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Money TalksCan further devaluation clear market distortion?

Can further devaluation clear market distortion?

Last week, prior to traveling to the United States to attend the latest US-Africa summit, the macroeconomic team, chaired by Prime Minister Abiy Ahmed (PhD), convened in a closed meeting in Bishoftu town to seek a long-term solution to the country’s macroeconomic crisis, which ranges from the balance of payments deficit to the looming inflation.

Policymakers and officials were there to advise the team, which included State Minister of Finance Eyob Tekalign (PhD). The government is particularly concerned about the foreign currency reserve, which now only covers around three weeks’ worth of imports. It is a meeting conducted the same week that Yinager Dessie (PhD), the governor of the National Bank of Ethiopia (NBE), made a stormy appearance in Parliament, outlining the situation.

“There is a big balance of payment deficit. We are trying to minimize the gap between the official and parallel markets exchange rates. The amount of debt payment we have to service is increasing significantly. We have to pay the central government’s external debts. We have to pay import bills of fuel, medicine, and other basic items. We import capital goods and pay for contractors of GERD,” Yinager told the Plan, Budget, and Finance Affairs standing committee of the Parliament on December 8, 2022.

The debt service expected in the coming months, in particular, is another source of concern, with serious consequences in the event of default. The government also needs close to USD 22 billion for the reconstruction of the northern part of Ethiopia that was affected by the two-year war. Donors and aid groups are expected to give a large amount, which could add to the NBE’s reserve while the same amount in birr fills the budget gap.

The government has already taken initiatives to save forex, such as restricting the import of 38 products, which is estimated to save up to USD one billion per year based on what Prime Minister Abiy indicated in his latest speech before the parliament last month. The G20 debt restructuring and the IMF’s new program, which were highly anticipated by the Ethiopian government after the Pretoria Peace Agreement was signed, are not expected to arrive any sooner.

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“Once sustainable stability is achieved, we will resume negotiating with the IMF. The last discussion we had with IMF and World Bank officials was not about this issue. The previous programs have expired. Now, we have to design new programs for the IMF and WB. The time is not now to request a new program from the IMF. If the peace is maintained, we will request a new program from the IMF,” a member of the macro-economic team, who spoke to The Reporter on condition of anonymity, said.

The World Bank Group stated in a December 1, 2022, statement on the current situation in Ethiopia, “We continue to monitor the situation on the ground across the entire country, and we sincerely hope for stability and a permanent cessation of hostilities in order to facilitate accelerated, inclusive development.” Hence, permanent peace and stability are also requirements for the international financial institutions to deem Ethiopia eligible for fresh loans.

But the IMF and World Bank experts gave the macro team a risky piece of advice to solve Ethiopia’s immediate shortage of foreign currency.

The experts underlined that exchange rate reunification is a must and must be done as soon as possible. The government has accepted it in principle but is a bit resistant and has yet to make a decision. The macro team argued that prior to the measure, better backup is required. The macro team questioned the impact of reunification on inflation.

There is already a heated debate about massive devaluation among international financial institutions (IFIs) and government officials.

The wide premium between the official and parallel markets has distorted the government’s balance of payments significantly. It also created big distortions in the economy. As a result, the IMF, World Bank, and UNDP are pushing for a reunification of the official and parallel exchange rates through a one-time massive devaluation. The IFI recommended this as a precondition for the Ethiopian government to get any financial support from the IMF and WB.

Basically, the IMF and WB do not call it “devaluation” but “exchange rate reunification.” Of course, Ethiopia has paid the hidden cost of the divergent black market, which is a driving factor for Ethiopia’s balance of payment distortion.

The Ethiopian government accepted the recommendation as a principle, and further devaluation is highly likely in the next quarter, according to The Reporter’s sources.

However, experts fear two things. The first is that further devaluation could skyrocket the inflation rate, which is already above 30 percent. The second issue is that it is difficult to reunify the official and black markets, since the black market is always a moving target.

For instance, if the NBE devalues the birr by 75 percent, the official exchange rate increases from 53 birr now to almost 93 birr per US dollar. However, there is no guarantee that the parallel market rate will not double from around 100 birr at the moment. Currently, the black market exchange rate is over 100 birr if the amount to be exchanged reaches USD 10,000.

The IFIs have explanations for the consequences of further devaluation. The market is already operating at the black market exchange rate. Since profit margins and end prices are determined based on the black market rate, which is around 100 birr per USD, they argue that it is only about unifying the official and black market rates.

Because the economy operates on the black market exchange rate, the official exchange rate is currently just a symbolic tag.

Now, experts at the WB and IMF argue that the slow but continuous devaluation over the past few years has only piled up risk and not brought any positive change. It was not shocking enough to disrupt the black market. It only inflicted inflation. So to equate the official exchange rate with the parallel market, a devaluation of up to 75 percent is necessitated, according to the experts.

Additional devaluation, according to IFI experts, will not bring any shock to the economy because it is already operating with the parallel market exchange rate and not with the official exchange rate.

With the windfall of the black market, the current black market has helped certain business people prosper undeservedly. These people are also highly disruptive to the economy since they control the hard currency market. The ultimate assumption of further devaluation or reunification is to halt the market disruptors and channel the hard currency into government coffers.

Local experts also argue that floating the currency is better than further devaluation.

“The government is avoiding floating because it requires huge hard currency reserves to back it up. But devaluation does not require backup reserves; it is a payment readjustment. But in the case of flotation, it demands constantly keeping backup forex reserves. Once you make it float, you cannot return back to the managed exchange regime. Once floated, it operates by the market demand-supply,” said an expert who is close to the matter.

The official claims the government has no such reserves to maintain the post-float backup. “The backup reserve is required to maintain the ups and downs in the market. To that end, a constant forex source is necessitated, which the government does not have. Floatation at this time is highly risky for Ethiopia. That is why nobody is promoting floatation but devaluation.”

The official says devaluation is highly likely in the next quarter.

If devalued, speculators, who are running the parallel market, will disappear. Once the black market gap is closed, the operators have no premium incentive. Immediately, the underground economy has no option but to become official. And with it, the black market comes into the government coffers. Secondly, exporters will be encouraged because they can see market prices clearly once the distortion is removed.

The IMF and World Bank both believe that Ethiopia’s economy lacks foreign exchange. The problem, they say, is that the forex is in the informal market instead of the formal market. The big question now is how to bring that forex to the formal market.

The ideal solution is to disincentivize the black market operators by eliminating the premium. That is achieved through devaluation, but the devaluation must be significant so that the official exchange rate can completely undermine the black market premium. Devaluation is not only about the numbers but about clearing a distorted market.

For the WB and IMF experts, reunifying the two markets will solve everything, including inflation and the forex shortage. In reality, reunification facilitates both the parallel market and inflation. Their ultimate target is to legalize the black market.

Once the market clearing rate is introduced, everybody holding forex illegally will lose. The next premium buildup will not emerge at least until six months after the devaluation.

The point is that there is huge demand in Ethiopia, which did not express itself officially. People obtain LC from the NBE solely for the purpose of legalizing their activities, but their major forex source is the black market. Even after the reunification and after market pricing is cleared, the forex problem might remain unless the forex allocation system at NBE is corrected.

While reunification seems imminent, the macreconomic committee’s recent week visit looks to have helped the government’s economic troubles. After a meeting with Kristalina Georgieva, IMF Managing Director, Prime Minister Abiy tweeted that he had a “constructive discussion on Ethiopia’s transformative economic reform including the necessity for debt restructuring.” It was clear from what Eyob Tekalign (PhD), who is also the state minister of finance, that the discussion was productive.

We “concluded a very successful mission in Washington. It cannot get any better,” he tweeted.

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