The Ethiopian government must urgently address the overvalued currency and negative real interest rates as the central pillars of its homegrown economic reform agenda.
Imagine navigating a complex problem much like Alexander the Great in ancient Gordium, Phrygia, facing the legendary Gordian Knot. This intricate puzzle, tied around an oxcart, held a promise that whoever untied it would conquer all of Asia. In 333 BC, Alexander was confronted with this challenge. Instead of attempting to meticulously untangle it, he drew his sword and sliced it apart — a testament to his unique approach and ingenious thinking. This tale sets the stage for our discussion on how to tackle seemingly insurmountable problems by applying unexpectedly simple, innovative, and rule-bending solutions, much like slicing through our very own Gordian Knots.
Ethiopia's economy is currently embroiled in a complex web of challenges, much like the infamous Gordian Knot. Prominent among these economic problems are two critical distortions - an overvalued currency and negative real interest rates. These issues not only stifle growth but also induce macroeconomic instability and chip away at the confidence of investors and consumers alike.
Distortion One: The Overvalued Ethiopian Currency
The issue of overvalued currency stands as a significant impediment to rectifying Ethiopia's trade imbalances, thereby exacerbating the country's macroeconomic difficulties. Rising income levels that have resulted in increased imports, coupled with stagnated export earnings, have created a significant mismatch leading to a widening balance of payment deficit. The inability of the National Bank, which sets the official exchange rate, to adapt quickly and decisively exacerbates the problem. While the Ethiopian government has acknowledged the issue, its actions to rectify the situation have often been inadequate or delayed.
Despite intervention from the International Monetary Fund (IMF), attempts by the National Bank of Ethiopia (NBE) to redress the birr's overvaluation, including a 20% yearly devaluation over the past four years, have been hindered by domestic and global shocks. These disruptions increase import bills and decrease foreign exchange inflows, the gap between the parallel and the official rate has widened like never before causing not only imported goods but other domestically produced goods and services prices to be priced through the price diffusion impact of the parallel rate. Commercial Banks now match the parallel market rate by offering importers foreign currency with up to 100% premium under the guise of facilitation commission for foreign currency supply.
Distortion Two: Negative Real Interest Rates
The other equally damaging distortion pertains to the negative real interest rates. Given that inflation currently stands at a staggering 34% while interest rates remain low at 7% for standard saving accounts, the country's economy finds itself caught in a vicious cycle. This situation leads to a reduction in savings and increased consumer spending, with low investment rates continuing to fuel inflation. A restrictive financial sector aggravates the situation further, suppressing competition and hampering efficient resource allocation. These distortions are interlinked, as evidenced by Ethiopia's recent monetary policy developments. Broad money growth has averaged 24% during the previous three fiscal years, contributing to persistently high inflation. Factors such as the Russia-Ukraine conflict, foreign exchange shortages, and exchange rate depreciation exacerbate the situation, pushing inflation above 30% for the first time since 2009.
The consequences of these distortions are evident in Ethiopia's economic indicators. Private consumption has risen to 77.4% of GDP in 2022/23, while savings have dwindled to a mere 15.3%, a far cry from the ambitious target of 28% set for 2024/25 in the ten-years development plan. Government capital spending is also at its lowest in a decade with below 3% of GDP. As a result of low savings, gross capital investment has fallen to 25.3% of GDP in the 2022/23 fiscal year, well below the 36.9% required to achieve the projected 10% GDP growth rate in the Ten-years plan. For the sake of comparison, gross capital investment was 37.3% of GDP in 2016/17. This decline in investment, coupled with the government and private sector's increased consumption spending creates a vortex of continued price rises that jeopardizes the country's economic future.
Untangling the Knot: Decisive Measures Required
To address these challenges effectively, the Ethiopian government must take decisive action akin to Alexander the Great's approach to the Gordian Knot. By addressing the overvalued currency and negative real interest rates head-on, Ethiopia can create a pathway toward a stable, resilient, and prosperous economic future.
To address these distortions, the Ethiopian government must implement a comprehensive set of policy measures to foster macroeconomic stability and restore investor and consumer confidence. The following policy recommendations should be central to Ethiopia's economic reform agenda:
Liberalize the exchange rate regime: Let the market set the currency exchange rate to ensure it reflects market conditions and eliminate the gap between the official and parallel market rates. This would help curb speculative behavior and promote competitiveness in the export sector. The current system that rewards speculators and black-market agents at the expense of exporters will not only impact growth but also divert investment away from productive sectors.
The key lesson from previous attempts to address exchange rate distortions through devaluation shows it doesn’t work as it will not sufficiently remove the incentive to use a parallel market. Devaluation will not remedy the problem, but it will only push parallel markets to increase the premium. Hence, liberalizing the exchange rate regime is the only reasonable solution.
As Ethiopia embarks on a path to liberalize its exchange rate regime, it simultaneously invites a host of unpredictable variables. Of particular concern is the potential surge in inflation due to the nation's substantial dependence on imports. The availability of essential commodities, including but not limited to food, cooking oil, fertilizers, fuel, and life-saving medicines, could become precarious, primarily affecting those with fewer means. This demands the government's immediate attention and decisive intervention to safeguard the consistent availability of these crucial products.
In response, the government must consider implementing safety measures that provide an effective cushion against the potential inflationary impact. Such strategies may include instituting price caps on essential items or allocating targeted subsidies to maintain affordability. Simultaneously, it is crucial to recalibrate the balance between import dependence and local production. By fostering and supporting local industries, their productive capacity can be enhanced, promoting the use of alternative, locally sourced resources.
Recognizing the need for immediate and targeted governmental intervention is equally critical during this transition period. It is necessary to subsidize key food and consumer products until domestic production levels are sufficiently heightened to leverage the economic competitiveness that a liberalized exchange rate brings.
The government should also work diligently to diversify its foreign exchange inflows. This includes strengthening forex reserves in cooperation with international financial institutions to ensure the uninterrupted supply of essential import items. By adopting strategies that expand the sources of foreign exchange inflows - enhancing the competitiveness of the export sector, encouraging foreign direct investment, and drawing remittances through formal channels - the government can alleviate forex shortages and promote a more stable exchange rate.
The liberalization of the exchange rate will undoubtedly present its own set of challenges. However, through strategic planning, targeted interventions, and enduring commitment, the government can effectively steer through these tumultuous waters. The ultimate objective remains to foster a more competitive, resilient, and prosperous Ethiopian economy.
Second, Reform monetary policy: the government needs to implement monetary policy reforms that focus on targeting inflation, rather than merely controlling the money supply. This would involve transitioning to an inflation-targeting framework, improving the central bank's independence, and enhancing the effectiveness of monetary policy tools. Adjusting interest rate targets to match prices in the economy will ensure capital distribution will favor those with real value added in the economy and remove the incentive to shell out loans to importers and real-estate speculators.
Furthermore, Financial sector liberalization encourages competition in the financial sector by relaxing entry barriers for private banks and allowing foreign banks to operate in the country. This would spur innovation, improve efficiency, and lead to a more effective allocation of resources.
Enhance financial inclusion and deepen the capital market: Promote financial inclusion by expanding access to financial services for the unbanked population, and develop the capital market to provide alternative sources of funding for businesses. This would encourage more savings and investment, and contribute to economic growth.
Foster a conducive business environment: Implement regulatory reforms to improve the business environment, enhance business efficiency, and reduce bureaucratic red tape. This would help attract both domestic and foreign investment, spur entrepreneurship, and facilitate the growth of the private sector.
The policy measures outlined above represent a comprehensive approach that, if implemented effectively, could help to disentangle these economic challenges and lay the foundation for sustainable growth and stability. By implementing these policy measures, Ethiopia can begin to untangle the knot of its twin economic distortions, paving the way for a more stable, resilient, and prosperous future.
The road ahead is undoubtedly challenging, but with a clear vision and a concerted effort, Ethiopia can overcome these obstacles and unleash its full economic potential. While the journey will be arduous and may require difficult trade-offs, the Ethiopian government must remain steadfast in its commitment to reform. By addressing these distortions head-on and implementing sound policy measures, Ethiopia can unlock its economic potential, foster a prosperous future for its citizens, and secure its place as a thriving and dynamic economy on the global stage.
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