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A botched introduction could increase economic volatility.
When coming to power in 2018, a new Ethiopian government embarked on an ambitious path of reform, inspiring widespread optimism at home and abroad.
After political changes backfired, oppressive practices returned, and the efforts at economic modernization have suffered from the turbulence.
Amid these efforts, Ethiopia’s economy has been grappling with severe challenges, both exogenous, like the disruption to global supply chains and high energy prices, and endogenous, such as conflicts and chronic drought.
Yet the government’s approach, including inconsistent fiscal and monetary policies, aggravates the problems.
According to Fitch Ratings, which again recently downgraded Ethiopia’s credit rating, the country is now at “significant risk of default”, directly attributed to low foreign currency reserves and lack of a convincing strategy to replenish them.
The projected deficit of the 2022/23 budget is 281 billion birr out of an approved 800 billion birr. Underlining the constraints, State Minister for Finance Eyob Tekalign recently hinted that the government payroll may have to be slimmed down.
In addition, the Civil Service Commission has approved a bill that allows public servants to hold two roles at the same time. The state minister also confirmed that the Ministry of Finance will not be able to meet any supplementary budget requests.
Capital Policies
It is in this environment that the government is seeking to establish a capital market for the government, businesses, and individuals to buy and sell securities, such as bonds, stocks, and derivatives.
The National Bank of Ethiopia’s 2021 Capital Markets Proclamation proposed a ten-year implementation plan structured around four pillars: market development, capacity development, infrastructure development, and policy reviews.
The law established the Ethiopian Capital Market Authority and led to the creation of the Ethiopian Securities Exchange in late 2022 under the supervision of the Ministry of Finance and guidance of FSD Africa.
The ESX launched fundraising efforts in May 2023 by selling 75 percent of its equity with 25 percent held by Ethiopian Investment Holdings, a new sovereign wealth fund.
While these policies are geared towards a desirable goal—as a fully functioning capital market would eventually boost investment—given Ethiopia’s currently challenging socio-economic landscape, it is a risky move, and so needs to be carefully prepared for and sequenced with other economic policies.
Monetary Fragility
First of all, Ethiopian policy makers need to address the risk of a sovereign default. The government has been struggling to meet interest payments on its debt in recent years as hard currency reserves dwindled.
The balance of payments crisis emerged as growth, loans, grants, investments, and exports all slumped or stagnated, the latter not helped by the U.S.’s removal of duty-free market access on textiles and other selected goods due to Washington’s concerns over the conduct of the Tigray war.
Furthermore, reforms have been impeded not just by economic conditions and political turmoil but also by restrictive regulatory action.
In early 2021, Ethiopia appealed to the International Monetary Fund (IMF) for help. The negotiations, partly over debt restructuring, have progressed since and, since April 2023, Ethiopia was rumored to be in line for a $2-billion bailout.
Devaluation Dangers
While this would provide much-needed hard currency, the IMF is likely to urge liberalization of the exchange-rate regime, which in Ethiopia’s case would surely mean a drop in the over-valued birr.
This would bring its own set of challenges.
In the long run, devaluation might attract foreign investment by lowering production costs and making Ethiopian exports more competitive. However, in the short run, a rise in import and debt-servicing costs could exacerbate the foreign exchange crunch and reinforce inflationary pressures.
Therefore, Ethiopia’s central bank would need to impose higher interest rates to curb inflation, increasing borrowing costs for businesses and consumers. This would deter some of the foreign investors that the Ethiopian stock market aims to attract.
These worries partly explain why the government has so far resisted exchange-rate liberalization or another major central bank-driven devaluation.
Real Risk
Fortunately, there are measures to mitigate these risks, such as the government intervening in currency markets to shore up the value of the birr (which may explain reports that Addis is seeking as much as $12 billion from the IMF and other sources), and investors seeking assets like real estate that tend to increase in value during inflationary periods.
But this latter remedy comes with yet another bitter pill: while it might work for investors, it may well not for the public.
In fact, as Ethiopia’s real estate sector has become one of the main magnets for investment, it poses a concentration risk, meaning the simultaneous and heightened losses that arise when unfavorable circumstances hit a portfolio largely consisting of a single asset.
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This situation is particularly troubling because, like the broader economy, Ethiopian real estate has its own array of problems. Inflation has eroded the value of rents and led to rent hikes. With wages failing to keep up with these rises, demand from renters is likely to slow due to inability to pay.
Still, the Centre for Affordable Housing Finance in Africa estimates that Ethiopia needs to add more than 486,000 units each year from 2025 to 2035 to satisfy the nation’s demand. This sounds like a lucrative investment opportunity.
However, as construction materials’ prices swelled in recent years and because the bulk of the demand comes from low-income households who look for affordable housing, the sectors’ prospects may not be so rosy, and an absolutely essential service is unaffordable for many.
Theoretical Merits
The picture sketched out above is further complicated by the government’s fiscal weakness. This situation, exacerbated by the conflict in Tigray, is in part the result of expansive government spending.
The government is of course trying to promote growth to increase revenues, and the establishment of capital markets can help transform developing economies by stimulating economic activity and underpinning financial stability. But as these markets potentially increase short-term financial volatility, they require both a clear legal framework and meticulous evaluation of the economic landscape.
In particular, the stock market is sensitive to swift changes in investor sentiment, political developments, or technological breakthroughs.
While a wave of investor optimism can propel prices upwards, a surge in apprehension can result in large-scale divestment. In the latter scenario, prices would plummet, with destabilizing effects. Such consequences can partially be prevented if an adequate ecosystem of institutions and experts is in place.
Risk Skills
Another serious constraint the Ethiopian government faces in its attempt to create and maintain a capital market is the relative lack of skilled financial risk professionals. To mitigate against the potentially destabilizing effects described above, expertise in dealing with equity, liquidity, and valuation risks is required. This is missing in Ethiopia.
Let’s take actuarial sciences as an example. The discipline applies mathematical and statistical methods to assess risk, mainly in insurance and finance, and thus is instrumental in dealing with volatile environments.
In the U.S., actuarial work has contributed to the stability and resilience of the U.S. capital market, even in the face of economic downturns and financial crises. Actuaries have been at the forefront of shaping financial sectors by designing and pricing insurance products, valuing liabilities, managing risk, and ensuring regulatory compliance.
Panel discussion led by Brook Taye, Director General of the Ethiopian Capital Market Authority; ESX market sounding and soft roadshow; 16 May 2023
In Ethiopia, however, the actuarial profession is virtually non-existent. There are no institutions dedicated to offering actuarial programs, and the country lacks a professional body to regulate and support actuaries. Tellingly, there are no registered actuarial professionals operating in the country.
This dearth of expertise is a significant impediment to the development of a thriving capital market, as it makes it challenging to accurately price risk and design suitable financial products.
Furthermore, it hampers the development of a robust insurance sector, which can provide a safety net for investors, protecting them against financial losses and managing risk in a capital market.
Smart Policy
This indicates that successful liberalization requires sharp policy solutions, such as incentivizing the development of the insurance sector and promoting financial skills among the youth.
Encouragingly, through recent entrepreneurship, Ethiopia’s digital and technological capacities have shown progress. Therefore, the capital market is well positioned to benefit from the development of data management, collection systems, and technology-related linkages, which may boost the transparency of markets.
Still, the pervasiveness of the informal economy obstructs accurate quantification of Ethiopia’s economic risks, thus increasing the financial models’ instability.
Finally, the government should increase efforts to align local business practices to global standards of operations and accounting, as this would go a long way in increasing Ethiopia’s attractiveness as an investment destination.
The Ethiopian government hails ongoing economic reforms as necessary steps toward realizing the country’s potential. This might indeed be the case, yet, as argued above, the harmful potential of an ill-implemented capital market could increase volatility.
Overall, a capital market will succeed in stabilizing the Ethiopian economy and attracting investors only if it is transparent, independent, and built upon an unimpeded and intelligible flow of information.
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Main Image: (L-R) Ermias Eshetu – CEO FSD Ethiopia, Brook Taye – Director General of the Ethiopian Capital Market Authority, and other panelists; ESX market sounding and soft roadshow; 16 May 2023
This is the author’s viewpoint. However, Ethiopia Insight will correct clear factual errors.
Published under Creative Commons Attribution-NonCommercial 4.0 International licence. You may not use the material for commercial purposes.
