Protectionism: Ethiopia’s Exceptional Path?

Ethiopia’s financial system is characterised by a high degree of regulation, protection and poor use of technologies. The underdevelopment and traditional practices in the sector is even worse than the standard of neighbouring countries such as Kenya. For instance, the sector to GDP ratio (a measure of financial sector development) is half, and the number of banks is also less than half of Kenya’s. This difference becomes more notable when we consider Kenya’s 54 million population size as compared to Ethiopia’s 115 million in 2020.The role of the government for the underdevelopment and closedness of the sector is considerable. The government has not only significantly involved itself in banking but has also placed a range of restrictions on banking activities. For instance, state banks in Kenya control less than 5Pct of the industry’s assets whereas in Ethiopia the figure is more than 60Pct. The government’s huge stake in the banking industry has afforded the state bank, the Commercial Bank of Ethiopia (CBE), a number of special privileges including acting as banker for the Ministry of Finance (MoF), keeping almost all government’s and state owned enterprises’ (SOEs) deposits, exemption from the National Bank of Ethiopia (NBE)’s requirement to buy national bonds equivalent to 27Pct of the loans it advances, and also getting foreign exchange and credit from the central bank easily. These direct interventions have been backed by other repressive financial policies such as restricting the activities of private banks, increasing the capital requirements for setting up new bank, and others. These interventions combined with restrictions on foreign bank entry have created an industry which is highly protected, and its competition and resource allocation is distorted.

Many Sub-Saharan countries have permitted foreign bank presence in their territories. During the imperial times, foreign investment in banking was allowed as long as the majority of ownership was slotted to Ethiopians. However, the Dergue regime nationalised all banks and insurance companies following the 1975 nationalisation proclamation. Even though change was hoped for when the Ethiopian Peoples’ Revolutionary Democratic Front (EPRDF) took over the country in 1991, the front carried on the legacy of the socialist era. As a result, the banking sector has remained closed to foreign competition. For this, the EPRDF invoked pragmatic and ideological grounds. Beginning from the financial sector reforms of the early 1990s, pragmatic grounds have invoked that the National Bank of Ethiopia (NBE) lacks the capacity to regulate foreign banks that deal with complex financial products, and domestic banks are not in a position to compete with foreign banks that have strong resources—financial, technological and human.

Ethiopian policy makers have been less keen on opening the banking sector for ideological reasons too. Drawing on their theoretical underpinnings from the developmental state paradigm, Ethiopian policy makers recognise the degree of failures in the banking industry. Market failures exist due to a low lending-saving trap, high interest margin, funding services and merchandise sector, and the belief that foreign banks only target profitable opportunities and finance large and multinational businesses. The banking policies based on this view prefer a highly interventionist and closed banking system to support industrialization. This kind of approach was pursued by Korea and Taiwan during their economic miracle of the 1960s and 1970s.

Pragmatic and ideological factors have played a great part for the closed banking system in Ethiopia, inducing excessive growth of the state banks, over protection of the banking industry and failure of the central bank to upgrade its capacity for regulating an open and sophisticated financial system.

The protectionist policy has created a situation where CBE (for its policy role) relies on captive domestic markets for most of its products, special regulatory treatments, and implicit and explicit state support. This induced a state-dominated financial system whereby state banks have overgrown, resulting in an increased vulnerability of the financial system. It is only since the past two years, that the combined capacity of the 16 private banks has begun to slightly and gradually exceed that of CBE, in terms of profit, branch size and assets. CBE’s unfruitful loans to SOEs under the former regime, and an abrupt decline in state preference under the new administration is already reversing the imbalance. Lack of foreign competition coupled with regulatory entry barriers has also allowed private banks to enjoy considerable returns mainly by focusing on urban areas while being reluctant to expand access to finance to industrial and small businesses.

No doubt, allowing foreign banks entry will bring benefits including increased competition, efficiency by means of technology and skills transfer, and strong financial backing. However, foreign banks’ entry is not without cost. Any economic problem in a country where a foreign bank is based will spill over to the host country. Foreign banks are always in search of better investment opportunities across borders. When they find better investment options elsewhere, they move their capital quickly to take advantage. This increases volatility in the financial system, and as a result could trigger financial crisis. Latin American countries were the victims of such crisis in the 1970s.

If allowing foreign banks is accompanied by the swift lifting of restrictions on the investment activities of banks, the intense competition may force banks to engage in risky loans and other investment activities, causing default and bank failures. This situation could be exacerbated by the entry of new local banks in the pipeline.

Ethiopia cannot remain closed to foreign banks forever. As part of the current liberalisation process, we need to have a roadmap to create a situation for foreign banks’ entry. The roadmap can include revising the current restrictive rules, restructuring state banks and reducing their role, upgrading the regulatory capacity of the central bank, and developing a regulatory framework for an open financial system.

9th Year • Dec 16 2020 – Jan 15 2021 • No. 93