The Ethiopian government has recently decided to open the country’s banking sector to foreign investors with the aim of modernizing the industry and improving its global competitiveness. The decision also seeks to achieve other broader economic goals: to enhance further the role of the banking and the finance sector in the economy and to make the industry more effective, efficient, and results-oriented.
This article examines the merits and demerits of the government’s decision to liberalize the banking sector with the participation of foreign banks. By drawing lessons from other countries, the article provides alternative and forward-looking perspectives and recommendations.
The IMF, along with other commentators, including major development partners, has for years encouraged Ethiopia to liberalize the financial sector, arguing that such actions will make the banking and financial sector dynamic, internationally competitive, efficient, and innovative.
In contrast, this article takes a more cautious approach and argues that these laudable objectives could be achieved without necessarily engaging in complete liberalization of the sector (with the participation of foreign banks). In fact, a more pragmatic and strategic approach is needed to introduce a gradual and carefully sequenced liberalization of the sector while ensuring that these reforms are accompanied by an appropriate regulatory mechanism and the institutions to manage it.
Realistically, the country’s current macroeconomic, regulatory, institutional, and political environments do not support full financial sector liberalization and deregulation.
The key argument of this article is that, at this moment, what Ethiopia needs is not foreign banks but new-generation domestic banks. The ultimate objective of the article is to encourage a serious debate on the perceived benefits of financial liberalization and contribute to the country’s policy-making processes on the subject.
Banking and financial liberalization: the global context
A modern, dynamic, efficient, and competitive banking and financial sector is vital for mobilizing and channeling much-needed investments into an economy. The banking and financial sectors also play a crucial role in facilitating efficient and productive allocation and use of scarce resources in structural economic transformation, with governments playing a central role.
For developing countries and governments, the “liberalization” and “deregulation” of banking and financial services are linked to commitments under the Multilateral Trading System (MTS), which is overseen by the World Trade Organization (WTO). The General Agreement on Trade in Services (GATS) of the WTO is the only agreement that recognizes the primacy of government regulations over market forces (demand and supply) and the private sector (privatization) in banking and financial sector liberalization.
As such, the Agreement allows governments to intervene for “prudential reasons” vigorously. Unlike the General Agreement on Trade and Tariffs (GATT), GATS also permits governments to continue owning banks, be primary borrowers, and intervene to regulate “free financial markets” when necessary. This means that countries that are members of the WTO can liberalize their banking and financial sectors without necessarily inviting foreign banks’ participation in such a vital and strategic sector.
These provisions recognize that market forces alone are insufficient to determine “optimal real interest rates” as foreseen in the liberalization mantra, which assumes that such interest rates can increase financial resources available in the banking and financial services sectors.
Ethiopia is not yet a full member of the WTO. It has had observer status since 1997, with a Working Party established in 2003 to oversee the proceedings of Ethiopia’s accession negotiations and processes. Hence, given the status quo, the question is: why has Ethiopia taken unilateral or autonomous steps while it has no obligation to do so under the multilateral agreement governing trade in services (GATS)?
Available evidence shows that countries in the process of WTO accession, such as Ethiopia, can benefit more if they accept liberalization commitments through multilateral negotiations rather than unilateral or autonomous liberalization. Some of the benefits include (but are not limited to): learning from early adopters of GATS and upgrading or modernizing the banking and financial services sector; developing appropriate policies, rules, and regulations; and establishing institutions with supervisory and monitoring functions.
Accepting commitments through multilateral negotiations also accords newly acceding countries special and differential treatments (S&DTs) contained in the GATS, including robust and targeted technical and financial assistance. This is partly because unilateral liberalization tends to limit countries’ capacity to effectively implement commitments and forego some of the benefits built into the agreement when formally joining the WTO and accepting obligations under multilateral trade agreements.
In short, Ethiopia’s decision to unilaterally liberalize its banking and financial sector seems premature and untimely, and it may lead the country to a significant loss of potential benefits from its eventual WTO accession. Ethiopia may also be forced to incur high economic costs to fully implement or comply with WTO agreements, including GATS, when it finally joins the organization.
Such costs may include foregone benefits (or opportunities) from using S&DTs granted to LDCs and developing countries, as well as financial outlays related to developing new rules and regulations and establishing new institutions. Further costs can also include financial resources needed to build domestic technical and human resource capacities to effectively implement multilateral agreements such as GATS.
Sequence matters: Ethiopia’s financial liberalization policy is mistimed
Leaving aside multilateral trading systems or GATS provisions, Ethiopia’s decision to allow the entry of foreign banks seems premature, costly, and mistimed. Banking and financial sector liberalization efforts (with the entry of foreign banks) tend to be effective if they are preceded by mutually reinforcing and well-sequenced policy actions.
Some of these measures include (but are not limited to) putting in place effective rules and regulations; beefing-up monitoring and supervisory capacities; gradual, phased, and transactional capital account liberalization or removal of controls on international capital flows; abolition of explicit control on the pricing and allocation of credits; adoption of market-based real interest rates on loans and deposits; and the introduction of floating exchange rate regimes.
The gradual elimination of preferential credits and loans that favor selected sectors or business activities; the reduction of state revenues from the taxation of banking and financial services; the expansion of credit to the private sector; the integration of formal and parallel markets for foreign currency; and putting in place an equilibrium exchange rate regime with an open capital account, are also measures that can be reinforced.
At the current state of the Ethiopian economy and given the systemic weakness in the country’s banking and financial regulations and institutions, I do not think that these reforms could effectively accompany the entry of foreign banks into the Ethiopian banking and financial sector with any tangible socioeconomic gains for the country.
Moreover, internationalization of the financial and banking sectors raises expectations for national governments to take at least three measures or actions that can have serious policy and political implications for countries such as Ethiopia.
These are granting rights to domestic residents to hold foreign financial assets, including domestic firms to undertake external commercial borrowing; permitting foreign residents and banks to hold domestic financial assets; and allowing foreign currency assets to be freely held and traded within the domestic economy.
In a situation of weak supervisory (monitoring) and regulatory mechanisms as well as institutions, these changes in financial and banking operations can severely curtail the role of governments in formulating and implementing monetary, financial, and banking policies.
A situation like this can have disastrous consequences for a government’s ability to maintain a stable macroeconomic environment and generate resources for its development priorities and social policy goals. Even in highly advanced developing economies such as China, financial liberalization remains gradual and sequenced with “selective controls” and “strategic dialogues” with leading trading and development partners.
Since Ethiopia has done none of these, the proposed liberalization efforts seem mistimed or premature and are likely to cost the economy dearly. As evidence from the past attests, the 1997–1998 Asian and Russian financial crises, the 2008–2009 global financial and economic crises, and the 2018 Turkish financial crisis coincided with financial sector liberalization and the removal of regulations. And there is no guarantee that Ethiopia may not follow a similar path.
Not just sequencing and content, but context matters
Indefinite protection (monopoly) of the banking and financial sector is not a viable option, particularly in the long run. However, liberalization of the sector is not a panacea either for the problems and challenges facing the sector, particularly in developing countries such as Ethiopia. That is, for any financial liberalization to succeed, such policies need to be implemented in favorable macroeconomic, social, political, and institutional settings.
The current macroeconomic environment of Ethiopia is less sound or opportune. The banking and financial sectors are characterized by age-old protectionist and restrictive policies. Ethiopia’s gradual opening of the sectors to domestic investors is new, even by the standards of African countries such as Kenya, Nigeria, or Uganda.
The banking and financial sectors of the country have also been overburdened by low or negative real interest rates, excessive demand for credit, wide variation between parallel and official markets for foreign currency, skewed credit system (in favor of state-owned enterprises and public investments), proliferation and suffocation of “ethnic” banking services, high “broad money” to GDP ratio, excessive fiscal deficits, debt distress, and galloping inflation.
The country’s inflationary pressure seems to have reached a point of no return, and its public debts surpass sustainable levels. Likewise, Ethiopia’s increasing fiscal deficits (primarily due to the ongoing war) and the widening gap between parallel and official markets for foreign currency have reached inflection points.
Moreover, Ethiopia suffers from systemic corruption and glaring misuse of public (financial) resources. Added to this are socio-economic challenges and the protracted regional and interethnic wars and conflicts, which have weakened the government’s economic policy formulation and implementation capacities.
In such an adverse or unpredictable environment, banking and financial sector liberalization and the participation of profit-seeking foreign banks can aggravate the country’s economic difficulties and challenges. Peace, political stability, institutions, sound economic policies, and banking practices are the foundation for structural economic transformation, inclusive growth, and sustainable development.
The cost of mistiming and ignoring context
There is no agreement among economists, financial experts, and researchers as to the effect (impact) of banking and financial sector liberalization. However, most recent research and policy analysis findings, including those by the United Nations entities and notable academics, reveal that there is an emerging consensus on several areas.
First, developed and developing economies respond differently to financial liberalization. That is, while developed economies in general enjoy the positive impacts of financial liberalization, such as increases in employment, output, and associated efficiency gains, developing economies suffer from liberalization-induced excessive risk-taking, increased macroeconomic volatility, loss of financial autonomy, frequent crises, and systemic or structural macroeconomic instability.
Second, with free capital flows and open capital accounts, including unrestricted access to external borrowing by private domestic agents, national governments invariably lose policy space in their macroeconomic policy, including monetary and fiscal policy.
Third, the unfettered flow of capital and foreign portfolio investment can direct investments from “tradable” to “non-tradable,” aggravating trade imbalances. Fourth, evidence from episodes of financial crises caused by free capital flow shows that financial liberalization and deregulation lead to deflation, unemployment, appreciation of domestic currency relative to foreign currency, and governments’ inability to mobilize domestic resources to finance their development ambitions.
Finally, financial liberalization often leads to a massive demand for credit from households and firms that is not offset by a comparable increase in the savings rate. As a result, foreign capital increased because of increased domestic interest rates, creating an increase in foreign debt. This also creates unsustainable asset price increases, fueling investor euphoria and leading to incorrect investment decisions. In several cases, financial liberalization and deregulation have led to social and political crises.
In 2022, Argentina’s recurring financial crises (reminiscent of the country’s multiple crises of the 1980s and early 2000s) reached unprecedented levels with galloping inflation (70 percent) and sent four in 10 Argentinians below the extreme poverty line with impending political crises. This week, Lebanon is in unprecedented turmoil, with residents overrunning the country’s banking and financial sectors.
These are serious problems and challenges that could undermine countries’ economic recovery, growth, and development. More importantly, in the case of Ethiopia, the country’s weak or fragile banking and financial sectors could not withstand competition from established and highly advanced foreign banks.
Ethiopia should draw practical (operational) lessons (as to how to sequence and manage financial sector liberalization) from the African countries that are considered leaders in allowing the participation of foreign banks in their banking and financial sectors.
The experiences of Ghana, Kenya, Nigeria, and Uganda can provide important lessons and experience to latecomers like Ethiopia.
What kind of domestic banks and financial sector does Ethiopia need?
Ethiopia needs to restructure and revamp its domestic banking and financial sector so that it responds to the needs of the population and the economy of the country before opening the banking and financial sector to foreign banks. Ethiopia may also need to signal an alarm bell to domestic private and state-owned banks that complete liberalization of the sector (with the participation of private banks) is inevitable and that they must modernize their services and become innovative, efficient, dynamic, and competitive.
Restructuring and revamping the banking sector can include making available detailed information on the phases and sequences of liberalization with clearly defined objectives and timeline. It should also include modernizing banking operations through skill formation and technological upgrading.
The banking and financial sector must be “world-class,” dynamic, and competitive before inviting the participation of foreign banks in the economy. There should be effective and transparent financial rules and regulations in place, as well as monitoring and supervisory mechanisms.
These should also include sound, dynamic, and functioning institutions to formulate and implement new banking and financial policies and related rules and regulations, as well as supervise the activities of the financial and banking sectors with a strong judiciary and a corruption-free governance system.
For instance, Vietnam’s gradual, phased, and carefully sequenced reform of the banking sector enabled the country to foster competitive and innovative domestic banks (often state-owned). Technologically advanced and competitive banking operations have played a vital role in creating macroeconomic stability, sustaining economic growth, and further deepening the structural transformation of Vietnam.
As part of the banking sector reform, Ethiopia also needs to merge and consolidate some of its domestic banks, including private banks, to increase their capitalization and operational efficiency through skills, knowledge, and technological learning and upgrading.
The country, drawing practical lessons from successful countries such as Vietnam, should also gradually and tactfully relax regulations on credit rationing and ceilings, interest rate caps, and foreign exchange controls, as well as elaborate and up-to-date rules and regulations governing the sector, before inviting foreign banks into its banking and financial sectors.
Moreover, Ethiopia needs domestic banks that operate in a business model (not along ethnic and religious fault lines) that finances the country’s development endeavors with a balanced allocation of credit to the public and domestic private sectors.
In parallel with reforming and merging domestic banks, Ethiopia should strategically reposition itself in the banking and financial services sector by creating new banks or breaking current commercial banks into specialized financial institutions (e.g., banks and financial intermediaries to support trade, construction, or industrialization). Ethiopia also needs to revisit its own banking and financial sector of the past and bring back sectorally focused and specialized banking services.
For instance, the government needs to bring back a truly state-owned development bank that is entirely different from commercial banks in financing the country’s development priorities. Among the new or reinstated specialized banks should be a construction bank that provides financing for state-led megaprojects as well as long-term infrastructure financing to the public and private sectors.
Construction banks are vital for the reconstruction and rehabilitation efforts of war-torn economies, such as Ethiopia’s. Such exclusively dedicated banks can mobilize and channel savings and investments to targeted sectors and economic recovery programs in the country.
Ethiopia particularly needs a private or state-owned agriculture development bank that competitively finances the modernization of the sector, improves productivity and production, and ensures agricultural transformation through forward and backward inter-sectoral linkages. Such a bank is vital to target much-needed investments (private and public) towards agriculture and other productive sectors such as agro-processing.
The country needs dedicated agriculture sector insurance systems and mechanisms that underwrite multiple risks and uncertainties in the industry. It also needs new generation banking and financial services geared towards financing technological learning, adaptation, and dissemination, including financing tech start-ups.
More importantly, countries such as Ethiopia need an industrial development bank that supports industrialization and transformation policies of the government as well as the private sector with a focus on manufacturing, agro-processing, and transformational services sectors.
Along with these development-supporting banking and financial sectors, Ethiopia also needs to foster social policy banks that mobilize saving and channel investments to the social, pro-poor, and employment sectors to finance the government’s social policies. Finally, Ethiopia needs to invest as urgently as possible in massive financial literacy and numeracy, starting with schoolchildren.
In short, what Ethiopia urgently and immediately needs is a new generation of domestic banks, not foreign banks, at this infant stage of its development.
(Mussie Delelegn Arega (PhD) is an A/Head, Productive Capacities and Sustainable Development Branch, Division for Africa, LDCs and Special Programs, at the United Nations Conference on Trade and Development (UNCTAD). The opinions expressed in this article are the author’s own and do not represent the views of UNCTAD, the United Nations, or The Reporter. The author can be reached at ([email protected]).)
Contributed by Mussie Delelegn Arega
