Although much remains to be done, Ethiopia is on the path to a more balanced and sustainably productive economic model.
Since 2018, Prime Minister Abiy Ahmed’s administration has revamped the economic policy framework to shift away from a state-led development model to one led more by the private sector. The new approach favors a market-based financing model for the private sector while allowing the state to keep accessing concessional financing from development partners to fund infrastructure spending.
In the face of a growing debt burden, the “Homegrown Economic Reform Agenda” aims to create the “fiscal space” for further public investments in infrastructure, human capital, and institution building that are needed to leverage private sector investment.
But critically, a private sector-led economy is dependent on a well-functioning financial system and a prudent monetary policy that starts with a targeted inflation rate. The past two and half decades of Ethiopian central bank regulations were designed to cheaply fund the government budget deficits and facilitate much-needed public investment by keeping interest rates artificially low.
However, the focus on public investment-driven growth model has reached its limits and the resulting economic imbalances meant major impediments for a market-based allocation of financial resources, severely impacting private business. A market-based funding model for the private sector ensures pricing mechanisms in the allocation of financial resources driven by supply and demand for risk capital.
Now, therefore, is indeed the time for the authorities to unleash the financial sector. That starts with revamping the monetary policy and financial sector regulatory frameworks. It also means a shift from the past funding policies, away from Beijing and towards the West.
Ethiopia’s financial sector is in its infancy, dominated by the state-owned Commercial Bank of Ethiopia (CBE), with about 57 percent of deposits and 45 percent of profits from the total of 18 lenders.
Yet, over the past decade, it was another state bank, the Development Bank of Ethiopia, that supported enterprises and projects within industries the government deemed to be important for the national economy, such as the textile, commercial farms and sugar factories.
These projects were sponsored through funds mobilized by private banks by the compulsory purchase of National Bank of Ethiopia (NBE) bills. The deadweight in the private banks consisted of about 27 percent of their gross lending and it earned them a return well below the interest rate paid to depositors, funds the private banks could have deployed to profitable ventures at commercial terms.
Furthermore, deposit mobilization has been one of the biggest challenges faced by Ethiopia’s banks, thus stunting businesses’ need for long-term financing for expansion.
Despite significant increases in savings rate (by five percentage points to 22.3 percent of gross domestic savings as a proportion of GDP between 2011–2019), deposit mobilization continues to be a challenge due to preferences for consumption and about two-thirds of adults still remaining unbanked.
Almost all banks provide traditional collateralized loans, mostly through short-term trade finance, but they are only primarily accessible to well-capitalized traders, exporters, large established conglomerates, and foreign direct investments (FDIs). The state-owned enterprises (SOEs) access loans through the state banks.
Ethiopia does not have capital markets where businesses can raise equity financing. For long, local businesses have relied on selling shares directly to the public in disorganized and inadequately regulated markets. Almost all of the foreign investments in the manufacturing sector are channeled directly to projects as equity risk capital.
The country continues to experience acute foreign currency shortages and it is finding it difficult to fund the growing demand for imports of inputs into productive sectors. Private banks compete amongst themselves and with the commercial bank for the limited foreign currency, yet they are required to surrender 30 percent of their hard currency earnings to the government.
The government’s forex demands for infrastructure development and its investment in non-exporting SOEs have exacerbated the shortages and put a real strain on the availability of foreign currency for productive sectors, such as, agriculture, industry and construction. In particular, the manufacturing exporters that are dependent on imported inputs have suffered greatly from forex shortage.
Ethiopia’s dogged attempt to industrialize on the back of a state-led economic policy has contributed to the macroeconomic challenges. Unfettered government spending on the back of monetary expansion led to double-digit inflation, recurring budget deficits, and ballooning debt repayments that the government struggled to service given the meager foreign exchange receipts. State banks are saddled by massive non-performing loans that funded some of the notable FDI projects in textile, commercial farms and manufacturing enterprises.
In short, past policies that were focused on funding the budget deficit and implementing the state-led development priorities created mispricing that prevented the vast majority of small and medium sized enterprises from accessing the necessary financial resources to grow.
Prolonged high inflation, lately exceeding 20 percent, has had several ramifications. The most evident has been the transfer of wealth from depositors to borrowers that benefit from borrowing costs well below the rate of inflation and the banks that benefit from the widening spread.
The least evident outcome of inflation has been the diversion of scarce risk capital by those that need to access it, away from the productive sector of the economy into assets that merely provide safety. In most cases, such assets are tools to preserve value and are often times under-utilized, representing deadweight to the economy. It is not unusual for businesses to also hedge for inflation by investing in speculative and non-operating assets such as real estate.
Exporting, an economic activity that used to be conducted profitably, has long been relegated to earning the foreign currency businesses need to redirect into activities that yield profits from imports. In the past, well-capitalized traders in the import business who are able to afford to stand in a queue profited from foreign currency allocation at the expense of exporters operating on thinner margins.
For instance, coffee exporters lose a significant portion of their dollar earnings due to policies that forces them to convert most of their earnings into local currency. Over time, the downward pressure on ‘export only’ businesses ratcheted up as more importers sell goods abroad, often trading at loss, to simply generate the foreign currency they need to run the more lucrative import business.
The market now consists of importers running a parallel exporting business. These imposter exporters drove out legacy traders to take advantage of the small amount of foreign currency being retained by exporting activities. In essence, the implied currency mispricing failed to create the right incentives for exporters, causing the precipitous decline of export earnings over the past decade, while imports have increased dramatically, along with the perpetual inflation.
Although formal remittances have increased over the past decade, evidence suggests that informal networks remain a prominent way for Ethiopians to send money home. There are estimates that put the extent of informal remittances to consist of about three-quarters of the total. Apart from the high costs associated with formal remittances, the existence of parallel market and a widening spread between formal and informal rates contributes to the skyrocketing use of informal transfers.
FDI flows have either remained stagnant or declined over the past couple of years primarily as a result of the uncertainties caused by the changing political landscape. The overvaluation of the Birr (by as much as 25 percent, according to the IMF) is a serious headwind undercutting the administration’s efforts to attract investment. COVID-19 has further exacerbated the downward pressure on the local currency, resulting in a steep depreciation over the past six months to one year, in line with the administration’s plans to transition to a more flexible exchange-rate regime.
Reform implementation is hampered by lack of expertise, slow adoption of financial technology, weak institutional capacity and also the absence of the right incentives, which are all essential to crafting a synchronized economic model to execute a comprehensive financial reform agenda.
The development key
The administration has placed a priority on removing the constraints for the development of the private sector, which also involves implementing structural reforms and improving on ease of doing business to increase productivity. The government will also need to carry out the planned privatizations and refocus its role to promote competition and ensure the state and public enterprises do not crowd out the private sector.
In particular, the availability of short-, medium-, and long-term financing at the right cost is the key to improving productivity and competitiveness. Estimates put the demand for loans from the micro, small and medium sized enterprises as exceeding current supply by as much as four times. As well as boosting businesses, improving access to finance will benefit Ethiopia’s massed ranks of low-productivity smallholders that still use traditional farming methods.
Organized and regulated capital markets could also play a key role in helping raise substantial risk capital form the public, both inside and outside of the country. Lack of capital markets adds to the difficulty for the efficient allocation of risk capital to deserving projects.
The Development Bank of Ethiopia’s (DBE) role in allocating the limited debt funding and forex available to projects the government deems priority sectors has not helped either. Sponsors that funded projects by cheap loans and generous allocation of forex from DBE have, for various reasons, struggled despite overt support from prior administrations. Many have either diverted the resources elsewhere or abandoned projects altogether and vanished, leaving the bank saddled with non-performing loans and ever-increasing distressed assets to the extent of a third of loan portfolios.
In general, risk capital and credit to the private sector is limited, and the forms and features offered do not necessarily match the needs and demands of businesses. Severe limits on availability of foreign currency for imports of machinery, spare parts, raw materials and other productive inputs have impeded the exporting manufacturing sector, further putting downward strain on the financing it needs to grow.
There is compelling evidence of the government’s earnest work towards modernizing its policies regarding controlling inflation, deficit financing, exchange-rate determination and overarching monetary policy.
For example, in December 2019, it shifted away from the compulsory purchase of the central bank bills to the launch of Treasury Bill auctions at a rate sufficient to cover the banks cost of funds—this is a step in the right direction. Banks can still choose to fund the government initiatives, and there are indications that the returns on government T-bills will be used as a reference policy rate, more like a benchmark ‘risk free’ interest rate, for banks to set the minimum borrowing rates.
The overvalued birr, which for years contributed to slowing FDI, is now being allowed to depreciate almost daily, as opposed to the one-time devaluations of the past. Despite such efforts, the spread with the parallel market, which now stands at about 30 percent over the official rate, fails to abate.
The administration allowed the participation of Ethiopian diaspora in the financial sector a little over a year ago, but with a directive requiring the purchase of shares of financial institutions in foreign currency. There is little surprise it didn’t get much traction—the currency mispricing could not make up for the implied premiums on the shares. The government’s policy has thus far effectively reserved participation in the financial sector only for Ethiopians.
The administration considers liberalizing the financial sector and floating the birr as key reforms. The regulator has signaled the exchange rate regime will liberalize in the next two to three years, and there are indications of the financial sector opening sooner.
However, the recent announcement to hold off the privatization process of some major SOEs means the administration will have difficulty in floating the currency as it lacks the foreign currency reserves to stabilize the birr and the resources it will need to deal with the impacts of imported inflation and the resulting ballooning budget deficits.
Unleashing the financial sector
The leasing proclamation from a few years back, the only financial area open to foreign investment, had actually opened the door for international players to enter into capital goods leasing—an expertise severely lacking within the local banks—and the move at the time was applauded for offering creative solutions to pressing credit problems. Yet, regulatory hurdles continue to limit its potential to provide much-needed equipment financing for SMEs.
The recent central bank announcement allowing private banks to tap into foreign currency loans from overseas lenders is yet another step in the right direction. Although the details are yet to be seen, the move indirectly opens the financial sector for foreign banks by allowing them to provide wholesale type of loans through the local banks, which would then avail much-needed foreign currency to businesses.
What remains unclear is the cost of foreign currency loans to the local banks and how the foreign currency interest costs for the businesses compare with the low local currency borrowing costs. There is little doubt that the availability of foreign currency loans will eventually drive up the costs of birr loans to account for inflation.
In an effort to control prices, the government recently unveiled new currency notes and demonetized the old birr. The aim was to control the billions of black money circulating outside the banking system, often times deployed in informal activities and driving up asset prices.
Demonetization is intended to rein in the informal sector that has for long avoided paying taxes and bring them into formal economy. It is also aimed at curbing the circulation of paper money outside of the financial system—this will be a windfall deposit mobilization for banks. Faster adoption of electronic payment technology within the financial system will reduce the circulation of paper money, which will also help to preserve the gains made from demonetization.
The new investment bill will go some distance in attracting more FDI in the coming years. However, significant marked-based funding, possibly in the hundreds of billions of dollars, will be needed for the private sector to deliver on the lofty expectations of the reform agenda aimed at promoting a sustainable path that enables the creation of jobs and boosting exports on the back of the private sector. There is little disagreement that the financing gap to realize such lofty expectations is just too wide and well beyond the capacity of the existing financial sector.
Ethiopia’s state-biased macroeconomic policy and overbearing financial regulations have long been unsustainable and at times counterproductive.
What is unfolding was the culmination of past policies that linked to one another and had unintended ripple effects. Unless addressed with a reset, the problems would have continued to grow. There is no getting ‘back on track’—because the track that was followed resulted in the macro crisis in the first place.
The government’s willingness to devise and implement reforms for private sector-led development has been commendable. Commercial enterprises play a key role in creating jobs and promoting sustainable economic growth. The unshackling of the financial sector, in particular, means there is light at the end of the tunnel.
Economic policy is now geared to implementing policies to rein in budget deficits, control inflation, and make smart infrastructure investment decisions. Further financial reforms will be key to aligning incentives, remedying mispricing, and ensuring a level playing field for all economic participants. People respond to incentives, and the right financial policy is one that allows maximum number of economic actors to be competitive. Gradually, we seem to be finally heading down that fruitful avenue.
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Main photo: The National Bank of Ethiopia.
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