By Adunya Zerihun
Addis Abeba – On 29 July 2024, the National Bank of Ethiopia announced a reform of the Foreign Exchange Regime, introducing a floating exchange rate – a system where the value of a country’s currency is determined by market forces, which can be influenced by trade balance, inflation, interest rate, and above all by factors affecting security and stability. The exchange rate can fluctuate widely due to changes in supply and demand of hard currencies. Central bank can hardly intervene to determine the value of local currency (Birr). The transition from managed float regime (pegging Birr to other hard currencies with periodic adjustments) to free market (float) forex regime disempowers the national bank to protect the value of local currency and manage disorderly conditions that may need government interventions.
We all understand that it was the critical shortage of foreign currency earnings that coerced the government to surrender to the IMF conditions and requirements without having adequate preparation to put on the ground. The economic condition of the country, however, would not allow the government to benefit from this unprecedented policy change. Severe political conflicts and social unrest, weak and corrupt institutions of the government do not seem to effectively manage the huge and complex consequences of the policy change. Of course, the whole burden rests on the shoulders of the people, particularly the majority poor.
Following the government policy decision, the IMF approved a four-year arrangement, granting the country 2.55 billion in special drawing rights (SDR), roughly 3.4 billion dollars, under the extended Credit Facility (ECF). On July 30, 2024, the World Bank (WB) also approved USD 1.5 billion ($1 billion grant and $500 million concessional credit from the International Development Association (IDA)) to support the government’s Home-grown Reforms, and to help boost protections for poor and vulnerable households during periods of economic change. In addition, the WB has announced a total financial package of over $16.6 billion undisbursed and future commitments available over the next three years subject to the WB Board approval of new operations and availability of IDA resources.
The government insisted that the exchange rate reform is critically necessary to overcome the emergence of an unanchored parallel market exchange rate that has given rise to large-scale contraband exports and diverted the country’s foreign exchange earnings away from the formal banking system. The market-based exchange rate reform is, therefore, to address this market distortion and allow banks to exchange foreign currencies. This reform would help entrepreneurs expand exports, boost manufacturing, and lay the foundation for a stronger hard currency position of the country. The government ambition to attract foreign direct investment has also been noted in the reform.
The market-based exchange rate reform (floating rate) is the most ambitious and risky reform. It is ambitious because the market-based exchange rate is expected to restore macroeconomic stability, boost private sector activity, and ensure sustainable, broad-based, and inclusive growth. If it is to achieve these ambitious macroeconomic goals is to be seen.
The question is, can the objective reality on the ground allow these ambitions of unprecedented macroeconomic reform to happen? Prices of essential goods are already high; the unemployment rate is at its highest peak ever; and the country’s balance of payment is excessively negative and widening. More importantly, the industrial and agricultural productions in the country have severely been hampered by incessant internal conflicts, which limits the prospects of export promotion to adequately generate foreign exchanges in a sustainable manner. Obviously, if the banks cannot meet the demand for foreign exchange, the black market will remain significant – worsening the economic situation. Furthermore, even the government has admittedly acknowledged that several challenges will arise out of introducing the new floating exchange rate system.
The policy lacks adequate consultation with relevant professionals and other key stakeholders although the government has expressed its commitment to transparent communication and engagement with stakeholders throughout the implementation of these reforms. The sudden exchange rate reform to market-based (floating) garners attention of several people as it decisively impacts the economic future of the country.
As it stands now, inflow of hard currency is very limited compared to what the economy needs.
Undoubtedly, millions of Ethiopia will never benefit from the market-based exchange rate at least in the few years to come. The youth who are already vulnerable due to high unemployment rates (including graduates from tertiary level education) will suffer significantly as the reform is less likely to lead to the anticipated economic growth and job creation. Millions of unemployed youths will bear the burden of the exchange rate reform’s negative consequences. The new forex regime puts these vulnerable groups at significant risk without guaranteeing substantial improvements to the overall economic situation. The local currency value fell by 100% before reaching its two weeks (August 16, 2024). In just the first ten days after the reform the local currency (Birr) value dropped by more than 85%. The national bank concluded its first auction with a weighted average rate of Birr 107.90 per USD to banks on August 07, 2024. The 30% decline in Birr value on the first day of the reform was immediately followed by substantial price increase in essential goods.
The crisis has already begun to manifest itself. What we don’t know is where and how it ends. The Ethiopian markets are largely captured by speculators who would like to benefit from every emerging crisis. Government actions hardly help control the speedy inflation. As it stands now, inflow of hard currency is very limited compared to what the economy needs. We don’t anticipate any mechanism that helps us slow the speedy fall of the local currency (Birr). The black market is also further dropping the value of Birr by the day although the gap between the formal and parallel markets are getting closer. The parallel market exchange reached over Birr 130.00 per USD in the first week of the reform.
What is most worrying is the rate at which prices of goods are increasing. Some early observation has indicated that the rate of price increment of some goods is faster than the currency decline rate. For instance, the price of one kg of nails on August 1,2024 suddenly increased to Birr 300.00 from its price of Birr 200.00 before two-days. The 50% price increment of nails is going beyond the 30% local currency drop of the day. The price of edible oil increased by 40% in the first two days. Not only price increases, but shops are also hiding imported edible oils in the anticipation that the price will go higher despite the government’s announcement of subsidies.
Ethiopia had already been in a difficult economic position when the reform was announced. The price of basic consumer goods was already skyrocketing. Dropping the value of Birr is like adding fuel to the worsening living conditions. Price of consumer goods began to rise immediately following the announcement. Speculators have started to withdraw saleable goods from the market to create artificial shortages and unnecessarily raise prices beyond the impact of the exchange rate reform. The case at point was that the Addis Ababa city administration announced taking actions on 71 business organisations on August 1, 2024, for the unnecessary price increment on commodities allegedly sabotaging the macroeconomic reform. One week later (on August 8, 2024), the Ministry of Trade and Regional Integration announced taking various legal actions on over 7,600 business organisations including deregistration and imprisonment. However, such government legal actions are temporary and unsustainable. It only shows the unpreparedness of the government to address the inevitable challenges.
The government should have done the policy change gradually and progressively. This sudden shift to a market-based forex regime is dangerous. Several reasons can be noted. The fast-dropping value of Birr in the first week of the policy reform was an indication that the amount of hard currency available in the market was very limited. Banks were competing over this limited supply of hard currency. Balancing foreign currency demand with its supply is a very difficult economic impediment in years to come. Ethiopia experienced a current account deficit of over 12 billion USD before the policy reform. Ethiopia’s export earnings of about 3.5 billion USD cannot suddenly rise to the level required for obvious reasons. For instance, growing coffee, our major export commodity, requires four to five years. That means, while the costs of imports will be rampant because of excessive dependency on imports, the gains from export will be contained at a low level -widening the gap of the balance of payment.
We know that increase in local revenue through increased taxation and reduction of government expenditure are normal requirements for the IMF and the WB both having detrimental effects on the ordinary people.
The inflationary impact affects not only the people (consumers) but also it extends to government spending as more than a third of the budget requires foreign currency. The recent government announcement to increase the budget by about Birr 550 billion for the 2024/25 budget year was the immediate effect of the local currency value drop. It was not a net gain. The budget is meant to address the shortfalls of the previously endorsed budget due to change in the exchange rate regime. This budget increment is largely used to finance subsidies (salaries, Fuel, edible oils, medicines, and fertilisers), which the government calls ‘comprehensive preparations’ to ensure an orderly transition to the new exchange rate system.
Above all, timing is of a great essence in this reform agenda. Peace and security are prerequisites to realise growth and development. The macroeconomic policy reform has taken place at a time when the Oromo Liberation Army (OLA) and the Amhara wing movement called “Fano” are at war with the government. Development activities were already constrained by the on-going conflicts between the government and the ‘freedom seeking groups’ in the most productive areas of Oromia and Amhara National Regional States. Attempts made so far to resolve the conflicts through political means have failed to deliver results. The economy is seriously weakened due to these conflicts. Addressing these conflicts should have been the priority agenda before indulging in this unprecedented macroeconomic policy reform. At the same time, the country suffered from the already prevailing high by the time this new exchange rate reform took place.
The current government policy to increase tax collection will further infuriate the injuries caused by inflation. We know that increase in local revenue through increased taxation and reduction of government expenditure are normal requirements for the IMF and the WB both having detrimental effects on the ordinary people. Since the economy is already weakened, both tax increment and expenditure reduction hardly attain their goals without hurting people. This may insist the government to print more currency to offset the burden which will further mount the present high inflation.
The poor have almost exhausted resorting to competitive consumer goods and almost reached the threshold of having no better choice. Hopelessness is in its highest peak for many of the unemployed youth.
Floating exchange rates theoretically raise exports and foreign direct investment and enhance the country’s foreign exchange reserves thereby accelerating economic growth. As mentioned above, this cannot be practical due to the prevailing civil war, conflict and political unrest.
Life is increasingly difficult for most of the poor. Some civil servants are spending lunchtimes in churches because of their inability to afford the cost (as reported by members of the parliament this year). The poor have almost exhausted resorting to competitive consumer goods and almost reached the threshold of having no better choice. Hopelessness is in its highest peak for many of the unemployed youth. These conditions are too abnormal to go for such a radical and unprecedented macroeconomic policy reform. The government plan (subsidies) to address the negative impact of the policy reform seems like an attempt to treat the symptoms, not the root challenges of the economy.
The government has sufficiently met the rigid IMF and WB requirements to extend loans to Ethiopia. Once the deal is done and the packages of the reform are implemented, IMF has already forecasted that the Ethiopia’s economy will sustain annual growth of near 8 percent, reduce inflation to 10 percent, raise fiscal revenue to 11% of GDP, reduce debt to 35% of GDP, increase goods and services exports to $20bn, boost FDI to $6bn, and enable foreign exchange reserves to reach $10bn (equivalent to 3.5 months of import cover) in the next four-year period. However, this forecast does not seem to happen.
The government recently announced a salary increment for civil servants earning less than Birr 25,000.00 civil servants. It is still doubtful if the salary increment can offset the burden of increased inflation. Civil servants constitute a small portion of the people in need of support. The government does not have the capacity to address the majority of the poor whose lives are disastrously affected except some civil servants and beneficiaries of the Productive Safety Net program (PSNP). If subsidies made to these groups of people can offset the burden to be brought about by the policy reform remains a concern. Majority of the population are left unattended by any form of support program.
Allowing exporters and commercial banks to retain foreign exchange earnings and removing some import barriers may seem to enhance foreign exchange supplies to the private sector and create a more competitive economic environment. But, its actual impact may not always be positive.
Many professionals in the field argue that the reform brings no significant gains except perhaps attracting contrabandist exporters to the mainstream market. In fact, foreign currency shortage is one of the key challenges of the Ethiopian economy, but not the only one as the government would like to persuade us. Given the previous policy, there were other key issues of concern that the business community wanted the government to address before indulging in radical policy reform. These include addressing insecurity caused by the on-going internal conflicts, bad governance, corruption, malfunctioning institutions, and lengthy bureaucratic process to import goods, among others. These impediments cannot be solved by the policy shift to a market-based exchange rate. Rather, these problems will crowd out benefits gained (if any) from the market-based exchange rate regime and constrain to ensure equitable distribution of benefits regardless of individual connections to the system.
The weak institutional capacity of the country is a significant concern. Effective reform implementation requires robust institutions capable of monitoring, regulating, and managing the forex market. However, the existing institutional framework may need to be adequately prepared to handle the complexities and challenges of a market-based exchange rate system. The market-based exchange rate demands strong institutions, among others, to manage proper financial flow, prevent business related risks, collect government revenues, and provide independent legal services. The prevailing weak institutions further exacerbate on-going challenges and problems rather than solving them. The government did not take proper actions to strengthen its institutions as part of the preparedness to combat the challenges coming with the introduction of this unprecedented policy reform.
Allowing exporters and commercial banks to retain foreign exchange earnings and removing some import barriers may seem to enhance foreign exchange supplies to the private sector and create a more competitive economic environment. But, its actual impact may not always be positive. Removing import restrictions could lead to price increases for essential goods, as market-based foreign exchange rates are much higher than the previously controlled rates. The poorer segments of society are likely to suffer as this price increase erodes their income and further exacerbates poverty and inequality. The government temporary subsidies for essential import goods may not be adequate to offset the overall consumer cost increase.
Despite the government claims that it has begun to export wheat production, agricultural production has been on decline primarily due to ongoing conflicts. Supply of fertilisers was obstructed by the widespread conflicts in the last few years. The price of fertilisers and other imported agricultural inputs will significantly increase due to the newly introduced forex exchange rate regime. The government commitment to subsidise fertilisers will unlikely offset the total price increment brought about by the new policy reform. The market-based exchange rate will only be disincentive to the farming community. The already impoverished smallholders are pressed to carry the additional burden of the policy change.
In conclusion, the unprecedented macroeconomic policy is likely to result in more problems and challenges than benefits and opportunities to the majority population. The government decision was majorly driven by the dire shortage of foreign currency and limited debt service. Peace and security, and robust and adequate institutional and economic preparedness to face the adverse consequences of the forex exchange reform should have preceded the reform agenda. The floating exchange rate may result in Stagflation – the combination of slow economic growth, high unemployment, and a sky-rocketing prices of goods and services for some years to come. This dangerous and risky policy reform may trigger popular revolt against the ruling regime with unpredictable consequences to this economically weak and politically fragile country. AS
Adunya Zerihun, is an economist with extensive background in civil society as a development practitioner.
