Financial Reform in Ethiopia

In my commentary published on EBR last month I showed that the experiences of many countries indicate privatization does not automatically improve performance; the 1998 scandal involving the Uganda Commercial Bank is a case in point. Moreover, the World Bank’s experience of financial reform in the former Soviet Union drew the conclusion that early privatization does little to improve the quality of the banking system and may be counterproductive when institutions are weak and prudential regulation is underdeveloped. Therefore, it is by no means self- evident that Ethiopia should follow Mozambique’s example of privatizing state banks early in the transition stage.

Be that as it may, the controversial liberalization issue of opening the financial system to foreign banks remains on the table. The benefits of opening up the industry includes recapitalization of the banking system (a strong motivation for the opening to foreign banks in Angola and Mozambique) and the transfer of modern banking technologies. However, although some (but certainly not all) foreign banks have considerable ‘reputational capital’—and may therefore transfer high standards to Ethiopian partners—they can introduce new risks (such as excessive and unhedged short-term foreign borrowing) which the National Bank of Ethiopia (NBE) has little experience in containing.

Moreover, NBE faces considerable pressure in effectively supervising the financial system as it stands. NBE also needs to build its capacity to grade the quality of the foreign banks; some poor- quality Asian banks have set up in Africa’s transition economies.

The ideology of using public banks for the developmental interest is a strong argument to control the sector in a poor country such as Ethiopia even today. In addition, considering the large number of regulation and control rules that exist today in the sector, it is understandable if the government worries about what will happen to the stability of the macro economy in general and the financial sector in particular if it lifts all these controls without a well-equipped regulatory and supervision capacity even today.

In addition, recent trends point at an incipient foreign owned investment banking activities and representative banking offices that are in the course of entering the country using the equity finance scheme (from UK, USA, Germany, South Africa, and China, among others). These developments not only call for capacity and institutional building at the NBE to regulate and manage such financial institutions but also brings to the spotlight the issue of the risk of liberalizing the sector and opening the capital account.

Given the closed nature of the Ethiopian capital account and the huge financing requirements of the economy, Ethiopia may not afford to restrict capital inflows into the country by imposing strict capital control regime forever. In revisiting the capital account management regimes there is a need for capital control instruments to be tailored to fit the country’s circumstances. It should also be gradual with a time specific schedule; it should also move from simple to complex. For instance, the operation of foreign companies can be limited to some activities such as management contracts or in equity holding with indigenous public and private banks having a majority holding to protect the ownership structure. Given the capacity at NBE, another design consideration is the administrative ease of imposing a particular capital control instrument.

Finally, from a macroeconomic perspective, financial stability is also conditional on a prudent policy to address the serious problems of capital flight that reached over USD30 billion in the last three decades, growing level of external and domestic debt (which is over 60Pct of the GDP), alarming level of trade deficit (which is about -17.5Pct of the GDP), the consolidated public deficit (which is about -17Pct of GDP) and its possible monetization, and hence inflation and exchange rate depreciation effect. This is important because next to the exposure of the Commercial Bank of Ethiopia (CBE) and the Development Bank of Ethiopia (DBE) to unviable or poorly managed projects and connected lending, macroeconomic instability that includes shortage of foreign exchange and inflation, is one of the major systemic risk factors for the financial sector stability in Ethiopia.

To conclude, financial reform raises complex technical issues over which there is, at best, partial consensus. Since the reforms began, Ethiopia has seen considerable reorganization of the state banks as well as the entry of private banks and insurance companies. Interest rates have been significantly decontrolled and interbank foreign exchange and money markets have been established. Simultaneously, the regulatory capacity has been strengthened. Financial reform has been gradual, but nevertheless determined. The government has been completely aware of the structural and institutional problems that need to be overcome for a market-based financial system to develop. This has at times provoked disagreements with the IMF, but from the reform experiences in Africa and in the transition economies of Asia and Europe it demonstrates that there are many paths through transition, some successful, others not.

The creation of a sound financial system is crucial for transition and reconstruction, and to raise the living standards of Ethiopia’s citizens. However, after a decade and half in this path, the challenges of further liberalization and building capacity to regulate and supervise them have become more complex and difficult.

In this regard, two policy directions need to be pursued in the immediate future. The first policy direction relates with the issue of deepening the financial sector to enhance domestic resource mobilization. Recent survey-based evidence and CBE’s saving mobilization performance, following its aggressive branch expansion, shows that providing financial services to those that are out of reach from banks including through mobile banking, investment and housing loan-based saving schemes as well as attractive returns on savings are important factors behind saving. Pursuing such policies and getting closer to a positive real interest rate seems like the policy direction to pursue. This also helps to manage the excess money out of the economy and fight inflation coupled with the Birr’s depreciation.

The second policy relates to the cautious opening up of the financial sector as it cannot be protected forever, the need to create a level playing field both for public and private financial sectors, and building the capacity for supervision and regulation at NBE in a very short time. The latter is important as the NBE’s current capacity is weak to handle further liberalizations that are getting complex by the day. It is estimated that it takes about 15 years to have the best regulator in a central bank and the NBE has recently lost the director that has been there for over this 15 years (Getahun Nana). It is difficult to replace experts like that in a short time. Thus, towards that end the NBE needs to have (a) time specific, say a five-year, plan to have a highly motivated (probably highly paid) high caliber staff to regulate and supervise the sector. This again needs to be complemented by continuous training; work out on partial opening of the sector through various modalities such as joint ventures with local banks, management contracts with the majority holdings remaining on indigenous banks and learning from that to build capacity.

In addition, NBE should be worried about the incipient investment banking type firms that are coming in the form of foreign bank representatives and equity firms for it has not developed the capacity to manage and regulate them.

8th Year • Sep.16 – Oct.15 2019 • No. 78

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