Supply Distortion The Law_1

Supply Distortion The Law of the Jungle at Work

Ashenafi EndaleNovember 15, 202035330

As a developing country, the Ethiopian economy is largely characterized by the informal sector with studies indicating its expanding size. The International Monetary Fund estimates that in countries in transition, like Ethiopia, the underground economy accounts for as high as 40.1Pct of GDP. Although the government has been taking different measures to reduce the role of the informal sector, these interventions have failed to materialize. However, the government now says its latest measure of replacing currency notes with new ones is positively working in that direction. But experts disagree with the government’s concision by saying the expansion of the informal economy is highly interconnected with the formal economy’s failure to produce enough goods to satisfy national demand. EBR’s Ashenafi Endale reports.

In the last two decades, the government took various measures to lessen the role the informal sector plays in the economy. But these interventions have failed to diminish the informal sector and integrate it into the national recognized economy. The failures carry much more implication than simply that of wiping out the informal economy. It has altered and reduced the impact of any development programs and plans.

The latest measure undertaken to diminish the informal economy is demonization. According to the government, the move is intended to restore macroeconomic balance by reducing the hefty amounts of money circulating in the informal economy. “The significant money circulating outside the banking system, money laundering, and contraband, among others, is threatening the economy,” said Prime Minister Abiy Ahmed (PhD) while announcing the new currency notes. “The currency note replacement will effectively stop the damage.”

Despite the claim, however, experts stress that the task of reducing the role of the informal sector requires understanding its root causes first. “The government is yet to grasp the nature of the problem,” argues Amin Abdella (PhD), Director of the trade and industry department at the Ethiopian Economic Association. “When there is a huge gap between the demand and supply of goods and services, the informal economy thrives. This needs a policy action beyond changing currency notes.”

Inflexible government regulations when granting business permits, land and title deeds, as well as high rural to urban migration can catalyze the informal sector. Yet, in many developing countries, like Ethiopia, that have experienced rapid population growth alongside underdeveloped agriculture and industrialization, the expansion of the informal economy is highly interconnected with the formal economy’s failure to produce enough goods to satisfy the aggregate demand.

When economic growth is not accompanied by enough production to satisfy demand, the informal economy is given a boost, which will capitalize on the supply shortage created. This is why experts stress the limited capacity of the agriculture and manufacturing sectors to produce sufficiently is a major factor behind the expansion of the informal economy. “Government is not in a position to shrink the informal economy and detect the direction of the economy without narrowing the supply-demand gap,” argues Amin.

Government, on the other hand, claims the currency change brought an additional ETB31 billion saving into the banking system as of October 18, 2020. “In the first four weeks since the new currency notes were introduced, one million unbanked Ethiopians opened bank accounts,” pronounced Yinager Dessie (PhD), Governor of the National Bank of Ethiopia (NBE), during a press conference held last month. “We expect more people to join the banking system. An estimated ETB92 billion circulates outside the formal sector.”

However, Mercato, the largest market center for most of the wholesale and retail business conducted in both the formal and informal sectors, remains active even after the central bank’s move to squeeze and pullout money circulating in the informal economy “The government’s policies barely capture the problems, let alone capitalizing on a crisis-induced opportunity,” articulates Demis Chanyalew (PhD), a well published Agricultural Economist.

Contraband is one of the main components of the informal economy falling outside government’s control. It is estimated that close to 90Pct of cross-border trade along borders, is informal. Although information about this unofficial trade is not available in Ethiopia, it is possible to get a glimpse by analyzing contraband items seized by authorities. In 2013/14, ETB270 million worth of illegally smuggled items in border areas was seized, which increased to ETB1.6 billion in the last fiscal year, according to the Ministry of Revenue. In the first quarter of the current fiscal year, contraband items and currencies worth ETB270 million was also confiscated. Although the figure doesn’t show the whole picture, it indicates how large the informal economy is becoming.

Electronics and garments of various types are the dominant items traded illegally in border areas, followed by food items, perfumes, and cosmetics, among others. In 2019, over 30 million contraband phones entered the market, of which 75Pct are smart phones, according to assessment by the Information Communication Technology Association Ethiopia (ICT-ET). Annual demand for cellphone devices averages around 25 million in Ethiopia.

“Most of the contraband phones come from neighbor markets like Kenya and Tanzania, but also from Dubai,” laments Abiy Minwuyelet, Group Chairman at ICT-ET. “Local mobile assemblers face severe foreign currency shortages but contrabandists have no such problem, and thus, can bring in as much as they want. Contrabandists are filling a market we could not.”

Hoarding is another illegal economic activity fueling the informal economy. For example, there are shortages of agricultural commodities in the country and the government imports 1.2 million tons of wheat annually by spending billions of Birr. However, significant portions end up in the hands of illegal operators. Additionally, contraband commodities are smuggled through Bole International Airport. In a single day last year, contraband items worth ETB219 million were seized.

These are some examples attesting to the size of the informal economy and its expanding behavior owing to the shortage of goods in the economy. Although it is difficult to ascertain details of the size and characteristics of the underground economy in Ethiopia, few studies suggest that its size is expanding. The International Monetary Fund (IMF) estimates that in-transition countries like Ethiopia are faced with an underground economy accounting for as high as 40.1Pct of GDP.

According to experts, the root cause of the bulging informal economy, are supply-side shortages. Ethiopia has been investing 36Pct of its GDP over the past decade but without boosting the aggregate output significantly. As a result, Ethiopia’s economy became import-dependent, which constitutes 24Pct of the GDP over the past decade, on average, according to NBE.

“Everything from construction materials to hotel catering services are imported,” explains Amin. “The manufacturing sector is also totally dependent on imported raw materials while agriculture is determined by imported fertilizer, improved inputs, and agricultural tools and machinery.”

Ethiopia’s annual import bill is currently USD15 billion. Out of the total import bill, the majority (33Pct), is spent on capital goods while 28Pct goes towards consumer goods. The remainder addresses fuel, raw materials, and semi-finished goods imports.

The government’s emphasis of the past two decades has been to actively support the export-oriented and labor-intensive sectors. As a result, agricultural demand-led industrialization and export promotion became a key component of its economic policies and strategies. Although the Ethiopian economy has grown by close to 9Pct in the last decade annually, the economic growth has not improved competitiveness nor brought about significant change in the structure of the economy.

Just like three decades ago, the share of the manufacturing sector in GDP at 5.6Pct, while the main export commodities are still agricultural products such as coffee, oilseeds, chat, pulses, and flowers. Exports of manufacturing products continues minimally. Mainly due to the slowdown in the export earnings of goods, merchandise trade deficit inched close to USD12 billion. Currently, export earnings finance only 20Pct of imports, annually.

This shows that the government’s policies don’t address the supply problem. “Ethiopia’s emphasis on export promotion is mainly driven by the need for foreign currency,” argues Fikru Woldetinsae, a renowned Banking Expert. “However, government’s concern should be boosting local production by creating a favorable operating environment for the private sector.”

Even the government’s current moves to privatize major public enterprises is mainly aimed at foreign currency generation. “Privatization generates ample foreign currency for the government, extremely important for the economy,” said Ahmed Shide, Minister of Finance, while presenting his office’s report of the current fiscal year’s first quarter to members of parliament on October 13, 2020.

Michael Raynor, US Ambassador to Ethiopia, echoes the advantage of import substitution for the country. “Producing for the local market is the only win-win solution for Ethiopia,” said Raynor after signing a memorandum of understanding with between USAID and Ethiopian Airlines, on October 16, 2020. “Creating vertical and horizontal value chains with farmers and producers here in Ethiopia is highly advantageous, instead of depending on suppliers abroad.”

Aklilu Abate, Vice President of the Ethiopian Machinery and Spare Parts Producers Association, explains that in many developing, and even developed countries, small and medium enterprises (SMEs) play a crucial role in local production. “Ethiopia is importing what SMEs in China and India produce. On the contrary, SMEs in Ethiopia remain uncompetitive with their higher production costs resultant of labor, tax, customs, logistics, and other operating expenses.”

In addition to high production outlays, the business and investment environment in Ethiopia is not fit. Investing in the agriculture and manufacturing sectors is tiresome. As a result, investors chose to invest in relatively swiftly profitable sectors like import trade, real estate, housing, and construction. “Unless various policy and incentive packages are geared towards the agriculture and manufacturing sectors, Ethiopia will continue to depend on imports to bridge the supply-demand gap,” adds Amin.

Although various foreign companies are coming to operate in Ethiopia following the attractive plug-and-play industrial parks and cheap labor, local sourcing and value chain integration with SMEs and other domestic industries remains inexistent. Instead, foreign firms rely on imported raw materials. “Foreign firms cannot continue their strategy of dumping on us for this long. It has been our own failure,” said Amin.

The reason for Ethiopia’s high dependence on imports is due to the government following an export-led economic growth strategy without having a single competitive advantage at hand, according to experts. “The government ignored import substitution, in which Ethiopia has various competitive edges,” stress Amin.

Finance accessibility by investors in the agriculture and manufacturing fields is the main problem limiting local production. Most of the capital in the country is allocated towards the service sector, specifically import. Import businesses usually benefit at the expense of farmers, manufacturers, and exporters. Out of the ETB556 billion in outstanding loans, the banking industry gave ETB102 billion for international trade and ETB65.4 billion for domestic trade. Agriculture received ETB20.4 billion.

“Banks provide ample finance for importers, because the business is profitable and the high probability of recovering the loan,” explains Amin. “Lending to importers has very low risk for bankers.”

Absence of agricultural and investment banks in Ethiopia is the major bottleneck as existing banks avoid long-term loans. “As an economist who undertakes cost-benefit analyses, I cannot encourage any entrepreneur to invest in agriculture or manufacturing, under the prevailing circumstances,” argues Amin. “Government bemoans investors are not willing to invest in these sectors, but I say they are right to do so.”

Similar to access to credit, foreign currency allocation also favors importers. “It has been long since we planned to establish a large vehicle assembly and spare part manufacturing factory in Ethiopia, in order to reduce imports of aged cars. But we could not access sufficient foreign currency,” says Mohammed Amede, President of the Ethiopian Vehicle Importers Association, which has close to 3,000 members.

Yinager Dessie (PhD), Governor of NBE, says the central bank recently took measures to rectify the problem, however. “Recently, the bank introduced a new directive forcing commercial banks to allocate 45Pct of their foreign currency to investors engaged in manufacturing and agriculture,” Yinager disclosed.

Yohannes Dinkayehu, State Minister for Trade and Industry says the government is revising Ethiopia’s industrial policy, shifting towards import substitution of selected commodities. “As stipulated in the homegrown economic reform, attention will be given to import substitution, by the end of the plan period. We are hopeful the supply side will boost and improve our current account position.”

Although the government is working to substitute some imported items such as wheat by increasing local production, experts stress that import substitution should become an integral part of national economic policy. This is because implementing import substitution in an uncoordinated manner by selecting only a few items will not bring about significant change. “Domestic self-sufficiency can be the sole survival means for the long term,” stresses Amin.

For instance, Ethiopia spends close to USD4 billion importing consumer goods annually. Since the demand for consumer goods is assured with the large and growing population, and their production processes un-sophisticated like intermediate and capital goods, Ethiopia should set targets for the next ten years to substitute significant portions of imported consumer goods by producing locally. EBR


9th Year • Nov 16 – Dec 15 2020 • No. 92

Ashenafi Endale


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