Credit Cap Conundrum

Balancing Inflation Control with Economic Growth

Ethiopia’s central bank has imposed a credit cap to tame soaring inflation, but the measure has unintended consequences for businesses, especially exporters. While inflation has eased since the bank introduced the policy a year ago, the credit crunch stifles economic growth. Economists advise policymakers to strike a delicate balance. According to economists, targeted credit measures, support for SMEs, and fiscal discipline are crucial. By fostering a conducive business environment and prioritizing key sectors, Ethiopia can achieve both price stability and sustainable economic expansion, writes EBR’s Eden Teshome.

Ethiopia’s central bank, the National Bank of Ethiopia (NBE), imposed a 14% annual credit growth cap on commercial banks last year, a move aimed at curbing the country’s high inflation. While this policy measure has positively impacted arresting inflation, it has sparked discussions on the need to strike the right balance between inflation controls and supporting the growth of Ethiopia’s foreign trade and productive sector.

The 14% credit cap has posed significant challenges for export-oriented businesses, particularly enterprises, which traditionally rely on bank loans to finance their operations and expansions. Tadese Melaku, Manager of Coffee Trade at Horra Trading, explains that the cap has significantly impacted his business, which is heavily involved in the coffee industry. Tadese explains that a single container of coffee costs around seven million birr. As his company exports more than 50 containers of coffee monthly, the business requires a staggering ETB 350 million for the transaction every month.

“The coffee business requires substantial capital, and the lack of access to financing has severely hindered our ability to maintain our export levels,” Tadese laments. Other exporters echo this sentiment, finding it increasingly challenging to secure the necessary funding to sustain their operations and pursue growth opportunities.

The NBE’s decision to implement the 14% credit cap arises from its efforts to arrest high inflation, a persistent challenge for Ethiopia’s economy for almost two decades. In the 12 months following the credit cap’s announcement, Ethiopia’s annual headline inflation rate had declined from 29.3% to 20%.

“High inflation is damaging from both a macroeconomic perspective and from its negative impacts on the livelihoods of millions of ordinary Ethiopians,” the central bank said in its analysis of the inflation data.

The NBE’s analysis identified a combination of factors contributing to the surge in inflation, including supply-side constraints, cost-push pressures, and expansionary fiscal and monetary policies. The central bank concluded that a comprehensive, coordinated approach was necessary to address the issue effectively.

“The central bank stated that the long-term solution to Ethiopia’s inflation necessarily involves coordinated efforts in multiple areas,” highlighting the need for supply-side measures to improve production and productivity and structural reforms to enhance the country’s transport networks, logistics systems, and trade competitiveness.

The credit cap was one of the critical components of the NBE’s “comprehensive package” of decisions aimed at reducing inflation. By limiting the growth of credit in the banking sector, the central bank hoped to curb the expansion of the money supply and, in turn, helps bring down the rate of price increases.

While the credit cap has also significantly impacted banks and the broader Ethiopian economy, an anonymous branch manager at one of the top-tier private banks explains that banks’ primary function is to collect deposits and allocate them where needed. When these deposits are not distributed, it creates pressure on banks. This is because it costs the banks in interest payable to the depositors.

“Most exporters do not produce the goods they export; instead, they source them from local farmers and businesses. While some critical businesses may not be directly affected by the credit caps, such restrictions can impact market channels. If local businesses are not financially supported, they may struggle to supply goods that meet the demands of exporters. So, the credit cap indirectly affects exporters through their suppliers and is also likely to impact foreign currency generation,” the bank executive notes.

Striking the right balance will be crucial as Ethiopia’s policymakers navigate the complex task of balancing inflation control and supporting the growth of the country’s export sector.

“It’s a delicate balancing act,” says Dawit Mulueta, an economist who works in the banking sector. “The central bank needs to find a way to rein in inflation without unduly constraining the ability of exporters to grow and compete in the global market.”

According to Dawit, one potential solution could be a more targeted and flexible approach to the credit cap, where the central bank tailors the restrictions based on the specific needs and challenges different sectors face.

“Perhaps the credit cap could be set at a higher level for export-oriented businesses, or there could be exemptions for certain types of export-related financing,” Dawit suggests. “This would allow the central bank to maintain its broader inflation-fighting objectives while still providing the necessary support for the country’s export sector.”

The NBE’s decision to impose the credit cap has been a delicate balancing act between controlling inflation and supporting the growth of Ethiopia’s export sector. According to the central bank’s analysis, a combination of supply-side constraints, cost-push factors, and expansionary fiscal and monetary policies have contributed to Ethiopia’s recent inflation surge.

To address this issue, the NBE has introduced a comprehensive package of measures, including further reducing direct advances to the government, increasing the interest rate on its emergency lending facility, and adjusting the foreign exchange surrender requirement to promote a recovery in exports, particularly for the manufacturing sector.

As part of this effort, the central bank has set an ambitious target of reducing inflation to below 20% by June 2024 and below 10% by June 2025. This target signals a clear commitment to tackling the country’s high inflation rates, which have had a detrimental impact on the livelihood of millions of Ethiopians.

While the credit cap has presented challenges for exporters, industry experts and policymakers believe that the NBE’s broader push for economic reforms, including the gradual liberalization of the banking sector, could ultimately strengthen Ethiopia’s export competitiveness, provided that the government strikes the right balance between inflation control and supporting the growth of the country’s external trade activities.

The branch manager at the private bank suggests that policymakers should consider local markets and various sectors in policy reforms, especially credit-related ones, as these sectors are crucial for exporters and other businesses. Additionally, the manager recommends that foreign currency from exports be used to import products that would effectively mitigate inflation rather than being used to import [luxury items].

As Ethiopia navigates this delicate balance, it will be crucial for the government to engage closely with the private sector, particularly the export-oriented businesses, to understand their unique challenges and design policies that can effectively support their growth while also addressing the country’s broader macroeconomic concerns.

Banks have implemented credit caps, which limit the maximum amount of credit they will extend to individual borrowers or businesses. This credit cap helps banks manage their overall risk exposure and avoid overextending credit, which can lead to loan defaults and financial instability. Credit caps ensure banks maintain a diversified portfolio and don’t become over-reliant on any single borrower. Additionally, credit caps can encourage more responsible borrowing, as customers are incentivized only to take on debt they can realistically afford to repay. This, in turn, promotes financial prudence among consumers and businesses. Overall, credit caps employed by banks provide an essential safeguard against excessive lending and contribute to the overall stability of the economic system.

Indeed, Ethiopia’s credit cap has effectively curbed inflation but hindered economic growth. Economists recommend a nuanced approach to reconciling these objectives.

The government should consider a targeted credit cap rather than a blanket restriction. This approach highlights the need to prioritize sectors crucial for economic growth and job creation, such as agriculture, manufacturing, and export, which also help stabilize the economy. It should enhance financial inclusion and access to credit for small and medium-sized enterprises (SMEs). These businesses are often the backbone of the economy and can be supported through tailored credit facilities and risk-sharing mechanisms. However, the blanket credit restrictions will have huge effects on them.

Finally, the government should complement monetary policy with fiscal discipline. Reducing government spending, improving tax collection, and prioritizing public investment in productive sectors can help stabilize the economy. Lastly, structural reforms to enhance the business environment, reduce bureaucracy, and improve infrastructure are essential for long-term growth. By adopting these measures, policy pundits express that Ethiopia can effectively manage inflation while fostering a conducive environment for economic development. EBR

12th Year • Aug 2024 • No. 132