“The Private Sector is not Bold Enough to Set up Specialized Banks.”

Fikadu Digafe is Chief Economist and Vice Governor of the National Bank of Ethiopia (NBE). He strides in the most laboring job in the central bank ever since the bank started baptizing itself with reforms ensuing the landslide reshuffle of October 2019. He was previously in charge of external economic analysis and international relations at the bank. For many years, Fikadu has been engaged in the research works of the central bank, including scripting for the quarterly bulletin of the bank, Birritu. As per his current position, Fikadu is central to many of the ongoings of the central bank and its policies shaping the banking industry and economy as a whole. With this responsibility, he looks to steer in turbulent waters disturbed by the pandemic, inflation, and distressing state-owned enterprises’ debt. In its caretaking role, NBE has enacted moves to strengthen the position of banks, root out illegal business activities with digitization, and foster strong but not excessive competition. The expected stock market and liberalization of exchange and interest rates further down the road are also a call for thought.

The central bank has undertaken a number of swift measures over the last six months including currency redemption and cash and transaction limits. Its latest move of raising banks’ minimum paid up capital from ETB500 million to ETB5 billion has become an existential threat to small and newly-forming banks. However, Fikadu says the objective of the directive is to rather create sound banks faced by an enlarged demand for credit as economic plans are getting bigger. He reflects on a range of issues raised by EBR. The following are excerpts.

What is the general objective of the latest augmentation to the minimum paid-up capital threshold?
As NBE is working on the implementation of a modern risk-based capital adequacy ratio prudential supervision, a bank with a low level of capital will not fulfill the required level of soundness indicators. Hence, increasing the minimum capital to be met over time is a vital and timely decision.

The government has recently launched the Ten-Year Perspective Plan where the level of the banking sector has been clearly indicated level by level with GDP-related indicators. This means financial markers like credit to GDP and deposit to GDP ratios must be significantly increased from today’s levels so that the projected significant growth in GDP will accordingly be supported by financial sector development. Therefore, the minimum paid-up capital for newly entering and existing banks shall be improved upward to meet prudent GDP ratios.

Apart from buffering banks’ lending capacities, financial inclusion should be part of the capital raising objective. The effort to make few giant banks, a causation of the new directive, ignores the importance of small banks. Global experience shows that few giant banks serve few big businesses, while the mass of small banks serve rural areas and SMEs. Is the aim to make relatively giant banks? Why does NBE consider them all as commercial banks without categorizing them according to specialization and set varying parameters conferring upon their sectoral performances?
Increasing the minimum capital to set up a new bank does not negatively affect the enhancement of financial inclusion. Is not a must to have many small banks. What is rather important is having strong banks that can invest in various technologies to reach every corner of the country through digital and physical means. We therefore cannot view this directive as discouraging financial inclusion. The objective is not to create few giant banks, but rather banks that can resist risk as measured from various points of view. Had the objective been the creation of few giant banks, NBE would not allot a five- and seven-year grace period in addition to the six months for under-establishment banks to meet the current threshold. All this is witness that the main objective is not to create few giants.

The argument that small banks serve rural areas contrary to big banks is a generalization. As long as there is enough competition amongst banks supported by digitalization efforts, there will be enough attention from banks to the rural areas in due time. Rural areas and small businesses are not properly served not because of the size of banks but rather because of the lack of adequate collateral. Having big banks with adequate capital can help them invest in project appraisal and enabling technology so that they lend to viable projects without collateral. We also have many microfinance institutions serving rural communities and small businesses. They are filling the gaps.

It is not NBE that categorizes all banks as commercial banks. NBE cannot control the type of banks the business community is setting up. Thus far, due to various unidentified reasons, almost all existing banks, including under-formation ones, are commercial with the one exception being Goh Betoch Bank. Therefore, the private sector needs to be looked at as to why specialized banks are not being set up, not NBE that will amiably welcome this.

The increased competition between banks could move them to lend to higher interest paying businesses. Won’t this result in the exclusion of farmers, manufacturers, and SMEs?
The existing banks are already serving very few sectors and especially cater to traders. Increasing the minimum capital will not further the problem of unfair sectoral distribution. One of the reasons for the concentration on few sectors and thus inability of serving risky areas is banks’ low capitalization. Enhancing banks’ capital will not necessarily hold them from serving disadvantaged sectors. To the contrary, it will increase the sectoral coverage of banking services through investment in digitalization and project analysis by the banks.

Since last year, NBE has been encouraging the establishment of new banks. Why abruptly tighten the entry barrier now?
NBE does not discourage or encourage the establishment of banks. What is important from NBE’s standpoint is having a prudent and developed banking sector that can fairly serve all economic sectors. Increasing the minimum capital requirement might reduce the number of banks but it will not negatively affect how the economy is serviced by the sector. It is important to have banks that can resist systemic risk and be efficient. This is attainable by having economies of scale via large strong banks.

What is the outcome of demonetization, in terms of reducing cash outside the banking system, boosting banks’ liquidity, improving credit disbursement, and mitigating the informal economy?
The government undertook the demonetization measure in September 2020 mainly aiming to bring currency circulating in informal economies into formal systems. Additionally, the move is believed to have increased financial inclusion in the country, improved banks’ liquidity levels, and discouraged illegal money transfers and transactions, amongst others.

Our assessment shows that the measure has produced the intended objectives on relative terms. The ETB107.4 billion outside of banks just a month prior to the change of legal tender, shrank to ETB64.7 billion in just one month. Further, 7 million new accounts brought in more than ETB106.6 billion in fresh deposits as of the end of February 2021. As a result, commercial banks’ liquidity levels have shown a significant improvement. Their improved position in this regard has led to bettered loan disbursements. During the first six months of FY 2020/21, banks loaned ETB155.4 billion, a growth of 43.4Pct to the previous year’s corresponding period.

NBE’s recent measures tightening cash withdrawal and holding thresholds, as well as transaction frequencies are criticized by cash-dependent businesses, including wholesalers, contractors, and agricultural commodity suppliers. Cash is restrained without availing sufficient alternatives, including digital ones. Businesses are holding cash in hand rather than in banks, mainly because they cannot sufficiently access their own cash. Many say this will create a liquidity crunch in the long run. Do you think NBE considered such outcomes when introducing limiting directives?
We understand the importance of cash in our cash-based economy more than anyone. However, given the drawbacks of cash as a dominant payment instrument, NBE aspires to move our economy away from relying heavily on cash. There are a lot of inefficiencies arising from this condition. Cash-based transactions also open doors for illegal activities, tax evasion, low levels of financial inclusion, etc. Thus, the national bank, in collaboration with other stakeholders, is working to modernize the country’s payment systems.

The directives enacted by NBE to authorize and license technology providers to issue payment instruments as well as operate payment systems are good examples of NBE’s efforts to digitalize the field. Thus, in addition to providing alternative payment instruments, NBE believes that cash-based transactions should be discouraged as a payment system, and this requires policy intervention.

Before issuing the directives limiting daily cash withdrawals and in hand, as well as weekly account to multiple account transfers, we have critically analyzed the potential impacts. The measures are being implemented because the positive impacts outweigh the negatives on the economy. The main objective is to tackle illegal money transfers that have especially fueled foreign exchange parallel market premiums and illegal business activities. There are several coping mechanisms to the limitations where legal and established businesses are given special treatment at banks’ discretion without conferring with NBE. For example, coffee traders, live animal traders, government institutions, diplomatic communities, NGOs, and other established legal organizations and companies who can prove their source of income can be treated differently.

We aim to target illegal actors and serve legal businesses. Thus, even though there will be temporary side-effects, medium- to long-term upshots of the policies are very important as a nation. We knew demonizization would not be a permanent solution. These actions, however, will be proper remedies.

Inflation is currently in the double-digit zone. What is NBE doing to control inflation?
In most cases, inflation is again the result of supply and demand side factors as well as exogenous shocks or the combination of these factors. There is empirical evidence that inflation in Ethiopia ensues from a combination of demand-supply factors as well as occasionally occurring shocks. As a mandate, led by stable inflation, NBE is responsible to maintain macroeconomic stability, which is specifically insuring single digit inflation. However, NBE’s role is limited to controlling only the demand side factors whereas inflation is caused by both supply side factors and demand management, which we effect by controlling the amount of money in circulation. The less money is in circulation, the less demand there is for products, and thus the lesser inflation will be.

Towards this, we have planned a very tight monetary policy stance measured by base money growth in 2020/21 relative to more than 22Pct expansion in 2019/20. Base money expansion is in turn affected by direct advances to finance budget deficits, among others. In this regard, the government has already started financing its budget deficit through market-based treasury bills since December 2019. Therefore, there will traditionally be the lowest direct advance to the government from NBE in 2020/21. Still, however, supply side constraints and exogenous shocks have considerable roles in fueling inflation in Ethiopia.

What measures is NBE taking to overcome increasing non-performing loans (NPL) resultant of the COVID-19 pandemic?
Since the first case of COVID-19 was discovered in Ethiopia in early March 2020, there was no evidence of declining loan repayments for the sector as a whole compared to similar months in 2018/19. Assuming current trends continue, we can be optimistic about the banking sector in 2020/21, albeit the impact of the pandemic shall not be undermined.

How effective are the 25Pct and 2Pct, respectively, banks are mandated to allocate for branch expansion and human capital development?
Regarding the 2Pct for human capital development, financial institutions were doing very well before COVID-19 broke out and affected training activities. With regards to the 25Pct for new branches, however, we need to make an assessment and see the data. Bank branches grew to over 6,500 in a decade.

Do you think NBE is discharging its duties duly to control capital flight?
There are various causes for capital flight, including macroeconomic imbalances, where we see a big gap between forex demand and supply. Capital flight will be the result of export under-invoicing and import over-invoicing where exporters and importers try to divert the forex from formal channels. The very reason for these actors to engage in this diversion is the big gap between supply and demand for forex that, in turn, increases the premium between official and parallel exchange rates.

NBE has tried to control capital flight through stringent forex directives. But as long as there is a huge gap between demand and supply, our efforts might not be sufficient. Capital flight might also result from corruption. Here, closing the gap cannot be a solution and hence political commitment is required rather than policies. NBE has several directives governing various activities involving forex, yet we are not in a good position to control capital flight due to the fact that it is resultant of a mismatch between supply and demand for foreign exchange.

Is there a magic bullet to improve Ethiopia’s export performance? How do you evaluate the real impact of devaluation on exports? How can it shift the economic balance to tilt from demand to supply?
Devaluing nominal currency is one of the recommended remedies to encourage export earnings, it at least theoretically improves the current account position. The assumption is that currency devaluation makes local goods cheaper in the international market and imported goods more expensive locally, correspondingly affecting their demand.

To make exports cheaper and attract local-made demand—intended objectives of currency devaluation—two important issues must be evaluated. First, as the quality of goods will affect demand and not only relative price, improving this quality shall be a foremost issue. Second, there must be surplus production available for export in order to benefit from devaluation measures and meet the expected demand from abroad. In both cases, there aren’t sufficient efforts.

In the case of making imports more expensive locally, there is no probability of stopping imports despite price increases as there are always necessary imports like capital goods, fuel, and medicine amongst others. This makes Ethiopia a net importer where imports are price inelastic. As a result, exchange rate increases pass on to domestic prices, overvalue the real exchange rate, and affect the nation’s competitiveness the other way around. Therefore, as long as we are a net importer—due in part to poor import substitution schemes and structural bottlenecks to increase production—lacking productivity, quality of goods, and horizontal and vertical diversification, devaluation alone will not enhance export earnings and improve the current account situation. In the Home Grown Economic Reform Program (HGERP), import substitution, export diversification, production and productivity enhancements, logistics, and the general business environment will be significantly improved towards the supply side. On the demand side, prudent monetary and fiscal policies will be in place. Then, real exchange rate overvaluation is expected to be improved.

Therefore, by the end of the HGERP and beyond, there is hope that both supply and demand side factors will improve exports. This will be combined with reduced imports via import substitution schemes. To sum up, currency devaluation alone has never been successful enough to boost exports and will never be successful unless otherwise supported by effective demand-side management and supply-side improvements.

What are NBE’s major targets in the Ten-Year Perspective Plan (TYPP)? What is the economic model?
NBE’s target will be to modernize its monetary policy formulation using more indirect monetary policy instruments to create a stable macroeconomic environment; develop financial markets for efficient resource allocation through market-based interest rates and exchange rate policies; and digitalize the financial sector to enhance ease and outreach. On a specific case, improving financial sector development, measured by private sector credit to GDP ratio, will be our key target. We aim to at least increase it to levels of the current Sub-Sahara African average, from its lowest point of 16Pct in June 2020.

The economic model might be private sector led albeit government’s participation in key sectors in collaboration with the private sector through Public Private Partnerships (PPPs) will be an important step.

Currently, the government is restructuring state-owned enterprises’ (SOEs) distressed debt. This means SOEs will need more finance in the coming years. What will be the impact on the financial sector, particularly NBE and the Commercial Bank of Ethiopia (CBE)?
In the Growth and Transformation Plan (GTP) editions one and two, SOEs’ mega projects were expected to be financed by CBE through long-term bonds issued by the institutions. As most of the mega projects were expected to be operational on schedule, no downside effects were anticipated on CBE. However, almost all mega projects are not finalized on time and expected revenues have not been realized while both external and local debt repayments are maturing. As a result, CBE’s asset quality has been put under the question mark. Therefore, improving CBE’s asset quality has been one of the comprehensive HGERP moves targeted through restructuring SOEs’ debt, among other schemes. In this case, an assessment has been done with help from World Bank experts and its implementation will be in place from 2020/21 onwards. This, without doubt, will improve CBE’s asset quality.

What is the secret behind the Ethiopian banking industry remaining highly profitable?
Banking sector profitability might be on account of various factors including economic growth creating demand for financial services, relatively less competition, resilient supervision from the central bank, and the good internal operations of the banks, amongst others.

Government is pledging to avail sufficient space to the private sector by reducing the state’s hand in the economy and shifting from the past developmental state regime to a market-led economy. What is in store for the private sector in terms of accessing more finance and becoming internationally competitive?
This issue is properly addressed in the HGERP as well as in the recently introduced TYPP. We have already embarked on this broad objective of enhancing the role of the private sector by repealing the mandatory 27Pct NBE bill purchase in November 2019. Efforts underway to improve CBE’s asset quality are also part of reducing state enterprise financing to increase the bank’s role in lending to the private sector. The role of the government will be to limit possible market failures in a manner that will not create governmental failure as was the case under GTP I and II. The other major arrangement in our economic program is the enhancement of PPPs, especially in key areas like energy.

Currently, a number of new banks are under formation. Will this pressure NBE to extend the timing of the opening-up of the financial sector? Is liberalization or privatization better for Ethiopia? NBE encourages banks to merge and form larger banks with the new directive raising the minimum paid-up capital ten-fold a move in this direction. Still, the number of banks is expected to blossom. Will this affect the growth of banks?
The number of domestic banks might not have a direct relationship with the timing of the opening-up of the sector to foreign investors. Currently, there are 18 banks, including DBE, to service about 110 million people. One branch is serving about 17,000 people as of June 2020. In this case, the oncoming of additional banks might not be excessive for such a large population. Kenya, with a population half of Ethiopia’s, has about 42 banks.

Regarding liberalization or privatization for Ethiopia, state-owned banks must be strengthened to compete with private banks instead of being privatized. Countries’ experience reveals that having strong domestic banks is a pre-condition for the invitation of foreign banks. In this case, merging banks to create relatively big banks will be one of the preconditions for the opening up, albeit it is not a must as there will be chances for individual banks to be large enough own their own. As the merging of banks might not be affected by their number, a high growth in the number of banks in the near future might not necessarily be a down-side consequence. A larger number of banks might affect the forbearance of implementing merging activities, however.

NBE recently disclosed it will liberalize the exchange rate regime as well as interest rates. What will be the exact prevailing exchange rate model after three years? Are NBE and the economy ready for floating? What will be the impact on banks and imports?
Currently, NBE’s exchange rate policy is a managed floating regime where daily inter-bank exchange rates are decided by NBE. The plan is to have exchange rates settled by demand and supply factors instead of directly by NBE. Thus, a market clearing exchange rate regime will be implemented by the end of the HGERP. In that case, the role of NBE will be to signal the market rate through foreign exchange interventions done by increasing or decreasing foreign exchange holdings based on the situation on the ground.

Regarding the readiness to implement a floated exchange rate, the answer will be ‘no’ as of today, but if the preconditions indicated in the HGERP and other reform agendas are properly implemented, there will be no reason to fear a floating exchange rate. Preconditions include improvement of NBE’s international reserve levels; employment of prudent monetary and fiscal policies; reduction of structural bottlenecks to boost export; and the substitution of key import items like wheat, edible oil, and sugar amongst others.

Regarding market-cleared interest rates, the key factors are a modern monetary policy formulation using more indirect monetary policy instruments and the development of capital markets. Currently, NBE’s nominal anchor is base money growth i.e., we use operational quantitative target. We are working on modernizing the monetary policy framework where shifting our nominal anchor to interest rates is the key reform agenda. This will be supported by the introduction of effective liquidity forecasting, inter-bank money market development, and capital market development in general. To have a market-cleared interest rate, there shall be effective monetary policy transmission mechanisms where a change in the policy or discount rate will affect the inter-bank rate, treasury bill rate, and term loan rate. These in turn influence the ultimate target which is inflation.

Government also envisages opening a secondary market in the near future. What kind of secondary market will there be and what are the preparations underway?
Currently, a study has been finalized and sequentially presented to the bank’s management and board of directors. The reform has three phases where developing a money market, capital market, and corporate bond market are to accordingly be in place. A secondary market will also be developed for securities and shares/ equities. EBR

9th Year • Apr 16 – May 15 2021 • No. 97