Ethiopia: Pressure to devalue currency

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Ethiopia’s current account deficit position is increasing the pressure to devalue its currency but a weaker money means more inflation.

This article is the second part of a series looking at Ethiopia’s current economy.The first report was published on June 7, 2023. A few more will be added to the series.

The Washington based international financial institutions (IFIs), IMF and World Bank included, advise a major constraint to foreign direct investment and private capital inflow into Ethiopia, besides conflict and instability is foreign exchange (FX) availability. Shortages in FX is indeed a chronic impediment to most African economies. The IFIs maintain a flexible market clearing exchange, otherwise knowns as a floating exchange rate would alleviate FX Shortages in Ethiopia. This will certainly be a topic of important discussions between the National Bank of Ethiopia (NEB) and the IMF this month.

Besides reducing costs and uncertainties for remittances, they argue a flexible FX exchange rate will reduce uncertainty for investors and improve competitiveness of Ethiopia’s export sector. These arguments echoed in a 2019 report by the World Bank, namely “The Exchange Rate: Why It Matters for Structural Transformation and Growth in Ethiopia, 2019” will feature large in this latest round of meetings between Ethiopian authorities and the Fund.

Fund managers also argue flexible exchange rates are needed to bring about rate-unification, economist jargon meaning to unity between the official exchange rate and the parallel informal rate. Currently the parallel exchange rate in Ethiopia stands around one hundred ETB to one USD. The other option is for NEB to depreciate the ETB exchange rate gradually. This is the preferred option by Ethiopia, as it entails the least socio-economic impact in a heightened inflationary market. The process of depreciating which began in 2019 at two percent per month has sense reduced to less than one percent however. The downside of this approach gradualist approach has been problems with market signaling, and more uncertainty for market participants.

State owned enterprises (SOEs) which manage the bulk of critical imported goods, such as fertilizer and fuel will incur an abrupt cost increase if flexible rates are applied. This cost will eventually be passed down to the consumer, which will have political consequences. In addition, any cost increase of SOEs will increase liquidity and credit risk exposure to the banking sector, particularly to Commercial Bank of Ethiopia (CBE), which holds most of the SOE debt in Ethiopia. Abren published a recent report on the nexus between SOEs and banking sector in Ethiopia.

Additional risks associated with a flexible exchange rate are as follows.

  • Social impact: Coming out the the Covid pandemic, Ethiopia went into a series of shocks, which include civil war, droughts, effects of the Ukraine war. Ethiopia’s inflation is already high, and recent removal of subsidies for fuel has led to more price increases. This will have a negative impact of the urban poor disproportionately and has potential to lead to more social discontent.
  • Uncertainty in Foreign Exchange: FX suppliers may hoard currency in the near term until a clear market exchange signal is established. If this takes too long there could be even more inflationary pressure for households.  
  • Market Signaling: If the policy framework and new unified exchange rate is not seen to be credible inflation will increase.
  • Vested Interests: If new exchange rate unification program is taken seriously and implemented, substantial pressures will come from entrenched SOE institutions who have a vested interest in accessing available. For example, given the in SOE and CBE nexus, wavering commitment and FX guarantees could lead to re-emergence of a parallel market spread, uncertainty and continued depreciation pressures of the Birr.

Structural economic change as envisioned by the Washington based IFIs will be difficult, and risk mitigation recommendations are likely to be unpopular, and perhaps ineffective. Proposals to ease this transition, including removal of restrictions on imports to assuage consumers and workers affected by currency devaluation will have little impact.

Another risk mitigation proposal discussed by the fund is spending on cash transfer programs to help low income earners. This too is not possible without extensive external support, which traditional foreign partners in the West are not too keen on these days. The balance of payments deficit means the possibility for temporary deficit spending by the ministry of finance is doubtful.

Any structural adjustment program for Ethiopia, as suggested by the 2019 IMF plan as well as subsequent discussions and reports cannot be realistically implemented in the current environment without adequate financing to make the package politically and economically palatable. Prime among these support packages is strengthening social protections to cushion low-income earners. In addition to temporary measures to bring inflation down, social safety net programs must be reinforced. However, there is no sign any of this is currently happening. On the contrary, based on a very recent report of humanitarian food aid suspension by WFP and USAID, we can say externally supported social safety nets are becoming ever more unreliable.

Short of significant monetary policy support, which realistically means more drawing rights, and more money lent to Ethiopia, it will be highly risky to implement a rapid exchange rate unification as envisaged by the IMF’s structural reform plan. This is one the reasons Ethiopia had requested more than three times its current drawing right. The program foresees significant tightening of financial conditions and provision of substantial financing upfront would be needed to soften impact of adjustment.

Proposed plans are contrary to long held industrialization plans by Addis Ababa. Authorities have also resisted changes that may negatively impact recent drive for import substitution, an idea discussed in Ethiopia’s Home-Grown Economic Reform Plan. Ethiopian authorities are proud to have brought down the country’s debt to GDP ratio by 8 percentage points to 48 percent of GDP, of which 23 percent is external debt.

GDP continued to grow at a relatively fast pace proving doubters wrong. Growth this year is expected to be in the mid 6 percent range and forecasted rise to about 8 percent in the next 3 years. Based on these predictions, the economy would be one of the worlds leading growth markets in nominal terms.

Speaking at IGAD coherence on June 12, 2023, Kenyan president, William Ruto urged states of the Horn of Africa to trade in local currency via the Africa-Exim bank instead of seeking dollars or euros.

Current IMF funding readiness to Ethiopia remains ambiguous, as geopolitical and security considerations loom large in the Horn of Africa, and the wider world. So far, important member state have hesitates have hesitates in giving the green light to disbursement of funds.

Regional states may seek steps to mitigate the lack of hard currency reserves by attempting to integrate their markets into free trade zones, that does not depend on the Dollar or the Euro. Much praise was given to such initiatives at the most recent meeting of the Inter-governmental Authority on Development (IGAD), a regional body that includes Ethiopia, Kenya, Eritrea, Sudan, Somalia, South Sudan, Uganda, and Djibouti. Reducing barriers on the movements of goods and services within the region however is a longterm plan. In the meantime, current account deficit positions are increasing the pressure to seek external support, and devalue regional currencies, which adds to inflation.  

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