ETB113 Billion

Why is it Outside the Banking System?

Just two months ago, Ethiopian Bankers Association (EBA) recommended change of currency to the government in order to reduce the amount of money circulating outside the banking system. The bankers thought this would improve the liquidity of commercial banks. However, the recommendation received a mixed reaction among the finance community. Many argue that the major reason for the sharp rise in the amount of money outside the banking system is the cash-based transaction system in the country. Economists also say that changing currencies cannot stop money laundering. They say, introducing monetary reforms is the best way to deal with the problem. EBR’s Ashenafi Endale reports.

In November 1998, just a few months before the bloody Ethio-Eritrea war broke out, the business community was in total surprise when the government suddenly announced the replacement of the birr note. The Birr notes were replaced back then because half of the currency in circulation was allegedly in the hands of the government of the then new state of Eritrea. The Ethiopian government then accused the Eritrean government of abusing this opportunity by accumulating huge amount of Ethiopia’s currency and illegally taking out foreign currency.

According to IMF data (1995), the Eritrean People’s Liberation Front (EPLF) acquired ETB1.3 billion between 1991 and 1993 alone, through its cash acquisitions and deliveries from the Ethiopian government. EPLF also took assets and cash from the vaults of the branches of the Development Bank of Ethiopia (DBE) and the Commercial Bank of Ethiopia (CBE) in Eritrea. It then changed the bank to Commercial Bank of Eritrea (CBEr).

The more money flow and transaction on Eritrean side but less on Ethiopian side created liquidity crunch in Ethiopia. Secondly, EPLF was buying and foreign currency from the parallel markets in Ethiopia with the local currency it acquired over the years. Eritrea, a country with no coffee plantations, also emerged as a notable exporter of the commodity in the global coffee exporters list by exporting Ethiopian coffee, for which it pays in Ethiopian birr. Although replacing the notes enabled Ethiopia cut the economic advantages Eritrea was taking over and enabled the government to be in command of the money circulating in the economy, , the move later become one of the contributing factors for the Ethio-Eritrean war.

Two decades later, Ethiopia is facing a similar problem with billions of Birr outside the banking system. The cash is reportedly in the hands of individuals, potentially feeding the shadow economy. “The huge cash accruing at the hands of individuals is financing crimes including purchase of weaponry. Putting in place a cap on the amount of money that can be withdrawn from banks at a time will have no impact on transactions but contributes to e-banking and also reduces fraud withdrawals, which are increasing,” said Yinager Dessie (PhD), Governor of the National Bank of Ethiopia.

Although there are reports that money currently circulating outside of the network of banks has reached at ETB113 billion as of June 2020, an NBE report which was issued a year before makes the figure ETB92 billion. This figure represents half of the total currency currently in circulation. The figure was ETB66.6 billion in 2015/16. It increased by 10.8Pct in 2016/17, by 16.9Pct in 2017/18 and 6.5Pct in 2018/19. The data clearly show that a large chunk of the currency went outside of banks when the political turmoil in Ethiopia was at its peak in 2017/18.

A number of factors contributed to the huge currency outflow from the network of banks. The first is the highly increasing demand for credit. In 2018/19, the credit disbursement of banks increased by ETB49 billion to a total of ETB164.5 billion. Outstanding credit jumped by ETB107.9 billion to almost half a trillion birr during the same period. On the other hand, the resource mobilized by banks increased only by ETB10.1 billion and stood at ETB308.2 billion. Loan collection by banks grew by ETB20 billion to ETB131.8 billion.

The second factor is the dramatic increment in broad money supply, which increased by 19.7Pct annually and stood at ETB886.8 in June 2019. This attributed to the 22.8Pct offset in domestic credit and 63.2Pct drop in banks net foreign asset (NFA). ‘Currency outside banks increased driven by improvements in money demand for transaction purposes and reflecting the growth in economic activities,’ states the NBE report.

Broad money supply grew from ETB22.17 billion in 1999/00 to ETB104.4 billion in 2009/10. It took ten years to grow 4.7 folds. However, it galloped 8.5 times just between 2010 and 2019. This clearly shows that the government printed and injected substantial volume of money since the first GTP was launched in 2009/10, in order to finance the ambitious goals set in the plan. Share of broad money supply to GDP increased from 42.7Pct in 2002/3 to 56.7pct in 2006/7 and 44.3pct in 2018/19.

The developmental state model the government championed, which deployed the approach of creating demand to arouse supply, also created phony money in the economy. Cash is required to guarantee GDP growth but it can also fuel inflation unless it goes proportionally with that growth. Fast growing budget, budget deficit and public expenditure in infrastructure also contributed to this end. The rate of growth in public expenditure was higher than the rate of growth of government revenue. The monetary policy sanctioned filling fiscal gaps by printing more money. “Large money entered circulation because the government printed and supplied money for budget deficits, government credits and expenditures, besides increasing private credit demand,” said Addisu Haba, Former President of the EBA.

The third factor that shifted cash from banks to pockets is inflation and devaluation. Despite the governmental effort to maintain inflation at single digit, inflation almost reached 20Pct. “Five years ago, an individual needed ETB100 in his pocket on average for weekly expenditure. Today, that has jumped to ETB1,000. The price of every item is doubling faster in Ethiopia. If we divide the ETB113 billion in the pockets of individuals to the total population of 110 million people, ETB1,027 will be left in every Ethiopians’ pocket. This is almost equal to what every average person spends weekly under the escalated inflation,” said Tekie Alemu (PhD), associate professor of economics at Addis Ababa University.

Events that took place in 2017/18 have highly contributed to the current shortage of cash circulating in the formal banking system. A large amount of cash was withdrawn that year. The government devalued the birr by 15Pct in 2017. In fact, the NBE continued to devaluate the birr at 0.4Pct on a weekly basis in the same year. Headline inflation also rose to 14.6Pct in the year. The three years political crisis that reached boiling point in 2017/18 was the immediate reason, although the galloping broad money supply was also at the background.

Zafu Eyesuswork, a veteran banker, cites four major reasons for the liquidity shortage and the impending increase in cash circulating outside the banking system. “The GDP growth over the last two decades is achieved through public expenditure on infrastructure, which increased money supply not backed with production. Secondly, people tend to depend on cash due to the increasing insecurity in the country. Nobody knows what will happen next week; so, everybody keeps cash on hand to survive. Thirdly, the Ethiopian government could not detach itself from its Marxian mentality of overtaxing businesses in the tax net to expand the tax base. Fourthly, a large section of the country’s population does not have a convenient access to financial service due to the underdeveloped banking services,” Zafu noted.

In a bold move, the Ethiopian Bankers Association (EBA) recommended currency replacement and raising the birr denominators. The Association publicly forwarded the recommendation during a press conference on May 20, 2020, although it has been pushing in that direction since the new PM and governor came to power two years ago. The press conference was held a day after Yinager Dessie (PhD), governor of the National of Bank of Ethiopia, held another conference to launch a new directive that placed cash withdrawal limits.

“The NBE introduced the directive because the EBA asked. We are even late. The Association has been calling for cash withdrawal limits and raising denominators for the last five years,” said Addisu Haba. “But the recommendation to replace currency notes is new and it is triggered by the rise in money laundering. Higher denominators make currency note easily manageable for banks and reduce money laundering.”

The probability of the government implementing EBA recommendations is high because the current NBE management and the government are more attentive to industry recommendations. However, insiders point out, the NBE has neither accepted nor declined the currency replacement recommendation as it has already ordered printing of existing notes to the UK based de La Rue Plc and French Charles Oberthur Fiduciare. The cost of printing money exceeded ETB700 million three years ago. In 2014, the NBE floated a tender to establish a local currency printing wing that would end the large foreign currency expense the country incurs annually to print birr overseas. The state-owned Berhanena Selam Printing Enterprise was considered to undertake the printing of the local currency. However, the decision later dropped.

Governments take swift measures to replace existing currency notes, especially to cutout illegal economic pockets. India’s Narendra Modi disclosed on November 11, 2016, that his government was replacing the currency the next morning. The move targeted unraveling the large unaccounted money in the economy and included the introduction of 500 and 1,000 rupee notes, which account for 45Pct of transactions. Banks were told to replace a few thousands but question those who turn up with hundreds of thousands and above.

Modern economies in the West, on the other hand, reduced cash money substantially relying more on e-commerce. Sweden is predicted to be the first country to be cashless by 2023. Transacting with cash is expensive in Sweden, which started online transactions short after the introduction of the internet. Share of currency in circulation to GDP dropped to less than 3Pct in 2007 due to increasing use of cards.

Experts advice that Ethiopia must work on digital transactions besides controlling broad money supply, money print, inflation, devaluation, banks credit and liquidity management. Cash is taken out of the economy slowly through burning of old currencies.

“Currency replacement could have been effective in Ethiopia a year ago, not now. If it is going to be replaced, the government should never talk about it. Currency replacement must be a surprise and an overnight operation. But now, the outlaws that have amassed the money can change it into foreign currency or look for other options,” said a consultant at World Bank who spoke to EBR on terms of anonymity. A huge section of the Ethiopian economy is run by the “Mercato Mentality”, i.e., without recording of transactions, totally cash based and gradually transforming into economic crimes, he remarked.

Money multiplies outside of the banking realm. Ethiopia’s economic structure enables such practices. Exporters, importers as well, buy commodities for highly inflated price from the domestic market. They export it for a loss at the international market. Then they use the foreign currency for import business. Finally, they sell the imported items for super inflated prices, in order to compensate their previous loss. This system is transferring huge money into the pockets of business people, fueling inflation. “Importers and exporters make exaggerated profits. But they cannot keep the money in banks, as it is largely made out of mispricing, a practice of under-invoicing and over-invoicing cost and sales to avoid tax. They open letter of credits (LC) for USD5,000 but end up importing items worth of over USD100,000. The sector has been totally unregulated and has now turned into a hide and seek economy,” said the expert.

As the economy is characterized by such woes, raising denominators will also lead to counterfeit, the expert said. “Nobody makes counterfeit ETB1 note; but ETB50 notes and above would be more susceptible to counterfeit. Increasing denominators would also fuel inflation. Making slight security changes to the existing ETB50 and ETB100 notes works. Higher denomination has no impact on improving circulation. Denomination should be minimized even further, since people do not want to carry a large number of notes. That could make people shift to electronic transaction than carrying a large number of notes with small value. If it is necessary, higher denominators can be printed as a special note or bond. That would reduce the cost of printing,” added the World Bank expert.

Banks have also contributed to the cash shortage, according to the expert. They have been giving huge chunks of credit, in cash, for their supposedly big clients. People borrow a large amount of money from a bank with nine per cent lending interest. Then they deposit the same money at another bank at 15Pct saving interest. The illiquid bank, which has loyal customers waiting for credit lends the money for up to 18Pct loan interest. “Replacing currency cannot be a lasting solution to bring cash back to the banks. The only lasting solution is incentivizing people to use banks and use electronic transactions. If the government facilitates the use of point of sale (POS) terminals, mobile money applications or any digital transaction mechanism for shops, fuel stations, supermarkets and all trade points and offers discounts for consumers who transact digitally, people will start using digital transaction,” the expert added.

Eyob Tesfaye (PhD), a macroeconomist, agrees that Ethiopia’s problem is the absence of electronic payment system. “Replacing currency will even worsen the liquidity problem. People will take the new currency from banks at once, since they need it for transaction. Banks will soon supply the new notes to their clients through huge loans. Replacing currency cannot be the solution. Eyob argues that the government used the double digit GDP expansion as a pretext to print and supply money in large quantities. “The NBE needs to undertake stringent liquidity management system in its policies and in all commercial banks, besides tightening its money printing policy. Digital banking and financial literacy cannot be achieved immediately; it may take years. The NBE has a gray area in the financial sector. It, for instance, has been pushing banks to expand their branches aggressively, by about 25Pct yearly since 2010. On the other hand, it hasn’t been calling for a similar effort to expand digital financial infrastructures. It is, however, waking up lately,” added Eyob.

Mesenbet Shenkute, President of Addis Ababa Chamber of Commerce and former President of Abay bank, agrees. “Bankers’ Association targeted at solving the liquidity problem of banks by replacing currency. At the same time, the NBE targeted at reducing money-laundering practice in the country. But replacing currency cannot help achieve both. The only solution is electronic payment system. It is not possible to modernize the financial system with traditional solutions.”

She argues that Ethiopia won’t achieve departure from the vicious circle, unless notes are replaced with digital money. “For instance, the NBE limited cash withdrawal from banks at ETB300,000. People will take ETB299,000 from many banks if they still want more money. The NBE needs [fresh minds] who really believe in digital money and financial technologies. Printing more money and replacing currency in circulation incurs significant cost, deploying huge human resource, logistics and other facilities. ” She added.

She also stressed that commercial banks need technical capacity to trace and control the increase in non-performing loans and loan rescheduling. Banks are unable to capture informal remittance that is increasing every year. These informal inflows are not properly recorded in the national accounts. This leads to a rise in the stock of money outside the banking system. The government is unable to regulate the underground economy and cross-border trades as well. Plus, broad money supply is outweighing real GDP expansion. She explains.

Mesenbet also pointed out that Ethiopia needs a separate agency mandated to remittance management. “Nobody is asking for remittance declaration papers. The NBE should outsource the tedious activities like bank supervision and controlling of the money circulation to an independent body of experts. It should rather focus on developing its capacity to regulate digital economy and ensure cyber security in the financial sector. Ethiopian banks are so exposed, that’s why many people still prefer private safe boxes.”

Addisu recommends that the NBE should make account to account transfers and cheque services mandatory. “If cheque can be used in real time, raising denominators is unnecessary. But cash must be supplied to rural areas where 90Pct of the transaction in the agricultural sector is cash-based.

“Currency replacement will definitely reduce the [money circulating outside the banking system]. However, digitizing transactions will offer a lasting solution. The operation would also be difficult under COVID-19. The current liquidity problem of banks is short term and manageable. It needs other liquidity management tools than currency replacement. If the network of banks increase and mobile banking takes root, then the rural population would start saving in banks. But this needs reliable power and Internet infrastructure across the country,” added Addisu.

Tekie argues neither replacing notes nor cash withdrawal limits can serve as a remedy to the excess money outside banks. “One can withdraw the maximum amount from different banks. It is difficult to trace this because many companies operate in various sectors. In some sectors like construction, employees take wages only in cash.”

Tekie argues that there are two methods to encourage people to keep money in the banks. The first solution is improving the network in banks and giving depth to digital transaction. “Even in most supermarkets in Addis Ababa, debit cards and POS machines do not work. Other countries introduced credit cards a long time ago. Credit card is highly used in developed countries because there is surplus production that outstrips the demand of buyers. In Ethiopia, there is no production that matches the growing demand.”

He said the government must modernize the market system first to modernize the finance system. “Unless wholesalers, retailers and consumers have access to electronic transaction or account to account transfer of payments, no one can force them. The finance and market system does not change because the government changes currency notes.”

The second solution is focusing on improving the real economy than changing the local currency. “The governor said people are using cash for illegal transactions like buying firearms. This can be stopped only by tracing and stopping such transactions, not by replacing currency or raising denominators,” Tekie notes. “Money laundering can be addressed by stringent financial intelligence operations. Besides, if people engaged in illegal economic activities know that the government is going to change the local currency, then they will change their money into gold, foreign currency and physical assets.”

Tekie notes one striking fact that is currently a reality of many banks. He argues that several banks distribute loans to their shareholders. And while the loans are not recovered, the interests have been recorded as incomes making their profits inflated. But the truth is, Tekie explains, the loan itself is not paid back to the banks. “Banks have been accounting over ten years of receivables as profit and have already paid them as dividends. This is how dividend per share is flying above 25Pct in Ethiopia. The banks are paying unearned income as profit. If the loan taker fails to service the loans, the bank loses.”EBR

9th Year • July 1 – July 15 2020 • No. 88