Policy or Police Intervention?

Managing Ethiopia’s Foreign Currency Problem

Economists understand the exchange rate of currencies just as they understand the price of any other commodities. In the foreign exchange market, the goods that are traded are currencies and their prices are the exchange rates. This means, just as with the price of any good or service, the exchange rate is primarily determined by demand and supply.The market for foreign currencies could crudely be classified into two categories: fixed (pegged) exchange rate regime and flexible (floating) exchange rate regime.

In a fixed exchange rate regime, a central bank determines the exchange rate, and influences the demand and supply for foreign currency relative to the home currency to ensure a predetermined rate is achieved as a market outcome. In a floating exchange rate regime, it is purely the forces of demand and supply that determine the exchange rate.

The exchange rate regime in Ethiopia inclines more towards the first type. It could more precisely be identified as an adjustable peg. This means the National Bank of Ethiopia (NBE) determines the exchange rate, and by managing the supply and demand of foreign currencies, it makes sure the pre-set exchange rate is maintained. When there is excess demand for hard currency, the NBE devalues the Birr.

Nevertheless, given that the country has a capital account closed to foreign competition, the pressure on the NBE to manipulate the demand and supply for hard currency is much less than what would have been in the case of an open capital account. Had the capital account been open, investors, private individuals and financial institutions, would have moved their financial resources into other currencies putting an even more substantial pressure on NBE to devalue the Birr. A speculative attack would have ensued, wiping the foreign currency reserve of the NBE out in a brief time. That wouldn’t happen as the capital account is closed.

Symptoms of Foreign Currency Shortage and Some Misconceptions
In an economy like Ethiopia, there are common symptoms of shortages of hard currency. First, as the shortage deepens, the black market will flourish, indicated by much higher premium than the official exchange rates. That’s why as the bank exchange rate is currently less than ETB28; while the exchange goes as high as ETB34 in the parallel market. This means, the parallel market offers 25Pct more price than the formal market. Perhaps this is the highest difference in the exchanges rates between the two markets since the 1991. Importers, not able to fetch the full amount of foreign currency they request from banks, they remain with no option other than resorting to the black market to meet their foreign currency needs. They do so by under-invoicing and obtaining a guaranteed small amount of foreign currency from official channels, and filling in the remainder from the black market.

Second, as the shortage of foreign currency becomes severe, the exchange rate will further move away from its fundamental value, the value that equates the demand for and supply of foreign currency, and the NBE will be forced to devalue. That’s been the case in the six rounds of exchange rate adjustments made since 1991.

Third, illegal cross-border trades boom in tandem with a booming black market. For fear of getting identified by officials, importers who obtain substantial foreign currency in the black market may resort to contraband trades. In fact, contraband trades and associated foreign currency mismanagement has forced the central bank to probe and expel some key executives in some private banks in recent years.

Last, and certainly not least, the three symptoms above jointly work to increase the inflation rate, and perhaps necessitating further exchange rate adjustments. This is also happening in Ethiopia with food inflation reaching 19.9Pct in March 2018, the highest since NBE devalued the Birr in October 2017.

Of late, the black market was underlined by Prime Minister Abiy Ahmed (PhD) and Yohannes Ayalew (PhD), NBE’s Chief Economist and Vice Governor of Monetary Stability in their remarks about the shortage of hard currency. Referring to the black-market transactions that are conducted a few hundred meters away from the NBE, they stress that measures could be taken to root out the black market and, thus, consequently channel the hard currency that circulates in the black market to mainstream sources. This, they hope, will assuage the hard currency shortage.
The view that the black market is one of the reasons for the hard currency shortage the country faces isamiss. Booming black market is in fact a symptom, not the cause, of the shortage of hard currency. This is a market that came into existence out of the inability of official sources to meet the growing need for hard currency in the country. If the NBE had sufficient stock of foreign currency reserves, this market would gradually thin out. Alas, the NBE’s stock of reserves is limited and declining, and over the years, the black market has been facilitating trade by providing foreign currency importers couldn’t obtain otherwise. Of course, this, in no way, is meant to say that the black mark should supplant the NBE as a primary source of hard currency.

A Few Instances the Black Market Would Actually be Black
There are at least a couple of obvious reasons why the black market could indeed be black. Frist, it makes it convenient for importers to import goods and services without paying the necessary tariffs imposed by customs. This happens as importers under-invoice, perhaps to guarantee themselves of the full amount of hard currency they request from banks. The under-reported prices will then be used by customs to levy tariffs, resulting in lower tariff collections in some instances. Of course, Ethiopian Revenues and Customs Authority in most cases, use international price of commodities instead of commercial invoices importers present to levy tariffs on imports.

Besides, individuals who wish to transfer their wealth, accumulated legally or illegally, to other countries will find the black market convenient. Our Birr doesn’t cross borders. About 10 years ago, I couldn’t convert Birr to Shillings at the center of Nairobi in neighboring Kenya. In particular, when wealth is accumulated through illegal means, the market is expedient to launder such wealth. In so doing, the black market could serve the role of a mechanism that ‘legalizes’ resources acquired illegally.

Despite these drawbacks, and certainly a lot more others, speaking of the black market as if it were the primary reason for the foreign currency shortage in the country is not only wrong, but dangerous. If the government were to succeed in extirpating this market, it would need to supply however amount of hard currency importers request and failing to do so would lead to severe shortage of foreign currency. As a result, the NBE would be under frequent balance sheet pressures to devalue Birr.

The Recurring Foreign Currency Problem
The foreign currency problem in Ethiopia is very fundamental. In 2016, Ethiopia’s imports of goods and services were about five times as much as its exports. Such trade deficit has grown steadily. This unbalanced trade depletes the foreign currency reserves in thecountry.

All the more, if imports are mainly investment goods that enhance future productive capacity and the trade deficit is temporary, deficits are not necessarily harmful. Trade (and current account) deficits reverse in the future when exports pick up. Historically, some countries have relied on temporary current account deficits to finance the import of investment goods. The textbook example would be Norway in the 1970s which run significant current account deficits to import oil drilling machines and run substantial current account surpluses once it started exporting the oil.
If imports are primarily consumption goods, in contrast, both economics and common sense suggests that current account deficit could ultimately end insevere currency and/or debt crises. Enroute to hard times, Birr continuously loses value, inflation becomes a norm, goods producing sectors shrink and the service sector booms. A recent example of this would be Greece.

The Elephant in the Room
Ethiopia’s foreign currency reserve amounted to a meagre 1.8 months of import in 2017. The significant trade deficit was partly offset by remittance.

Indeed, it is virtually impossible to overstate the importance of remittance in financing trade deficits. In 2016 alone, Ethiopia received about four billion dollars in remittance, according to the central bank. If, in the past, the hard currency shortage was manageable in any way, it was mainly because of remittances, foreign direct investment, loan and aid. While recent data is not available, it’s not hard to imagine that remittance has taken a hit lately. This is also evident in the PM’s plea to the business community to bring back their money deposited in Dubai back home and his remark for the Diaspora community to send more money directly through formal lines.

It would be a cliché to say that a problem is half-solved when it is properly diagnosed. Researchers at the NBE, Ministry of Finance and Economic Development, and academia should be tasked to investigate this recurrent issue from different angles. While there are some ongoing efforts on the government’s side to create a more competitive external sector (the expansion of industrial parks, for instance), the foreign currency problem the country perennially finds itself in indicates either it’s too early to see anything or what has been done is not enough. Of course, the later weighs more. In the meantime, blaming the black market as the main cause of the problem conflates causes with symptoms, and it is a testament to the lack of rigorous research backed policymaking in the country.

6th Year . May 16 – June 15 2018 . No.61