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Crunch time: Ethiopia’s forex predicament

If there is one characteristic that defines the incumbent EPRDF in the past two decades it would be its near-obsession resolve to bring about rapid economic growth and development in Ethiopia. Symptomatic of this developmental ideology, the party has always been sensitive to economic narratives, particularly growth figures. On multiple occasions, EPRDF officials were seen bending backwards to put a positive spin on some of the most obvious economic challenges the nation had to face.

Time and again, inflation was ascribed not as a macroeconomic malaise that it was but as a positive indicator of growth and output expansion; and the persistent foreign exchange shortage as some sort of rite of passage for fast growing economies, experienced in almost all of the recently developed countries. Also, while insisting one of the highly primitive and closed-off financial systems in the world—the Ethiopian financial system— to be far sighted and protective of home-grown financial institutions; the authorities were also hell-bent on putting a positive spin on Ethiopia’s lack of natural resource and many other economic challenges.

This was particularly true with economic planning and performance measurements. There was hardly any government agency that dared to announce it has performed lower that the target set for it; instead, if the actual performance was lower than the target the officials would find an innovative and new way of giving it a positive twist by comparing it to a much earlier performance figure and boasting the progress it has made by comparison.

In some scenarios, authorities were seen clinging to a line that claims specific development targets to be overstretched (overambitious) on purpose to test performance limits and that their failure is not actually a failure; or out rightly rolling back on their plans and attributing performance shortfalls to necessary ‘period of preparation’ or ‘learning instances”. 

In fact, it was quite customary to assign blame on the so called ‘implementation gaps’ when specific development policies fail to perform absolving policy framers of any fault.

Well, it appears that those days are gone now. The budget speech of the new finance minister, Ahmed Shide, this week, and its candid admission regarding the macroeconomic condition of the country, looks to be an indication to the departure from the old ways.

From the outset, Ahmed was bold in asserting that the 7.7 percent GDP growth projected for the current Ethiopian fiscal year meant that Ethiopia’s rapid growth streak is slowly fading away. Ahmed was in fact honest in telling Members of Parliament (MP) that Ethiopia is currently entering into unchartered territory having seen the successive decline of its overall growth performance over the past three years.

Detailing the macroeconomic performance of the country over past three years, Ahmed shared the meager performance records of the Agricultural, Manufacturing and Services sectors and their impact on the overall economy. For one, he characterized the current economic condition in the agricultural sector to be” progressing sluggishly” partly due to the effect of Elinno two years ago.

His take of the progress in the manufacturing sector appear to be much worse: “Having the understanding that the manufacturing sector has to register at least 20 percent growth annually for structural transformation to take place, failure to achieve improvement in manufacturing value addition over the past three years is indicative that the desired transformation targets are not going to be met,” Ahmed told the House.

The services sector as well, which is the leading contributor to Ethiopia’s GDP, is still dominated by the trade and distribution services subsector, instead of manufacturing complementing modern service activities, according to the budget speech.

Meanwhile, on the demand side, in spite of continued improvement of domestic saving as ratio of the GDP, the data presented by the finance minister tells another gloomy story which is the decline of investment, from 38 percent to 34.1 percent, both as a ratio of the GDP.  This decrease is indeed unprecedented in decades of Ethiopia’s growth narrative. The gains in per capita income from USD 720 to 883 and the slight shift in poverty headcount to 23.5 percent notwithstanding, the overall macroeconomic picture painted by the most recent budget speech is grim from any perspective.

According to finance minister, a rising tide of inflationary pressure is the newest challenge that his administration has to grapple with this year. “One of the primary macroeconomic policy targets—attaining a single digit inflation rate—was also bust as the average inflation rate for the past three years has reached 13 percent,” Ahmed told MPs, admitting that the new trend of non-food inflation (13.5 percent) which is slightly higher than food inflation (11.5 percent) is another alarming macroeconomic development.

Perhaps the most undercutting macroeconomic obstacle this year would be breaking free of the foreign exchange vicious circle that Ethiopia finds itself in. By the finance minister’s own admissions, Ethiopia’s foreign trade sector is being held hostage to the severe foreign currency shortage in the market and which in turn undermines the activities of exporters from the manufacturing sector who don’t have the foreign currency needed to import raw materials.

Similarly, the foreign currency shortages is also affecting the nation’s ability to properly service its external debt obligations, endangering the slim opportunity the nation had to access additional foreign financing to complete government projects with potential for export. This too is a vicious circle and breaking free from it would require an innovative idea.

In fact, the fateful foreign exchange shortage is now affecting the domestic tax collection potential of the country since imports have gone down considerably as a result of the currency shortage. Ahmed’s speech illustrates this perfectly, “With 143.5 billion birr in tax revenue, already collected in the past months, which is close to 69 percent of the target set for the year, it is clear that the tax target set for the current fiscal year is not going to be met with only two months remaining,” Ahmed said.

Consequently, the other macroeconomic variable—fiscal revenue—measured by the revenue to GDP ratio is also slowly slipping away in recent years. According to the budget speech, the tax to GDP ratio of 12.7 percent some three years ago has gone down to 10.1 percent in the current fiscal year with little to no room for improvement in the remaining months.

Andualem Telaye (PhD), Director of the Macroeconomics and Trade Centre with Ethiopian Development Research Institute (EDRI), is not at all surprised that foreign exchange shortage is trapping Ethiopia’s economy in this manner. “State driven economic model is bound to put a strain on the nation’s foreign currency reserve,” he explained to The Reporter via a phone interview. Managing debt-financed projects is a very intricate process, according to Andualem, since the success depends on the efficiency, speed and economic return of projects.

“As you know, our state-driven projects leave a lot to be desired in terms of speed, efficiency and of course ascertaining their exact economic return,” he argued. The absorption capacity of the government in terms of utilizing borrowed funds properly and executing its debt servicing responsibility is another important consideration, he explains. “For instance, borrowing USD one billion or two billion present completely different challenges for the borrowing party,” he expounds.

Nevertheless, Andualem is of the view that most of the current macroeconomic challenges have got to do with the improper usage of nation’s monitory policy instruments, over the years. “We have to admit that we have not used the monitory policy instruments at our disposal in a proactive manner,” he argues, adding that due to monetary policy mismanagement the nation’s exchange rate regime has allowed the Ethiopian Birr to be overvalued for a long time, as capture by the successive appreciation of what is called the Real Effective Exchange Rate (REER) [measurement of the real value of country’s currency against another currency or a basket of currencies].

Eventually, the overvaluation of the currency leads to serious distortions in the underlying market incentive structure, Andualem explains: namely discouraging exports and encouraging importers. “From there, it is really straight forward to imagine foreign currency shortage down the line since exports are actively encouraged to abandon their position and perhaps go into importing: and that is the actual impact of our monetary policy mismanagement,” he asserts. It is not difficult to see too, he says, just review Letter of Credit queue at any of the banks reaching up to two years. “Why such bloated interest in foreign currency?” he asks, alluding to fact that it is distorted inventive structure that economic agents, including exports, are responding to.

As matter of fact, following the 2017 devaluation measure, Andualem says, the dynamics in the parallel market, which gave rise to a 40 percent premium with official exchange rate, has been more damaging to Ethiopia’s export sector. “A 40 percent premium is powerful enough to lure anyone to the import sector, including exports,” he argues.

Apart from its actual distorting impact, monetary policy mismanagement also plays a role in eroding the credibility of the state’s policy instruments. “Policy is also about managing expectation. When policymakers decide to devalue their currency, they are communicating with economic agents that they intend to control overvaluation of the currency and achieve stable exchange rate,” he continues to explains, “nevertheless, if at the same time, other price distortionary measures like taking central bank advances are taken the credibility of government policy will start to be questioned and eventually agents might respond in a manner that could counteract the desired effect of the policy.”

However, Tewodros Mekonnen (PhD), an economist with the International Growth Center (IGC), is convinced that the macroeconomic woes—foreign currency shortage and inflation— seen in Ethiopia at the moment are nothing but symptoms of a deeply ailing economy. “Price destabilizations like inflation and foreign exchange overvaluation are most certainly indicative of a structural problem in the economy,” Tewodros told The Reporter.

Apparently, for Tewodros, it is not the shortage of foreign currency or the overvaluation of the currency that is worrisome, it is the weak export potential which heavily relay on agricultural commodities. The fact that this economic structure remains unchanged for decades is what needs fixing, Tewodros argues, and measures targeting the structural issues in the economy such as the distorted incentive structures which encourages investment on asset than productive sectors is what Ethiopia needs to think about.

Twodros is of the view that the recent macroeconomic challenges might not be easy to wiggle out of since he is convinced that the fundamentals of the economy might not be able to hold for long. “I believe due to the persist structural problems that Ethiopia has faced in the past and the lack of response on par with the problem, these issue has been slowly eating away at the pillar of the economy,” he asserts; and that there might not be straightforward solution to escape the current predicament.

In this regard, Tewodros says that he expected much more bold propositions at the recent budget speech delivered by the finance minister. “I really expected bold moves and new idea; but the entire budget proposal looks eerily similar to what we have been used to in the past,” he said.

I don’t think the sort of standard prescriptive remedies like debt rescheduling, easing the business environment or liberalization could get Ethiopia out of this jam, Tewodros maintains, adding that Ethiopia economy appears to be heading to a natural, grinding halt and it could prove difficult to jolt it back into action.

As for Adualem, short term solution should be well thought of since they might have the unintended consequences altogether. “If the government decides to cut down spending altogether we might be looking at a stagflation (a lethal combination of inflation and unemployment) which could be a cause for bigger social unrest,” he warns. Nevertheless, what Andualem can visualize is some sort of debt relief support which can give the country some breathing room and perhaps then think long and hard about our policies and how to utilize them in the future. Correcting the divergent path the parallel, REER and official exchange rates are on and thereby reducing the distortionary foreign currency premium between these markets would be a good starting point, he concludes.