Legalizing the Black Market Solves Ethiopia’s Foreign Exchange Woes

Ethiopia has been grappling with a severe foreign exchange shortage for many years, fueling a thriving black market. The government’s frequent response – a crackdown on illegal currency trade – has solved the problem.

In this commentary reprinted from 7th Year • Nov.16 – Dec.15 2018 • No. 68 of EBR, Tekie Alemu (PhD), a retired associate professor of economics at Addis Ababa University, provided an in-depth analysis into the heart of the problem, exploring the intricate dynamics of supply and demand in Ethiopia’s foreign exchange market. From the role of the diaspora to the pitfalls of government intervention, the article offers a fresh perspective on this pressing economic issue. The assistant professor explains how a legalised foreign exchange market could inject efficiency and transparency into the system while empowering commercial banks to focus on their core competencies.

– in retrospect from EBR 68 published from 7th Year. November 2018.

In Ethiopia, shortages in the availability of foreign exchange, also known as a foreign exchange crunch, have been one of the pressing economic agendas for quite some time and have led to heated discussions. In response to the prevailing shortages, the government has recently (December 2018) taken measures to alleviate the problem. Two actions stand out: a fast crackdown on black market operators and controlling the foreign currency that exits through Bole International Airport and border areas. As a result, confiscation of large amounts of foreign currencies (at least from the perspective of individual stances) has continued to be reported. In principle, shortage or surplus depends on the country’s export performance and other sources of foreign exchange, including foreign borrowing and remittances. So, the question is whether such actions lead to an efficient outcome, and if they do not, whether there is a more efficient way of organising the foreign exchange market given the demand and supply situation.

Interventions that aim to restrict prices and quantities lead to inefficiencies, meaning that both prices and amounts realised in the market could be more efficient. Even if one were to complete a crackdown, a market would inevitably crop up differently and probably more inefficiently.

Similarly, the market for foreign exchange is similar to other markets. Immediately after some actions, we may observe that the market stays dormant with little activity and a seeming equivalence between the parallel and official exchange rates. Eventually, however, the market will likely emerge and start functioning at higher margins than the initial ones. The higher margins correspond to the costs and higher risks of being caught. To see the pitfalls of crackdowns on these markets and confiscation of resources, we start by looking at demand and supply elements.

It would not be an exaggeration to speculate that the lion’s share of the supply of foreign exchange in Ethiopia emanates from Diasporas. Ethiopians residing in foreign countries send foreign exchange to their relatives informally. Most of the time, this is done through people who travel to Ethiopia. Most of the time, such individuals also come to the country to visit their families. Their countries of origin allow travellers to carry limited amounts of cash, but these ‘limited’ amounts are pretty large compared to the demands of our black market operators. For instance, an individual can carry up to 10,000 from the United States, which is quite significant from the point of view of the market we are discussing.

Similarly, tourists, including people who travel for business purposes and bring in cash, expatriates working in the country, and residents who travel abroad for various reasons and come back with some reserve foreign exchange, are all sources of supply for the black foreign exchange market. The amounts exchanged per transaction in these circumstances may be relatively small. However, when individual transactions are summed up, the total volume of foreign currency supplied by these sources would be immense.

It is common for expatriates to enter contracts for rental housing premises in foreign currency (usually US dollars). In some circumstances, such rent is paid in foreign currency. In addition, it is used as a means of deterring the effects of devaluation of domestic currency or inflation throughout the contract. If the transactions occur in foreign currency, this finds its way onto the foreign exchange market.

The demand side of this market is primarily composed of importers who need help finding sufficient foreign exchange from commercial banks. Most of the time, importers bring commodities in bulk. However, it is not uncommon for importers to get access to only a portion of the foreign currency they requested. The portion that banks do not fund would need to be augmented with additional funds from the black market.

Ethiopians who go abroad for various reasons, including medical treatment, education, and tourism, also require foreign currency. The amount of foreign currency available to these travellers is fixed at a given time and changes over time. The most important thing here is that the amounts of foreign exchange authorised for such needs are usually, if not mostly, insufficient to satisfy travel needs. The source of financing for these requirements comes from the black market.

A segment in this market also takes place in complete darkness. Say we have an individual living in Ethiopia who would like some payments to be made in a foreign country. One of this person’s actions is to seek a resident in that country who could make payments on his behalf—the transaction is concluded by the individual residing in Ethiopia making payment in local currency on behalf of such a claimant. In this case, no financial resource has moved in either direction, but a transaction has been completed. I am raising this to indicate how various demand and supply elements would easily interact and create a market. Think of the time and effort needed to find a double incidence in the market!

Wishing that I was wrong, but considering the amount of cash seized in one go these days, individuals are hoarding foreign exchange—two primary reasons for this: speculation and storing foreign exchange as wealth. Speculation could be pardoned in terms of comparisons of future returns from different options, but using cash (foreign exchange) at hand to store wealth is entirely indefensible. In the later, individuals keep dead assets that could have been used to lubricate the economy. This problem is compounded by domestic agents’ inability to open foreign accounts.

What orderly mechanism could bring efficiency to the foreign exchange market? The most apparent reason for inefficiencies is some form of monopoly. A market in which banks operate without specialisations worsens the problem. It breeds inefficiency that tends to exacerbate the problem. I propose that these two elements are present in the foreign exchange market in Ethiopia. Consequently, we need to break this monopoly.

The starting point of this intervention should be legalising the black market. Namely, offer permits to purchase and sell foreign currency that caters to the demand and supply I mentioned earlier. There are many advantages, including the transactions in this market being recorded, currencies raised in this market being pulled by commercial banks and used for international trade, and the sector employing personnel and paying taxes, among others. Commercial banks would then specialise in transferring financial resources to facilitate global trade.

By focusing on this, commercial banks can increase their efficiency. Commercial banks likely have a comparative disadvantage in dealing with piecemeal engagements in the small transactions carried out in the black market. It is even logical to question the viability (economic) of this segment of foreign exchange operations, given the levels of competition and instruments used by banks, such as lotteries and gifts offered to customers who exchange currencies at the banks. Of course, the details of the institutional requirements and regulatory framework for this should be studied and implanted by the appropriate authority, in our case, the National Bank of Ethiopia.

12th Year • Aug 2024 • No. 132