plays a crucial role in value addition to the GDP and national employment share.

The idea that devaluation of a currency in developing countries will not generate a rise in the volume of exports and a fall in imports is explained using the Marshall-Lerner condition, named after economists Alfred Marshall and Abba Lerner, is a concept in international economics that helps predict how a change in a country’s exchange rate will affect its trade balance (exports minus imports). The trade balance will likely improve if exports and imports become more (or less) sensitive to price changes due to depreciation (elasticities are high in absolute value). The Marshall-Lerner condition helps policymakers decide if currency depreciation is viable for improving a trade deficit.

As has been vividly seen in the numerous currency devaluations in Ethiopia, currency devaluation not only falls short of its intended objectives but opens up a Pandora box for severe socio-economic consequences. This includes deteriorating trade balance, increased foreign debt burden, inflation, loss of confidence in the local currency, widening gap in the official and parallel forex market, exchange rate volatility and an unpredictable business environment.

Inflation occurs when currency devaluation occurs in many developing countries. Often, this leads to a higher general price level as the cost of imported goods rises. Even locally produced goods increase in price because of the increases in transport costs that use imported fuel. Transport companies find spare parts and other accessories more expensive, which compels them to revise transportation rates. This can erode the purchasing power of consumers, particularly those on fixed-income schemes.

Why inflation?
If one litre of petrol is 1 USD and we need 57 birrs to purchase one USD, then 57 birrs will be enough to buy the one litre of gasoline. However, if the Birr is devalued, say to 100 birr/$, one needs to spend 100 birrs for the same litre of petrol (if international prices remain constant). Expensive petrol quickly raises the price of other goods and services, including- domestically produced ones. If what happens to petrol price also occurs on several imported goods, the cost of living is expected to skyrocket. As stated earlier, inflation will not be a problem if the devaluation is implemented by an industrialized country, as imported goods and services can be replaced with local produce in a short period.

Forex shortage hikes up when devaluation takes because uncertainty pushes people to dollarise their assets. As articulated in the above paragraphs, exports will not be able to generate enough forex, and imports will not fall to save hard currency. As a result, the existing trade deficit (what we sell to the rest of the world is less than what we spend on the outputs of the rest of the world) persists or may even deteriorate. This leads to quota-based forex allocation, delayed imports and disruption in production of goods and services.

The parallel market flourishes following devaluations—the forex shortage, in turn, forces business people to look for alternative sources of hard currency. The parallel market becomes attractive even when the dollar price is almost double the official rate. Shortage gives rise to official control. Control, in turn, leads to underground transactions. The underground transactions make the shortages even worse. The cycle continues. There is only an end in sight if the focus is investing in the economy’s supply side and solving structural bottlenecks that hinder production. There is a need to invest in the necessary resources to ensure a structural transformation of the economy in which local production is sufficient for local consumption, including the supply of raw materials to industries and the availability of various produce for the international market.

Foreign direct investment (FDI) declined following devaluations. Currency devaluation is an attractive incentive to FDI at the surface level. However, in light of the above scenarios, developing economies will only solve their forex shortages slowly, making it difficult for foreign companies to repatriate their profits/dividends. Thus, even though devaluation lures foreign investors due to their forex buying large amounts of local currencies, they take the difficulties they will encounter during repatriation and take all factors into the equation. Local or foreign investors appreciate stable and predictable currency regimes and other policy regimes when making investment decisions, especially on projects that have long-term benefits.

Deteriorating foreign debt burden can be a direct consequence of devaluation. Ethiopia’s foreign debt is 28 billion USD. If any percentage devalues the Birr, the volume of debt in Birr increases by the same amount. This requires the mobilization of more domestic resources to continue debt servicing.

So, what shall we do to reduce the trade deficit and alleviate the forex shortage? There are many answers to this question- some need a decade-long planning and intervention. Some immediate policy action can also be taken. One key measure is to encourage import substitution and further work on promoting the export of local produce. Shifting the economy from agriculture and non-tradable services into manufacturing and tradable service sectors is strategically essential.

Creating a conducive environment for foreign investors and tourists and securing non-conditional development assistance from friendly countries is also a step toward solving the foreign currency shortage. Encouraging legal remittance is also essential. Given Ethiopia’s large Diaspora population, doubling or even tripling the inflow is within reach with the correct set of incentives. Countries such as Egypt, whose overall Diaspora population is not far more than that of Ethiopia, get almost six times what Ethiopia receives. According to the National Bank of Ethiopia, there were two billion dollars in remittances in the second half of 2023. The top five remittance recipient countries in 2023 are India ($125 billion), Mexico ($67 billion), China ($50 billion), the Philippines ($40 billion), and Egypt ($24 billion).

The impact of a currency’s devaluation varies depending on an economy’s structure. For developing countries such as Ethiopia, the adverse effects far exceed the benefits of this policy intervention.

12th Year • May 2024 • No. 129