Can Ethiopia’s Bold Economic Overhaul Pay Off?
Ethiopia has boldly embarked on a radical economic transformation. The recent liberalisation of the foreign exchange market, a cornerstone of broader reforms, has sent shockwaves through the nation. Questions abound as the Birr plummets and prices soar. Will this drastic shift unleash economic growth or plunge the country into deeper turmoil?
EBR’s Munir Shemsu dissects the complexities of Ethiopia’s economic overhaul. He delves into the government’s ambitious plans, the challenges businesses and individuals face, and the potential long-term implications. Is this a risky gamble or a strategic masterstroke?
Panic, shock and confusion marked the morning of July 29 as Ethiopians awoke to the news that their currency had been floated after five decades of operating under a managed fixed exchange regime. What followed during the day only reaffirmed initial intuitions as the Birr depreciated by nearly 30% overnight from around 58 Br to 74 against the dollar basket of foreign currency. The figures reported by the state-owned Commercial Bank of Ethiopia (CBE) on the first day, coincidentally the biggest bank in the country, were only an omen of things to come.
The Birr has been spiralling downward against major foreign currencies since official exchange rates crossed the historical threshold of 100 in the second week of August, a startling figure historically dared only by traders in the parallel markets, colloquially referred to as the black market.
Markets immediately responded to the floated Birr, with prices of imported commodities like edible oil shooting up by around 27% and electronics by roughly the same amount. At the same time, international air travel tickets from the only national carrier (Ethiopian Airlines) almost doubled as it tags its prices with USD, where locals pay in the daily exchange rates of CBE. Agricultural commodities for export also showed similar price changes, with Green Mung Bean showing a drastic increase from ETB6150 per quintal on July 27 at the Ethiopian Commodity Exchange to ETB8500 on August 5. This 38% increase in price is probably the highest in agricultural products. Coffee and Sesame also showed a price shoot. While the price hike can be attributed to the coming end of a season where the trading of the commodities slows as supply dwindles, the changes in the exchange rate, whose immediate effect was the devaluation of the Birr, was the prominent cause for the dramatic price hikes.
Likewise, many locally produced and traded commodities showed a sudden surge in prices following the floating of the Birr.
The Addis Ababa Trade Bureau attributed the businesses’ kneejerk reaction to pure avarice. It went on a campaign of door-to-door inspections, leading to the temporary closure of around 500 shops in the capital’s largest open market (Mercato). Analogous attempts by city administrations like JigJiga entailed setting caps on overall prices for essential commodities. The inspection of shops to check prices reportedly caused the closure of shops further in many other regional towns.
As confusion and apprehension engulfed the economic landscape, Prime Minister Abiy Ahmed (PhD) gave a seminal address three days after the pivotal policy shift to a gathering of ministers, financial sector executives and senior government officials seemingly to allay the budding anxieties. He reasoned that Ethiopia’s imports, which have been above 10 billion dollars for the past four years, are primarily calculated in the exchange rate of the parallel market.
“Except fuel and fertiliser, all other imports use the exchange rates of the parallel market; that’s why an increase in prices lacks a logical foundation,” Abiy lamented.
The Premiere highlighted that liberalising the foreign exchange market was only a part of a comprehensive economic reform crafted over several years.
A radical overhaul of the macroeconomic framework dubbed the Home Grown Economic Reform (HGER) has been attempted since the immediate aftermath of Abiy’s ascendance to power in 2018, which fizzled out due to conflict and the global COVID-19 pandemic. The economic reform included a liberalised FX regime, opening retail and wholesale businesses for foreign capital, and introducing capital markets.
Most reform agendas have been implemented, and the change in the foreign exchange regime was the climax.
While pundits have debated how ‘homegrown’ the reform is, its second iteration, HGER 2.0, successfully shifted Ethiopia into a market-based exchange regime last month.
As senior Ethiopian government officials have called it, the Macroeconomic Stability Reforms’ packet entails much more than currency regime change. Central bank governor Mamo Mihretu, whose career includes tenure at the World Bank, announced a shift towards an interest-based monetary policy a few weeks before the currency overhaul.
NBE’s three-year strategic plan, unveiled in December 2023, outlines a comprehensive overhaul of the central banking infrastructure and includes 21 action plans targeting international best practices.
While increasing foreign currency reserves from just the meagre amount equivalent to just two weeks and a half worth of imports to stock sufficient for two months represented one of the quantitative targets, a structural transformation was the top priority.
Parsing through the recent decision to float the currency by factoring in the series of central bank reforms beginning in August of last year paints an illuminating picture.
Capping the annual growth of lending from commercial banks at 14%, cutting direct advances to the government by two-thirds, and sweeping haircuts on capital projects all cushioned the inflationary spike that could ensue in some black swan event.
The close to 20 billion dollar financing arrangement, contrived by a mix of development partners like the International Monetary Fund (IMF), the World Bank, and the International Finance Corporation, should provide an additional buffer.
Ermias Amelga, an economist by training educated in the US and who became an investment banker on Wall Street, which refers to the financial world in the US in general and big businesses and their interests rather than small ones, was among the early proponents of the reforms, heralding them as a cure to persistent economic impediments.
He even projected a near-doubling Ethiopia’s foreign currency earnings through the unshackled foreign exchange regime.
“Several sources of foreign currency will open up.” Ermias heralded. Excited by the policy changes, Ermias announced his plans to start two commercial and investment banks. Now our economy will have circulation and necessitate a high calibre; it’s the right time to invest,” he said in an interview with local media.
However, Ermias anticipated things could have been more straightforward. A week later, he even went to the media to express his bewilderment at how the exchange rate unexpectedly went from 74 to above 110 in a week. He said that the Banks need to be more accurate with the exchange rates while providing the foreign currency customers ask for.
In the nearly two weeks since the changes, the 31 commercial banks in the country have speculated their way into pulling down the Birr to almost 100 and with the particular foreign currency auction at the central bank on August 7 fetched a weighted average price of around ETB107.6 against the dollar.
Some finance experts, like Eshetu Fantaye, a banking industry veteran, point out that the limited information given on the recent auction could entail problems executing the policy reform. He points out the importance of transparency in successfully implementing the new policy, albeit a necessary reform for effectively communicating information to the market.
“The main issue has to do with the way the execution of the policy goes,” Eshetu explains.
He suspects the likelihood that the commercial banks are setting prices relative to their open foreign currency positions rather than a strictly market-based reaction. The finance expert estimates that the black market would effectively perish if only a third of the foreign currency amount promised by international donors is channelled.
“A price discovery auction prior to the float could have been quite illuminating,” he explained.
The expert suggested referring to the positions of Ethiopian banks by looking at the quotations posted by international remittance companies for some insight into their exact foreign currency position.
A banking industry with an overwhelming 96.1% of the country’s total financial assets as of June 2023 simultaneously pumped out 23.5% of the total 1.9 trillion Birr in loans and advances to just ten borrowers, reflecting the precarious nature of their financial position.
In addition, according to the NBE’s financial stability report, if 10 of each bank’s largest depositors were to withdraw all their funds simultaneously, 18 commercial banks would fall below the minimum regulatory liquidity requirements.
Nonetheless, the Birr’s price plummet was not restricted to the official exchange rate of the past two weeks.
Ethiopia’s parallel market has responded in a similar tone of confusion. After an initial jump, prices against the dollar also swayed between 116 and 120 birr for a dollar. They went further in the first few days and reached 136 before they started their descent to hinge around ETB129.
While a significant portion of Ethiopia’s imports are backed by foreign currency access sourced from the parallel market, customs duties, container rentals, and shipping costs are calculated based on official exchange rates. As a result, increases in exchange rates in the banks have an immediate impact because the customs levies, duties and taxes are based on that. This will immediately increase importers’ cost structure. A marked increase in the selling price of commodities is inextricably tied to the added cost that most importers have already faced.
Eshetu explains that Ethiopia’s distorted balance of payments arises from forex distortions and history of expenditures that ballooned during the era of double-digit economic growth. This period started in 2003/04 and sustained since. He referred to hidden capital flight, commercial banks facilitating the sale of foreign currency, and a backdrop of expensive commercial and non-concessional loans as one of the distorting factors that could slow down a quick transition.
Concessional or soft loans have more generous terms than market loans. These generally include below-market interest rates, grace periods in which the loan recipient is not required to make debt payments for several years or a combination of low interest rates/grace periods. During the high times of the growth and transformation plan, even earlier, Ethiopia has been borrowing expensive commercial loans to finance its long-term infrastructure projects, which were neither feasible in some cases nor adequately managed promptly. The servicing of the debts to these loans started before the projects were even completed.
“There is a lot of noise that needs to be cleared out,” the expert noted.
Despite being convinced of the inevitability and necessity of transitioning to a flexible exchange regime, he remains acutely aware of the pitfalls of mishandling execution.
Eshetu also noted how authorities’ harsh response of immediately reacting with an aggressive crackdown on wholesale businesses could send mixed signals about the government’s intentions.
He pointed out the possibility of creating some sense of guarantee for the importers that their next round of shipments would be calculated on some stable FX price.
“You can’t simply remove the entire system business are used to,” Eshetu underscored
However, Ethiopia’s foray into a flexible currency regime encompasses much more than a respite from a pinching dollar demand. The country is grappling with a precarious external debt position.
Ethiopia’s external debt of nearly 28 billion dollars is relatively mild compared to the other sub-Saharan countries, which account for around 17% of the GDP. Nonetheless, it necessitated an application to the Group of 20’s Common Framework mechanism in February 2021.
A staff-level agreement with the IMF is an nonnegotiable precondition for the creditor committee’s successful debt restructuring. The committee comprises 12 countries and is co-chaired by China and France.
While the shift towards an interest rate-based monetary policy, liberalisation of banking, and the slight shift towards the central bank’s autonomy all adhere to an IMF programme, success in debt restructuring has yet to be guaranteed.
The macroeconomic committee comprised NBE’s governor, Ahmed Shide and Eyob Tekalegen (PhD), minister and state minister for Finance, respectively; Abie Sano, president of the state-owned Commercial Bank of Ethiopia (CBE); Fistum Assefa (PhD), minister of Planning & Development; Teklewold Atnafu, senior monetary policy advisor; and, Girma Birru, chief macroeconomic advisor to the Prime Minister has conducted lengthy discussion in pursuit of terms amicable to the lenders and soothing to the economy.
Nevertheless, the close to 120 million populace already grappling with double-digit inflation rates for the past five years, which, according to NBE’s report, has slowed to around 23%, still needs to overcome an uphill challenge.
An importer who spoke to EBR on conditions of anonymity expressed confusion about the exact implications of the changes to his business. The businessman pointed out how he effectively paid for most of his merchandise at rates close to what the commercial banks currently offer while cushioned by the parallel rates for official payments.
“There is simply no way that prices won’t increase,” he says.
The astute importer also questions whether the commercial banks could provide the necessary foreign exchange when they frequently need help to settle payments made in Birr. He says Ethiopia’s exporters have historically operated at a loss, benefitting strictly from the sale of dollars to importers.
“How will they suddenly make their export business profitable,” he wonders.
According to the NBE’s December 2023 report to parliament, Ethiopia’s foreign currency earnings were 24 billion dollars the previous year, comprised of services accounting for 29.5% and remittances at 6.8 billion dollars. Foreign direct investment and export earnings provided 3.4 billion and 3.6 billion dollars, respectively.
All these sectors could benefit from higher values against the Birr, absent a Black Swan event or two. However, potential lucrative businesses in opening foreign exchange bureaus, providing digital remittance services, and intermediating for foreign investments eyeing capital markets are also possible under the market-based exchange regime approach.
Just as the dollar fell to a four-month low in the week Ethiopia floated its currency, the meticulous execution of the policy by the Ethiopian government, calibrated responses by prominent market actors, and sustained peace and security nationwide will be among the many factors determining how the economic dominoes fall.
Indeed, Ethiopia’s decision to fully liberalise its foreign exchange market in July 2023 marked a significant shift in its economic policy. This move, part of a broader macroeconomic reform agenda initiated in 2018, is expected to have profound implications for the country’s economy.
As anticipated, a major is already happening because of the unification of the exchange rates. For years, the Ethiopian Birr was criticised for being overvalued, distorting export incentives and discouraging foreign investment. Floating exchange rates have allowed the Birr to find a more realistic market value in the first two weeks. This makes exports more competitive and attracts foreign direct investment (FDI). This could lead to a surge in export earnings, job creation, and economic growth if complemented with other policy changes that would boost productivity and ensure surplus production.
Furthermore, the liberalisation is expected to improve resource allocation. A unified exchange rate will eliminate the black market for foreign currency, reducing rent-seeking behaviour and corruption, critical problems that have defined the Ethiopian economy for many decades. This will enhance the efficiency of resource allocation, as businesses and individuals will be able to access foreign exchange at market rates without the need for informal channels.
The absence of this formal allocation of resources has affected the customs values of goods based on which import duties are levied and the collection of taxes on the selling price of goods. To compensate for the unrecorded costs of forex acquisition from the parallel market, the price of imported goods only gets billed for half or less the actual value of the transaction. At the same time, the seller receives the balance value without issuing a sales invoice. In this scenario, the government loses tax collection from the bulk of the transactions as they happen informally. The situation leads to a sequence of contraband economies where crime and tax evasion are rampant. This new policy change cuts the long thread to this economic evil.
Undoubtedly, the short-term implications of the Birr floating will be challenging. The initial floating of the Birr has led to depreciation, increasing the cost of imports and fueling inflation.
This floating of the Birr has indeed eroded the purchasing power of citizens and will put pressure on low-income households in particular. The government has announced plans to subsidise essential commodities and triple the salaries of low-income state employees. The government has approved over half a trillion Birr in additional budget to serve these goals.
The significant allocation comes on top of the initial 971.2 billion Birr budget already approved for the 2024-25 fiscal year, making the total budget for the fiscal year over 1.4 trillion Birr. A significant portion of the new funds, approximately 240 billion Birr, is earmarked for social development programmes, indicating a strong commitment to addressing the needs of low-income citizens. The government’s decision to allocate additional funds reflects its efforts to fully implement macroeconomic policy reforms and address the concerns of low-income citizens. According to the brief presented with the extra budget bill, the bulk of the additional budget will be used to implement measures to mitigate the adverse effects of foreign exchange policies, such as targeted social safety nets and price controls on essential goods.
In the medium to long term, the benefits of liberalisation are expected to outweigh the costs. A more flexible exchange rate will act as a shock absorber, helping to mitigate the impact of external shocks like commodity price fluctuations. Additionally, it will deepen financial markets, as banks and other financial institutions will be able to manage foreign exchange risk more effectively.
The NBE has already passed a decision to grant licenses to foreign currency offices, which is a significant step towards further liberalising the country’s economy. It announced a call for license requests on August 8, 2024. By allowing foreign currency offices to operate, Ethiopia aims to increase the availability of foreign exchange within the country. They also play a crucial role in facilitating remittances from Ethiopians living abroad. This could boost foreign exchange inflows and support economic growth.
Foreign currency offices enhance investor confidence by providing easier access to foreign exchange. This could encourage more foreign direct investment (FDI) into the country. Given the experience of other countries, introducing foreign currency offices is likely to increase competition in the foreign exchange market, which could lead to improved services and better exchange rates for customers. However, the capital threshold of 15 million Birr and the need to demonstrate the ability to make a 30 million security deposit makes a step entry barrier.
While the proliferation of forex offices has numerous advantages, establishing a robust regulatory framework is essential to prevent illicit financial flows and money laundering. The NBE needs to closely monitor the foreign exchange market to ensure stability and avoid excessive volatility.
Granting licenses to foreign currency offices is a positive step towards Ethiopia’s economic liberalisation. By increasing foreign exchange availability, improving remittance services, and attracting foreign investment, this move can contribute to the country’s economic growth and development.
However, the overall success of the macroeconomic reform will largely depend on various complementary policy changes that require interventions in different aspects of the economy. Improving the overall business environment, reducing bureaucratic bottlenecks, and investing in infrastructure are essential for attracting more FDI and boosting exports. Allocating resources to boost the economy’s productive sector, which requires allocating a fair share of resources, is necessary. Strengthening the financial sector is also essential to ensure stability and facilitate trade.
Indeed, the full-scale liberalisation of Ethiopia’s foreign exchange market is a bold economic reform. While the long-term benefits to economic growth, job creation, and improved resource allocation are substantial, the implications of the policy changes on inflation and how that affects the cost of living for low-income citizens should be carefully assessed. The government’s ability to manage the transition effectively and implement supporting policies will be crucial for realising the full potential of this reform. EBR
12th Year • Aug 2024 • No. 132
Eden Teshome
Samuel Getachew
