Ethiopia’s Economic Experiment

Franco Valuta & the Path to Market Liberalisation

Ethiopia’s recent liberalisation of its foreign exchange regime has significantly changed its economic landscape. One of the most notable developments is the expanded use of Franco Valuta imports.

This scheme, which allows importers to settle their obligations with foreign currency outside the domestic banking system, has been controversial. While it offers businesses greater flexibility and potentially relieves pressure on the central bank’s foreign exchange reserves, concerns remain about its potential impact on inflation, parallel exchange markets, and illicit financial flows, reports EBR’s Munir Shemsu.

A hurling storm of change has swept Ethiopia’s financial architecture. What were once economic gears and levers carefully tweaked by the State have been left to the ‘invisible hand’ of market forces. Following nearly five years of negotiations with the International Monetary Fund (IMF), Ethiopia’s economic chieftains settled for a programme announced in July’s last days. While most pundits gawked at the decision to float the Ethiopian currency after five decades of state management, a much more thorough economic upheaval is adrift.

Nearly 14 hours after Prime Minister Abiy Ahmed (PhD) announced a macroeconomic reform capped by exchange regime liberalisation late Sunday afternoon, central bank governor Mamo Mihretu unveiled a green directive with significant economic implications. Albeit dominated by provisions on the modalities for the movement of currency, amendments to existing restrictions on capital account transactions and stipulations for import and export services were also included.

One of these standout measures was the allowance of Franco Valuta imports. This scheme allows the importation of goods in which foreign exchange from the domestic banking system is not payable. A move that effectively frees importers from the hassles of opening Letters of Credit ( LC) as they are commonly called cash against documents (CAD) and other advance payment modalities to cover their import bills

While a letter by Eyob Tekalign (PhD), State Minister for Finance, on August 19th lifted the 250,000 dollar cap and similar restrictions except internal combustion engines and intelligence equipment, Franco Valuta imports have had a quite unstable regulatory history in Ethiopia.

Abiy’s administration permitted the import of wheat, rice, sugar, edible oils, and instant baby milk through Franco Valuta two years ago as it struggled to control galloping commodity prices.

In the first eight months of this year alone, close to 474 million litres of edible oil, around 5.4 million quintals of sugar, nearly 3.6 million quintals of rice, and about 1328 quintals of baby milk were imported into Ethiopia through the Franco Valuta scheme.

The figures the Ministry of Trade & Regional Integration reported to the House of People’s Representatives were close to those reported in 11 months the previous year. Around 8.3 million quintals of sugar, 98 million litres of edible oil, and nearly 4.69 million quintals of rice worth 100 million dollars were imported.

Despite evolving into a neatly holstered policy weapon, unleashed only in times of pinching macroeconomic conditions, Franco Valuta imports were intended by the Imperial Regime several decades back for diplomatic missions and foreign-owned businesses. While now governed by Council of Ministers Regulation 88/2006 and a host of circulars after that, a more comprehensive application of the scheme has historically clashed with the objectives of the Ethiopian Customs Commission.

Amid the flurry of decisions in 2022 that looked to ration the dwindling foreign currency reserves, a letter by the Finance Ministry banned the allocation of foreign currency and import of 38 items classified as luxurious. Before the dust settled on how businesses could adjust, another letter came two months later by State Minister for Finance Semereta Sewasew, cracked a side window allowing duty-free shops to import those luxury goods, which un-ironically included soap.

Over the past two years, a thriving shadow ecosystem has emerged, further fueling the high prices for the US dollar in parallel exchange markets while maintaining a relatively stable supply of imports.

The central bank’s fourth quarter report for 2022/23 shows that over 2.4 billion dollars worth of imports were facilitated via the Franco Valuta scheme in the last two quarters. This figure represents nearly 12% of all imports during 2023.

Apprehensions about the arrangement primarily stem from the green light for businesses to settle their obligations to suppliers from foreign currency accounts outside their regulatory reach. After a company receives a Franco Valuta license from the NBE, it will be only subject to a one—or two-percent service fee for the bank’s facilitation. At the same time, everything else happens in financial corners that are inaccessible to Ethiopian authorities.

While incessant debate has surrounded the scheme’s pitfalls, including its potential fueling of parallel exchange markets and possibly illicitly obtained funds, its impact on inflation has been timid.

After the central bank’s sweeping monetary reforms, inflation rates have only slowed down on their thundering double-digit climb this year. While the 23% reported a few months back is high relative to much of the developed world, it is still markedly lower than the 32% peak the prior year.

With American economists like Steven Hanke from Johns Hopkins calculating Ethiopia’s inflation rate at nearly twice the figures reported by local officials, a central point of contention is not if but how severe the rise in price levels has been despite several policy pivots. There seems to be recognition that the decision to float the Birr could entail a biting aggregate commodity supply crunch with pinching consequences for fixed-income households.

Economists like Atlaw Alemu (PhD), an assistant professor at Addis Ababa University, identify removing restrictions on FX permits as one of the better macroeconomic decisions in recent history. He says the pressure of carefully tracking the legality of the foreign currency being used by the importers will require increased vigilance from the government.

“It will complicate things for the regulators,” Atlaw emphasised to EBR.

The economist points out how the efficacy of allowing the import scheme rests on which types of products are brought into the country. He foresees a lopsided benefit structure emerging if most goods imported are consumer items primarily purchased by high-income earning households. The astute economist indicates the need to incentivise the importation of intermediate goods to ignite local production rather than fueling niche consumer appetites.

“Resources will inevitably funnel towards where there is an attractive surplus,” the economist said, referring to foundational theoretical principles.

Atlaw finds the amelioration of pressure felt by the banks in servicing the foreign currency demands of importers as the most significant palliative in the prevailing foreign currency crunch. He explained how the move spares Ethiopian banks, already in precarious open foreign currency positions, from addressing importer requests.

“The banking industry may breathe a sigh of relief,” Atlaw says.

Nonetheless, senior banking industry veterans like Worku Lema point to a much more nuanced impact resulting from the relaxed arrangements regarding Franco Valuta. He considers the fears of worsening the parallel exchange contingent on the authorities’ supervising capacities.

“If properly regulated, it is largely a positive move,” Oromia Bank’s VP told EBR.

Worku underscored the importance of enhancing Ethiopia’s exports through improved market linkages as the most crucial element of increasing forex generation. Given their increased supervisory powers, the banker expects Authorities like the central bank to be up to the task of managing importers’ currency sources.

“The old days of converting local birr through illicit means is not so simple now,” he noted.

Worku suggests that banks can earn enough foreign currency reserves through export facilitation, remittance services, and collaborations with foreign direct investors.

However, reports from early 2018 show that the Franco Valuta arrangement primarily relies heavily on foreign currency sourced from parallel markets. This would effectively erode potential gains proposed when liberalising the foreign currency regime.

One critique of the scheme is that it creates a fertile space for cultivating rent-seeking behaviour due to the high concentration of power given to individuals within the Customs hierarchy. The 2013 directive by the then Ethiopian Customs & Revenues Authority granted deputy directors of branch offices the power to either issue or reject the Franco Valuta privilege to foreign-owned businesses.

The wave of shifting legal mandates between the Customs Commission, the NBE, and the Finance Ministry has also contributed to the bitter taste that Franco Valuta incites from onlookers. For instance, the NBE reestablishment proclamation pending ratification from Parliament wrestles all powers regarding the Franco Valuta from the Finance Ministry. The latest letter by the State Minister may be one of the last regarding the privileges when the proclamation receives a parliamentary nod early next year.

With the IMF forecasting a Balance of Payments (BoP) to GDP ratio of negative 4.6% by next year, a financial cushion is critical to facilitate a bite back from existing vulnerabilities exacerbated by a currency regime change. The IMF’s extended credit facility, which provides medium-term financial assistance to low-income countries with protracted BoP problems, is expected to provide some relief.

Nonetheless, Franco Valuta’s simplified access to reserves welcomes a business community that has increasingly been fed up with the limited FX provided by a central bank juggling less than three weeks of reserves.

Two importers who spoke to EBR pointed out that most Ethiopian businesses don’t have offshore accounts to have access, which ends up nudging them towards parallel market operators who do. One explained how most importers want their goods to come in quickly, pay back their debts, and go for another round of shipments.

“The black market guys operate in most import destinations,” he said.

The importers expect businesses to go wherever readily available foreign currency is if procedures at the banks need to improve. They also indicated expectations of further directives and regulations on how the Franco Valuta arrangement would be implemented in a new way.

However, looking back at the broader reforms towards liberalisation provides some sobering insight. Amid the conditions for the nearly 3.4 billion dollar extended credit facility provided under the IMF’s programme, the Finance Ministry is removing distortive current account controls. The decisions by the Finance Ministry stem from concessions to terms agreed much more than they do from reactive policy making.

A closer look at some legislative introductions throughout the past year and promises of further economic unbridling provide even more perspective on the latest decision.

While addressing a gathering of Ethiopia’s high taxpayers in March, Prime Minister Abiy indicated that the economy was opening up on several fronts.

“The economy was closed till now , we will be opening it up. You may want to get ready,” the PM cautioned the attendees.

Abiy had hinted at allowing foreign ownership of real estate in Ethiopia, opening up the retail and whole sectors to foreign capital, and imminently unbridling the banking industry.

Less than two months after the speech, a directive issued by the Ethiopian Investment Board, which Abiy chairs, unfurled the retail, wholesale, export, and import sectors to foreign capital. A draft baking law proclamation has also made its way to Parliament since it sets up modalities for the entrance of foreign participants.

An in-depth dive into the recently unveiled series of documents by the IMF depicting Ethiopia’s request for an arrangement under the extended credit facility proves quite illuminating in understanding the reforms.

It paints an economy assailed by a series of shocks, including the conflict in Northern Ethiopia, to be provided for some respite through the government Home Grown Economic Agenda financed in part by international creditors. With gross international reserves of 1.5 billion dollars at the end of March covering less than a month of imports, a declaration of the country as fragile and a missed Eurobond coupon payment in December 2023, almost any urgent help would have been welcomed.

The programme envisages a slowdown in economic activity in the near term as domestic credit drops relative to GDP. At the same time, imports dip slightly over two years despite inflation not spiking due to the sectors’ historic reliance on parallel exchange markets.

However, significant downside risks from social discontent, security risks, and poor programme execution are also identified. Pent-up foreign currency demand, which could be alleviated by removing restrictions on the Franco Valuta system, is also noted as a potential destabiliser in the near term.

While a shift towards a market-based economy marked by features of transparency is expected at the end of the four-year program, the opacity of the inaugural exchange auctions post float by the NBE, forced price controls by regional trade bureaus and the large spreads on FX transactions by commercial banks may signal early deviances from the prescribed pills.

Allowing imports through foreign currency outside of the Ethiopian banking system is but one element of reducing balance-of-payment vulnerabilities and ushering in overall economic stability.

Ethiopia’s currency swap agreements, first with the United Arab Emirates and two months later with China, represent novel strategies for curtailing sharp foreign currency shortages. Countries like Senegal, which removed foreign currency restrictions in 1998, allow importers to utilise foreign currency outside the local banking system. The move has not spared the country from a 72% debt-to-GDP ratio, mostly dollar-denominated, and consequently ambitious reforms towards autonomy by Africa’s youngest president, Basirrou Diomoye. Neither have the seven other countries that are part of the West African Economic and Monetary Union (WAEMU), whose foreign currency reserves have been halved since 2021, according to Moody.

The experiences of African nations with relaxed foreign exchange controls illustrate that a positive balance requires much more than a mere adjustment to FX rules.

The sharp rise in contraband goods over the last few years, as evidenced by the Ethiopian Customs Commission revealing nearly 10 billion birr seizures in a single year, presents a novel challenge to tax collection targets and accurate data on imported goods. Ethiopia’s ruling government, absent changes from elections two years down the line, has to contend with structural bottlenecks in conflict, corruption and repressive economic policies if the program has any chance of succeeding. Resurrecting merchandise exports, which have declined by double-digit figures in the past two years as most of the sector sells at a loss for the gains from the import side, might need a revision of principles from private and public stakeholders. EBR

12th Year • September 2024 • No. 133