Commentary

Exchange rate reform– damn if you do, damn if you don’t

Addis Abeba – The political and business corridors of Addis Abeba are overwhelmed by talks of an upcoming devaluation of the local currency – Ethiopian Birr. This is despite a recent statement by a state minister of finance that such talks are “unfounded”. In contradiction to his second-in-command, finance minister Ahmed Shide was heard addressing the 2023 spring meetings of the World Bank (WB) and International Monetary Fund (IMF) that his government is ready to “make adjustments to the exchange rate misalignment in the economy very soon”. He even went to pledge support from the Bretton Woods institutions and Western donors.

In his recent commentary, former president of World Bank, David Malpass, emphasized that the existence of a significant exchange rate premium between formal and parallel market in economies like Ethiopia is causing significant distortions. Malpass said not only does this reduce the value for money of bank-funded projects but it furthers corruption.

Indeed, the exchange rate regime in Ethiopia sees significant misalignment with parallel market premium often standing at 100%. This has created considerable distortions in the economy – with those having access to the limited foreign exchange resources of the country making huge sums of money without laboring much. Besides, the existence of the parallel market has opened the door for significant actions of illicit financial flows, money laundering and informal trading.

For the majority of the public, however, the current system brought inflation, continued erosion of disposable income and a slide back to poverty. The price of commodities and services, from basic agricultural produce to imported goods, from basic health services to transportation, has seen significant increase over the last five years. Average monthly aggregate inflation has remained above 19% over the last five years, with food inflation seeing a pick of 43% in April 2022.

True to Malpass’s argument, the exchange rate premium has created a pricing structure that is pegged to the parallel market rate. While small and medium businesses openly say that their base pricing considers the parallel exchange rate, multinationals also embrace the parallel market rate as “presumably the actual market rate”. To the surprise of many Ethiopians, a recent public bus procurement saga has even seen a government agency using parallel exchange rate as a basis for procurement decision.

So there seems to be little debate that the exchange rate regime needs adjustment, and a market clearing rate ought to be established. Most Ethiopians see that the current exchange rate regime is benefiting few at the expense of the masses. Where there seems to be a difference is on the analysis of the causes of the wide premium and how best to address them.

As government grapples with economic challenges, most of them self-inflicted (the fanfare to the senseless war in Tigray with a price tag of 28 billion USD was beyond imaginable), it is obvious that it needs the helping hand of the West

To many economists that have studied Ethiopian economy, the problem is structural. They associate the problem with export structure (dominantly primary goods), low economic competitiveness, low productivity, undeveloped financial sector and poor policy making. Hence, they argue that this cannot be addressed through monetary policy only. To prove them right, the four major devaluations that Ethiopia has undertaken in the last 20 years brought little to no change in the external stance.

To Malpass and his comrades based here in Africa Avenue, correcting the payment distortion in the economy is crucial to put the it back to the growth path. And hence, they have made it the primary conditionality for Ethiopia to get any funding from the Bank. This writer has heard a Practice Lead at the Bank saying “exchange rate reunification is the red line for them [Ethiopian policymakers] to access even IDA funding”. Beyond the dogmatism that the bank and its staff are known for, their advice relates to the fact that the exchange rate premium is standing as a hefty tax on the poor.

As government grapples with economic challenges, most of them self-inflicted (the fanfare to the senseless war in Tigray with a price tag of 28 billion USD was beyond imaginable), it is obvious that it needs the helping hand of the West. A recent funding analysis by IMF shows that Ethiopia faces a development funding gap of 6 billion USD till 2026. Hence, it is a matter of time before we see the scripts of WB and IMF happening on the streets of Addis. But risks remain.

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The ultimate result of any devaluation is making imports costly. For an import dependent economy that is seeing a consistent monthly inflation of more than 30% for over three years, any adjustment to exchange rate would easily translate into further inflation. Even agricultural supply chains, which are often considered domestic in nature, will not be spared as they make use of imported commodities and services, such as fuel, fertilizer, chemical, machinery and so on.

Devaluations supposedly reduce cost of exporting and hence increase export earnings. But if history is to serve a purpose, exchange rate adjustment does not guarantee enhanced export earning for Ethiopia. Over the last 15 years, export earning has largely remained around 3 billion USD.

Another argument made toward devaluation is that it will enhance FDI and other inflows, such as remittance. This might be true, but it is more intricate than it seems. Investors make decisions after accounting various factors. Exchange rate is just one such factor, but not the only one. Selling Ethiopia as an investment decision is proving very difficult thanks to devastating senseless wars across the country, rampant corruption, incompetent state structure and nonexistent rule of law. There cannot be a monetary way out of such a conundrum.

Remittance has remained a steady source of foreign exchange. However, higher transaction cost and growing informal channel stand as major challenges.

Devaluation also entails that Ethiopia would have to generate more local resources to pay back its debtors. According to the latest debt bulletin by Ministry of Finance, total external debt stock of the country stands at 24.4% of GDP (27b USD). Hence, devaluation will eventually make paying back such a huge debt stock a daunting task for an economy scrambling with post-war reconstruction and redevelopment, low tax-to-GDP ratio, and an ever lower business cycle.

Sandwiched between severe economic challenges and International Financial Institutions (IFIs) conditionality, the government of Ethiopia seems to have no choice but to do a devaluation soon

Latest actions by the government, such as withdrawal of fuel and wheat subsidies, indicate that the government is short of resources to sustain things. And hence, it is transferring its the financing burden to the public. Yet the ongoing public investment structure shows that government is putting hard-earned resources on unproductive and cosmetic investments that in no way help the productive capacity of the economy. Thus, what is obtained from subsidy withdrawal is being invested in parks and recreation centers. How unwise!

The foreign exchange reserves are also not favorable. Thin reserves mean that the government does not have enough resources to stabilize the markets. So the public will be bearing the brunt of any market volatility that might follow devaluation.

Sandwiched between severe economic challenges and International Financial Institutions (IFIs) conditionality, the government of Ethiopia seems to have no choice but to do a devaluation soon. It may help it access some IFI resources, but this will certainly come at the cost of huge economic disruption and further suffering of the public.

The best option that the country seems to be left with, at least for now, is to do the adjustment progressively. But even that is not acceptable for IFIs. Their book says that sending one sizeable shock is better than sending multiple smaller ones.

To the many Ethiopians that are having difficult time to put meals on the table, however, the days of economic stability and better livelihood are still far off. If anything, what devaluation does is push those days even farther. AS

  • Editor’s Note: The identity of the writer is withheld upon request.

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