Reforming the Ethiopian Financial Sector

one successful country’s experience

Financial reform in Ethiopia has an interesting history. The issue has been an important agenda in the Ethiopian financial sector since the mid-1990s. It was in 1994 that the first financial liberalization measures took place and continued until 1998.

During this period, the International Monetary Fund and the government had disagreements over the scope and speed of the financial sector reform. The issues ranged from restriction on the participation of non-citizens in the financial sector to the government’s control on a number of capital transactions. These have increased over time and continue to date.

The consideration of financial reform leads to the big question of, ‘What can Ethiopia, learn from the transition experiences of other countries?’ It is now evident that there is no ‘one true path’ to a market-economy. This is clear when one considers the diversity of strategies and outcomes among the European and Asian countries that went through a financial reform transition. For instance, there is a dramatic difference in the methods and performance between the former Soviet Union and China when it comes to financial reform. China avoided ‘big bang’ reform—the rapid privatization and market-decontrol seen in the early years of Russia’s transition. Instead, China went in favour of what the Chinese call ‘Crossing the river by feeling the stones under your feet’.

China reformed the agricultural sector at an early stage and achieved major expansion in non-traditional exports, only later did they accelerate privatization. Their financial reform has been notably cautious and for long the capital account transactions remained restricted. These controls facilitated the use of a monetary policy and the central bank’s price stability performance, which was greatly superior to that of Russia.

Despite the financial inefficiency—China’s state banks serious problems are now apparent—growth has maintained an average of nine percent a year for more than 20years and continues to do so. This is in part because of China’s private sector successfully relying on self-finance (including that provided by those living as diaspora) rather than an initial bank or state credit.

In this regard, Ethiopia may enjoy a similar advantage to that of China because of its large diaspora communities who have excellent financial and commercial linkages. Remittance is already surpassing five billion dollars per annum (a figure, larger than the total export earnings).

China’s gradual financial reform is one of the ‘highly contradictory ingredients ‘of its economic transition, a strategy that has never the less, delivered unprecedented growth. It demonstrates that elements of the former command economy can exist side by side with the new private sector, an anathema to proponents of rapid liberalization. However, this strategy—if implemented well—is not as paradoxical as it first seems, given that most policy-makers must live with the market imperfections characteristic of ‘the second best world’.

For these reasons, experts like Qian Liu, an economist based in China, argues that the main lesson from the Chinese experience is that achieving considerable growth is possible with sensible but not perfect institutions. In addition, some ‘transitional institutions’ can be more effective than the best institutions for a period of time because of the second-best principle. This principle advocates that if a requirement for achieving an optimum economic situation is not satisfied, making a concerted attempt to satisfy those requirements that can be met, might not be the second-best option, and may be harmful.

Hence, Ethiopia’s emphasis on maintaining macro-economic stability—even at the cost of retaining inefficiency in the financial system—may be optimal in the second-best world that characterizes most of Africa’s transition economies. This view is also validated by the official growth rate of Ethiopia, which is officially about 10Pct per annum. A consecutive figure for the last decade (however, my estimation shows that the growth rate is between six and seven percent, which is still considerable).

In caution, we must take care not to stretch the point too far. Clearly, much depends on how Ethiopia manages the market-controls that it does retain. In particular, how the authorities cope with the rent seeking behaviour from which such controls inevitably encouraged. Rent seeking, if unchecked, can pervert well-intentioned strategies and transform them from mechanisms to raise living standards, into means for personal gain. Such, after all, was the experience of the African transition economies that were under state socialism.

In addition, as the Chinese experience shows, a transition economy needs fast growth to tolerate the efficiency losses associated with the financial-sector controls (and market-interventions elsewhere). For Ethiopia, this means fast rural growth—where poverty is deepest— together with a major breakthrough in non-traditional exports (including tourism). A feat it has failed to do so far and in turn implies; close attention should be paid to improve the micro-finance and rural savings institutions. This will enable communities to participate in growth and reform of the financial sector.

8th Year • Aug.16 – Sep.15 2019 • No. 77