Last week, the National Bank of Ethiopia (NBE) released its Monetary Policy Statement, which covered several issues. Of particular importance are the measures aimed at addressing inflation.
The NBE emphasized that the root causes of Ethiopia’s rampant inflation are supply-side factors, cost-push factors, and loose fiscal and monetary policies. It acknowledged that significant credit expansion has undermined the fight against inflation, highlighting the role of monetary policy in addressing this issue.
The central bank has set targets to reduce inflation to below 20 percent by June 2024 and 10 percent by June 2025. To achieve these targets, the NBE plans to tighten its monetary policy by limiting direct advances to the government to one-third of the previous year’s amount and restricting the growth of bank credits to 14 percent.
While these measures appear bold, caution must be exercised in their implementation.
Although reducing government borrowing from the NBE is praiseworthy, the feasibility of this measure is questionable. According to the latest available data for the year ending on March 31, 2023, the government borrowed 167 billion birr from the NBE, and the sale of treasury bills yielded a net amount of 26 billion birr. Mandatory Treasury bond sales to commercial banks brought in 25.6 billion birr in the five months ending on March 31, 2023.
Considering the budget deficit of 281 billion birr for 2023–24 (with a domestic borrowing requirement of 242 billion birr) and the significant role played by the central bank lending in financing budget deficits, reducing government borrowing from the NBE to one-third of the previous year’s amount while heavily relying on the sale of treasury bills and bonds seems unrealistic.
If the government aggressively pursues fund mobilization through the issuance of treasury bills and bonds, it will likely crowd out the private sector, leading to an increase in both Treasury bill and lending rates.
A more preferable approach would involve preparing a well-thought-out and realistic deficit financing plan and gradually phasing out government borrowing from the NBE.
Limiting credit growth is a direct way to address monetary expansion when other methods fail. However, given the growth rate of credits, which has reached 24 percent in recent years, limiting the growth to 14 percent is akin to applying a sudden brake to a speeding car. While it helps reduce inflation, it may also cause a slowdown in economic activities, potential reductions in asset prices, and an increase in non-performing loans for banks. This measure may force banks to ration credits and raise lending rates. Therefore, when implementing this rule, the NBE should adopt a pragmatic and flexible approach.
The NBE aims to transition to an interest-based monetary policy framework after 2024, as the current measures are considered temporary solutions.
Currently, the NBE employs a reserve money targeting framework, which is common in many developing countries. In this framework, the central bank aims to control the growth of reserve money to influence the growth of broad money in line with economic growth. However, the expansion of the banking sector and increased financial inclusion over the past decade and a half have rendered these variables unstable, making the reserve money targeting framework nearly unworkable.
The existence of similar monetary situations in several Sub-Saharan countries, such as Kenya, Ghana, and Uganda, has prompted their central banks to adopt an interest-based framework. In this framework, the central bank uses a policy rate (consistent with inflation forecasts) as a nominal anchor, steering the overnight interbank rate through open market operations.
Moving to an interest-based framework does not require preconditions as long as the NBE maintains operational independence to set interest rates for achieving monetary policy objectives. However, the new framework should be part of a comprehensive reform agenda that includes establishing a clear mandate for the NBE (which is price stability), ensuring exchange rate flexibility, and developing a monetary policy communication strategy.
The successful operation of an interest-based framework depends on the presence of a well-developed financial system capable of transmitting monetary policy decisions. Unfortunately, the Ethiopian financial system faces several challenges, such as an inactive interbank money market and market distortions caused by government interventions, including the existence of various administered interest rates. This situation underscores the need for comprehensive reforms in this area.
Lastly, it is worth commenting on the Monetary Policy Statement as one of the instruments of Monetary Policy Communication. While the release of the statement is commendable, it should be part of a comprehensive monetary policy communication strategy. This strategy should address the objectives, contents, intervals, audiences, tools, and channels of communication.
(Abdulmena Mohammed (PhD) is a seasoned financial expert based in London.)
Contributed by Abdulmena Mohammed (PhD)
