Ethiopia: GDP, inflation and currency debate

This article is a third in a series looking at Ethiopia’s current economy.The first and second reports were respectively published on June 7 and 14 2023 . More will be added to this series.

GDP

Ethiopia’s economic growth has been more resilient than expected since the start of the pandemic and is expected to recover further in the medium term. Despite a tense political crisis and global dynamics, nominal GDP growth is strong. In 2018/19, the growth rate was 9 percent, which dropped to just over 6 percent in 2019/20 but rose to 6.4 percent in 2021/22(^{source: IMF)}. This resilience is attributed to an early reopening after pandemic lockdowns, particularly in the agricultural and service sectors. However, the manufacturing and construction sectors experienced a slowdown due to foreign exchange (FX) shortages and difficulties in importing necessary materials. Conflict was also a damper on growth.

The forecasted growth rate for 2022/23 is 6.1 percent, and 6.4 percent for 2023/24. Agricultural growth is hindered by low fertilizer imports caused by high prices and hard currency shortages, as well as droughts impacting livestock in certain regions. These FX shortages are expected to continue affecting industry and construction due to delays in the effects of exchange rate unification. In the medium term, growth is anticipated to increase to 7-8 percent as external and conflict-related shocks decrease, and the market-driven exchange rate brings about improved competitiveness and efficiency gains.

Looking ahead from 2022-2033, IMF estimates average real GDP growth at 7.2 percent, which is slower than the historical average of around 9 percent per year over the past two decades, but still significant when compared to current global GDP rates. This projection takes into account demographic factors, such as the relatively young population. The median age in Ethiopia is below 20 years. It also takes into account expected productivity gains resulting from reforms and economic transformation efforts.

The Ethiopian economy experienced rapid growth for 15 years but has recently faced various challenges that have led to a slowdown. From 2003/04 to 2010/11, Ethiopia achieved double-digit growth, averaging 11.4 percent annually, driven by increasing productivity. According to the IMF, Ethiopia economic growth continued from 2011 to 2019, supported by public sector capital investment financed by debt, although productivity declined during this period.

However, from 2019 to 2022, growth slowed down due to multiple shocks, including the COVID-19 pandemic, domestic conflicts, drought, and spillover effects from the war in Ukraine. According international financial institutions, despite these challenges, the GDP growth is projected to reach around 8 percent in the medium term.

The expected growth trajectory relies on the assumption of lasting peace, along with the fading impact of previous shocks. However, the recovery is still influenced negatively by ongoing drought and spillover effects from the war in Ukraine. In addition, political instability could reemerge in a way that negatively impacts growth.

The Washington based international financial institutions acknowledge recent reforms implemented in the country are anticipated to contribute to growth dividends. Structural, fiscal, and institutional reforms aim to enhance resource allocation, attract external financing, and increase productivity and private investment.

According to the IMF, moving forward, a moderate fiscal consolidation, shifting away from state-owned enterprise-led, debt-financed investments, and eliminating financial repression would foster competitive growth driven by the private sector. Prioritizing investments in education, health, and social protection would help build human capital.

Furthermore IMF suggests strengthening financial stability, particularly by addressing non-performing lending to state-owned enterprises by the Commercial Bank of Ethiopia (CBE), can support resilient economic growth.Vested interests as well as temporary inflationary aftershocks of some of these changes will present challenges

Inflation

Inflation has been a concern in the economy, with the rate rising from 20 percent to 37 percent from 2021 to the mid 2022. Since then, it has decreased, but remains above 30 percent. The increase in inflation can be attributed to various factors, including monetary financing and cuts in reserve requirements that were implemented in June 2021. These measures have worsened inflationary pressures, in addition to the impact of globally rising prices, including food prices, increases in excise rates and electricity tariffs, and the gradual removal of domestic fuel price subsidies.

While there has been a slight decline in food price inflation from its peak in May 2022, it was still at a significant level of 32.9 percent year-on-year in December 2022. This indicates that food prices continue to contribute to the overall inflationary pressures in the economy.

If the global supply of food as well as domestic production improves, it is expected that food inflation will decrease, which is good news for consumers. However, this positive development might be counteracted by the removal of fuel subsidies and ongoing monetary financing, although the latter is expected to decrease gradually.

Key inputs such as fertilizer are almost wholly imported using hard currency, which is in short supply.Ethiopia is set to import 7,250 metric tons of fertilizer by 2026, up 4.1% year-on-year on average. If political campaigns to curb or sanction remittances are successful it would make it difficult for Ethiopia to import key inputs like fertilizer, thus exacerbating food insecurity.

The process of removing fuel price subsidies for private vehicles began in July 2022 and will occur gradually over time, likely in quarterly increments. This means that fuel prices will gradually increase as the subsidies are phased out.

Additionally, if unification of informal and formal exchange rate for the Birr is achieved, then items in the consumption basket will experience a sudden increase in prices. This is true for those items that were not previously priced in line with the parallel rate. Furthermore, inflationary pressure due to expectations effects will occur, where people anticipate higher prices and adjust their behavior accordingly. Despite the tightening of monetary policy measures, these expectations effects of a flexible exchange rate are likely to cause inflationary pressure. A previous report published on Abren briefly touched on why IMF proposals to mitigate inflation resulting from rapid devaluation will not be effective.

Flexible Exchange

IMF line of thinking maintains that transitioning to a market-driven exchange rate would stimulate industrialization and eliminate uncertainty regarding foreign exchange availability. This move is meant to attract more foreign direct investment (FDI) and remittances, leading to increased exports and potential upside risks to conservative growth projections. Most importantly, it is argued, a free floating exchange rate would help alleviate shortfalls in available foreign currency.

However, the fund tends to downplay the the risks associated with a flexible exchange rate, particularly if massive financing support is not available from the fund to ease the transition. A bulk of critical inputs imported are managed by State Owned Enterprises (SOEs), which have priority access to FX at the current pegged rate. A sudden movement to a free floating exchange will cause an acute price hike for critical imports.

The risks of a flexible exchange rate are highlighted below.

1. Exchange Rate Volatility: A flexible exchange rate system allows currency values to fluctuate based on market forces. This volatility can pose risks to businesses engaged in international trade, as sudden and unpredictable exchange rate movements can impact the cost of imports and exports, potentially affecting profitability and competitiveness. This is especially risky for developing economies.
2. Economic Uncertainty: Exchange rate fluctuations can introduce uncertainty into the economy, making it challenging for businesses and investors to plan and make long-term decisions. Uncertainty surrounding exchange rates can deter foreign direct investment and reduce confidence in the domestic economy.
3. Inflationary Pressures: A significant depreciation in the domestic currency can lead to higher import costs, which can in turn contribute to inflationary pressures. If the exchange rate depreciation is not offset by increased productivity or export competitiveness, it can result in higher prices for imported goods and services, impacting consumers and businesses.
4. Financial Market Instability: A flexible exchange rate system can expose a country’s financial markets to increased volatility. Sudden changes in exchange rates can lead to capital flight, impacting the stability of the financial system and potentially triggering financial crises.
5. External Debt Burden: In economies with a high level of external debt denominated in foreign currency, a depreciation of the domestic currency can significantly increase the debt burden. This can lead to difficulties in servicing debt obligations, potentially leading to economic instability. This is called a debt trap.
6. Competitiveness Challenges: While a flexible exchange rate system can help restore competitiveness by adjusting the relative value of the currency, it does not guarantee automatic improvements. If the underlying factors affecting competitiveness, such as productivity or structural issues, are not addressed, a flexible exchange rate alone may not be sufficient to boost exports and overall economic performance.

In light of a large trade imbalance, lack of FX is an impediment to the economy. However, a sudden shift to a flexible exchange rate, without substantial international financial support to fix this problem can worsen inflation, which will increase social discontent in Ethiopia. In the absence of financial support from the multi-lateral development banks (IDBs), policymakers in Ethiopia are obliged to continue the gradualist approach on official currency depreciation. Authorities have to carefully consider the risks associated with a flexible currency exchange system and apply appropriate monetary and fiscal policies, as well as structural reforms, to mitigate the potential adverse impacts to the economy.