The bottom line is simply this: the price at which you can legally exchange the local currency for foreign currency is no longer fixed by the government. This doesn’t mean all finance is deregulated, you still need licenses to be a bank or other financial service provider. But last week, the price of dollars was 57 ETB/USD and any other price was technically illegal. Today it can be anything. 47, 57, 67, 97, 100…  It is up to the banks and their customers to agree on a price, like buyers and sellers of anything else. The price itself is no longer a crime. Free at last! 

Last year, in my post entitled “The mother of all distortions“, I wished for exactly this:

The government could simply revoke the law that says Abebe, Berhane and the banks are not allowed to exchange their USD for ETB at whatever price they agree to. That’s what is meant by jargon like “float” or “unification”, “liberalization”, etc. Just let the two parties agree on a price. No other laws need to change. Any product that is illegal can remain illegal. Banking licenses don’t need to change. Just decriminalize voluntary price. That’s it. 

And, surprise! That is actually the current Ethiopian government’s position. Don’t take my word for it. It said so in 2019:  Ethiopia: Central Bank announces floating exchange rate regime. And again in 2020: Ethiopia Plans New Key Rate, Floating Currency to Boost Economy. Even now in 2023, exchange rate unification remains the goal. But the policy is “gradual”, and 4 years in, the peg remains and the gap is growing. So what are we waiting for? Why don’t they just waive this magic wand today?  
[…]
To be blunt, the political cost of doing the right thing is very high.

So let’s applaud the government for finally doing it. A very courageous move. 

Defenders of the status quo

As expected, there has been a lot of discussion of this historic change. Much of it is excellent and constructive. The press has been vigorous, quick and has offered diverse views. Today I want to focus on a subset, the hard core defenders of the old status quo who are crying bloody murder. Intentionally or not, they are ensuring that the political cost we discussed above is paid in full!  Their arguments are predictable. In fact I haven’t yet heard any that are not already debunked (or rather “pre-bunked”) in my aforementioned article. It would be tragic if these fallacies caused a political failure of this reform. So here’s my modest contribution: by responding to some of them directly, maybe I can help the probability of success a tiny bit. But first, since I won’t be repeating the details, if you haven’t yet read my article, now would be a good time to go and read it. I’ll wait… 

Ok are you back? Once more unto the breach dear friends!

One of the loudest opponents of this freedom is Alemayehu Geda. A few hours after the initial statement, on Sunday evening, before the change actually took place on Monday, he was already out on the radio and social media attacking the reform. Here’s what he had to say (I will put his claims in italic, since as you can guess, I’m about to rebut them).

Proposition AG1: Ethiopia imports more than it exports. If the exchange rate is freed,  things that were imported at 50 ETB/USD will now be imported at 100 ETB/USD and so imports will be more expensive. This will cause inflation. Inflation will cause the currency to weaken further. And as the exchange rate goes up the prices will go up even more. And so we will have an unstoppable spiral of general price inflation and currency weakening. 

If you follow his argument carefully, you will realize it it mixes up cause and effect, and then loops back in a circular argument. It’s like saying: “Wet streets cause rain. This rain in turns causes the streets to get more wet. And the wetness of the streets causes more rain to fall. Because of these wet streets, soon there will be a hurricane!” Sounds scary. Indeed we’ve all noticed the close correlation between rain and street wetness! But in reality, it is more like astrology than meteorology. Econstrology.

To show why, let me ask some questions. Excuse me Professor, of course we all know the peg was keeping the rate artificially low, so when freed, it will naturally go up close to the “black” market rate. And you are saying inflation will go up if the government allows this. Then does that mean inflation would go down if they pegged the rate lower?  Maybe even  deflation? If the peg went to  50, 40, 30, … 0.01 Birr per Dollar, would the cost of living would get lower and lower? The central bank has a magic keyboard that lowers the cost of living?  What about the huge fraction of imports priced according to the black market exchange rate. If the new free market rate holds at or below the old black market rate, why would prices go up on those? 

One more question Prof! You then say if inflation goes up, the currency gets weaker.  How does that work? Let’s say we collectively spend 100 Birr every day. And we spend 50 Birr to buy domestic products, and 50 birr to buy US dollars to import stuff. If suddenly we have to spend say 65 on domestic stuff, now we only have 35 birr left to buy dollars with. Therefore there is less demand for dollars. How can that make the price of dollars go up? Conversely, if the dollar is more expensive we should have less money for the domestic stuff, so their price should go down. But you are saying both go up together… Very strange! Clearly if both were to go up together, there would have to be something else causing it (hint: money supply. But more on that later).

Clearly there’s a bug in your model. Here’s what was really happening. There was two foreign exchange markets. The official one which is pegged by law and the “black” market which I will simply call the market. The price of foreign currency on the market was double the official price.  For forex coming in, legally, you had to “surrender” your forex and get only 50% of the market value in Birr. Similarly for dollars going out, if you could get forex legally, you were basically getting a 50% discount on the market. And it is illegal to evade it. In other words, mathematically it is exactly like a tax and a subsidy. No magic wealth creation by fixing the price. Purely a mechanism of transfer. Taking money from exports and foreign investments, and giving it to consumption of imports. Meanwhile local producers who need forex for their capital investments were getting starved. So as a share of the whole economy: exports decrease, investment decreases, manufacturing decreases, and import consumption increases. More dollars go out and fewer dollars come in. This in turn increases the gap between the market and the official rate, so the implicit tax/subsidy effect gets bigger and the whole problem accelerates. This is the real spiral, and it is the reverse of your spiral.  Your model is right to point out the correlation, but it has cause and effect backwards.  Wet streets do not cause rain!

So, whither inflation? Shouting “everything will go up! panic!” is incorrect. All else being equal, the price of things that were implicitly subsidized by getting forex priority will go up, and the price of things that were implicitly taxed will go down. But of course not all else is equal, other variables will change. If the government wants to subsidize fertilizer imports, it will have to do so explicitly,  as government spending, with the choices and trade-offs that implies, not implicitly via distortion of the currency. This is the healthier way. Explicit and transparent. Implicit subsidies are prone to capture by special interests, and end up being regressive and corrupt.   

Another thing that can change is money supply. On that note, let’s go to the Prof’s second major point.

Proposition AG2:  Government budget includes a number of things paid for in foreign currency. So that portion of it will double.  Tax collection is already down in the last couple of years, because of war etc..Where will it get the money? And the white people want the government to cut spending and increase taxes. The economy can’t support that. This will lead to printing and inflation. Ethiopians are poor. Now they will be poorer.

Ok this is partially true. When government prints more money, when the amount of Birr increases faster than the real economic activity, then we get inflation. More money / same stuff,  means more money per unit of stuff, i.e. prices go up. It is possible government will just print more Birr and this would lead to inflation. The part that is not true is the implication that reforming the exchange rate will automatically cause the government to print more Birr. You have to ask: what actually creates the temptation to print more, and will the temptation be stronger now? In fact Ethiopia already had very high inflation, running at around 30% per year, before this reform! One of the reasons is that the currency distortion was killing real productivity, increasing implicit and explicit tax evasion. In those conditions, the government is tempted to print more as quick fix, like an addict taking more drugs to avoid dealing with a painful reality. So the old currency regime was contributing to inflation! Now this reform, by improving productivity, should reduce inflationary tendencies in the long term.

To be clear, the reform does not silence the siren song of the money printer. The transition will be disruptive. There will be winners and losers in the short term. The old winners of the letter of credit privilege game will now be on equal footing with everyone else. The old losers, those who were generating forex and were forced to convert below market rate, will now get more of the benefit of their efforts. Manufacturers will have an easier time with imported equipment and inputs. Banks and merkato traders will speculate on whether the new policy will hold, and this will add volatility in prices and supplies. It will take a bit of time for things to settle down. Until then, it will be tempting for the government to spend more to smooth some of the bumps, whether newly borrowed money or printing. 

For this reform to succeed, the government must resist the temptation. If it does succeed, it will lead to more efficiency and fairness, a more productive economy and therefore less poverty. As it turns out, the central bank (NBE) has actually been systematically reducing the Birr money supply for the last few months. Not to be too technical, but they “drained liquidity out of the system” by lowering the maximum amount of lending  as a fraction of banks’ balance sheets.  This is basically the opposite of printing money. So even though so the temptation will be there, there’s reason to be optimistic that this reform is well prepared and the discipline to see it through will be there.

Now his third and final point is the following.

Proposition AG3: The people are poor. Cost of living is high. 70% of the population earns less than 50 dollars [a month].  Inflation makes life harder for the poor. 

That doesn’t even need rebutting. It’s just stating the obvious. But it is not derived from the subject at hand. No reason is given why this reform will increase poverty or reduce it. This is a rhetorical tactic called “motte and bailey fallacy”. Continuing our previous analogy, it’s like saying: “Wet streets cause rain and rain causes hurricanes. Hurricanes are terrible!” Then if an opponent says  “No, wet streets don’t cause rain!” then he can respond with “Oh so you like hurricanes, you horrible person!” In this case, if you point out the incorrectness of his argument about the forex regime, this allows him to say “Oh so you want more poverty!”

One more thing. In Proposition AG2, there was a passing jab at  “ፈረንጆቹ”  (i.e. the white people)… He’s just using that as shorthand for the IMF, western governments etc. And the IMF is of course the most toxic brand in the third world.  If the IMF says the sky is blue, you can get a lot of political mileage by saying the sky is green. But that’s empty rhetoric. The reality is the IMF is more like a pharmacist and third world governments are addicted to prescription drugs. And this pharmacist (or drug dealer if you prefer) says: you really should stop the addiction, but I’ll give you a little dose to wean you off, if you promise to reform yourself. Most of the time, the reforms fail. This has been going on for decades and everyone hates the IMF as a result. But nobody ever cured an addiction with righteous indignation about the pharmacist. Ultimately the addicts need to repair themselves. IMF loans can be addictive and destructive in the long term. But if used correctly in the short term with exception discipline, they can also help wean the government off the addiction.  So please dear friends, don’t fall for the old  “Whitey made them do it!” attack. Just think from first principles about this reform. 

Finally, when asked if there’s anything positive, the Prof acknowledges that it may close the gap with the black market for remittances (true).  But then he simply asserts that exports can’t increase! He says exports have other problems like shortage of foreign currency (duh!). He also blames customs, bureaucracy,  corruption and lack of peace in the country for harming exports.  That’s all true. 

For example:

• Customs is hell. This week the customs commission suddenly decided to freeze imports of capital goods including those that are en route and those that have  already arrived and been cleared. This is a devastating cost to many businesses, including some that would be generating forex.
• Land transportation from Djibouti to Ethiopia, both trains and trucks,  is plagued by congestion and insecurity.
• The Houthi blockade of the Red Sea is extremely costly for trade to/from Ethiopia.
• Political problems and violence handicap many parts of the economy, including exports.

All that is true. Doing business in Ethiopia remains unfathomably difficult.  But none of that is a reason for opposing this particular reform. On the contrary, it *will* improve a lot of it. Much of the incomprehensible torture that you go through in customs or investment licenses, for example, is based on forex things like franco valuta, bank permits, etc. Having a freely exchange currency will definitely eliminate this important source of red tape and corruption.

To conclude, the professor despairs that he’s been a prophet but the government is not listening to him. But what he doesn’t say is that his approach was actually implemented for the last 50 years! And even though this reform has been the goal since 2019, such arguments have delayed it for 5 years.  So Prof, congrats on your team’s five decade policy victory streak. Now please have the humility and honesty to admit that your approach was tried and failed.  

Five decades is a long time. Over 95% of the population has never known a life where changing currency from one to another is no big deal, like in Europe, or America or indeed much of Africa. I’m confident Ethiopians will adjust to this little bit of extra freedom, and the benefits will accrue slowly but surely.

P.S. A personal note to Prof Alemayehu. If you ever read this, first thanks for reading and second, let me be clear, this is not  personal. In fact by picking on you, I’m recognizing you as one of the chief public  defender of the old system. You are widely respected. I just think you are wrong. Second, even though we don’t know each other, you’ve  made a couple of condescending public comments about my previous article, essentially calling me a simpleton. Since you blocked me, I never got to thank you. I took your insult as a compliment.  My goal is always to make things as simple as possible!

P.P.S. This post is too long so I’m stopping at the polemic. In a follow-up post, I will give some concrete predictions and maybe even offer some bets! A preview:

To find the original publication of this article click here

The post Free at last appeared first on Abren.

Full disclosure: I’m a co-founder of  QRB Labs, the first company to introduce Bitcoin mining to the country.  We’ve been quietly working since 2021 to do this the “right way” against tremendous odds.  But this post is not our company’s story.  It’s a skin-in-the-game opinion about how this industry should evolve for the benefit of the country. To highlight the good it can do. But also the risk of bad, and ugly.

The Good

First let’s talk about the positive. Energy in Ethiopia and Bitcoin mining are a match made in heaven. 

In Ethiopia, electricity generation capacity is growing very rapidly. From 2GW in 2020 to over 10GW in the next couple of years. The Grand Ethiopian Renaissance Dam (which I’ve written about before) is the biggest and most famous step in that growth, but there are many projects contributing to it. All of course phenomenally good. Indeed, practically nothing is better for economic growth and broadly improving lives than electrification.  For comparison, the average Ethiopian has 1/50th the electricity of an American. So, until we get to 100GW at least, another 1000% growth, increasing generation is unquestionably necessary. 

But there’s a catch. It is extremely difficult and expensive to deliver that energy to users. In the case of Ethiopia, some estimate that  $10B of investment and years of hard work are needed for transmission and distribution to catch up to generation. In the meantime, up to half of the generated energy remains unused. Which means the investment in generation takes longer to pay for itself. Meanwhile how do you finance the transmission and distribution? It’s a huge chicken and egg problem, and it’s unavoidable when there is rapid growth.  

In more developed countries, capacity may not be doubling or quadrupling but a similar problem exists with solar and wind power. Huge investments in supply are needed, but the demand may not match up with the supply, since consumption peaks don’t line up perfectly with the times when the sun shines or the wind blows.  Whether caused by the difference between the time of generation and consumption, or by the distance, this is the problem of “stranded energy“.

But what if there was a way to make money from stranded energy? In Ethiopia, this revenue could help accelerate electrification! That’s where Bitcoin comes in:   

“the competitive dynamics of Bitcoin mining are such that it shifts in time and space to the lowest available cost of electricity. This occurs not just by deploying hardware to various locations, but also by turning miners on or off instantly. This flexible demand-side support makes mining the ideal customer to balance variable supply….”  from “The Dynamics of Bitcoin Mining” by yours truly.

Thus the energy demand profile of data centers that host high energy computations makes them the perfect customer for Ethiopia’s stranded energy. Bitcoin even more so than other data applications because: 

• Bitcoin mining is location agnostic. It doesn’t matter if it runs in Antarctica or the Sahara as long as it’s connected to the Internet. 
• It’s also time agnostic.  Each hash computation is independent of the previous one. You can mine 24 hours a day, 12 hours a day, at random times. Of course miners, in order to be profitable, must be very good at making the complex trade offs between between energy cost and hardware utilization. But they don’t inherently need 24×7 power. 
• Further, contrary to common perception, it doesn’t actually need very much bandwidth. The entire blockchain is still barely more than half a terabyte! 
• And equally importantly, it’s all public data. The entire world can see all the inputs to the miners. So there’s no data sovereignty, legal information jurisdiction or cyber security issue.
• Mining is purely infrastructure for running computers. There’s no link between the locations of the miners and the users of Bitcoin. So Bitcoin mining doesn’t depend on local regulations about money and financial services, legality of “cryptocurrencies” etc. 

For traditional data centers hosting say streaming video, social media or corporate IT,  cheap electricity is nice to have, but they also require some combination of high bandwidth, low latency, and a compatible legal system for privacy, copyright, finance etc. These are all areas where it is presently tough for Ethiopia to compete globally — to put it mildly. But Bitcoin mining has in principle no disadvantage running in Ethiopia. 

Further, Ethiopia’s electricity generation mix is over 98% renewable. And even the 2% that isn’t is largely off-grid. So for a data center in Ethiopia, the energy is pretty much 100% “green” hydroelectricity. This is very desirable for the Bitcoin community. Bitcoin arguably doesn’t have to be green, any more than ice cream or football. In fact proof of work is one of the most noble uses of energy in the world. But Bitcoin has a lot of enemies who, as I have written about before on this blog. hypocritically or ignorantly use energy as an attack vector.  So “greening” mining is good for Bitcoin globally, and Ethiopia is perfect for that.

So there you have it.  The good is amazing.  Accelerating electrification for economic development of Africa. Geographic diversification and greening of Bitcoin mining.  That is literally the mission statement of QRB Labs. And also why Ethiopia and Bitcoin mining are truly a match made in heaven.

The Bad

But an electricity grid is a very complex beast. You can have too much energy in one place and too little in another at the same time.  When you have too much, it’s  a waste. And where there’s too little, consumers suffer outages which have negative economic and other consequences. In addition, both excess and shortage can cause costly damage to infrastructure. The best way to balance that is to manage the demand, through price and quantity allocation.

In the case of Ethiopia, while the people at the power company are dedicated to doing the right thing, historically it has not had the independence to manage pricing and demand as it needs to. By contrast, the airline, even though it is also state owned, has a long history of independence, allowing it to mange routes, schedules and prices on a purely commercial basis. This allows it to succeed in an extremely competitive and complex international industry.  But electricity prices have historically been dictated by politics.  Thus, when it comes to the relationship between the energy producer and Bitcoin miners, they don’t have the full flexibility to achieve true win-win pricing.  Consumer utility pricing is understandably more difficult to change. But at the wholesale level, the producer should be allowed to make stranded energy cheap, and conversely to charge higher prices where there’s lots of demand, whether it is from data centers, factories or households.  

Without modernized pricing from the supplier, the risk is that Bitcoin miners who don’t particularly care about the long term of the country can rush in  with demand in the wrong places, and destabilize the grid. Not because they are particularly evil or greedy. But just like water flows to the bottom of a valley, Bitcoin miners will go to where they can get energy at a good price. In this almost perfectly competitive industry, the purest embodiment of survival of the fittest, the typical buyer can’t afford to think for the seller.

The only solution is incentive compatible pricing. Rational, non-political, and based on supply and demand. Further, it is crucial that the pricing not be based on the industry, or what the energy is being used for. Electricity is fungible. So price discrimination by type of application never works well. If one industry  gets lower rates than another, it creates perverse incentives, where one will disguise itself as the other, and cause complexity in enforcement. This is also true for Bitcoin mining. Instead, energy should be commercially  negotiated based on quantity, location and time. Let the buyers find their niche. In a fair rational environment, Bitcoin demand will naturally stabilize and benefit the grid, and  monetize excess capacity to help long term electrification. And when the country’s transmission and distribution infrastructure is fully developed, when industrial and consumer demand can use all of the electricity being generated, then Bitcoin miners will not be able to pay the same price as factories or households. We should be happy to declare mission accomplished and look for cheap power somewhere else.

Another potential Bad is that Bitcoin mining can easily get politicized in Ethiopia. People who don’t understand the subtle win-win dynamics may complain that Bitcoin is taking power from the people. Or based on superficial nonsense about “cryptocurrencies”, especially in a bull market, assume Bitcoin miners are rich and should pay high prices. Such interference risks killing the goose that lays the golden egg. If handled correctly, mining is a tough global competition for miners but an easy win for local energy producers. But mishandling could very quickly kill a historic source of revenue.

Initially, the government made the mistake of temporarily blocking Bitcoin mining equipment imports in 2022 while it tried to come up with new regulations. Then in 2023, it implemented rules about Bitcoin mining as “cryptography” rather than “energy”. But in fact, mining involves no encryption in the conventional sense of trying to keep information secret. The computation is basically just a hash function with public inputs and public outputs. It’s just a race between miners to get the output faster.  (Even transaction validation, which usually is not even on the miner but in the pool, only involves checking signatures which anyone can do — no secrets). At one point we were even told that only foreign companies could participate in this industry, which is unconstitutional! Fortunately, over the last couple of months, these errors are getting understood and things are moving in the right direction.

The Ugly

An unfortunate side effect of taking the wrong regulatory approach is potential for corruption.  Bitcoin miners are not all idealistic. Even when they are so inclined, competition is so fierce there’s always a temptation to look for legal short cuts. On top of that, many foreigners come with a “this is Africa” attitude. Translation: corruption is a natural feature of the landscape. So they try bulldoze their way in with bribery. If it doesn’t work, they try the next place. If it works, they exploit it as fast as possible, and when it inevitably blows up, just pack up and move to the next hunting grounds.

For many countries, oil wealth turned into the infamous “resource curse“, undermining governance and even being negative for economic development. In the worst cases, it goes beyond bribery to outright theft: taking the energy and not paying for it. This is a danger with Bitcoin for electricity-rich countries too. Kazakhstan, Angola, and some other countries have experienced this ugly side. Fortunately, there’s no evidence of this occurring in Ethiopia yet, but it is perhaps the greatest theoretical danger.

The best way to avoid this is for the government to eschew regulatory micromanagement. Rather than trying to control it through hardware imports, or make it political, or treat it as cryptography, or have too many stakeholders at the table, it should allow this industry to naturally find a win-win buyer-seller relationship with energy. This means allowing flexible electricity capacity allocation and pricing.  

The government’s focus should be on monitoring the bigger picture: that the energy security of the country is not compromised. So rather than trying to regulate the details of what miners do, the government should require the power company to regularly report on overall high and medium voltage demand by region, generation and transmission capacity, and provide assurances that supply and demand are sustainably managed across all industries and regions.

So there are a few ways things could go wrong. It’s important to understand them. But part of me fears that I have given ammunition to the haters. I hope I’ve struck the right balance.  Reviewing this post, I see I’ve devoted a lot more words to the good than to the bad and ugly. And that is as it should be.  We face a historic opportunity for two things I care deeply about: Ethiopia and Bitcoin. May both live long and prosper!

P.S. This post is months overdue! And it’s too long. To quote Mark Twain: “I didn’t have time to write a short letter, so I wrote a long one instead.”

This article first appeared Here

The post Bitcoin mining in Ethiopia: the good, the bad and the ugly appeared first on Abren.

Perhaps the biggest economic topic in Ethiopia today is foreign currency. Sadly, much of the discussion around it is low quality. Instead of reasoning from first principles, people drown in jargon and misunderstood theories: inflation, socialism, neoliberalism, colonialism, IMF,  China, bla bla bla. Whether the motivations are naivete or special interests, the result is many strongly held but incoherent beliefs. To navigate this, let’s be guided by this (perhaps apocryphal) quote from the great physicist Richard Feynman: “If you can’t explain something to a child, there’s a chance you don’t understand it well”. So don’t let any expert tell you: “it’s too complex, don’t try to understand, just believe my prediction”. In that spirit, dear reader, please leave your isms and schisms at the door and join me in this ELI5 version of the problem of foreign currency in Ethiopia.

Notes: 

1. In this post, we will talk about US Dollars as the “foreign” currency, but all of it applies equally to  Euros or any freely exchanged and widely used currency.
2. Feedback is welcome. If there are factual errors, please let me know and I will correct them. If you have a solid counter-argument to any point made herein, feel free to comment here or contact me on Twitter, and I will respond and update the post (with credit!).

Two markets

How much is one US Dollar worth in Ethiopian Birr? Officially the price is pegged, currently at around 55 ETB per USD. But if an ordinary person, let’s call him Abebe, simply goes to his bank and asks to buy 1 dollar for 55 birr, they will say no. There is a limited supply of dollars.  Ok how about 56, 57, …? Nope. Now what if at the same time, another customer, let’s call her Berhane, has a dollar and she’s willing to sell it for 56? Naturally, the bank should be happy to buy that dollar at 56 and sell it to Abebe at 57. The buyer, the seller, and the bank would be happy. Problem solved! Actually no, by law, the bank is not allowed to do that. It must sell only to approved buyers at the official price and if that means those two customers go home unsatisfied, so be it. 

So what is the alternative? Abebe and Berhane could meet privately, find a mutually agreeable price and exchange. This is called the parallel market (also known as the “black” market).   Of course, even though it’s a private transaction, just like when people buy and sell eggs or bread or whatever, information gets around and a market price emerges. These days it is apparently around 105 ETB per USD. No one is forcing this price, it’s just a rough average of a lot of private transactions. In each case,  the buyer and seller get what they need. Problem solved! Actually no, by law Abebe and Berhane are not allowed to do that.

So we have two markets: the official one where the price is pegged by law, and relatively few people can transact.  And the “parallel” market where the price is voluntary but it is illegal.   

Mind the gap

Having two markets would be no big deal if they were reasonably close. Even in free market prices, there are gaps due to distance, convenience, time delays, etc.  But in this case, one price is almost double the other! This is an extreme gap by historical standards, a structural gap created by a legal barrier between the two markets. Let’s examine how this barrier affects different people.  

There are two groups, buyers (who have birr and want dollars) and sellers (who have dollars and want birr). 

First consider the sellers. What brings dollars into Ethiopia? Roughly: 

• Remittances: $6B/yr
• Foreign investment: $4B/yr
• Exports: $4B/yr
• International aid: $3B/yr
• Tourism: $0.4B/year

So anyone involved in those activities using the peg is getting 55 instead of 105. If an exporter sells coffee abroad, and brings back $1, they are getting half as many birr that trickle back to pay farmers, transportation etc. In other words, it’s like there’s a 50% tax on exports. Similarly if an investor wants to bring $1M into Ethiopia they are getting the equivalent of 50% tax on their investment before they even hire their first employee or lay the first brick.  Ditto for remittances, if a diaspora Ethiopian sends money to family in Ethiopia at the official rate, 50% tax. For visitors, it’s like they are paying double for everything they consume in Ethiopia. Of course, it’s not literally a tax. But with the peg, the only choice is to pay 50% or not do the activity at all. In other words it’s just like a tax. And whenever something is taxed, at the margin, the tax can be the difference between an activity being feasible or not, which means the volume of that activity is less than it would be without the tax.

Now, having left ideology at the door, we won’t assume taxes are automatically good or bad. Instead, let’s ask what are the costs and benefits. We know the cost: it reduces legal exports, investment, remittances and to a lesser extent tourism. What or who does it benefit? 

The buyers of course. Those who get dollars at the pegged rate. To get legal dollars, you need a “letter of credit”, which allows the bank to take your birr and give you dollars to use abroad. This permission goes to the government itself and to private imports prioritized by the government.

Debatable priorities and the problem of central planning

This leaves the Ministry of Finance the unenviable task of deciding the relative importance of hundreds or thousands of things, and deciding which ones should get higher priority for letters of credit, lower priority or none at all. Last October, the government decided to ban letters of credit for 38 items. 

The list includes oddly specific items like “Vimto”, impossibly vague categories like “Different games”, and hilarious ones like “Artificial and Human hairs” and “tiaras”.  Comedy aside, some choices are really sad.  “Bicycles”! That one really broke my heart.  

Oil gets a double subsidy: first from foreign currency priority, and second from getting explicit subsidies of the price at the fuel pump.  Believe it or not, in Ethiopia which doesn’t produce any oil, has a foreign currency crisis, and where less than 1% of the population has cars, the price of gasoline is half of the price in neighboring Kenya! Fuel subsidies may be one thing that is even crazier than the foreign currency nightmare, but let’s leave that for another post.

Meanwhile, businesses are suffocating because they can’t get foreign currency. If you make electrical equipment, you can’t get the dollars to import copper, so you stop and wait. If you are constructing a building, you can’t get dollars to buy steel, so you stop. Over 200 business ceased operations because of lack of foreign currencies. Manufacturers are getting less than 15% of the foreign currency they need for raw materials, according to the Ministry of Finance. A common sight around Addis Abeba is unfinished buildings, sitting half-built for months or years, a constant demonstration of wasted land, wasted capital, lost opportunities. If you talk to anybody in manufacturing, you will be overwhelmed with stories of dying companies.  Companies fail all the time of course, that’s the nature of business. But the heartbreaking thing is they are not failing for business reasons. Imagine you  have the right idea, you invest lots of money, hire the right employees, make the right product, find the right customers.  You are willing to pay for inputs at market value, but, understandably, you don’t want to go to the black market.  So you just sit and wait for permission to buy your inputs. And eventually close up shop. That is the tragic fate of many many businesses that could help the livelihood of  millions, dying because of this foreign currency policy.

Perhaps the starkest illustration of the failure of this central planning approach to prioritization is: “Lack of forex to import fertilizer threatens agricultural output“. Nothing is more important than agricultural production, and the government understands that. So they planned ahead and allocated $1B for fertilizer,  much more than last year. But due to global market changes, the need is $1.2B. So here we are with a shortage of fertilizer.  

In short what we have is the classic “economic calculation problem” which forever plagues central planning. The problem is not that the planners have bad intentions, nor that they are not smart enough, nor that they don’t have the right data, nor that they need more powerful computers. It’s more fundamental. In a large economy, the full information to make the optimal allocations simply does not exist in one place at one time no matter how much you try. You cannot sit at a desk and decide for 100M people whether steel is more or less important than copper, or whether aspirin is more important than fertilizer. The information is distributed in the subjective values and decisions of thousands of different actors, and when they act locally on their specific problems, their collective intelligence is much greater than even the best possible central planner.

Inefficiency of indirect subsidies

Further, even if we assume the priorities are perfectly correct and everyone agrees, there is another basic problem. Who pays for them? The cost is of course being born by the sellers we identified above: exporters, people receiving remittances, etc. And the benefit goes to specific imports. Which raises the question: why should coffee exporters or remittances carry the cost of gasoline for car owners? Why shouldn’t plumbers, teff farmers or real estate businesses share the burden? A society may decide the rich should subsidize the poor, or some things should have punitive taxes, etc. But implicitly making one sector pay for another specific sector is unfair and inefficient, and leads to many unintended consequences. If the society wants something to be subsidized, then it’s better for the government to spend money directly on that thing, using money that it collects through normal explicit taxes. The optimal mix of taxes (VAT, duties, income tax, etc.) is a separate debate the society can have. But whatever the specific combination of taxes, explicit taxes are better than an implicit tax via currency controls.

Corruption

Another problem is that access to foreign currency becomes an exorbitant privilege, so there’s an extreme incentive for corruption. Common sense says that when there’s a magic way of doubling your money, there’s bound to be some cheating. The people who are most adept at playing the privilege game will get more of it, while those who are politically naive  get less. To think otherwise is to ignore human nature.  Cronyism and corruption is rewarded and productive work is penalized. This is of course extremely damaging to the economic and moral health of the society.

The grey zone

Inevitably, many of those who can’t get this privilege resort to the parallel market. Indeed, the black market has become mainstream. Increasingly this is not just individuals like Abebe and Berhane in our story above, but also in business. Research shows that prices of imported commodities are tracking the parallel market rather than the peg. Banks too are flirting with the black market, by adding transaction fees as high as 60% to bridge the gap. Even parts of government are resorting to the black market. For example, earlier this year, there was a huge public bus procurement scandal. The Addis Abeba city government paid 19 million birr per bus, which according to the peg, is about $350K. Critics screamed that those same buses cost less than $150K internationally, so surely someone pocketed the difference! But an alternative explanation soon emerged: the importer had to get their foreign currency at the parallel market rate. Using that rate, and adding the cost of shipping etc., the price seems more reasonable. Should you praise the importer for creative problem-solving (after all the city does need more public buses!), or condemn them for price gouging? You decide. It is a bit like the debate about “illegal” vs “undocumented” immigrants in the US, but much worse. Exploiter and exploited start to blur into an unhappy grey zone. Huge swaths of society are operating outside the law. The hypocrisy is staggering. People will publicly defend the peg and privately use the black market. That’s not only legally risky for everyone involved, it’s deeply corrosive to the rule of law. Ethiopia is becoming a mafia state.

The solution

The polite economist word for this nightmare is “distortion”.  And while the consequences are very wide and complicated, there is a simple and narrow solution.  The government could simply revoke the law that says Abebe, Berhane and the banks are not allowed to exchange their USD for ETB at whatever price they agree to. That’s what is meant by jargon like “float” or “unification”, “liberalization”,  etc.  Just let the two parties agree on a price. No other laws need to change. Any product that is illegal can remain illegal. Banking licenses don’t need to change. Just decriminalize voluntary price. That’s it.  

And, surprise! That is actually the current Ethiopian government’s position.  Don’t take my word for it. It said so in 2019:  Ethiopia: Central Bank announces floating exchange rate regime. And again in 2020: Ethiopia Plans New Key Rate, Floating Currency to Boost Economy. Even now in 2023, exchange rate unification remains the goal. But the policy is “gradual”, and 4 years in, the peg remains and the gap is growing. So what are we waiting for? Why don’t they just waive this magic wand today? 

The reasons for this inability to execute the change fall in two categories. First, this inefficiency benefits some special interests, even if it hurts the majority. And multi-billion dollar special interests, both within and outside government, are tough get rid of. The second set of reasons is many sincere but misguided fears, both within and outside the government, of what would happen with such a change. Let’s examine them.

Inflation: the map and the territory

The most common fear is: if the currency is floated, inflation will go up. But this is due to a misunderstanding. Let’s say the international price of copper is $0.10 per gram. And the local competition is such that  importers can’t make more than 10% profit. If copper is a priority and importers get letters of credit allowing them to buy dollars at 55 ETB/USD, they can import it for 5.50 birr and sell it to you for 6 Birr. Ok great. But if the importers can’t get foreign currency, what is the price? It’s as if the price is infinity. You could go bankrupt while waiting for copper to be available. Or go to jail buying it from smugglers. Now suppose the importers can get dollars at a market rate legally, they will bring it in at a cost of 10 birr and sell it for 11. The naive academic might say there is inflation because the price went up from 6 to 11.  But people in the real world realize that 11 is less than infinity! Scarcity is a form of inflation. Focusing only on official prices while ignoring scarcity is mistaking the map for the territory, or mistaking the thermometer for the temperature. 

Of course inflation is a serious problem so it’s easy to fall for this fallacy. But would you trust a doctor using a broken thermometer who says: if we fix the thermometer, you will develop a fever? No, you want a practical one who sees the thermometer is broken and that you already have a fever. So while academics and commentators talk about potential inflation, people who provide real goods and services know that the inflation they fear is already happening. 

Exchange rate

A closely related concern is that if the exchange rate is floated, then the currency will rapidly lose value. There are three versions of this worry.

Some think that, by some unexplained law of nature, the black market has to remain more expensive than the official market. So if the official market is floated and ETB/USD goes from 55 to 100, then the black market price will go to 200. That is nonsense The black market responds to supply and demand. If there is a functioning legal market, then there’s no reason for anyone to pay a higher price and also take the risk of doing something illegal! It’s just human nature, people prefer to pay less, and people don’t like going to jail.

A more sophisticated version of this worry is the following: in the black market, both supply of and demand for foreign currency are suppressed, and if you legalize free exchange, the demand might increase more than the supply so the market price will be higher.  But this is also incorrect. Usually, when there’s prohibition, supply is more suppressed than demand. Or to be technical, the elasticity of supply is greater than the elasticity of demand. Without prohibition, all else being equal, the price is lower.

Another variant of the same fear is based on historical examples. In a recent discussion on this topic this example came up: once upon a time, Sudan floated their currency. At the time of the change of policy, the USD on the black market was at 550 SDP. After the float, the market price rose to 600 SDP/USD.  So proponents of currency control claim that getting rid of it caused the SDP to lose 10% of its value. But they should note that in the preceding decade, the black market price of USD had risen 5000%! The currency was losing value very fast. And floating it, if anything, slowed it down. Similarly in the case of Ethiopia, I wouldn’t say that if the exchange rate is allowed to float today, the price of foreign currency will go down tomorrow! Most likely it will continue to rise but it will slow down.  Here’s a picture to illustrate the point (the dots represent real values of the black market as reported in news articles over the last 5 years): 

In short, the black market price is the free market plus a risk premium. If it is decriminalized, the risk premium goes away. So the black market is an upper bound on what the natural market price would be.  

Speculative attacks

A closely related fear is that if the currency is freely exchanged, international currency traders would swoop in and wreak havoc by “speculating”. It is true that financial markets can be volatile but let’s put that in perspective. That volatility is much less than the brutality of the practical forex market as currently experienced by Ethiopians today. The random shocks of getting or not getting a letter of credit are much worse. You can go for arbitrary length periods with an effective price of infinity and volume of zero! 

Sure, if the currency was freely traded, the National Bank of Ethiopia (the central bank) and the Ministry of Finance may make monetary or fiscal policy errors, reserves might run low, etc. But all that would be child’s play compared to the devastation the current currency regime is inflicting on the real economy.  That said, the government can and should shore up reserves. Two obvious moves: stop fuel subsidies; sell off non-strategic and poorly-performing state enterprises (of which there are many).

Sequencing reforms

A related point often made by academics and commentators is: yes the parallel market should be decriminalized, but first the economy must be strengthened, productivity must increase etc. This argument is a bit like sitting in a burning house and saying: yes the fire is bad, but first let’s invest in non-flammable furniture and curtains. It’s missing the burning issue. The currency not being freely exchangeable is suffocating the very things that make the economy more productive.

Upside down tiger

Another argument given against free exchange is that some countries, like the so-called Asian Tigers and China, grew their economies while controlling their currencies. The irony is that in those cases, the control consisted of under-valuing their currencies, to promote exports and investments, while suppressing imports and domestic consumption. They essentially delayed the rise in standard of living in exchange for faster industrialization. But what we have in Ethiopia is the exact opposite: the peg over-values the currency, which subsidizes selected imports, while lowering investment, domestic production and exports! You might call this the “upside down tiger” de-industrialization strategy. No country has grown out of poverty this way. 

Brace for media impact

If the peg is abandoned, we can be almost sure that a lot of the commentariat will miss these two points:

1. they will compare the new free market price to the old peg, instead of comparing it to the old black market price, falling for the map and territory fallacy;
2. they will comment on the increase of foreign currency exchange rate, rather than the fact that the rate of increase declines.  

Even economics professors confuse a decline in the rate of change with an actual decline in the price! So what are the chances journalists and social media activists will be rational? Low. They will probably scream bloody murder.  And governments know that. Hence the “gradual” policy. To be blunt, the political cost of doing the right thing is very high.  

Deva!uyashun!1!?

It’s amazing how many people think the strength or weakness of a currency is determined by a government simply deciding on a price. And they talk about “devaluation” as if it is a matter of just typing in a larger number. Their concept is: the bad guys will force African countries to use a larger number! Oh no, devaluation! We must fight the IMF! Neocolonialism! Bla bla bla. I’m very critical of the IMF and the current international financial order, but this conception of “devaluation” is complete nonsense. But it is political dynamite and a lot of energy is spent trying to defuse it.Here’s how I would respond to it. If you think “government type big number = bad”, then ask yourself do you believe that “type small number= good”? If it’s that easy, do you think that, tomorrow, the Ethiopian government could set the peg at 50 ETB/USD instead of 55 ETB/USD and all imports would automatically be 10% cheaper? If they peg it at 0.01 ETB/USD would imports suddenly be 5000 times cheaper, and the average Ethiopian would afford a Ferrari? Of course not. 

Root cause of currency strength or weakness

From a policy making perspective, the exchange rate is an effect not a cause. It’s an output signal, not an input variable. The real price (which is approximated by the black market not the peg) is a reflection of a basic reality: how many dollars are coming, and how many dollars are going out. This is called the balance of payments. The birr gets weaker if the economy is not bringing in enough dollars. Exports and foreign investments are too little compared to the consumption of imports. And this imbalance can only improve if a) the economy produces more things the rest of the world wants, and b)  the country is more attractive for investment.

Now as we saw earlier, the first order victims of the peg overvaluing ETB are exporters, investors, and remittance recipients. The gap between the market and the peg is a de facto tax on them so it directly reduces their volume. Fewer dollars come in.  At the same time, it’s a de facto subsidy of specific imports, which means more dollars go out. Which makes the currency weaker. Which increases the gap. That’s the death spiral of a weakening currency.  The second order victims are manufacturers and producers more generally; even if they are not exporters, they help the balance of payments by creating products that would otherwise have to be imported. Plus they are part of making the society more productive which improves chances that the society will make stuff the rest of the world wants. Thus, by choking producers, the peg further increases the imbalance, another vicious cycle.

There is no solution that doesn’t include facing reality. Recognize that 55 ETB is just not worth 1 USD. The peg doesn’t make the currency stronger. A broken thermometer does not cure fever! The cure starts by getting rid of the peg, which will

1. in the short term, eliminate the risk premium, improve availability of consumer goods, eliminate an unfair de-facto tax and subsidy, reduce corruption, and stop a major cause of socio-economic rot;
2. and in the longer term, increase exports, foreign investments, and productivity of the society, which will help fix the structural weakness of the currency.

People voluntarily exchanging things at prices they agree on is not a neo-colonial imperialist capitalist evil that needs to be forbidden. It’s what humans have always done naturally everywhere, including in Ethiopia.

This article was originally published here

The post The mother of all distortions: Ethiopia’s foreign currency peg appeared first on Abren.