Demonetization Antithesis to Shadow Economy, Politics?

Ethiopia, which has undergone political turbulence in recent years, has now fired a direct shot at the nation’s lingering macroeconomic imbalances by unveiling a new generation of currency notes on September 14, 2020. In addition to the replacements of the old Birr 10, 50, and 100, a new 200 Birr note was also issued by the government. The five Birr note remains unchanged and will soon be turned into a coin. While the government stress that the introduction of new currency notes is part of the ongoing economic reform in the country, critics argue the move is rather driven by politics and an assertion of power. EBRs Ashenafi Endale explores.

In the shiny morning of September 14, 2020, the presidents of commercial banks operating in Ethiopia were gathered in a conference hall inside the compound of the Office of the Prime Minister located on Lorenzo Taezaz Street. Many suspected the announcement of a policy decision that could relieve them from the lingering liquidity crunch and foreign currency shortage ailing the banking industry; but none assumed news of such amplifying implication for the entire nation. They soon heard from the premier himself and the chief of the central bank of the government’s decision to replace the existing currency notes with new ones.

“Introducing the changes in our currency notes was deemed necessary to salvage the country’s fractured economy,” Prime Minister Abiy Ahmed (PhD) said during the announcement. “The new notes will curb the financing of illegal activities, corruption, and contraband.”

Equipped with enhanced security features to minimize counterfeiting as well as varying color, content, and outlook, the new Birr notes for the 10, 50, and 100 denominations were unveiled while a new 200 Birr note was introduced for the first time in Ethiopia’s history. A total of 2.9 billion new notes worth ETB262 billion is printed, at a cost of ETB3.7 billion.  Although the existing five Birr note was neither replaced nor reprinted, it will soon be phased out to be replaced with a five Birr coin. “The general public has a three-month window to exchange old currency notes for new ones,” Yinager Dessie, Governor of the National Bank of Ethiopia (NBE) disclosed.

Abe Sano, President of the Ethiopian Bankers Association and Commercial Bank of Ethiopia, absorbed the move as surprising, yet righteous and timely. “But it must be implemented in even less than the planned three months, so that illegal money holders cannot maneuver and find a way back to banks,” Abe tells EBR.

Economic Necessity or Consolidating Power?

The government stresses that the move is intended to restore a macroeconomic balance by reducing the large amount of money circulating outside of banks as well as curbing illegal money transactions and contraband. Dismissing critics’ argument that the change is all about political power assertion, Abiy’s administration asserts the move was out of economic necessity. “The currency note replacement was necessitated to save the economy from further collapse,” explained the Prime Minister. “The introduction of new currency notes is part of the ongoing economic reform in the country.”

Abiy’s administration identified the circulation and use of the Ethiopian currency by many illicit businesses and actors as one of the major obstacles to the ongoing political-economic reform. The significant amount of money circulating outside the banking system, money laundering, contraband, and other activities are threatening the economy, according to the premier, underlining the note replacement will effectively stop the damage.

In its statement, the Ethiopian Economics Association (EEA) stated that this significant move has economic implications both on the financial sector as well as on the real and on-the-ground economy, although further analysis is necessary to quantify the potential effects. According to the Association, the immediate impacts include a surge in deposits and hence, savings. The removal of fake notes and wiping out of large stocks of “black money” from the economy will also occur. While in the medium and long run, the move will boost government revenue, stabilize inflation, and if the accumulated “black money” is channeled into the banking system, lead to greater productivity.

Economic activities that fall outside the control of government accounting is known as the underground economy. These include illegal, unreported, unrecorded, and informal activities conducted outside government regulation, taxation, and are against the rule of law. These activities can alter and reduce the impact of development programs and plans. Although it is difficult to know the size and characteristics of the underground economy in Ethiopia, few studies suggest that its growing in its prominent existence. For instance, the International Monetary Fund (IMF) estimated that in countries in transition, like Ethiopia, the underground economy accounts for as high as 40.1Pct of GDP.

As the experiences of many developing countries with vast underground economic activity reveal, the main catalyst of the underground economy is money.  More precisely, money circulating outside the banking sector. It is no different in Ethiopia. According to NBE, currency circulating outside official channels showed an estimated increase from ETB97 billion in March 2019 to ETB109 billion in March 2020.

“The currency change is necessary to cut out the lifeline of the underground economy. So, it was necessary to cut out the informal economy,” explains Yohannes Ayalew (PhD), former Chief Economist at NBE, recently appointed as President of the Development Bank of Ethiopia. “But it should be implemented efficiently.”

Demonetization, which is a change of currency where new units of currency replace old ones, has proven to be one of the successful methods of fighting illegal business activities and cracking down on black money. For instance, in India where once huge amounts of fake currency notes used to circulate, demonetization proved to be a valuable tool by converting fake currency notes into mere pieces of paper. As the Indian Statistical Institute reported, before 2016, fake currency notes amounting to Rs 4 billion were in circulation at any given point of time in the economy and around Rs 700 million fake currency notes were injected into the economy every year. With the government’s demonetization decision to ban old currency notes of Rs 500 and Rs 1,000 to replace them with new ones, the circulation of fake currency completely stopped as the new notes have highly advanced security features.

Devendra Kumar Tiwari, Associate Professor at United Institute of Management, India, in his study entitled “Demonetization and its Impact” published in 2017, further adds that the demonetization process in India proved to be a turning point for the Indian economy by cleaning up fake money and bringing in more borrowings to the treasury, improving inflation outlook, and increasing gross domestic product.

Yet, a large portion of the unaccounted money circulating in India before 2016, never made it to official banking channels as a small portion of the black money existed in the form of land, gold, and buildings rather than in the form of cash. Experts indicate that the same might become true in Ethiopia. “As rumors about the government’s plan surfaced in the past few months, individuals involved in illegal activities bought assets like houses or foreign currencies like the US dollar,” explains a financial consultant working at the IMF Ethiopia Office. “In fact, holding real assets that appreciate through time is preferred in Ethiopia instead of holding cash or bank deposits due to the high inflation rate. These factors made the underground economy thrive in the first place.”

The Birr replacement is forcing people to keep their money in kind, according to Teke Alemu (PhD), Lecturer of finance and economics at Addis Ababa University. “Government’s decision to change birr note forced people to think of what people weren’t thinking, lose trust in birr and keep asset in kind.”

Experts also argue that money circulating outside the banking system increased partly due to inflation, increasingly worsening since 2016. “The large money outside of banks is understandably necessitated by inflation,” explains Teke.

Abdulmenan Mohammed, Accounts Manager for the Portobello Group Ltd, a London-based holding company, argues that large amounts of money ended outside of the banking system mainly because the economy necessitated it. “As long as inflation is high, access to banking services low, and electronic banking systems inefficient, people will continue to carry large amounts in cash. The currency notes, even the new ones, will eventually end up in people pockets, since the demand for cash is there. The currency replacement is a waste of enormous resources for uncalculated benefits.”

Alemayehu Geda (PhD), Professor of economics at Addis Ababa University agrees. “Money outside the bank system increased due to inflation,” he explains. “Broad money supply has now reached ETB986 billion, from just ETB104 billion in 2009/10. The government has been printing and injecting money into the economy.”

The large amount of money circulating outside of the banking system cannot be channeled into the banking system just by replacing notes, according to the IMF’s financial consultant. “The problem persists as the reason for people needing extra cash at hand also persists. People will withdraw the new note as fast as possible and finally the new money will end up in individuals’ pockets and in the informal sector.”

Power Assertion?

While experts like Abdulmenan and Alemayehu struggle to find an economic rationale for the introduction of the new notes, others argue that the move is driven by politics and an assertion of power.

Enforcing the rule of law in Ethiopia has remained difficult, especially in recent years. The administration of Abiy points its fingers on individuals and groups who have access to the large hordes of money circulating outside the banking system to finance illegal operations including smuggling and unlicensed weapon trading; all the while persuading the large unemployed young population to engage in destructive activities and social media wars to destabilize the country.

“The huge currency circulating outside banking systems and found in the hands of criminals is one of the major identified obstacles to the reform,” said Abiy, expecting the new notes will restrain various illicit activities.”

For the financial consultant at the IMF, the economy and politics are closely linked. “Although the introduction of the new currency notes has some economic justification, it also takes political factors in to consideration.”

As many observing the issue point out, the government, now led by the Prosperity Party (PP) formed through the merging of three former Ethiopian People’s Revolutionary Democratic Front (EPRDF) member parties and other regional parties, wants to weaken the Tigray People’s Liberation Front (TPLF) and its allies. The two sides have been condemning each other in recent times. While PP blames TPLF for conducting unconstitutional activities, TPLF, a key actor and instrumental organization in the creation of the EPRDF coalition, accuses PP for working to end the federal system in the country and endangering the constitution itself. So, some believe the introduction of the new notes is not only intended to drain a financing source of those who want to instigate and fuel violence across the country and engage in illicit activities, but also to weaken adversaries of the current administration.

The New Player

The introduction of a new 200 Birr note is another issue generating much controversy. Much of the uproar is focused around the supposed inflationary effects of introducing a higher denomination note. The government stress this heavier note will complement its current policies. “Right now, the economy is recovering from a recession,” Abiy stated, adding that controlling inflation has become difficult and is not at the desired level. “Since the large amounts of money circulating outside of banks exacerbated the problem, the new currency notes could play a paramount role in resolving the problem.”

Yet, some economic experts, political actors, and business owners oppose the decision. They criticize and fear that the introduction of the higher denomination notes at a time when the nation is recording double digit inflation will not be in the interest of the majority of consumers as well as the economy at large.

Especially in recent years, Ethiopia has suffered from high inflation. In the past 15 years, average annual inflation rate stood at 16Pct. Ethiopia’s inflation was practically synonymous with food price inflation since food prices and money supply have a direct correlation. Non-food prices are determined by international prices in the long run. The fact that the five Birr note remains unchanged and the government intends to turn the five Birr note into a coin indicates the declining purchasing power of lower denominations. Highlighting this, critics contend that the introduction of a higher currency note will heighten inflationary tendencies and be counter-productive to the government’s drive to tame inflation.

Studies indicate that the introduction of the higher denomination banknote will decrease the demand for lower denomination banknotes since higher denomination banknotes are more attractive. In its statement, EEA also expressed its concern, pronouncing it may result in a preference shift towards holding currency instead of deposits.

Yet, others say the introduction of the higher denomination banknote is well-matched with the current inflation rate and even recommend the introduction of a 500 Birr note. “Even higher banknotes should be introduced because of the high inflation rate facing the country,” argues Abdulmenan. “This is because lower denomination banknotes will lose their value too quickly.” EBR

9th Year • Oct 16 – Nov 15 2020 • No. 91

Ashenafi Endale

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