Beyond the Credit Cap

Ethiopia’s Multifaceted Fight against Inflation

Ethiopia’s recent decline in inflation, from a staggering 33.5% in April 2023 to 23.3% in April 2024, offers a glimmer of hope for the nation’s economic stability. However, the fight against inflation remains far from over. Etsubdink Sileshi (PhD), EBR’s Economic Research & Business Intelligence Unit Director, delves into the factors that contributed to this decline and analyze the complex relationship between inflation, infrastructure development, and Ethiopia’s pursuit of rapid economic growth.

Inflation is a continuously rising general price level and falling purchasing power of a currency. A 100 birr today buys fewer goods and services than a 100 birr could buy a month or a year ago (given that the qualities of goods and services remain the same). Moderate inflation (anticipated inflation) is not all bad. For the market, negative inflation (deflation) discourages production. Of course, deflation could lead to a recession. A certain degree of inflation is needed to heat the economy, while it does not significantly affect planning and forecasts.

The factors behind Ethiopia’s inflation decline stem from a combination of monetary and fiscal policy measures implemented by the National Bank of Ethiopia (NBE) and the Ministry of Finance.

With the coming of Mamo Mihretu as the 10th governor in January 2023 and even earlier, the NBE has employed stricter monetary policies to curb inflation. These policy measures include raising interest rates and discouraging borrowing and investment, thereby reducing the amount of money circulating in the economy. Additionally, the NBE has implemented measures to limit the money supply, making it more difficult for businesses and individuals to access credit. The 14% credit cap NBE implemented in August 2023 shows the determination of the government to arrest inflation and the institutional independence it has slowly started to gain.

Credit cap policy, limiting credit expansion by banks, is a tool to control inflation. Whether or not the 14% cap is enough and how long depends on Ethiopia’s specific economic situation. This decision requires exploring several factors. The NBE’s credit cap is a double-edged sword. It can control inflation, as evidenced in the last year. Still, it might hinder and slow economic growth, as has been the case with exporters and manufacturers already needing more loans to expand their businesses or, at times, fulfill the commitment. The long-term effect of the policy on the overall economy needs scrutiny to decide how long it should serve.

The credit cap has two positive impacts on controlling inflation. It reduced the money supply. By limiting credit, the NBE restricted the amount of money circulating in the economy. When the money that circulates is low, each local currency unit is more valuable, reducing inflation. It also lowered the demand for goods and services. With tighter access to credit, businesses and individuals spend less, reducing overall demand. Arguably, the credit cap led to stability across many commodities and services. The favourable price stability and reduction in the real estate market are positive. In contrast, the stable or modestly increasing price of several food items has given citizens lower stress.

However, one needs to be cautious because the credit cap has a spillover impact that slows business growth. As businesses rely on loans for project-based investment, the effect of which limits business expansion and job creation, the credit cap needs to be surgically analyzed to determine if a blanket policy is good for the economy’s overall health. The credit cap has hindered exporters’ and manufacturers’ ability to access loans that help them generate highly needed foreign currency to import raw materials for manufacturers. Properly sequenced and planned manufacturing positively impacts supply-side deficiencies that the market needs to control inflation and sustain growth. A blanket restriction of loans even to sectors that help reduce inflation and spur healthy economic growth requires a rethink.

The credit cap reduces investment, as businesses depend on credits to continue investing in new projects. Indeed, access to credit fuels investment, as companies need far more than working loans to kick-start new projects. A credit cap can discourage investment, impacting job creation and productivity.

Causes of inflation in Ethiopia

Ethiopia’s recent economic story has been one of ambition. In the early 2000s, the government embarked on a large-scale infrastructure development push to propel the nation towards a faster economic takeoff. This strategy, however, has had an unintended consequence: a surge in inflation.

The cornerstone of this plan was financing these projects. The National Bank of Ethiopia (NBE) significantly increased the money supply, putting more money in circulation. Further amplifying this effect, the government required private banks to channel a significant portion of their loans towards purchasing low-interest treasury bills. Because of this, resources are diverted away from private-sector lending and towards state-driven projects.

While infrastructure is crucial for economic growth, the strategy came at the expense of the productive sector, particularly agriculture. Despite employing over 70% of the workforce and contributing substantially to GDP and exports, agriculture received neither a proportionate share of the government budget nor adequate financial support from banks. This lack of focus had severe consequences. Population growth and rising incomes led to a surge in demand for essential goods, particularly agricultural products. Ethiopian agriculture, however, needed help to keep pace. This unmet demand and the continuous injection of money into the economy fueled inflationary pressures.

The Ethiopian government’s focus on infrastructure development was not inherently misguided. Roads, bridges, and power grids are essential for a thriving economy. However, neglecting the productive sector, particularly agriculture, created a critical imbalance. Increased money supply without a corresponding rise in production created a situation where more money chased fewer goods, leading to price hikes.

This historical context sheds light on the challenges Ethiopia faces in managing inflation. While the government has made strides in developing infrastructure, a more balanced approach is needed. Increased investment in agriculture, through improved access to credit, technology, and training, can boost production and meet the growing demand for food. Additionally, the NBE needs to carefully manage the money supply carefully, ensuring that growth in the monetary base is matched by real economic growth.

Finding the right balance between infrastructure developments and supporting the productive sector is crucial for Ethiopia’s continued economic journey. By addressing the historical causes of inflation, the nation can ensure a more stable and sustainable path to prosperity.

The recent achievement of stopping the spiral growth of inflation is indeed good. It’s a result of sound policy and leadership at the Central Bank. However, if supply-side constraints still need to be addressed neither keeping the downside growth of inflation nor avoiding the unintended consequence of economic slowdown can be possible. Accordingly, Ethiopia should still return to the drawing board and address the structural causes of inflation.

Despite experiencing economic growth for nearly two decades, Ethiopia grapples with a stubborn problem: high inflation. This economic instability demands a multi-pronged approach addressing monetary and fiscal policies.

Looking further abroad, a stark contrast exists. Developed nations like Japan and the US face inflation rates well below 3%, with central banks actively working to lower these figures. Meanwhile, emerging economies like China struggle with deflation, where prices decrease. This underscores the urgency for Ethiopia to find solutions specific to its context.

The current inflationary situation necessitates a critical reevaluation of existing policies. While bolstering agricultural and manufacturing sectors through improved financing can enhance supply to some degree, a more fundamental factor is at play: peace and security.

The precarious situation hampers Ethiopia’s path towards economic stability in Amhara and Oromia, two of its most resource-rich states. Currently embroiled in conflict, these regions contribute significantly to the nation’s resource base. Without lasting peace, efforts to achieve significant economic growth or control inflation will likely be in vain.

Examining Ethiopia’s historical dance with inflation reveals a complex story. During the Derg regime (1974-1991), strict government control over prices kept inflation artificially low. However, this came at the cost of shortages and inefficiencies. Following the Derg’s fall, low inflation persisted due to displaced workers and a low influx of foreign aid.

However, recent years have seen a surge in inflation. The debate around the primary culprits for this phenomenon remains heated. The government often points towards supply-side bottlenecks and external price shocks, particularly the rising fuel cost. Economists, on the other hand, frequently highlight factors like expansionary monetary policy, leading to an excess of money supply and fiscal mismanagement by the government.

This lack of consensus on the root causes makes tackling inflation even more challenging. A comprehensive approach that addresses both potential causes – demand-side pressures from increased government spending and supply-side constraints affecting agricultural production – is crucial.

Furthermore, fostering a business environment conducive to investment and job creation is essential. This involves improving infrastructure and ensuring the free movement of labour and capital.

Ultimately, achieving a stable and prosperous Ethiopia hinges on securing peace. This will unlock the nation’s vast resource potential, create an environment where businesses can flourish, and contribute to a more balanced and resilient economy. Ethiopia can chart a course towards a brighter economic future by addressing the historical and contemporary factors contributing to inflation.

12th Year • June 2024 • No. 130