Market-Driven Foreign Currency Market

Market-Driven Foreign Currency Market

Is it applicable in Ethiopia

Recently, officials of the National Bank of Ethiopia (NBE) pledged to implement a market-driven exchange rate regime over the next three years. Governor of the NBE, Yinager Dessie, said that his government will opt for a more flexible foreign exchange market to stabilize the level of its currency, deemed overvalued by the IMF. While this is a decision welcomed by the Bretton Woods institutions, it also stirred up controversies over its relevance in solving the forex crisis which has existed for over two decades. Experts fear that it would worsen inflationary pressures and result in an economic crisis shortly thereafter. EBR’s Kiya Ali explores.

Yonas Adinew (name changed upon his request) is a 31-year-old accountant at a private company. He usually comes to the Ethiopia Hotel area, walking distance from the headquarters of the National Bank of Ethiopia (NBE), to exchange foreign currency with birr in the parallel or black market. “Whenever I get dollars, my first choice is the black market. Who hates to get a rate that is 35Pct higher than the official market?” Yonas wonders.

Yonas is not alone. “We have many regular customers,” Tesfaye Negash, a foreign currency dealer working around Ethiopia Hotel, tells EBR. Just like Tesfaye, it is common to see black market dealers calling individuals passing by and asking whether they want to buy or sell foreign currency in the parallel foreign exchange markets found around National Theatre, Ethiopia Hotel, Gandhi Hospital, American Gibi, Stadium, and Tele Bar.

Since the government believes that the parallel market is responsible for the foreign currency rate instability, it usually cracks down on market operators. Even few months ago, dozens of shops were closed by the police and millions of foreign currencies were confiscated in order to put a tight-grip on forex movement across the country. But none of the administrative measures were able to bear fruit. In fact, the gap between parallel and official exchange markets has now reached a historic high of ETB11.

Although the major factors behind the persistence of the parallel market are multidimensional, it is common in countries like Ethiopia where a controlled exchange rate regime exists. There are two types of controlled exchange rate regimes: pegged and managed floating. Pegged exchange rate system, also known as a fixed exchange rate, occurs when a country ties the value of its currency at a certain level against a basket of major foreign currencies. But if the local currency is allowed to fluctuate within a certain interval, it is called a managed floating exchange rate regime.

Officials at NBE classify Ethiopia’s exchange rate regime as managed floating, but the International Monetary Fund (IMF) considers it as crawl-like due to the stability of the exchange rate. Considered as a part of a fixed exchange rate regime, crawling-peg allows the local currency to depreciate or appreciate relative to the basket of major foreign currencies gradually. This system permits the full use of key attributes of the fixed exchange rate regime as well as the flexibility of the floating exchange rate system.

A crawling-peg exchange rate system can be defined by two characteristics, according to the IMF: a fixed par value of the currency that is frequently revised and adjusted due to market factors such as inflation; and a band of rates within which it is allowed to fluctuate. As a result, the annual pace of nominal depreciation of the birr against the USD has been gradual and quite stable at about five percent in recent years, according to a 2019 World Bank report. But this is not free from flaws. It has resulted in the overvaluation of the Birr and has reduced the competitiveness of the country in the international trade arena. It has further contributed to export earnings being wedged around three billion dollars over the past decade while the import bill has climbed to USD15 billion, creating a large balance of payment deficit.

Taking such macroeconomic problems into account, the government is now planning to liberalize the exchange rate regime within the next three years. Recently, Yinager Dessie, Governor of the NBE, announced his government’s intention of moving to the market-led type of forex management slowly, probably in the coming three years. “There is no doubt that we should move slowly to the market-led type of forex management. But our issue is that we need to look at the timing,” Yinager said. “Within the coming three years, we would like to relax a little bit on the foreign currency management.”

Floating exchange rate system is one of the common market-oriented regimes used globally. It is usually adopted in an effort to make the foreign currency market more aligned to the market determined equilibrium rate. Under this system, foreign currency rates are determined daily by the forces of demand and supply, while no restrictions are imposed by the government. An extension of economic liberalization, such a system is mainly adopted in a bid to provide greater degree of monetary policy autonomy and flexibility, important to stay afloat during external shocks like large and volatile capital flows.

Flexible exchange rates believed to be instrumental in order discourage short-term capital inflows and prevent a buildup of large unhedged foreign currency and stimulate prudent risk management, according to a study conducted by the IMF.

Supporters of flexible exchange rate regime assert that it avoids economic woes arising from undervaluation and overvaluation of one’s local currency against a basket of major foreign currencies. For instance, in the case of developing countries like Ethiopia where there is a huge deficit in balance of payments and overvaluation is common, a flexible exchange policy, according to its advocates, is instrumental in making exports cheaper and discouraging imports, thereby automatically correcting trade deficits.

Such policies, according to its supporters, help the government concentrate on solving their domestic problems of economic stability, inflation and unemployment; freeing it from balance of payments woes. Above all, the bottom line for flexible exchange rates is allowing countries autonomy over their monetary, fiscal, and other policy instruments, while maintaining a considerable degree of freedom in international transactions that they chose to allow their citizens to enjoy. Practically, however, floating exchange policy is not as alluring as it may seem and there is limited empirical evidence that the system will always be successful in realizing the objective for which the foreign exchange market was liberalized.

Such concerns are shared by many who are against floating exchange rate regimes. Especially at a time when Ethiopia is facing a series of economic challenges that are highly interconnected, many fear that targeting squarely at only one source of distress often exacerbates and complicates others.

Despite such concerns, experts argue that Ethiopia should only follow either a pegged or fixed exchange regime as the government fears a move to greater flexibility would result in losing policy credibility. Not only that, proponents of flexible exchange rate regimes argue that it creates uncertainty about the exact inflows and outflows of foreign currencies, thereby hampering foreign trade and capital movements between countries. It is also criticized for promoting inflation and leading to political upheaval as the cost of living would be beyond control. It may also lead to widespread speculation about exchange rates of foreign currencies, leaving a destabilizing effect on these rates, and thus making it difficult to achieve market equilibrium.

What is better for Ethiopia?
Bretton Woods institutions, including the World Bank and IMF, have been advising Ethiopia to change its exchange rate regime to a floating rate system in order to promote exports and tackle the growth of the parallel market. In its latest study published earlier this year, the World Bank urged the country to employ a more flexible exchange rate regime, where the market is determined by demand and supply. This will make the birr more competitive, can bring about structural change, and enhance productivity. According to the World Bank, countries with competitive currencies tend to experience rapid growth in the manufacturing sector.

Given Ethiopia’s export earnings are largely dependent upon agricultural commodities, Bretton Woods institutions suggested the country employ a very flexible exchange rate regime, which will spur up real depreciation that can increase foreign trade and discourage domestic leakage. “A one percent real devaluation increases Ethiopia’s manufacturing exports by 1.06Pct and agricultural exports by 0.33Pct,” the World Bank study says. “A one percent real devaluation increases exports by 0.5Pct and reduces imports by about 0.6Pct, thereby leading to 1.1Pct improvement in the external trade balance.”

To the contrary, Abdulmenan Mohammed, a Financial Expert with over 16 years of experience, argues Ethiopia shouldn’t trust the advice of Bretton Woods institutions recounting that “their advices regarding devaluation caused more harm than good.”

In order to narrow the huge balance of payments deficit, the government has been taking measures which failed to accommodate the interests of the business community and the general public as was witnessed whenever the government devalued the local currency. For instance, the last time the birr was devalued against a basket of major foreign currencies by 15Pct, it led to inflation. This is well observed by Solomon Mulugeta, General Manager of the Ethiopian Metal and Metal Products Producers Association. “I remember how the prices of steel escalated right after the government devalued the Birr by 15Pct. “Subsequently, the prices of other products skyrocketed just because of speculation, but largely as a result of government failure to analyze the consequences of its actions.”

Although experts agree that adopting a floating exchange rate regime is an important step in improving the forex reserve and external balance of the country, they believe that certain preconditions be fulfilled before doing so. “Before relaxing the currency market, the country should have a stable political environment to avoid further crisis. Otherwise, it is going to have repercussions,” argues Atlaw Alemu (PhD), Assistant Professor of Economics at Addis Ababa University. In fact, experts say that this is not the only precondition that must be met before adopting a more flexible exchange rate regime.

The successful ingredients for floating include developing a deep and liquid forex market, formulating intervention policies consistent with the new exchange rate regime, simplifying foreign currency legislation or putting in place adequate payment and settlement systems, increasing information flows in the market while reducing the central bank’s market maker role, and building the capacity of market participants to manage exchange rate risks and of the supervisory authorities to regulate and monitor them.

But none of these prerequisites are met by Ethiopia. “Implementing a flexible exchange rate proved to be futile in developing countries like Ethiopia. It is noth ing but a recipe for economic crisis,” says Alemayehu Geda, professor of economics at Addis Ababa University. “It is going to be inflationary and further widen the gap between the parallel and official market. If this happens, whoever is ruling Ethiopia would face what the Sudanese government encountered recently.”

Of course, the toppling of Sudanese President Omar al-Bashir proved that avoiding a currency crisis may be key to political survival. Although the government did not fully liberalize the forex regime, it devalued the Sudanese pound to the dollar by 40 to 47.5Pct in October 2018. The parallel market was quick to respond. The currency’s black-market rate tumbled again to trade at around 75 pounds per dollar, while inflation hit as high as 120Pct. “The same thing would happen if the foreign currency regime liberalized in Ethiopia,” argues Alemayehu.

Ayele Gelan (PhD), an economist, argues that the move to a floating exchange rate is nothing different from devaluation. “It is like “daily devaluation” with the only exception that the exchange rate automatically adjusts according to demand and supply. Devaluation has not contributed any improvement to boosting exports or discouraging imports. The only thing the country has gained as a consequence is massive and uncontrollable inflation,” says Ayele, who argues that floating the currency would bring no different outcome unless it is implemented when Ethiopia has built the capacity to produce enough and export.

Abdulmenan also thinks that Ethiopia is not in a position to float its currency. “If a floated exchange rate regime is introduced, the local currency, which is currently overvalued, will adjust to the real exchange rate, resulting in the depreciation of ETB by a huge amount,” he says. “This has implications on the price of imported goods and external debts. Increased costs of imported goods will further increase inflation. When the birr depreciates, the interest and principal payments on external debts will become unbearable.”

Abdulmenan suggests that the huge current account deficit in the balance of payments and the severe forex shortage should be sorted out by improving exports and prioritizing government projects that are consuming huge forex. “Volatility and depreciation of the local currency causes uncertainty, deterring investors from investing in the economy. Investment thrives in an atmosphere of currency and price stability,” Abdulmenan warns.

Experiences of other African countries indicate the unpopularity of the floating exchange rate regime. No fewer than eight sub-Saharan African countries (Burundi, Democratic Republic of Congo, Ghana, Guinea, Liberia, Mozambique, Rwanda and Zambia) moved away from de jure floats to adopt less flexible exchange rate regimes. In 1996, 16 countries in the region were operating a de jure independent floating exchange rate regime, and eight countries were operating a de facto independent float. By 2014, not a single sub-Saharan African country was listed as a de facto independent floater with the exception of South Africa and Uganda.

Egypt was the latest African country to liberalize its foreign currency market. Being part of a government economic program, the liberalization of the exchange rate in Egypt came along a series of austerity measures aimed at securing a three-year USD12 billion loan from the IMF. However, the flotation of the Egyptian pound in 2016 triggered a steep wave of inflation that reached record highs and peaked at 35.8Pct, a rate unmatched in the past 70 years, though it did reach 15.4Pct the previous month. While the pound’s flotation has lifted Egypt’s foreign reserves to an all-time high topping USD45.1 billion, lower middle-income families and those closer to the poverty line have been severely impacted because of the ballooning cost of living.

While there is no guarantee that this won’t happen in Ethiopia, experts suggest that the government must first build a sufficiently liquid and efficient forex market, even before gradually adopting a more flexible exchange rate regime. “Balancing the supply and demand would be difficult if the birr is floated against a basket of major foreign currencies without sufficient amount of forex circulating in the market,” Solomon advices. Atlaw Alemu (PhD), Dean of the Department of Economics at Addis Ababa University, agrees. “If the birr is floated without enough forex reserve and import substitution, items brought from abroad would be expensive and will eventually impact local production costs, which would in turn adversely impact the competitiveness of the country,” Atlaw says.

Kibru Fondja, former President of Nib Bank, however, suggests that the private sector must be the driver of the economy first to effectively use a floating system. “The private sector can potentially improve the supply-side problem and is able to bring more foreign currency.”
But for Ayele, the right way to deal with the foreign currency crisis is adopting a dual exchange market and legalizing the parallel market. Adopting a dual exchange rate would be in the interests of all actors involved in foreign exchange, according to him. “The total benefit to the economy would be much greater than the sum of the separate benefits to different groups of actors in the foreign currency market. It will be like a win-win situation for everyone involved in the forex market,” Ayele concludes.

8th Year • Nov.16 – Dec.15 2019 • No. 80

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