Throwing More Money into the Market A Curse or Blessing for the Ethiopian Economy, Private Sector?

A country’s broad money supply refers to money in its various forms – be it notes, coins, currency deposits or even credit from banks. When the supply is increased, it can have beneficial or disastrous effects, from spurring economic growth to increasing inflation to astronomical levels, which has a deleterious impact on quality of life, especially in developing countries. As Ethiopia aims to continue its path of double-digit economic growth, EBR’s Samson Hailu spoke with economists and government officials to learn more about the debates surrounding broad money supply and where it fits in to the country’s overall development aims.

When members of the International Monetary Fund (IMF) mission visited Addis Ababa in May 2011, they were concerned by the inflation rate, which stood at 29.5Pct a month before their arrival.
Their fears emanated from Ethiopia’s experience in 2008, a year that witnessed the worst inflation in the country’s history. Although the prices of food and non-food items had been rising since 2003, a record high inflation rate, which economists refer as ‘hyperinflation’, was recorded in July 2008. It rose to 49.6Pct, which significantly deteriorated the purchasing power of consumers and disturbed the macroeconomic equilibrium.
To avoid such a catastrophic event, the government agreed to cut broad money growth – one of the variables believed to be a contributor to inflation – to below 20Pct as described by the letter of intent the Ethiopian government sent to the IMF after their discussion.
By the time the IMF mission suggested that the broad money supply only expand within this limit, domestic liquidity as measured by broad money supply stood at ETB145.4 billion. Five years later, however, that figure reached ETB371.2 billion, growing at an average of roughly 30Pct each year.

The Link Between Money Supply, Economic Growth and Inflation
As developing countries start to expand their broad money supply, the relationship between money supply and its impact on variables such as gross domestic product (GDP) growth and inflation are being examined by independent experts, international financial institutions and governments in recent years.
As a result, the importance of the money supply as a guide for the conduct of monetary policy and as a catalyst for economic growth for developing countries has expanded over time. This is because the growth of the money supply is an important factor not only for supporting economic growth but also for the realisation of price stability in the economy. This means if the objective of a given economic policy is to speed up development with stability, there must be a controlled expansion of the money supply.
Alemayehu Geda, Professor of Economics at Addis Ababa University (AAU), says the relationship between money supply and economic growth has received more attention than any other subject in the field of monetary economics in recent years because of two factors: a desire among governments of developing nations to boost the level of credit and to control inflation.
“Credit is part of the money supply, which is reflected on the other side of the balance sheet,” he explains. “If the level of credit has to increase, so does the money supply.” According to Alemayehu, this is evident when the availability of financial resources is one of the main constraints to increase investment in developing countries.
For instance, Ethiopia’s broad money supply reached ETB371.2 billion in 2014/15, a growth of 24.7Pct compared with the previous year mainly due to a 31.3Pct surge in domestic credit, according to a report published by the National Bank of Ethiopia (NBE) last year. The high growth of domestic credit was attributed to a 32.8Pct increase in credit to the private sector and 14.1Pct growth in credit to the central government.
According to the Regional Economic Outlook published by the IMF, Ethiopia ranked fifth in terms of broad money supply growth among sub-Saharan African countries in 2015. Although the average broad money supply growth for these countries was 19.6Pct of GDP, Ethiopia’s figure stood at 24.2Pct.
Despite its influence on economic growth and inflation, the definition of ‘money’ is sometimes difficult to apprehend. This is because providing a uniform definition for policy purposes is still a major issue to be addressed by monetary theorists.
One school of thought stresses the role of money as a medium of exchange, thus defining money supply as currency held by the non-bank public plus the private demand deposits of commercial banks. However, Karl Brunner, a Swiss economist, and Allen Meltzer, an American economist, define money in terms of its “functions”. Therefore, the money supply is defined as currency held by the non-bank public plus the private deposits of saving institutions. This narrowly defined money supply is referred to as M1.
Milton Friedman, an American economist who received the prestigious 1976 Nobel Memorial Prize in Economic Sciences for his research on consumption analysis, on the other hand, stresses the empirical functioning of money, where assets that serve as a temporary reservoir of purchasing power should also be regarded as partial money supply. The definition of ‘money supply’ then becomes currency held by the non-bank public plus private demand deposits plus time deposits. This broader definition, which is the one the NBE uses, is referred to as M2.
Haile Kibret, (PhD) Director of Research at the Horn Economic and Social Policy Institute and Professor of Macroeconomics at AAU, says that there are three ways that the government can increase the money supply in the economy. According to Haile, the first way of increasing money supply is by borrowing from the local market while the second revolves around making use of external sources to access money. The third method to raise the money supply is by printing new notes.
Experts note that because the monetary supply through these methods may affect growth through its impact on investment, changes in domestic credit or money is likely to affect output through investment. In fact, a recent study conducted by the World Bank indicates that a 10Pct reduction in the growth rate of domestic credit or money supply leads, on average, to an almost 1Pct reduction in the growth rate of output over one year in developing countries.
Although many studies suggest that aggregate money supply is positively related to development, economists like Haile argue that the impact of the money supply on economic growth mainly depends on the sectors on which the money is spent. “In Ethiopia, the increasing money supply is being invested on infrastructure and the manufacturing sector,” Haile told EBR. “Investing in both can have different results.”
Haile sees investment in the manufacturing sector as a positive catalyst for economic growth since it will have a direct effect on employment, productivity and increased output.
Within the last few years, Ethiopia’s economy grew by double-digit rates utilising an expenditure policy that allocates resources to build economic and social infrastructure and provide basic services with the aim of eradicating poverty and achieving rapid economic development.
Despite this growth, Haile stresses that investing in infrastructure is complicated. “Although expanding infrastructure can be good for the economy, when too much money is spent on different projects it might have a negative result,” he argues. “This is because the return on investment of huge infrastructure projects takes a longer time [to attain], which increases the direct and opportunity cost for the economy.”
However, Yohannes Ayalew, Vice Governor of Monetary Stability at the NBE, says the country is investing in different infrastructure projects in a responsible manner. “Money will only be spent on projects that undergo different studies to check their significance to the economy,” he stresses. “Although they are necessary, there are many projects that are not launched just to keep the balance.”
Alemayehu, on the other hand, says under the current circumstances, the government should prioritise their investments. “This is necessary to get the best out of the invested money.”
It is not only the level of growth that will be affected by the type of investment – there will also be implications for the achievement of price stability in the economy. This is because the healthy growth of an economy requires that there be neither inflation nor deflation, although inflation is the greatest headache for a developing economy.
Haile says that in the long run, massive money supply growth undoubtedly leads to inflation although its short-term impact depends on the methods the government employs to boost money supply. “Borrowing from the local market is the safest way of increasing money supply because there will not be additional money in the economy that wasn’t there before,” Haile explains. “Borrowing from external sources and printing money have a tendency to exacerbate inflation although the latter is the worst.”
In addition to these, Haile says the status of the economy also determines whether any growth in money supply leads to inflation. “If the economy is already matured and increasing production is no longer possible, even minor money supply growth can increase prices,” he notes. “But in an economy like Ethiopia, where resources like productive labour are idle, reasonable money supply growth leads to productivity.”
Although Yohannes is concerned that any increase in money supply might be a factor for price increase in an economy like Ethiopia’s, where many individuals are self-employed, he agrees with Haile’s assessment. “For a developing country like Ethiopia, money supply growth could have a positive effect on the economy,” Yohannes told EBR.
However, Demeke Abate, Director of the Fiscal Policy Directorate at the Ministry of Finance and Economic Cooperation, has a different perspective. “Broad money supply is nominal. The real GDP growth should be converted to the nominal GDP growth in order to have a clear picture about the broad money supply in Ethiopia,” he explains. “Based on this analysis, the growth rate of nominal GDP is almost equal to the growth rate of the money supply. So, the inflationary pressure in this case is minimal or insignificant.”
Demeke argues that the money supply in the market should go in line with the country’s rate of economic growth to support transactions. “When it goes beyond that rate, it will result in inflation,” he says. “To reduce poverty, the only alternative is to invest in the basic sectors that are focused on human resource development, such as education, health and infrastructure. In this regard the government is on the right track.”
Certainly, the consumer price index, which is compiled by the Central Statistical Agency, shows that the yearly average inflation rate decreased from 18Pct in 2010/11 to 7.6Pct in 2014/15. But starting in April 2016, the monthly inflation rate began to surpass the single-digit mark.
Alemayehu, on the other hand, argues the growth of money supply has two inflationary implications. “The direct implication of increased money supply is that it will lead to inflation, particularly if the agricultural sector’s growth is lagging behind,” he explains. “Since a good part of raw materials that are purchased by the money supplied by the government are imported, it will bring about pressure on exchange rates by causing depreciation of the local currency, which in turn puts pressure on inflation.”
He notes that even the money supply figure that the government prints through NBE reports understates the total money supply because money that is lent to microfinance institutions and funds disbursed by the Development Bank of Ethiopia (DBE) are not included. “If you include that, the money supply and its growth will be much larger,” Alemayehu argues.
Data obtained from the Micro and Small Enterprises Development Agency reveals that in 2014/15 alone, close to ETB6.5 billion was disbursed to 271,579 enterprises, demonstrating a 29.2Pct increment compared to the previous fiscal year. In addition to that, the DBE provided credit worth ETB4.1 billion last year. The money that was injected into the market by the two government institutions increases last fiscal year’s money supply by 2.6Pct, to ETB381.8 billion.
However, Demeke stresses that the government’s budget deficit is less than 3Pct of GDP. “Under this circumstance, the growth of money supply doesn’t have inflationary pressure,” he argues. “The government budget is also structured in a way that 60Pct of the money is to be spent on projects as capital budget, which have returns.”
Demeke’s analysis seems appropriate for developing nations like Ethiopia, which face inadequate resources in their initial stages of development and increase the money supply to finance budget deficits. Different development studies also support the argument that the growth of money supply to finance budget deficit may stimulate investment by raising profit expectations and extracting forced savings.
But in this case, runaway inflation will be detrimental to economic growth; therefore economists argue it has to be kept within safe limits. Haile recalls the period in 2008 when the overall inflation rate reached an all-time high, which drowned the purchasing power of citizens when the government increased money supply to assert it should be kept within proper limits to decrease its inflationary pressure and accelerate economic growth.

The Effect of Monetary Policy on the Private Sector
The IMF projects Ethiopia to grow 8Pct in the 2015/16 fiscal year. In a statement the Fund issued last year, it said “Ethiopia’s state-led development model has delivered rapid and broad-based growth over many years. The country has also reduced poverty significantly, while keeping inequality low. The outlook for Ethiopia remains highly favourable….” However, the IMF is concerned the credit growth to state-owned enterprises might crowd out the private sector.
The World Bank, in its 4th Ethiopia Economic Update report published last year, echoes the same concern. According to the report, public investments accounted for more than half of GDP growth. Public investment contributed 56Pct to total GDP growth in 2013/14 while private investment growth contributed 24Pct to overall growth.
Based on these findings, experts challenge the figure the central bank is reporting, which gives a bigger slice of the pie to the private sector. “If the majority of the credit goes to the private sector, it should be that sector that contributes more than half of GDP growth,” says a macroeconomist who worked for the government and now manages an independent consultation business, and who spoke to EBR on the condition of anonymity. “This shows how the financial and banking sectors are failing to fulfil the demands of the private sector.”
For years, Ethiopia’s financial system remained relatively underdeveloped because of deficient financial intermediation and a lack of financial inclusion, which the economy requires for sustained growth. But recently, the recapitalisation in the banking sector resulted in increased bank branches and innovations of new products and technology.
In principle, the development of the financial sector, coupled with the growth of money supply, will improve access to credit for the private sector. This is because when government increases the supply of money to banks, they will lower the lending interest rates in order to encourage people and firms to borrow more. More individuals and firms will borrow money, thus boosting the aggregate demand and the output of the economy.
But in Ethiopia, this isn’t the reality. According to the NBE’s annual reports, the average lending rate stood at 11.88Pct In 2010/11, a figure that stayed the same in 2014/15. “This implies either the private sector demand is increasing, which offsets the growth of money supply or the money is not channelled to the private sector appropriately,” notes the macroeconomist.
Ephrem Mekuria, Communications Manager at the state-owned Commercial Bank of Ethiopia (CBE), says even though the CBE increased its capacity, the Bank still could not accommodate all the credit requests. “The demand for credit increased significantly in recent years,” Ephrem told EBR. “This is why we only provide credit for priority sectors first.”
Haile says the crowding out of the private sector further exacerbates this reality because the government began to borrow from the local market. “Government takes a portion of money from private banks to finance its projects,” he explains. “This limits the money that could go to the private sector.”
This lending restriction was imposed on private banks, which are required to allocate 27Pct of their loan disbursements to purchase fixed and low interest-bearing NBE Bills. According to private commercial banks, this directive has had a negative impact on their liquidity and lending capacity and they are therefore not able to lend as much as they want.
The central bank introduced the NBE Bill in April 4, 2011 in order to mobilise resources from private banks to finance priority sectors identified by the government as key for long-term growth of the economy. Since its introduction until the end June 2015, NBE bills amounting to ETB37.4 billion were sold to the banking sector.
Although a momentary solution was provided by the central bank by lowering the reserve requirement down from 10Pct to 5Pct and the liquidity requirement from 25Pct to 20Pct, the liquidity problem that started in 2011 still appears to still be an issue for private banks.
Alemayehu’s advice is for the government to work with the private sector, which can bring sustainable development. “The government shouldn’t operate alone,” he argues. Haile, on the other hand, says that it is critical to make sure that the private sector receives a major portion of the money supply that is currently growing. EBR

4th Year • June 16 2016 – July 15 2016 • No. 40