Journal Issue
Share
Article

The Federal Democratic Republic of Ethiopia: Selected Issues

Author(s):
International Monetary Fund
Published Date:
July 2008
Share
  • ShareShare
Show Summary Details

III. External Stability and Competitiveness in Ethiopia21

A. Introduction

1. The sharp rise in the real effective exchange rate in recent years merits close examination because of the potential risks to competitiveness and external stability. Since 2004, the real exchange rate has appreciated by 25 percent while the import coverage of reserves has declined from 5 months to under 2 months. The appreciation of the exchange rate has reflected much higher inflation in Ethiopia compared with partner countries; the trade-weighted nominal effective exchange rate has tended to depreciate since 2002. The real appreciation has not prevented strong export growth, but import growth has been even faster, leading to a considerable widening of the trade deficit.

2. The exchange rate is a key equilibrating mechanism for the balance of payments. Real depreciation can help to stem or reverse the trends in the trade deficit. However other factors are also important, including the growth of the economy and related demand for imports and cost factors that affect export performance. And more generally, higher external financing, if sustainable, would allow Ethiopia to run persistently large trade deficits.

3. Against this background, this paper reviews indicators of the competitiveness of exports and applies various techniques to assess whether the real exchange rate is above the level associated with fundamentals and macroeconomic stability. Given data limitations and difficulties in assessing key inputs to the analysis—such as the cyclical state of the economy and the sustainability of external financing—the results are highly tentative. They do, however, suggest some potential overvaluation of the real exchange rate at present.

B. Competitiveness and Recent Trends in the Balance of Payments

4. This section reviews the factors behind recent trends in Ethiopia’s balance of payments, the competitiveness of exports, and the reasons for the surge in imports.

Current and capital accounts and reserve cover

5. The deficit on goods and services has deteriorated considerably since early 2000 and is currently running at about 20 percent of GDP. This deterioration has been heavily influenced by import growth, with the ratio of imports to GDP rising by 10 percentage points of GDP since 2000/01 to 32 percent in 2006/07. Exports have also grown in relation to output but at a slower rate. The deterioration in the current account has been more modest as a result of increases in private and official transfers. These have grown from 10 percent of GDP in 2000/01 to about 15 percent in 2006/07 and have helped to maintain the current account deficit at about 5 percent of GDP on average over this period.

Reserve coverage, growth, and the real exchange rate 1999-2007

Source:WEO, INS

6. The decline in external reserves in recent years is thus partly due to deterioration in the capital account. Since 200 1/02 the capital account has deteriorated, mainly on account of a fairly persistent decline in net borrowing. Indeed, since 2003/04, the cumulative disparity between the capital and current account has reached 3 percent of GDP. However, in 2006/07 the overall balance of payments was almost zero, allowing reserve coverage to stabilize at 2 months of imports. Reserve cover is quite cyclical. During the drought years of 2001 and 2002, imports were compressed considerably leading to a build up of reserve coverage. Since then, as the economy has expanded rapidly, reserves have fallen to low levels and pose a risk over the medium term as the economy continues to expand.

7. In practice there is considerable blurring of the elements of the current and capital account. External official financing switches between grants (transfers) and lending while private transfers are a relatively autonomous source of financing for private imports. Errors and omissions have also been a volatile and sometimes sizable component of the balance of payments. From this perspective, the decline in reserve cover is due to a failure of external financing more broadly defined (including transfers and errors and omissions) to keep pace with the rapid widening of the deficit on goods and services.

Factors contributing to the recent healthy performance exports

8. Exports have been strong in recent years. While coffee exports represented about 0.6 percent of world coffee exports in 2003-04, the ratio rose to an average of 0.9 percent in 2005-06.22 Export shares in Ethiopia’s other main commodity export markets have also risen, with oilseeds and flowers demonstrating the largest export market gain of almost ½ percent of the world market. In addition, although figures for world market share are not available for 2007, growth in exports has been strong in all categories except for coffee.

9. As price takers on the world market handicapped by the land-locked status of the country, three factors are crucial in enhancing the competitiveness of Ethiopian exporters: wage costs, the ease of doing business and changes in infrastructure. Although wage data is difficult to obtain, reports from the main business journal in India on the health of the flower sector indicate that the wage for a farm laborer in Ethiopia is only $20 per month while the corresponding wage in India is about $60 per month. Indeed, a number of Indian entrepreneurs are relocating to Ethiopia to develop its thriving flower industry and this development has led to gains in market share at the expense of neighboring countries (Box 1). Similarly, the 2005/06 report on Africa in the Foreign Direct Investment magazine indicates that Ethiopia is the most cost effective country on the continent with manual workers earning about $60 a month. This figure is comparable to the Indian laborer wage. As a comparison, the ILO estimates that the average wage for a manufacturing worker in China is about $190 per month.

Box 1.Ethiopia’s blooming flower industry

Ethiopia’s flower industry began as recently as four years ago when the government made an aggressive push for investments by establishing a presence at major international floricultural events. Since this time, export earnings from this sector have grown to about US$65 million in 2006/07 and are projected to double over the next few years. Ethiopia is well positioned in this export niche because highland temperatures make it ideal for horticulture, the wage rate is low at only US$20 per month, the price of leased land is reasonable at about US$13 per hectare, and the government has facilitated tremendously entry of new businesses into this sector in recent years.

Some analysts believe that Ethiopia could rapidly increase its market share in cut flowers over the medium term. This view is supported by the fact that a number of Indian businesses have relocated to Ethiopia to take advantage of the cheaper costs available in this country and the generosity of the government in attracting investment. Moreover, the country is also gaining market share at the cost of Kenya, the current leading exporter of cut flowers in Africa. The table below shows that Ethiopia is competitive with both India and Kenya in attracting investors to the horticultural sector. Moreover, this will be amplified in 2008 when Kenya’s horticultural industry will be subject to a new 5 percent tariff because of its inclusion in the Generalized System of Preferences.

Factors Affecting Location of Horticultural Investment
Wage RateLand priceFreightCustoms Duties
(USD per month)(USD per hectare)(USD per kilo)(in percent)
Ethiopia20131.5-20
Kenya44n.a.1.60 (5 percent from 2008)
India58650026-9
Sources: India Business Times; Kenya’s Cut-Flower Cluster, mimeo; ILO; Horticulture in Eastern and Southern Africa, Price Waterhouse Coopers

Current and Capital Accounts

(in percent of GDP)
Development of Ethiopia’s export market share(exports in percent of world exports)
CoffeeOil seedsLeather productsLive animalsFlowers
2003-040.620.340.130.030.12
2005-060.930.790.180.220.67
Change 2005-06 relative to 2003-04 (in percent of world exports)0.310.450.050.190.55
Ethiopia export growth in 2007 (in percent)-1.522.220.129.9133.4
Sources: World Integrated Trade System Database
Factors Associated with Export Competitveness
Wage RateEase of doing businessTime to start a businessCost to exportCost to importInvestor Protection
(USD per month)(rank)(days)(USD per container)(USD per container)(rank)
Ethiopia971617002455118
Farm Laborer20
Manual Laborer61
Botswana481085241159118
Kenya83541980232560
South Africa29358508509
China187933533537583
India13435864124433
Farm Laborer58
Manual Laborer68
Sources: India Business Times, FDI magazine, ILO, World Bank Doing Business survey

10. Of course, low wages are only beneficial for promoting export growth in agriculture if they remain low and there are sufficient opportunities for increased production through greater development of acreage and higher productivity (or yields). Unfortunately, there is no time series data available on wages in Ethiopia—only a snapshot of the wage level. But although wages are likely to be growing fast on account of the continued high inflationary pressures in Ethiopia, rapid rising agricultural productivity is helping to restrain the growth in unit labor costs as suggested by the table below on recent estimates of increased acreage and yields for the major agricultural export. With improved use of fertilizer and better seeds, this positive assessment is likely to continue, unless a sharp drought reoccurs.

Trends in cultivated area and yields for major export categories and cereals
Cultivated Area

(percent change)
Yield

quintal per hectare
2004-052005-062006-072004-052005-062006-07
Cereals9.35.74.713.114.415.2
Pulses22.7-4.26.4109.811.5
Oil seeds44.6-3.5-7.26.46.16.7
Coffee0.413.06.06.68.2

11. In terms of doing business, Ethiopia ranks high among African countries, only surpassed by Botswana, Kenya and South Africa. For example, it takes only 16 days to set up a new business in Ethiopia and about 133 days to obtain a new license. On the other hand, export and import shipment costs are fairly prohibitive because of the country’s land-locked status and investor protection is weak. To foster export development, the government has provided a number of incentives for companies to invest in Ethiopia. These include a 5–year tax holiday, duty free machinery imports, and easy acquisition of leased government land at low cost. While the government’s initial focus was on the flower sector, the government recently announced the provision of 750 hectares of free land for investors willing to invest in fruits and vegetables. These incentives are already providing a strong boost to exports and hence competitiveness. Indeed, the availability of direct flight connections to Europe, Asia, and North America is key to the success of the industry.

12. Over the past two years, Ethiopia’s position on the global competitiveness index has improved somewhat, albeit from a low base level. Ethiopia is in the top decile of countries that are the least competitive. Characteristics that continue to deter improvements in competitiveness include the quality of staff, the brain drain phenomenon, the absence of foreign ownership, and the lack of access to loans and venture capital. However, while its logistics performance index is also below that of neighboring Kenya, its ranking at the 69th percentile is higher than for the global competitiveness index. This solid performance is associated with low logistics costs and timeliness although the economy continues to be hindered by weak infrastructure relative to other countries, especially in the area of telecommunications.

Factors Associated with Export Competitveness in 2007
Ease of doing

business
Global competitivenessBusiness

competitiveness
Logistics

Performance Index
20072006
(rank)(percentile)(percentile)(rank)(percentile)
Ethiopia9794958910469
Botswana48584757
Kenya837672477651
South Africa293430262416
China932728473020
India1343734243926
Sources: India Business Times, FDI magazine, ILO, World Bank

13. Infrastructure is at a relatively basic level, but is improving rapidly. Although up-to-date information on air and road transportation is limited, available data indicate that air transport of freight (in terms of million tonnes per km) rose by 46 percent between 2002 and 2005 and air transport of passengers rose by almost 9 percent, slightly below corresponding figures for Kenya at 76 and 9 percent respectively. The road network rose by almost 5 percent per year between 2000 and 2006 while it was barely unchanged in Kenya. Moreover, the World Bank recently extended its investment in road infrastructure in Ethiopia through 2012 with the objective of improving its reliability. The investment will support the government’s goals of raising the road network by an additional 11,000 km of new federal roads and 5,500 km of new regional roads (a combined increase of about 40 percent in the road network).

14. Investment in telecommunications lags that in other areas of infrastructure. Ethiopia has the lowest mobile cell phone converge in the world with only about 20 per 1000 people currently owning a cell phone compared to over 700 in South Africa. However, cell phone coverage has been growing rapidly from a low base and the telecommunications company has ambitious investment plans with target coverage of 60 per 1000 people by 2009/10.

Imports

15. Rapid import growth in recent years has partly reflected Ethiopia’s development focus on improving infrastructure, which has a high import content. While all import components are making contributions, the fastest growing component is for capital goods, especially in road and air infrastructure. The substitution of foreign goods for domestic goods associated with the real exchange rate appreciation and the rapid rise in economic growth have also contributed to the import surge (Box 2).

Box 2.Import Determinants

To assess the relationship between imports, economic growth, and the real exchange rate, a regression of import volume on real GDP and the real exchange rate was conducted over the period 199 1/92 – 2006/07. All variables are measured in logarithms. Since real GDP and real imports have risen over time it is necessary to check for stationarity of the data. The Phillips-Perron statistic indicates that the error term is stationarity and hence allows for valid inference. The regression yields a coefficient of 1.37 on real GDP and a coefficient of 0.24 on the real exchange rate (the significance of the real GDP term cannot be determined because it is non-stationary). While considerably below unity, the real exchange rate coefficient is significantly greater than zero, supporting the view that the recent real appreciation of the currency has stimulated import demand. Given structural changes in the Ethiopian economy, a significant degree of uncertainty surrounds the estimates. The elasticities are, however, within the range typically found for many countries.

Determinants of Real Imports
Real GDP1.37
Real exchange rate0.24 *
No. of observations16
R squared0.94
Phillips –Perron statistic-2.84 *
Notes:

To assess the extent to which the recent rapid growth experience and real appreciation have influenced the behavior of import volumes, a counterfactual analysis was conducted. The chart below shows the counterfactual import volume growth behavior assuming that the real exchange rate was fixed at its 2003/04 level through 2006/07 and that output grew at its 10-year historical average growth rate of 7 percent over the same period.

Import Volume Growth

The chart shows that the counterfactual developments would slow import volume growth considerably in 2004/05 and 2005/06. In 2006/07 when the authorities postponed imports related to large infrastructure projects, the counterfactual scenarios would be above the actual outcome. Over the 3 year period, import volumes grew by 14.1 percent per annum, while the scenario with output fixed at its historical growth rate would yield an average import volume growth rate of 11 percent per annum. If the real exchange rate was also fixed at its 2003/04 level, import volume growth would decline an additional 1.3 per annum to 9.7 percent.

Composition of Imports

 (in percent of GDP)

Source:

C. Assessments of Competitiveness and the Real Exchange Rate Level

16. This section applies IMF methodological approaches23 to assess whether the real exchange rate is at an equilibrium level—i.e., at a level either consistent with “fundamental” determinants or at a level consistent with a sustainable medium-term current account balance.

Equilibrium real exchange rate analysis

17. Single equation (“reduced form”) models find that Ethiopia’s real exchange rate is above the equilibrium level predicted by fundamentals. For example, Gilmour and Chudik’s single country analysis (2006), and Chudik and Mongardini’s panel analysis (2007) find that Ethiopia’s real exchange rate is positively related (as suggested by theory) to the terms of trade, productivity in Ethiopia relative to its major trading partners, and government consumption in relation to GDP.24 It is negatively related to openness, measured as the ratio of imports and exports to GDP. Based on fitted values for the long-run cointegrating relationship from Gilmour and Chudik’s estimated equations, the real effective exchange rate was about 25 percent above its level based on fundamentals in 2007.

18. However, model results are sensitive to changes in assumptions. A shortcoming of the analysis is that the net foreign asset (NFA) position is not included in the equilibrium exchange rate panel specification because of its insignificant effect when countries are treated as a group. A stronger NFA would, other things equal, allow a country to have a higher real exchange rate because it would provide room to borrow more to finance a larger current account deficit. Ethiopia’s NFA position has improved considerably in recent years following the HIPC and MDRI initiatives. When the ratio of NFA to GDP is included in the single equation analysis the estimated overvaluation of the real exchange rate largely disappears (Box 3). The amended estimates suggest that the real exchange rate was close to equilibrium through 2007, but that subsequent real appreciation through April 2008 has made the real exchange rate somewhat overvalued.

Box 3.Alternative estimates of the equilibrium real exchange rate

When net foreign assets are included in a regression of Ethiopia’s real exchange rate, they have significant explanatory power and the error term remains stationary. At the same time, the effect on the real exchange rate of openness and terms of trade is considerably stronger, while government consumption has the wrong sign.

Determinants of the Real Effective Exchange Rate(In percent of GDP, unless otherwise stated)
Gilmour and ChudikChudik and MongardiniRevised
Openness-0.447-0.473-1.32
Government consumption0.5590.227-0.14
Growth differential1.0161.0400.86
Terms of trade (index)0.2550.1860.39
Net foreign assets0.44
No. of observations 1/282616
R squaredn.a.n.a.0.89
Phillips-Perron statisticn.a.n.a.-3.21**
Notes:

External Sustainability Analysis

Flow analysis

19. The analysis of external stability through flow and stock analysis is an alternative way of assessing the level of the real exchange rate. For flow equilibrium, the method estimates how much the real exchange rate would need to change to bring the current account into line with a sustainable level of medium-term external financing assuming full capacity utilization. The method used here differs slightly from the macro-balance approach to external stability in that it assumes a reserve cover target as its anchor rather than an equilibrium current account estimated on fundamentals. This is justified because reserve cover is currently judged to be too thin to provide adequate cushion against external shocks. For Ethiopia, the methodology requires a number of difficult-to-quantify assumptions:

  • What is a reasonable/sustainable level of grant and debt financing flows?

  • What should be a satisfactory level of reserve cover in the medium term?

  • How overheated is the domestic economy at present?

  • What is the responsiveness of exports and imports to changes in the real exchange rate?

Estimates of Equilibrium Real Exchange Rates 1999-2007 2000=100, unless otherwise indicated

20. The first two assumptions fix the equilibrium or sustainable current account deficit. The medium-term reserve cover target, assumed to be at the mid-point of the authorities’ target of 10-12 weeks of imports, is important because the analysis needs to incorporate the policy objective of running an overall balance of payments surplus to bring reserve cover to a more comfortable level. That is, the average current account deficit over the medium term must be lower than the estimated available external financing if the balance of payments is to reach a sustainable level.

21. The third assumption is needed to estimate the underlying current account and the fourth assumption is required to estimate how much the real exchange rate would need to change to bring the underlying current account deficit in line with the equilibrium level. For example, if GDP is in excess of potential (because, for example, the economy has been growing at too fast a pace) then a return to potential through slower growth would by itself lower import demand and the current account deficit and could obviate the need for a real exchange rate depreciation. The underlying current account deficit is a measure of the deficit assuming output is at its equilibrium level. However, while rising inflation at a time of good harvests is prima facie evidence that the economy is overheating, the extent of overheating is hard to estimate. If the underlying current account still differs from its equilibrium level trade elasticities are required to partial out the amount of real exchange rate change that would be needed to eliminate the disparity. The amount of needed depreciation gives an estimate of the extent of overvaluation.

22. Since there is considerable uncertainty about the degree of overheating and sustainable financing, results are presented using a range of estimates for these variables. Three scenarios are used for the domestic imbalances or “output gap”: high (5 percent of GDP), medium (3 percent of GDP), and low (zero). Three external financing scenarios are also used: one based on current IMF official financing estimates and the other two assuming additional/reduced 1 percent of GDP per annum borrowing over the next five years. The real exchange rate movement needed to achieve the target of 2 ¾ months of imports by 2012/13 for each permutation of output gap and financing is then derived based on the estimated income and price elasticities for imports in Box 2.25

23. Based on these assumptions, the magnitude of the real exchange rate change required to satisfy the reserves target varies from a depreciation of 25 percent to an appreciation of 8 percent. The 3-dimensional chart below shows output gap alternatives in the x plane, real exchange rate changes in the y plane and the three external financing options in the third dimensional axis. Scenarios suggesting little need for real exchange rate depreciation or possibly appreciation assume there is a large output gap and external financing will be above current expectations. The latter assumption softens the needed reduction in the current account deficit and the former assumption puts the onus of adjustment to a lower deficit on a reduction in domestic economic imbalances through lower growth relative to potential. These scenarios are shown on the far right of the chart. At the other extreme as the output gap is assumed to be smaller and external financing falls short of the baseline projection, the real exchange rate would need to depreciate by up to 25 percent to bring the current account deficit down to a sustainable level. The mass of observations is located above the horizontal axis at zero, indicating that the most likely equilibrium outcome is a depreciation of the real exchange rate.

3-dimensional view of real exchange rate outcomes

Stock Analysis

24. The stock approach to medium-term debt sustainability is akin to analyzing whether the ratio of net foreign assets to GDP is on a stable path except that it uses a long-term projection for debt rather than the current value of NFA. The debt trajectory is based on assumptions about exports, imports, and grant and loan financing and is assessed against the benchmark for debt sustainability established by the international community. If the debt trajectory is within reasonable bounds and the underlying trajectories of the components of the balance of payments are credible, the current real exchange rate is assumed to be in equilibrium.

25. The baseline scenario in the Joint IMF and World Bank Debt Sustainability Analysis (DSA) provides a long-run profile of the level of debt and shows that the ratio of debt to exports stays within prudent limits. However, the room for maneuver is slight suggesting that any additional financing to shore up reserves should be concessional. One of the scenarios assumes that Ethiopia obtains greater external financing to relieve some of the pressure on reserves (DSA appendix). If additional financing were obtained on market terms it would raise the ratio of the NPV of debt to exports to considerably to 142 percent at its peak, compared with 119 percent under the baseline scenario. By contrast, if the financing were obtained on IDA terms, the ratio of the NPV of debt to exports would reach 127 percent at its peak.

D. Conclusions

26. Analysis of competitiveness and the real exchange rate paints a mixed picture, although on balance there is a likelihood that real appreciation has resulted in a real exchange rate that is above the level associated with fundamentals and macroeconomic stability. On the one hand, Ethiopia has succeeded in raising its global export market share; low wages, rising productivity and an improving infrastructure should enable the country to continue to attract foreign investment and expand its export base. On the other hand, the rapid growth in imports, in large part associated with the infrastructure development, has led to a wide trade deficit and low reserve cover. Part of the weakening of the balance of payments position is almost certainly cyclical and would be eased by a moderation of growth to eliminate overheating pressures. There is also scope for more financing to alleviate the external constraint—although nonconcessional borrowing would need to be considered carefully. But on balance, analysis of a sustainable external position points to a degree of overvaluation. This is also confirmed by updated single equation estimates that suggest that the real exchange rate may be moving above a level determined by fundamentals.

References

    Chudik, Alexander and Gilmour, Andrew,September2006, “Estimating Ethiopia’s Equilibrium Real Exchange Rate”. IMF, Unpublished

    Chudik, Alexander and Mongardini, Joannes,April2007, “In Search of Equilibrium: Estimating Equilibrium Real Exchange Rates in Sub-Saharan African Countries”. IMF Working Paper No. 07/90

    Lee, Jaewoo, Milesi-Ferretti, GianMaria, Ostry, JonathanDavid, Prati, Alessandro, and Ricci, Luca Antonio,April2008.“Exchange Rate Assessments: CGER Methodologies”, IMF Occasional Paper No. 261.

The main contributor to this chapter is Alun Thomas.

The average of the calendar years 2003 and 2004 (2003-04) is used as the base period to minimize the impact of the drought in 2002.

See Lee, Milesi-Ferretti, Ostry, Prati and Ricci, IMF Occasional Paper no. 261 (2008).

Gilmour and Chudik, mimeo, (2006); Chudik and Mongardini, IMF working paper 07/90 (2007).

For exports a similar sized, although oppositely signed, elasticity is assumed to apply.

Other Resources Citing This Publication