Service Bonanza

Service Bonanza

Why Ethiopian Investors are Avoiding the Manufacturing Sector

In our meetings with Prime Minister Meles Zenawi, he frequently raised questions regarding the lack of private sector dynamism [in Ethiopia]. One of his questions was why Ethiopians with large sums of money invested in urban properties instead of building factories. On another occasion he asked how East Asian governments steered the private sector away from speculation and rent seeking and into manufacturing and technology. He also wished to receive literature explaining concretely how Meiji Japan and post-WWII Korea absorbed technology so quickly from foreign-assisted industrial projects.” This is a reflection of researchers in a joint paper produced by the National Graduate Institute for Policy Studies (GRPIS) and Japan International Cooperation Agency (JICA) on industrialization and the Growth and Transformation Plan (GTP). The researchers were referring to policy dialogues held with the late prime minister on industrial development in Ethiopia.

A statement of the same concern on why local business people are avoiding the manufacturing sector, to be engaged in trade, property development and the service sector was made by Hailemariam Desalegn, successor of the late Prime Minister Meles Zenawi in recent weeks. Following reports that show a continuing dominance of service sector investment, particularly from domestic investors, the government has been forced to issue a sober call so that local investors can divert their investment towards the manufacturing sector. The message was crafted particularly to the growing number of business persons who made their fortune in the trade sector.

So why are local investors not interested in engaging in the manufacturing sector in the first place, despite numerous incentives by the government? And what can the government do to change this problematic trend?
Industrialization is frequently considered the replacement of farming and resource extraction by manufacturing and service activities. It is the extensive organization of an economy for the purpose of manufacturing. Industrialization also introduces a form of philosophical change where people obtain a different attitude towards their perception of nature and a sociological process of ubiquitous rationalization.This transition takes different forms in different places at different times.

The first country to be industrialized was the United Kingdom during the Industrial Revolution, commencing in the second half of the 18th century. Apart from Japan, where industrialization began in the late 19th century, a different pattern of industrialization followed in East Asia. One of the fastest rates of industrialization occurred in the late 20th century across four countries known as the Asian tigers (Hong Kong, Singapore, South Korea and Taiwan). Research on these economies attribute the rapid industrialization to the existence of stable governments and well structured societies, strategic locations, heavy foreign investment, a low cost skilled and motivated workforce, a competitive exchange rate, and low custom duties.

India and China, while roughly following this development pattern, made adaptations in line with their unique histories and cultures, their major size and importance in the world, and the geo-political ambitions of their governments.

Since the mid-late 20th century, a few countries in Latin America, Asia, and Africa experienced substantial industrial growth. The success of countries like Indonesia, Turkey, South Africa, Malaysia, Philippines, Mexico, Costa Rica and El-Salvador was fuelled by export-oriented policies in which manufactured goods were sold to countries and regions that have large economies such as the United States, China, India and the EU. Yet in Sub Saharan Africa, the average contribution of industry to the GDP is below 30Pct and industrialization has yet to fully begin in the continent.

In Ethiopia, modern manufacturing plants emerged in the 1920s. According to some historical documents, as of 1927 about 25 factories were set up, mostly by foreigners. Between 1950 and 1960, the imperial government enacted legislation and implemented a new policy to encourage foreign investment in Ethiopia. This new policy provided investor benefits in the form of tax exemptions, remittances of foreign exchange, import and export duty relief, tax exemptions on dividends, and the provision of financing through the Ethiopian Investment Corporation and the Development Bank of Ethiopia. In addition, the government guaranteed protection to industrial enterprises by instituting high tariffs and by banning the import of commodities that might adversely affect production of domestic goods.

This policy attracted considerable foreign investment to the industrial sector. For instance, in 1971/72 the share of foreign capital in the manufacturing industries amounted to 41Pct of the total paid-up capital. Many foreign enterprises operated as private limited companies, usually as a branch or subsidiary of multinational corporations. The Dutch had a major investment (close to 80Pct) in the sugar industry. Italian and Japanese investors participated in textiles; and Greeks maintained an interest in shoes and beverages. Italian investors also worked in building, construction, and agricultural industries, according to a research paper by Thomas P. Ofcansky and LaVerle Berry.

With the advent of the Socialist regime, the Dergue in 1974, most of these industries were nationalized by 1975. Subsequently, they were reorganized under state-owned corporations. This development, and the socialist policy of the regime which restricted private sector development, hampered the healthy growth of the manufacturing as well as other sectors of the economy.

After the Ethiopian Peoples’ Revolutionary Democratic Front (EPRDF) took power in 1991 the new government took a decade to come up with a clear industrial policy. Leaders of the party, who are strongly influenced by the successful economic management and development stories of Japan, Korea and Taiwan, crafted the country’s comprehensive Industrial Development Strategy (IDS) in early 2000s. The policy highlights the linkage between the industry and the agriculture sector as its primary principle. Export-oriented and labor intensive sectors are also designated to lead the industrial development and be given priority.

The 2003 IDS states that priority sectors shall get direct support from the government. Textile and garment; meat, leather and leather products; agro-processing industries, construction, and micro and small enterprises (MSEs) were the main focus of the government in this regard. The list of priority sectors has been updated through time to include some import-substituting industries such as metal and engineering, chemical and pharmaceutical sectors. Institutionalization of Kaizen as a productivity tool in addition to benchmarking, proposed enhancement of MSE policy, expansion of the Technical and Vocational Education and Training (EVET) system and creation of new industrial zones, have been given priority.

Not Attractive Enough

The Ethiopian government is aiming for the share of industry to be 27Pct of total GDP by 2025 from 12Pct in 2012, in order for Ethiopia to join the club of middle income countries. Furthermore, 63Pct of this industry sector should be manufacturing. Yet a study conducted by the Common Market for Eastern and Southern Africa (COMESA) revealed that Ethiopia’s manufacturing sector is not yet ready to be competitive internationally and is showing little sign of improvement. Problems noted by the study include low productivity, high production costs, shortage and low quality of raw materials, shortage of foreign exchange, lack of skilled manpower, and frequent power interruptions.

These and other reasons are pushing the local private sector away from the manufacturing sector. Mengistu Hiluf, planning and information management directorate director at the Ministry of Industry cites low level of saving, which currently stands at 17.7Pct, input shortage in agro processing plants, transport and logistics inefficiency, power interruption and lack of institutional capacity at the ministry itself as additional reasons the private sector has not been joining the industrial sector as expected.

It is not only these factors which have pushed local investors away from the manufacturing sector. There are pull factors in sectors such as the hospitality, real estate and trade sectors which have been viewed as sectors that make money quickly as opposed to long term investments like agriculture and manufacturing which have retracted returns.

As its main concern, many expect the Ministry of Industry to study why the private sector has not been interested in the manufacturing sector. Surprisingly, it has never undertaken any research on the issue.

Miftah Mohammad (name changed), a business man engaged in chemical importing business for the last ten years told EBR “Many business people do not undertake business in an honest manner, especially traders in the Merkato area of Addis Ababa are known for unlawful business practices. This has for long enabled many to get rich easily and quickly. The government must at any cost get rid of the loopholes that created such situations first. It is only then that business persons in the trade sector can consider joining the manufacturing sector. Traders must also know that it will not be possible for them to continue making money easily and fast.” Although the government vows to fight these practices of rent seeking, it has a long way to go.

Kasaye Mekuria, Engineer, is general manager of Nazaret Garment Factory and former president of Ethiopian Textile and Garment Producers Association. He and his partners bought the company from the Ethiopian Privatization and Public Enterprises Supervising Agency (PPESA) in 2006 on an as-is-basis. Located at Adama, with around 600 workers, the company mainly exports its products to countries in Europe and America. “Manufacturing is not an easy thing to do. It needs know how, discipline, and strict planning and implementation. It is more risky than other sectors and profitability depends on the effort exerted. It is not a simple operation like buying and selling goods with exorbitant mark ups.”

Kassaye attributes the reasons local investors are avoiding manufacturing to a number of reasons: the lack of efficient bureaucracy, slow logistics and customs services, utility problems like power, telephone and water supplies, high labor turnover and input shortage being some of them. According to a research by Central Statistics Agency (CSA), lack of needed inputs is the number one problem faced by industrialists in the country. Since agriculture and other primary sectors are not well developed, 50Pct of inputs for agro processing industries and more than 90Pct of inputs for metal and heavy industries are imported.

Manufacturing is still only less than five Pct of the GDP and this does not seem likely to change any time soon. According to the 2012/13 second quarter report of Ethiopian Investment Agency, real estate accounted the largest share in the number of investment projects (59.5Pct), followed by manufacturing with only 13.4Pct, construction with 12.1Pct and agriculture, hunting and forestry with 6.5Pct. Accordingly, the investment capital in real estate renting and business activities constituted 50.3Pct, while manufacturing projects took 26.5Pct and hotels and restaurants’ share was 5.9Pct.

Generally there is not enough investment on manufacturing, and even less from domestic investors. This is partially explained by the young age of private industry in the country (22 years), according to the Ministry of Industry. “My financial capacity is limited. And it is hard to get inputs for manufacturing and you have to import everything and there is limited backward and forward linkage in the sector. These have made my decision to join the sector very hard,” says the Chemical importer.

Most of the wealthy people in the economy, those with the needed capital to establish a factory, are uneducated. This know-how gap is seriously reflected on investments in the sector. Long established family businesses in trade and service delivery, dependant on under-the-table trading have created their own codes of conduct, and have become an obstacle for the transformation of the economy.

The outdated collateral-based financing in the financial sector has also made it too difficult for professionals to access investment capital. Management problems at the company level and low level of productivity and usage of technology are also among the factors that pose critical challenges the growth of the manufacturing sector. Other technical issues like standardization and limited knowledge on how to access the international market have left a dent on manufacturing investment in the country.

Though not effective in changing the investment dynamics in the economy, incentives and economic privileges for investors in manufacturing has long been put in place. Investment and export tax incentives with privileges that range from generous tax exemptions to duty free imports and duty drawback are given to investors in the manufacturing sector. However, according to Tadele Ferede(PhD), assistant professor of economics at Addis Ababa University, this is not enough . “To benefit from the privileges, investors must make a commitment and the government must do a strict follow up.” I do not think this is what is happening now says the economist.

The Ministry of Industry says it is taking initiatives to pull the domestic private sector shift to manufacturing. “We have started identifying, contacting and convincing business people in the service and trade sector to join the manufacturing sector. We are also working to solve the problems of ongoing projects and enhance utilization of full capacities of existing plants” (for a variety of reasons, most factories in the country do not operate at their optimal capacity; production is rather as low as 60Pct of their full capacity) according to Mengistu. “We are building shades and industrial zones soon to be administered as a corporation benchmarking and tuning private investments. We have established technology transfer institutions and two more are coming: for food, beverage and pharmaceuticals and for chemical and construction inputs. And Domestic industrialists’ transformation directorate is being established.”

Ethiopia’s Manufacturers Association is undertaking a research on why Ethiopian investors are not engaging in manufacturing as they do in other sectors like trade, service and real estate, according to Gebrehiwot Gebregziabeher, president of the association. “In the meantime we have designated potential manufacturing sectors for investors to engage in. We have identified 36 traders and lobbied them to join the manufacturing sector and we are succeeding in convincing them. In association with our partners we have also identified consumer products that are being imported while 60-100Pct inputs for these products are available in the country.”

The story of foreign investment in the sector is a little bit different though. The country was among the top destinations of Foreign Direct Investment in Africa in 2012. “Foreign investors are queuing up to take advantage of the industrial zones that we are building, where as local investors are almost absent,” says Mengistu. There are criteria and commitments that investors must fulfill and made to set up shops in industrial zones. FDI is generally beneficial to the economy as it brings direly needed capital, technology and market but it must be balanced with domestic investment. Around 40Pct of the overall loan portfolio of Development Bank of Ethiopia, the main manufacturing projects financer in the country is held by foreign investors. This proportion can be significantly higher if data of the last couple of years is taken, as massive foreign investors’ engagement is a recent phenomenon in the Ethiopian economy.

Fast and Unsustainable Growth

The ongoing private sector development which is dependant on investments in trade, service and urban property boom may continue for a while but it cannot continue as it is unless investments in manufacturing, especially from the domestic investors, go hand in hand or even at a higher rate with the tertiary economic activities. Unless the economy transforms itself in to an industrialized one in a given period of time, in the next 15-25 years, it will be a challenge to correct structural flows in the future. “The service sector by its nature cannot sustain shock. A nation should not be dependent on other countries for every manufactured item. A service-dominated economy will end up importing everything. So incentives given to the manufacturing sector must be revised, the changes that they bring about in their long period of existence must be known,” the economist highlighted.

Industrialization requires: markets for manufactured commodities, labor force, raw material, technology, enterprise and finance, appropriate skills and knowledge, organizational abilities, effective financial institutions and stable government. In addition to this regulatory and institutional support, standardization and laboratory facilities and efficient bureaucracy are needed. Changing the incentive structure and artificially distorting the economy so that it favors investments in the manufacturing sector should also be made according to the assistant professor. “In South Korea there was big government support when the country started its industrialization path. Less electric charge for manufacturing plants, less interest on loans to and priority in accessing foreign exchange was provided. And the government and the industrialists plan and appraise their performance together. Ethiopia should take lesson from Korea.”

“What our domestic manufacturers produce here are expensive compared to imported manufactured products; this implies that higher import tax should be imposed on selected industrial products” Gebrehiwot suggests. This is highly unlikely, as the country is in negotiations to join the World Trade Organization. Depreciating the exchange rate may not be the solution either, since the real exchange rate depends on inflation and this is influenced by the inflation rate in economies of Ethiopia’s major trade partners.

Increasing production capacity and quality, through solving the different problems of the sector, like shortage of inputs must take precedence. The economist recommends the expansion of commercial farms as a solution to increase inputs for agro processing plants.

“We believe private domestic investment is the base for industrialization in Ethiopia and the role of the government should be administrative, but if the private involvement continues to be unsatisfactory the government may selectively engage in manufacturing without distorting the economy,” says Mengistu. Currently, the government is engaged in manufacturing, but more aggressive engagement is a risky venture and it may push private investment even further.

Not all hope is lost though. Miftah told EBR that he will invest in the manufacturing sector in the next three years. He plans to engage in the consumer product sector like detergent production and produce inputs for bigger companies and hopes to learn from them on how to run his plant. Kassaye also has plans to expand his factory, even though there are serious of series obstacles that he has to overcome.

There is no single magic formula to engage domestic investors in the manufacturing sector. However in his response to the late Prime Minister’s question, the researchers of GRPIS and JICA on industrialization and the GTP continue: “our answer on how to wake up a sleepy private sector was the initiation of a national movement for mindset change. A comprehensive programme of aspiration, philosophy, mass campaign, factory projects, training, awards and institution-building that lasts for at least a decade until it becomes self-sustaining and an integral part of popular mindset, which usually aims at quality, productivity and life improvement by instilling the spirit of activism and cooperation.” Maybe it’s time to take the advice of these researchers and implement systems that have worked for countries like Japan. EBR

2nd Year . November 2013 . No9


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