Ethiopia’s Foreign Currency Market Liberalization: Does the Move Meet Ethiopia’s Long-Term Economic Goals?

Addis Abeba — Ethiopia has a rich historical legacy when it comes to the introduction and use of currencies. The issuance of modern banknotes by the Bank of Abyssinia in 1915 marked a significant milestone in the country’s monetary history. Prior to the introduction of its national currency, the Birr, Ethiopia utilized various foreign currencies, including the British East African Shilling and the lira, during the Italian occupation.

Over the years, the Birr has undergone various policy changes and devaluations in accordance with the recommendations from the International Monetary Fund (IMF). Notably, the most recent devaluations occurred in 2010 and 2017.

In a recent development, the Ethiopian government has introduced a highly anticipated macroeconomic reform, transitioning from a fixed exchange rate system to a free float exchange rate regime. This Reform stands as one of the fundamental components of the Ethiopian government’s Home-grown Economic Reform Agenda. For many years, the country has grappled with significant macroeconomic challenges, including foreign exchange shortages, increased risk of external debt distress, growing vulnerabilities in the financial sector, limited access to finance for the private sector, high inflation, and potential misallocation of resources.

In response to these and other challenges, the government has introduced a home-grown economic reform agenda aimed at ensuring macro-financial stability, rebalancing the economy, and sustaining economic growth. Hence, one of the critical components of this economic reform agenda is the liberalization of the foreign currency market, which is expected to play a key role in achieving the objectives of the home-grown economic policy.

This policy change signifies a major shift in the country’s foreign currency market. The adjustment commenced with a deliberate devaluation of the Birr by approximately 60%. This decision aims to relinquish control over the exchange rate, enabling market forces to play a pivotal role in determining currency valuations. But it’s crucial to understand that this exchange rate regime shift should not be conflated with a currency devaluation. The value of the dollar may fluctuate based on economic fundamentals, presenting a key point of differentiation from devaluation.

Some scholars argue that floating exchange rates are less inclined to overvaluation when compared to fixed exchange rate systems; they may not necessarily translate into lower inflation, reduced volatility, or enhanced trade integration. Therefore, the recent shift in Ethiopia’s foreign currency market needs an in-depth evaluation of its implications on the nation’s overall economy and its long-term impact.

The Ethiopian government is actively promoting a policy change with the aim of securing long-term economic benefits for the country. Despite the government’s optimism, some scholars remain pessimistic and are expressing concerns about the potential macroeconomic challenges in the near future.

Some of their concerns are related to our export competitiveness, the underdeveloped state of our manufacturing sector, the existence of a distorted and unproductive internal market incapable of substituting imports, as well as issues concerning peace and security. Additionally, apprehensions have been expressed regarding the overall impact of the reform on consumers, particularly on individuals with low and middle-income citizens. Furthermore, critiques have been directed at the positions taken by the IMF and the World Bank regarding the country and the introduced reform.

However, despite our efforts to blame the international financial institutions, we have not instituted any substantial changes. The manufacturing sector remains underdeveloped and has not progressed sufficiently. Furthermore, the flow of goods and services has been impeded by security and logistics challenges, and our governmental and private institutions lack discipline in various aspects. One potential solution to foster essential competitiveness and bolster institutional capabilities is the liberalization of the foreign currency market, among other initiatives.

Economists have cautioned against adopting a free-floating exchange rate system in a country where there is an imbalanced foreign exchange framework and trade imbalance. However, Ethiopia’s unique socio-economic and political structure, coupled with its institutional strength, sets it apart from these general assumptions. The National Bank of Ethiopia (NBE) has recently reaffirmed its commitment to intervene in the foreign currency market to address any market disruptions. Such intervention may manifest in various forms.

Firstly, the NBE might engage in buying and selling foreign currencies as a participant in the market. While the NBE may not solely dictate exchange rates, its participation can effectively transform the free-floating system into a managed floating system within a specific band. Thus, the foreign currency market is not solely determined by banks and parallel markets, as the NBE also plays an active role as one of the key market actors. The National Bank of Ethiopia (NBE) may offer the purchase of a significant amount of foreign currency, such as 100, 200, or 300 million USD, to banks. This sum will be equivalent to 10 billion, 20 billion, or 300 billion Birr, respectively, based on the prevailing exchange rate set by banks. Notably, local commercial banks may lack the stated amount of liquid cash in Birr, so this intervention of excess supply of USD in the market will mitigate the escalating exchange rate. It is also important to note that the NBE not only formulates policies and regulates the financial sector but also operates as a bank and lending institution for the government and financial sectors. To further support the mitigation in the market, the NBE may utilize other mechanisms, such as selling government treasuries and bonds in Open Market Operations. Through these operations, the NBE can manage the circulation of Birr in the market while also potentially implementing the newly introduced Interest Rate Based Monetary Policy by increasing the 15% policy rate.

During a recent discussion with different stakeholders, PM Abiy Ahmed mentioned that only 18% of the consumer price index is constituted by imported goods, such as fertilizers, petroleum, and medicines. The remaining 82% consists of goods either sourced from local markets or imported according to the rates of the black (parallel) market. As a result, these commodities are less affected by market fluctuations, as they are either not directly linked to hard currencies due to being consumed locally or are influenced by the parallel market’s rates. Moreover, under the liberalized market, importers will have access to foreign exchange at market rates. This implies that any inflation is more likely to be driven by artificial factors within the market, such as hoarding and other unfair trade practices, rather than resulting from macroeconomic policy reforms in the foreign exchange sector. Therefore, effective control by the government and its agencies is crucial.

Another significant issue impacting the market is how banks determine the daily foreign exchange rates. Ideally, based on economic fundamentals, this determination should align with the optimal and equilibrium foreign currency exchange rate in the short run. Recent actions by banks in the market highlight the wide gap in exchange rates, indicating challenges faced by banks in determining exchange rates within optimal and equilibrium levels. Let’s see the recent buying and selling rates of USD at various banks.

On August 2, 2024, the Commercial Bank of Ethiopia quoted a buying rate of 83.9413 birr and a selling rate of 85.6201 birr for one USD. On the same day, Awash Bank’s rates were 90.0009 for buying and 94.5011 for selling, while Dashen Bank’s rates were 90.7899 for buying and 98.0531 for selling. On August 03, 2024, the Commercial Bank of Ethiopia adjusted their rates to 95.6931 for buying and 101.4347 for selling. Cooperative Bank of Oromia’s rates on the same day were 97.7329 for buying and 107.5062 for selling, and Dashen Bank’s rates were 90.7899 for buying and 100.7768 for selling. This requires a well-organized and market-driven approach to forecasting exchange rates based on supply and demand. Moreover, the role of the NBE is pivotal in maintaining checks and balances and controlling the market as an independent entity to prevent potential market disruptions, including inflation.

On the other hand, banks and other financial institutions that take part in the market are required to report their daily exchange values to the national bank. The national bank uses this data to evaluate the overall market conditions and determine whether genuine market competition is impacting the activity. In the case of floating exchange rates, the NBE’s role is limited, but it will intervene if there are significant disruptions due to illegal activities and manipulation, aiming to maintain integrity and transparency in the exchange market.

Additional measures for proficient control and implementation:

In order to effectively control and implement the Reform, it is important to leverage Ethiopia’s solid-state structure and capacity to manage changes. This can be achieved by establishing strong partnerships between law enforcement agencies, the National Bank, Ministry of Trade and Regional Integration, Regional Trade Bureaus, Trade Competition and Consumers Protection Authority, and other stakeholders to curtail artificial inflation caused by irresponsible business practices. Additionally, the government should prioritize efforts to enhance peace and stability in the country, creating a conducive environment for Foreign Direct Investment (FDI), boosting productivity, and facilitating the movement of goods and services for improved market access.

Issues that require careful consideration:

In the short term, it is important to anticipate artificial inflation in most commodities. Experiences over the years have shown that there is always a tendency to increase prices whenever there is a rise in salary or devaluation of the Birr, regardless of the actual impact of the measures. This is why it is necessary to effectively control unfair trade practices and the hoarding of commodities.

Additionally, to mitigate the impact of inflation on low-income civil servants, it will be necessary to allocate additional budgetary resources to subsidize specific sectors and commodities. This measure, in conjunction with the reformed safety net program, will address short-term market challenges and enable the government to manage inflationary pressures affecting low-income citizens.

It is also important to recognize the significance of independent Civil Society Organizations (CSOs) when it comes to consumer protection. While Proclamation No. 813/2013 (Trade Competition and Consumers Protection Proclamation) established the Federal Trade Competition and Consumers Protection Authority, the establishment of independent CSOs is also crucial as they play a key role in advocating for consumer interests and working with regulators to ensure proper representation. This type of initiative will also focus on raising consumer awareness, disseminating market information, safeguarding consumer rights in transactions with suppliers of goods and services, and ultimately facilitating for the effective implementation of the macroeconomic policy reforms in the long run. Considering these and other similar justifications, it can be suggested that the macroeconomic Reform is more likely to succeed within a short time frame in contrast to the apprehensions expressed by our economists and commentators who oppose the Reform.

In a nutshell, the Reform is a crucial step towards ensuring long-term economic growth for the country, and it’s a comprehensive change that positively impacts investment and trade in goods and services. The effective curbing of illicit movements of foreign currencies through exports, remittances, and contraband activities, as well as combating unfair trade practices and hoarding of commodities, will play a significant role in achieving the reform’s promises and bolstering economic stability. Furthermore, the National Bank of Ethiopia (NBE) should play a key role in providing foreign currency to banks and financial institutions based on competition, thereby preventing potential exchange rate hikes and addressing foreign currency shortages. This proactive approach will ultimately meet the demand for imported commodities in the long term. As stated earlier, foreign currency liberalization is one of the pillars of the Home-Grown Economic Reform. Liberalizing foreign exchange and forex accounts and allowing the use of current account transactions for goods and services is essential for maximizing the benefits of WTO membership and trading under AfCFTA and paving the way for Ethiopia’s long-term economic gain. AS

Endalkachew Abera Mekuriya (LLB, LLM in International Economic and Business Law), Lecturer of Laws and Advisor to the President of Haramaya University. Can be reached at [email protected]