Ethiopia
Selected Issues

This Selected Issues paper examines economic development in Ethiopia during the 1990s. In mid-1992, the government began implementing significant economic reforms aimed at stabilizing the economy and deregulating economic activity. Since that time, substantial progress has been made with respect to both objectives. Policy measures have aimed at correcting price distortions, lifting restrictions on the private sector, deregulating the labor market, reducing macroeconomic imbalances, realigning the exchange rate, and liberalizing the external exchange and trade system. Moreover, the decentralization of the political system and reform of the civil service have been initiated.

Abstract

This Selected Issues paper examines economic development in Ethiopia during the 1990s. In mid-1992, the government began implementing significant economic reforms aimed at stabilizing the economy and deregulating economic activity. Since that time, substantial progress has been made with respect to both objectives. Policy measures have aimed at correcting price distortions, lifting restrictions on the private sector, deregulating the labor market, reducing macroeconomic imbalances, realigning the exchange rate, and liberalizing the external exchange and trade system. Moreover, the decentralization of the political system and reform of the civil service have been initiated.

I. Introduction

In mid-1992, the Government of Ethiopia began implementing significant economic reforms aimed at stabilizing the economy and deregulating economic activity. The progress made with respect to both objectives is described in Section II. Over the 1992/93–1994/95 period, 1/ there was a marked moderation in the rate of inflation, compared with that in the immediately preceding several years, reflecting, in part, relatively restrained monetary growth. From a longer-term historical perspective, the key role of changes in the money supply, along with the importance of exogenous shocks in influencing price behavior in Ethiopia, is examined in Section III. Although Ethiopia generally benefited in 1994/95 from the surge in world market coffee prices, the policy response to the windfall export earnings was less than fully adequate. A discussion of the issues involved is presented in Section IV. The devolution of governmental responsibilities to elected local and regional entities was substantially advanced by the ratification of the Constitution of the Federal Democratic Republic of Ethiopia in December 1994. Section V summarizes the effects of moving to a more truly federal system, and the implications for fiscal and macroeconomic management.

Tables on recent economic and financial developments are presented in Appendix I, and a summary of the tax system as of June 1995 is provided in Appendix II.

II. Performance and Policies. 1992/93-1994/95

Throughout the 1980s, the Ethiopian economy suffered a marked deterioration that stemmed from the effects of the prolonged civil war, recurrent droughts, and inappropriate—mainly centrally planned—economic policies. In mid-1992, the Government began implementing significant economic reforms aimed at stabilizing the economy and deregulating economic activity. Since that time, substantial progress has been made with respect to both objectives. Policy measures have aimed at correcting price distortions, lifting restrictions on the private sector, deregulating the labor market, reducing macroeconomic imbalances, realigning the exchange rate, and liberalizing the external exchange and trade system. Moreover, the decentralization of the political system and reform of the civil service have been initiated.

1. Overall developments and performance

The end of hostilities, coupled with measures to liberalize prices and improve access to production inputs, contributed to a strengthening of the real economy. After contracting at an annual rate of 3¼ percent in 1990/91 and 1991/92, real GDP expanded on average by 6⅓ percent during 1992/93–1994/95 (Appendix I, Table I). In 1992/93, agricultural production rebounded, which, combined with a surge in activity in other sectors, brought about a 12 percent increase in real GDP. The particularly strong performance of the industrial, transportation, and construction sectors was underpinned by the increased availability of foreign exchange. While a subsequent drought in 1993/94 led to a contraction in agricultural output, a further expansion of the industrial and service sectors resulted in overall real GDP growth of 1⅔ percent. Official estimates for 1994/95 suggest real economic growth of 5 percent, despite erratic rainfall, as the expansion of the industrial and service sectors has been sustained.

The annual rate of inflation (as measured by the Addis Ababa retail price index on a period-average basis) dropped from 21 percent in 1990/91 and 1991/92 to an average rate of 8¼ percent during the 1992/93–1994/95 period (Appendix I, Table VIII). Important contributory factors included relatively restrained monetary growth—the money supply increased by a cumulative 56 percent, compared with an expansion of 64 percent in nominal GDP—and the increased availability of foreign exchange for imports.

Ethiopia’s fiscal performance during 1992/93–1994/95 reflected mainly the postwar availability of external capital financing, major reforms to the tax system, and efforts to restrain and reorient the allocation of expenditure. Government revenue performance improved within a context of significant tax reforms that included sharp reductions in key rates. As a result, government revenue increased from 11 percent of GDP in 1991/92 to 13¾ percent by 1993/94 and, owing to increased receipts from coffee export and direct taxes, as well as profits from financial institutions, to 18⅓ percent in 1994/95 (Appendix I, Tables XI and XII).

While the compression of defense outlays provided some room for expenditure switching, the overall infrastructure and reconstruction needs precluded a reduction in the ratio of government expenditure to GDP over the 1992/93–1994/95 period. Capital spending nearly doubled in 1992/93 to 8⅓ percent of GDP, which more than offset a compression of recurrent outlays (Appendix I, Tables XIII and XIV). The surge in total expenditure in 1993/94 to 30¾ percent of GDP reflected further increases in both capital and recurrent outlays for reconstruction. In keeping with the Government’s priorities, capital spending—which increased to 12⅓ percent of GDP—was reoriented toward economic development (transportation and communications) and social objectives (public health and education). In 1994/95, total expenditure dropped back to 26⅓ percent of GDP as recurrent spending—including wages and salaries—was contained, and capital expenditure declined to 9¼ percent of GDP, owing to a reduction in the implementation rate and to lower levels of external financing. However, total expenditure was still higher than the 21¼ percent of GDP recorded in 1991/92.

The overall fiscal deficit (excluding grants) increased to 11½ percent of GDP in 1992/93, from 10 percent in 1991/92, and to 16¾ percent in 1993/94, before narrowing to about 8 percent in 1994/95. Bank financing of the deficit declined in both 1992/93 and 1993/94 and, in 1994/95, the Government made substantial net repayments to the banking system.

Monetary developments over the period 1992/93–1994/95 largely reflected outturns in the fiscal and external sectors, as the scope for autonomous monetary policy was limited by the paucity of available instruments. The growth in broad money over the three-year period resulted from the accommodation of an increased demand for credit by the private sector, which was needed to support the private sector recovery; the continued—albeit declining—financing needs of the government budget; and substantial increases in net foreign assets, owing to high export earnings and other generally favorable balance of payments developments (Appendix I, Tables XV, XVI, XVII, and XVIII). In the event, despite the limited scope for monetary policy, the expansion in domestic liquidity was held in check, as the dominant commercial bank carried large excess reserves, reflecting the narrow spread on its lending operations (Appendix I, Tables XIX and XX). In addition, as indicated above, the more favorable fiscal situation in 1994/95 permitted the repayment of government debt to the banking system. Moreover, steps were taken to develop financial markets and introduce new monetary instruments. Importantly, in January 1995, an auction for 90-day treasury bills was introduced.

Ethiopia’s overall balance of payments position started to improve in 1992/93, and continued to strengthen in 1993/94 and 1994/95, associated in part with a significant cumulative depreciation in the real effective exchange rate (63 percent) (Appendix I, Table XXV). The current account (excluding grants) recorded a deficit of about 10 percent of GDP in 1992/93, as imports recovered to 1990/91 levels in response to the incipient liberalization (Appendix I, Tables XXI, XXIII, and XXVI). A marked rebound in the level of coffee exports and a sharp rise in exports of leather and leather products mitigated to some extent the impact of higher imports in that year (Appendix I, Tables IV, V, XXII, and XXVII). In 1992/93, the overall balance of payments deficit was about halved to SDR 71 million. The current account deficit declined to 7 percent of GDP in 1993/94, owing to a further large increase in coffee and leather and leather product exports and a decline in imports, which, coupled with a sharp improvement in the capital account, led to an overall balance of payments surplus of some SDR 121 million, notwithstanding a decline in official transfers. External developments in 1994/95 were dominated by the exceptionally favorable world market coffee prices, and coffee export receipts were almost twice their 1993/94 level. This increase, combined with continued strong growth of leather and leather product exports, more than offset a recovery in import levels. Thus, with a large improvement in the services account, and despite the easing of restrictions on invisible transactions noted below, the external current account deficit was narrowed to 4⅔ percent of GDP. Moreover, despite a large deterioration in the capital account, an overall balance of payments surplus of SDR 43 million was recorded. Gross liquid official foreign reserves rose from 3⅓ months of imports in 1992/93 to 6½ months in 1993/94, before declining to 5¾ months in 1994/95.

With regard to exchange rate policy and developments, in October 1992, the official exchange rate for the Ethiopian birr (Br) was changed from US$1 = Br 2 to US$1 = Br 5, and, in May 1993, biweekly auctions for foreign exchange were introduced. The marginal auction market rate subsequently depreciated gradually through mid-1994, but then stabilized at about Br 6.25 per US$1 in 1994/95 (Chart 1). On May 15, 1995, the official exchange rate was set at Br 6.26 per US$1, the average of the auction market rates of the preceding month, and thus these two rates were, in practice, unified; in July 1995, the rates were unified de jure. After the auction market was introduced, the spread between the auction market and parallel market rates steadily narrowed from 52 percent to 15 percent through December 1994. Subsequently, the parallel market premium rose to about 21 percent at end-June 1995.

In order to reduce its external debt burden, in 1992 Ethiopia obtained debt relief from Paris Club creditor countries on London terms, estimated at US$371 million. As a result, Ethiopia’s total debt service ratio (excluding ruble-denominated debt to Russia) declined from 82 percent in 1991/92 to 65½ percent in 1992/93, 42⅓ percent in 1993/94, and 30 percent in 1994/95.

2. Financial and structural policies

The generally improved macroeconomic performance of the Ethiopian economy over the 1992/93–1994/95 period was underpinned by a wide range of fiscal, monetary, and external policies, as well as important structural reforms, which aimed at fostering a stable economy that would be both market based and oriented toward the private sector.

The changing economic climate was reflected in the implementation of a number of important tax policy reforms. In the first instance, the direct tax system was revised with a view to increased efficiency and equity. The personal income tax system was progressively simplified over the period: the number of bands was reduced from 18 to 5, while the top marginal rate was lowered in 1992/93 from 85 percent to 50 percent, and further to 40 percent in 1994/95. The tax scheme for unincorporated business income was similarly streamlined; the top marginal rate was aligned with the flat tax on corporate income, and in 1994/95 both rates were reduced from 50 percent to 40 percent. Several important reforms were also taken with regard to indirect taxation. Taxes on international trade were simplified: export taxes were abolished for all goods other than coffee, and the import tariff system was streamlined and the top rate sharply reduced. To offset the revenue effects of these reforms, other measures were implemented to broaden the tax base and improve collections. Specifically, the sales and excise tax systems were simplified; the coverage of the sales tax was extended to a broader range of services; and taxes were introduced for capital gains and rental income. As for the improvement of revenue collections, tax administration was further strengthened with external technical support; an independent Revenue Board was established, comprising the Customs and Inland Revenue Administrations; and the management and monitoring of counterpart funds from external assistance was improved. Other measures, including an expansion of presumptive taxation and rural land taxation, as well as reform of the agricultural income tax, were in progress by end-1994/95.

Chart 1
Chart 1

ETHIOPIA: Developments in Exchange Rates Trade-Weighted Exchange Rates, 1990–95 1/

(Indices, 1980=100)

Citation: IMF Staff Country Reports 1996, 052; 10.5089/9781451812602.002.A001

Sources: IMF, Information Notice System; National Bank of Ethiopia; and staff estimates.1/ Based on marginal rate of foreign exchange auction since May 1993.

On the expenditure side, outlays were redirected to essential infrastructure and social services, and expenditure for the military and for government production activities was sharply scaled back. Upward pressures arising from a revision of the civil service pay scale were substantially offset by a rationalization of the civil service (which is still ongoing). The allocation of capital outlays for the period 1992/93–1994/95 reflects the priority accorded to infrastructure, energy, public health, and education.

As for structural reforms in the financial sector during 1992/93–1994/95, important monetary and financial sector legislation was promulgated, which, among other things, codified the authority of the National Bank of Ethiopia (NBE) regarding the oversight of commercial banks, and permitted the start-up of private banking and insurance activities. In 1994/95, the first private bank started operations, two banks were restructured, and five private insurance companies were licensed. Also, a more active interest rate policy was pursued and, as noted, auctions for treasury bills were introduced. Nevertheless, most previously outstanding government debt is long term in nature, and only a relatively small volume of treasury bills is available through the auctions to meet asset demand. Sector-specific interest rates administered by the NBE were terminated in 1994/95, and a minimum deposit rate (10 percent) and a maximum lending rate (15 percent) were established by the NBE.

As indicated above, following the large initial depreciation of the birr, a foreign exchange auction was introduced on May 1, 1993, to determine the exchange rate applicable to most transactions. The negative list that limits the activities for which foreign exchange may be purchased in the biweekly auctions was subsequently pared to products restricted for security and health reasons and used items; restrictions on payments for invisible transactions were considerably liberalized; and foreign exchange was made available in between exchange auctions for imports of capital goods. In addition to the reform of the exchange system, a duty-drawback scheme was introduced and, as noted above, the import tariff system was significantly rationalized. Specifically, tariff rates were cut, and the number of brackets and the scope of exemptions were reduced. For example, the maximum tariff rate was slashed from 230 percent to 80 percent, and the number of tax-exempt categories was reduced from 327 to 138.

As for the principal domestic structural reforms, direct price controls were almost completely eliminated, the distribution and transport of most commodities were liberalized, and new investment and labor laws were enacted. A market-oriented land-lease system in the urban areas was introduced, and an autonomous agency was established for the privatization of public enterprises. Through mid-1995, there was a limited public auctioning of urban land leases; and 7 state farms, 15 manufacturing firms, 24 hotels, and 71 retail stores were put up for divestiture. The divestiture process was modified to allow for sales, leases, employee buyouts, and management contracts to facilitate the privatization of state-owned enterprises. In addition, following revisions to the tender process, the reservation price was included with the tender offer to avoid unacceptably low bids. In addition to procedural issues, the divestiture process has also been affected by restitution claims based on ownership prior to nationalization under the Dergue regime. Meanwhile, most state-owned enterprises are now managed as autonomous commercial entities, with the Government’s role limited to participation on the management boards.

Finally, social and demographic indicators point to some favorable developments over the past decade or so. As indicated in the table on page vi, life expectancy has risen modestly; population per physician has declined; and access to safe water has expanded. In addition, the overall illiteracy ratio has fallen sharply; and both the secondary education enrollment and pupil-teacher ratios have improved. These developments broadly reflect the Governments’ long-standing aim of promoting health and education as a means of accelerating economic development. However, over the same period, the index of food production per capita has declined; population per hospital bed has increased; and the primary education enrollment ratio has fallen. In this context, to redress these and other deficiencies, the current Government, as noted above, is reorienting public spending from defense toward social objectives.

III. Money. Exogenous Shocks, and Prices

1. Introduction

Over the last 30 years, Ethiopia has experienced moderate, albeit sometimes volatile, inflation, with an annual average rate of increase of consumer prices of some 7 percent. Given the benefits of low inflation in establishing a predictable macroeconomic environment conducive to sustainable growth and development, policymakers in Ethiopia have made low inflation a key objective. Over the same period, dramatic changes in macroeconomic policy have occurred, and the Ethiopian economy has been buffeted by a number of large exogenous shocks. This section empirically investigates the importance of both these factors—policy and shocks—in influencing the price level. Specifically, the scope for monetary policy in achieving a low-inflation objective and the impact of exogenous demand and supply shocks are examined.

The key role of changes in the money supply in determining prices has consistently been documented in empirical studies of other countries. Its limited financial asset market would lead one to also expect an important role for money supply changes in the determination of prices in Ethiopia. Apart from policy, the importance of rain-fed agriculture in the economy—accounting for more than half of GDP—and the dominant role of coffee export receipts in the balance of payments—more than half of all export earnings—make the Ethiopian economy directly susceptible to the adverse effects of periodic droughts and the volatility of world coffee prices. Both such shocks could have a significant feedback into the price level, the former through a supply contraction, and the latter through changing disposable income and thus domestic expenditure.

2. Theoretical considerations

Econometric studies of the money-inflation link have traditionally applied regression models for the study of time series data, paying little attention to the specification of the dynamic structure of the time series (see Kennedy, 1992). Furthermore, those models implicitly sometimes failed to control for the nonstationarity of the economic data. 2/ A number of studies have shown that if economic data are nonstationary, serious problems could arise with respect to the validity of the results. A wide variety of tests have been developed in order to test for the stationarity of a variable. Among those, the following are the most commonly used in the literature: (a) Dickey-Fuller (DF) (see Fuller, 1976); (b) augmented Dickey-Fuller (ADF) (see Dickey and Fuller, 1979); and (c) Phillips-Perron (PP) (see Phillips, 1987, and Phillips and Perron, 1988).

Once stationarity has been established, the relationship between money, prices, and other variables can be tested, and the question of whether movements in the dependent variable (money or the price level) are caused by movements in the independent variable(s) can be addressed. For this purpose, the statistical concept of “causality” is often applied. 3/ This involves regressing the dependent variable Y on past and current values of the independent variable X, and establishing whether the estimated coefficients for the independent variable are significantly different from zero. 4/

3. Empirical analysis

The broad measure of money supply (M2) is employed, which is defined as the sum of money and quasi-money, and was obtained from the International Financial Statistics (IFS) database. The price index (P) data are realizations of the Addis Ababa retail price index. Data on coffee prices (COFFEE) are quotations for African coffee in New York and were obtained from IFS. Rainfall (RAIN) data are based on readings by weather stations located across Ethiopia. These are indicated in millimeters and were obtained from the Famine Early Warning System (FEWS) database. The natural logarithms of all variables were used in the empirical analysis, and all data are quarterly and cover the period 1966–95, with the exception of rainfall data, which are quarterly but cover only the period 1966–90. Chart 2 depicts developments in the price level and broad money over the sample period.

The first step is to control for potential nonstationarity of the data on M2, P, COFFEE, and RAIN. Table 1 presents the results of stationarity tests using the DF, ADF, and PP procedures. All procedures indicate that both M2 and P are not stationary, while COFFEE and RAIN were found to be stationary. The nonstationarity of money and prices is in line with estimates for many other countries; the estimated stationarity of coffee prices is consistent with results obtained in the literature on commodity prices (see Deaton and Laroque, 1992); and the stationarity of the rainfall data accords with the intuition that climatic conditions are unlikely to change significantly over only a 25-year period. Table 1 also indicates, however, that data on M2 and P can be treated as stationary around a deterministic time trend (trend-stationary). 5/

As money and the price level were found to be trend-stationary, and the price of coffee and rainfall were found to be stationary, causality tests can be conducted in order to identify the direction of causality between money, consumer prices, coffee price, and rainfall. 6/ Test results for two models explaining Ethiopian consumer prices are presented in Table 2. Specifically, Model 1 covers the period 1966–95 and regresses consumer prices on a constant, a time trend (T), five lags of money supply, four lags of consumer prices, and eight lags of the coffee price. Model 2 covers the period 1966–90 (owing to the lack of data on rainfall since the end of 1990) and regresses consumer prices on a constant, a time trend, five lags of money supply, two lags of consumer prices, and eight lags of rainfall. In addition, Table 2 presents a third model, which covers the entire 30-year period, and sets out determinants of money supply. Model 3 regresses money supply on a constant, a time trend, a post-Dergue regime dummy variable, consumer prices and two of its lags, six lags of money supply, and nine lags of the coffee price.

Chart 2
Chart 2

ETHIOPIA: Relationship Between Money and Prices (1966:Ql - 1995:Q4)

Citation: IMF Staff Country Reports 1996, 052; 10.5089/9781451812602.002.A001

Table 1.

Ethiopia: Stationarity Tests

article image
Source: Staff calculations.Notes: The sample covers the period 1966–95 (120 quarterly observations), with the exception of rainfall, which covers the period 1966–90 (100 quarterly observations). The critical values for the test statistics are: −3.51 (1 percent); −2.89 (5 percent); and −2.58 (10 percent). The number of lags in the ADF and the PP tests was determined on the basis of the Akaike information criterion (see Akaike, 1973). One asterisk (*) denotes significance at the 10 percent level, two asterisks (**) significance at the 5 percent level, and three asterisks (***) significance at the 1 percent level.
Table 2.

Ethiopia: Granger-Causality Tests

article image
Source: Staff calculations.Notes: One asterisk (*) denotes rejection of the null hypothesis of “does not Granger-cause” at the 10 percent level of significance; two asterisks (**), rejection at the 5 percent level; and three asterisks (***), rejection at the 1 percent level. The number of lags was determined on the basis of the Akaike information criterion. The symbol “=>” indicates the direction of causality.

Models 1 and 2 provide strong evidence that money supply changes cause changes in the price level, and that lagged values of prices (and especially the first lag) are significant determinants of current prices (both results are significant at the 1 percent level). It is important to note that money supply changes have an almost instantaneous effect on prices; the first lag of money supply turned out to be positive and highly significant, indicating that increases in money supply lead to price increases in the following quarter. However, longer lags have smaller additional effects on prices.

The results of Model 1 indicate no statistically significant (at the 10 percent significant level) causal relationship between coffee and consumer prices. On the other hand, the results for Model 2 indicate that rainfall is a highly statistically significant causal factor in affecting consumer prices. Specifically, the first few lags of rainfall (lags one, two, and four) have a negative impact on prices, indicating that an agricultural season already affected by a drought leads to gradually higher prices in the following quarters. It should be noted at this point that the inclusion, in Model 1, of a post-Dergue-regime dummy, which takes the value of one for the period since the third quarter of 1991 and zero for the earlier part of the sample period, yielded an insignificant coefficient. This result is consistent with the notion that the initial increases in prices after the liberalization in 1991/92 of the prices of certain commodities that were subject to administrative controls under the Dergue regime did not have a lasting effect on the overall price level, and they are not expected to recur in the future.

Turning to the determinants of money supply, test results based on Model 3 point to strong causality between past values of money supply and current money supply (significant at the 1 percent level), but also show that coffee prices exhibit strong causality with money (significant at the 5 percent level). With regard to the latter result, it should be noted that causality is mostly driven by the strong positive impact of the first lag of the coffee price, while other lags have less significant effects. 7/ The null hypothesis of no causality from prices to money could be rejected only at the 10 percent level of significance, indicating a relatively weak causality pattern from prices to money. A post-Dergue-regime dummy was positive and significant, pointing to the conclusion that the post-Dergue liberalization of the economy led to higher money growth. In the context of the result that the post-Dergue period did not have a significant effect on the price level, this finding indicates that the more stable and market-based environment after 1991 has induced a positive shift in money demand.

4. Summary

In this section an attempt was made to estimate the causal relationship between money, prices, and other supply- and demand-side variables for the Ethiopian economy over the 30-year period extending from 1966 to 1995. The objective was to provide evidence on whether money supply affects prices or vice versa, and on whether other supply-side factors could affect the determination of prices and thus the monetary policy stance.

The results obtained provide insights on the dynamics of price level determination in Ethiopia. Importantly, it is found that both macroeconomic policy and exogenous shocks are significant determinants of the price level, with money growth having an almost instantaneous effect. Therefore, the monetary authorities have an important role to play in the pursuit of their low-inflation objective. The pertinence of monetary policy is further highlighted by the finding that coffee price developments feed their way into prices only indirectly through monetization effects. Given the volatility of coffee prices and the importance of coffee exports, this outcome points to the need for a vigilant policy to contain the monetary effects of surges in coffee prices in order to realize the inflation objective. 8/ The same argument extends to the role of monetary policy in offsetting other types of demand shocks.

Finally, the above analysis is less optimistic with respect to the possibility of eradicating price volatility. This is due, inter alia, to the importance of agriculture for the Ethiopian economy, periodic droughts, pest infestation, and changes in fertilizer availability, and reflects the demonstrated significance of supply shocks in influencing the price level. On the other hand, while there might be little scope for direct monetary policy intervention in response to harvest shortfalls, in the more liberalized economy of recent years, it might be possible to mitigate the price effects of such shortfalls through increased imports.

IV. The Coffee Boom—Economic Effects and Policies

1. Introduction

Increases in commodity prices in the recent past have offered economic benefits to a number of low-income countries, including Ethiopia. Ethiopia witnessed an approximate doubling in the price for coffee—the country’s major export item—during 1994/95. While yielding a welcome increase in export earnings, the resultant windfall gain also posed challenges for the Government’s overall policy goal of development led by the private sector in a noninflationary macroeconomic environment. In this section, the magnitude of the windfall is estimated, the policy options available and those pursued are discussed, and the distribution of the windfall gain between the public and private sectors is reviewed. The section concludes with a discussion of some policy implications for the future.

2. Coffee price and export developments in 1994/95

In response to the harvest shortfall in Brazil, coffee prices in the world market rallied after May 1994, with the average composite price calculated by the International Coffee Organization increasing by 110 percent. Ethiopia’s earlier liberalization of agricultural marketing allowed for the full pass-through of world prices into domestic producer prices (Chart 3) and thus put coffee farmers in a position to increase their earnings in line with the higher world market prices. In the event, a price-related windfall gain of 2¼ percent of GDP was realized during 1994/95. The actual increase in earnings from coffee exports was even somewhat larger because coffee farmers—in response to the Government’s efforts to improve price information via daily radio broadcasts of producer prices—depleted their stocks, and sales for domestic consumption declined. As a result, the exported quantity increased by 7½ percent over the previous year’s level, further boosting coffee export receipts by about ⅓ percent of GDP.

3. Macroeconomic effects of the coffee windfall

The significant windfall gain from higher coffee prices, as well as the higher export earnings from the ensuing supply response, afforded the economy an opportunity to increase savings and investment and thereby lay the foundations for higher sustainable growth in the years after the coffee boom. Based on empirical work for other countries, it would be expected that the propensity to save out of windfall gains would be significantly larger than that out of a steady income stream (see Collier and Gunning, 1996). On the other hand, windfall gains of the size estimated above, with the associated large inflows of foreign exchange, may risk large monetary expansions that put at risk inflation and exchange rate objectives. Therefore, depending on the choice of policies adopted, such windfalls have the potential to boost the future growth potential of the economy through increased savings, or to undermine macroeconomic stability.

Chart 3
Chart 3

ETHIOPIA: Selected Indicators

Citation: IMF Staff Country Reports 1996, 052; 10.5089/9781451812602.002.A001

Sources: Data provided by the Ethiopian authorities; and staff estimates.

The monetary effects of the coffee boom in Ethiopia result from an accumulation of net foreign assets of the banking system. A connection between coffee prices and the stock of net foreign assets would be expected, given that coffee exports account for more than half of total exports. Moreover, this connection is particularly close in Ethiopia as a result of a 100 percent export earnings surrender requirement (i.e., exporters must surrender all export proceeds to the banking system in exchange for domestic currency). This regulation prevented exporters from immediately using their foreign exchange proceeds for imports—for example, to finance capital goods imports—which could have dampened the buildup of net foreign assets. Furthermore, other restrictions on the purchase of foreign exchange for imports supported the accumulation of net foreign assets. Ethiopia’s much improved net foreign asset position thus posed the risk of a large increase in money supply which, other things being equal, would not have been met by a matching shift in money demand. Based on the analysis of the money-price link in Ethiopia presented in Section III, developments in Ethiopia strongly suggested the risk of a significant and rapid acceleration of inflation.

4. Policies to address the coffee boom

For the Ethiopian authorities, several policies were available to contain the inflationary pressures from the excess money supply. The “sterilization” policy options that could have been adopted can be broadly divided into three sets: (1) policies to dampen and contain the buildup of net foreign assets; (2) policies to reduce the level of domestic assets and thus offset the monetary impact of the buildup in foreign assets; and (3) policies to increase money demand and encourage financial deepening, thereby reducing the inflationary consequences of the increases in money supply. These options and the policies actually pursued are now discussed in turn.

First, if the Government had opted for the policies aimed at limiting the buildup of net foreign assets during the coffee boom, Ethiopia could have taken advantage of the high demand for capital goods imports, reflecting the urgent need to rebuild the capital stock that had been destroyed during the 1980s. Under these policies, the National Bank of Ethiopia (NBE) would have accommodated the economy’s demand for foreign exchange for such imports in a period during which so doing would not have threatened the balance of payments position. In the institutional context of Ethiopia, such a policy stance would have entailed larger allocations in the biweekly foreign exchange auctions—technically equivalent to a relaxation of the export proceeds surrender requirement—which would have been reinforced by more frequent auctions, as well as by a further narrowing of the negative list of goods for which bidding at the auction was not permitted. 9/ Alternatively, the import regime would have been liberalized further through various measures such as more tariff reductions, additional streamlining of licensing procedures, and permitting a wider group of bidders at the auctions.

In fact, the allocations of foreign exchange in the biweekly auctions were increased, but not in line with the higher export earnings from the coffee boom. Furthermore, the export proceeds surrender requirement was not relaxed, and access to the auction—though expanded by a reduction of the negative list—continued to be limited, notably with respect to bidding for imports of used goods. All these factors worked to ration the demand for foreign exchange. Thus, while significantly more foreign exchange was made available to private sector bidders through the auction, not all of the import demand was accommodated and, on an average monthly basis, an excess demand of US$6 million developed at the auctions. In order to meet this excess demand and to prevent any increase in the net foreign assets, the NBE would have needed, on average, to make 30 percent more foreign exchange available to private bidders at the auction.

Coupled with such a rationing of import demand, Ethiopia’s constrained capacity to meet a real demand shock by increasing domestic supply led to upward pressures on prices. This in turn provided a strong disincentive for exporters and coffee farmers to store their wealth in birr-denominated assets. In the absence of alternative assets, however, such portfolio diversification could only be into foreign exchange, thereby further boosting the demand for foreign exchange. On the other hand, supply in the only other market for foreign exchange, the sizable parallel market, did not increase. The stronger overall demand for foreign exchange resulted in a near doubling of the parallel market premium, from about 12 percent in April 1994 to about 21 percent at end-June 1995. While the policies pursued did contain the rise in net foreign assets somewhat, the coffee boom contributed to an increase of net foreign assets of about 15½ percent of beginning-of-period broad money, and additional measures would have been needed to prevent an equivalent monetary expansion.

The second set of possible policy options would have aimed at checking the monetary impact of the increase in net foreign assets by lowering the stock of net domestic assets. Importantly, the Government could have attempted to boost its savings and reduce the fiscal deficit through a policy of revenue enhancement and expenditure restraint. This would have allowed for a reduction of the Government’s indebtedness to the banking system.

In the event, the Government’s role in checking at least part of the monetary expansion associated with the increase in net foreign assets was facilitated by aspects of the Ethiopian tax system that provided for the automatic taxation of part of the windfall gains. As a result, the Government effectively received additional revenue of ¾ percentage point of GDP from the direct and indirect taxation of the coffee boom through additional revenue from coffee export taxes, the taxation of the increased imports in response to the boom, and the direct taxation of the additional incomes of coffee farmers and exporters. Apart from the taxation of the coffee windfall, revenue collection was enhanced, and the Government’s overall financing needs were further curtailed, by a reduction in expenditure equivalent to some 4 percentage points of GDP, so that the fiscal deficit (excluding grants) in 1994/95 was some 7 percentage points of GDP lower than in 1993/94. Owing to all these factors, net repayments to the banking system by the Government were equivalent to some 5 percent of beginning-of-period broad money. This was well short of the increase in net foreign assets. Taking into account a large rise in credit to the nongovernment sector—discussed below—a monetary expansion of 20½ percent ensued.

Containment of the inflationary effects of monetary expansion, the aim of the third set of possible policies, would have sought to encourage financial deepening. Under these policies, the development of alternative domestic financial assets and an asset market would have been hastened, providing the private sector with alternative, high-yielding assets into which financial savings would have been channeled. Substantial sales of short-term treasury bills to the nonbank public would have absorbed some of the excess liquidity in the economy (and also allowed the Government to further reduce its indebtedness to the banking system). Moreover, the demand for broad money would have been increased through an interest policy that succeeded in maintaining positive real rates of return.

In the event, the authorities did take some important steps toward effecting financial deepening in Ethiopia, mainly by introducing in 1995 an auction for 90-day treasury bills. However, the treasury bill sales were limited in volume and taken up mostly by the Pension Fund, which used the bills as an alternative to its unremunerated excess cash holdings, thereby depressing returns on the bills. The resulting low nominal return on treasury bills, far short of the rate of inflation, significantly lowered their attraction as a store of wealth for the private sector. Moreover, over 1994/95, deposit interest rates were not adjusted, and then the nominal return on holdings of broad money fell increasingly short of the rate of inflation, actually dampening money demand.

Thus, while the policies pursued over 1994/95 contained elements of an appropriate policy response, they were less than fully adequate. In particular, net foreign assets grew sharply, the increase was largely monetized, and, with the generally quick pass-through of money supply changes into the price level, inflation increased. The actual acceleration in inflation from some 1 percent in 1993/94 to about 13½ percent in 1994/95 was, however, also driven by the lagged effects of the harvest failure in 1993/94.

5. The incidence of the benefits of the windfall

As the economic development program of the Ethiopian Government is premised on growth led by the private sector, the Government’s aim in 1994/95 was to have the benefits of the windfall accrue to the private sector—in the first instance, mainly to coffee farmers and exporters. The policies pursued to achieve this objective included a predictable tax regime that was not adjusted in order to reap additional receipts for the public sector during the coffee boom, as well as large increases in the banking system’s loans to the private sector.

The direct and indirect taxation of the coffee windfall (¾ percentage point of GDP) was fully compatible with the Government’s objective of channeling the windfall gains to the private sector, that is, no discretionary or unforeseen taxation was imposed on the private sector in response to the coffee boom. To provide additional resources to the private sector, the earlier rationing of credit—an important impediment to private sector growth—was significantly relaxed in 1994/95. Other things being equal, the increase in credit contributed further to excess liquidity in the Ethiopian economy. This, combined with the accumulation of net foreign assets in response to the coffee boom, spurred inflationary pressures, and the associated receipts from the inflation tax amounted to 2⅔ percent of GDP. Of this amount, based on the analysis in Section III, at least ⅔ percent of GDP—about one fourth of the entire windfall gain to the Ethiopian economy—can be attributed to the inflationary impact of the monetization of the coffee boom. In the event, and taking receipts from the inflation tax into account, more than half of the coffee windfall accrued to the Government.

6. The outlook

Although world market prices for coffee are tapering off and are projected to decline over the medium term, a reversal could occur at any point and thus pose a policy challenge for the Ethiopian Government similar to that in 1994/95. The policy choices would remain the same as in 1994/95, and, based on the experience of that year, some lessons may be drawn.

Most importantly, while significant parts of the windfall gain were indeed transferred to the private sector, the resultant demand expansion gave rise to inflationary pressures. Such pressures in the future could be checked, but only through a comprehensive set of policies comprising fiscal vigilance, liberalization of the exchange and trade regime, and a quickened development and deepening of financial markets. While these challenges remain, the benefits of higher receipts from coffee earnings for the Ethiopian economy cannot be overstated. In particular, the unique opportunity to increase savings and imports of essential capital goods in a manner that does not put the balance of payments at risk offers long-term rewards in the form of higher sustainable growth.

V. Developments in Regionalization Policy and Fiscal Implications

1. Introduction

The right of self-determination by the “nations, nationalities, and peoples” of Ethiopia within their territories, and the right to effectively participate in the Central Government were integral features of the reform agenda put forth in late 1991 by the Transitional Government of Ethiopia (TGE). 10/ This principle was subsequently reaffirmed with the ratification of the Constitution for the Federal Democratic Republic of Ethiopia in December 1994. An important aspect of this principle is the right of the nations or nationalities to alter a particular federal structure and merge with contiguous units, divide into smaller units, or secede if the envisaged right to self-determination is not adequately protected. 11/

The structures and responsibilities articulated in the Constitution build on those promulgated by the TGE, albeit with significant modifications that reflect both the experience of the past several years, and the continued transformation from a centrally planned to a market-based economy. In particular, the Constitution establishes a considerably more advanced form of federalism and, accordingly, substantially reformulates the allocation of fiscal authority. As a result, the definition and codification of the fiscal responsibilities of the different layers of government has taken on an increased importance.

2. Fiscal devolution from 1991/92 to 1994/95

The 63 identified nationalities that constitute Ethiopia provided the basis for structuring the official Regions as the foundation for a federal type of government. 12/ Following the merger of five of the original Regions, a structure of nine Regions and two provisional administrations (Addis Ababa and Dire Dawa) has emerged. The relationship between the Central and Regional Governments was defined by legislation that established the original composition of the Regions, and the basis for altering their composition; articulated the structure of the government at the central and regional levels; and articulated the rights, obligations, and responsibilities of the various levels of government. 13/

The allocation of fiscal responsibilities during this phase of the devolution reflected the principle that the Regional Governments were “in every respect, entities subordinate to the Central Transitional Government.” 14/ As a result, the Central Government was given the authority to set not only monetary and financial policies, but also to determine economic and social development strategies, education and public health standards, civil service pay scales and benefits for the Regions and Central Government, and revenue policies. The regions were initially assigned subordinate authority to implement these policies. In this context, the Regions were allocated the responsibility for submitting recurrent and capital budgets to the Ministry of Economic Development and Cooperation (MEDC) and the Ministry of Finance, respectively, as part of the preparation of a consolidated budget. 15/

Revenue sources were classified into three categories: those that belong to the Regions; those that belong to the Central Government; and those designanted as belonging jointly to the Regions and the Central Government—to be distributed according to the determination of the Central Government (Table 3). 16/ In addition to determining the policies applied to its own and joint revenue sources, the Central Government was also charged with ensuring that measures enacted by the Regions and the Central Government were consistent with a unified tax policy base. This, combined with the explicitly subordinate status of the Regions, provided a limited basis for the Regions to pursue independent revenue policies, even within the specified subset of revenue sources at their disposal.

The devolution of expenditure to the Regions followed functional lines, and was not reflective of their widely differing revenue capacities. 17/ With regard to recurrent spending, the Regions acquired responsibility for personnel costs associated with their administrations, including health and education, albeit with pay scales, benefits, and grading defined by the Central Government. 18/ Responsibility for a significant share of capital outlays, particularly in the areas of agriculture, health, education, and road construction, devolved quickly to the Regions.

Table 3.

Ethiopia: Distribution of Powers of Taxation

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There was a predictable imbalance between expenditures and revenues for the combined Regions. External resources comprised an increasingly important source of public finance for Ethiopia, and the Central Government had also been allocated historically important revenue sources, including duties and charges on imports and exports, and tax revenue from enterprises owned by the Central Government. In contrast, the resources allocated to the Regions—which included personal income taxes (excluding employees of the Central Government), taxes on the profits of individual merchants, and some sales taxes—were difficult to collect, particularly in the context of the wide variation in institutional capacity at the Regional level. The imbalance was magnified by including as part of the Central Government’s total revenue collections those sources designated as belonging jointly to the Central Government and the Regions. On the expenditure side, the extent of externally financed capital projects, and the devolution to the Regions of most civil service personnel provided the basis for a substantial structural deficit.

While about one-half of the Regions required substantial assistance from the Central Government in preparing their budgets for 1992/93, owing in part to the wide disparity in institutional capacity, budget submissions were prepared on a largely independent basis by 1994/95. By this time, the regions accounted for about 38 percent of recurrent spending and about 40 percent of capital outlays financed from domestic sources (Table 4). The bulk of capital expenditure in the areas of health, education, agriculture, and road construction had devolved to the Regions. Recurrent spending by the Regions on economic services grew rapidly, owing to the devolution of civil service personnel and their responsibilities for agriculture and natural resources, industry, trade and tourism. While there appears to be a considerable disparity in the composition of expenditure among the various regions, a lower share for capital outlays in a particular Region may reflect the ommission of donor-supported projects that have been shifted to the Regions from the consolidated budget.

The revenue contribution from the Regions was highly concentrated, with four Regions accounting for more than 80 percent of receipts. Overall, the Regions accounted for about 37 percent of receipts from income and profits taxes, but only 17 percent of tax receipts overall, owing to the substantial contribution from sales and import tax revenues. In terms of nontax revenues, increases in receipts to the regions from sales of goods and services, as well as fees and charges, were more than offset by higher receipts from enterprises owned by the Central Government, particularly financial institutions. Moreover, land fees—which accrue to the Regions—were low, reflecting difficulties with regard to the auctioning of urban land-use leases.

Table 4.

Ethiopia: Central and Regional Allocation of Revenue and Expenditure, 1994/95

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Sources: Ministry of Finance; and staff estimates.

Recurrent spending excludes external grants of aid in kind.

Captial expenditure excludes outlays financed from external grants and loans.

The bulk of regional spending, therefore, was supported by transfers from the Central Government, which include the allocation of joint tax receipts as well as foreign assistance. Beginning in 1994/95, allocations from the Central Government to the Regions reflected a range of factors intended to capture the extent of existing expenditure needs as well as absorptive capacity. Initially, allocations were made separately for recurrent and capital budgets, and the distribution of external resources reflected the decentralization of ongoing projects to the Regions. While the Regions were granted the right to borrow from domestic sources, this was effectively precluded by separate legislation that disallows the commercial banks and the Central Bank from lending to the Regions. 19/

3. Devolution in the Federal Democratic Republic of Ethiopia

The Constitution, ratified in December 1994, articulates a more advanced federal framework, compared with the earlier proclamations. In keeping with this transition, the Constitution also provides for a change in nomenclature: the Regions are now known as National States; the Central Government has become the Federal Government; and the consolidation of the States and Federal Government is termed the General Government.

The relationship between the States and the Federal Government is substantially different from that between the previous Regions and the Central Government. Foremost, all powers not explicitly given to the Federal Government—either separately or concurrently with the States—automatically devolve to the States. 20/ Moreover, while the Federal Government is granted authority for policy formulation in several areas, 21/ the Constitution also accords the States a substantial role in policy setting.

In terms of revenue policies, the authority to determine the rates, bases, and allocation of revenue sources belonging to the States is clearly vested with the States themselves, while the allocation of those sources described as joint now falls under the jurisdiction of the Federal Council and the Council of the People’s Representatives that comprise the Federal Government. 22/ Moreover, undesignated revenue sources can be allocated only with the consent of two-thirds of both Councils, with more stringent conditions for the reallocation of revenue sources included in the Constitution. In general terms, the resources allocated to the States and to the category of joint revenues are likely to be more buoyant over the medium term, particularly with improved administrative capacity and expanded private sector activity.

Provisions regarding expenditure are considerably less detailed than those for revenue, particularly regarding the responsibility for providing services. The requirement that the States implement conditions of service for their employees equivalent to those for the federal employees has been eliminated, and replaced by the requirement that educational and training requirements for civil servants employed by the States approximate national standards. The Federal Government does retain a more narrowly defined authority to establish broad policies, including national standards for public health and education. The further decentralization of expenditure, however, is limited, owing to the Federal Government’s continued responsibility for defense, interstate commerce, the administration and regulation of all forms of transportation, postal services, and telecommunications. While, state revenue resources are expected to become more buoyant, transfers will remain important as a means of offsetting the sharp differences between States both in terms of, revenue capacity and expenditure needs.

The need to ensure that fiscal decentralization is consonant with the overarching objective of macroeconomic stability will be important in the further definition of the roles accorded to the States and to the Federal Government. 23/ Transfers and grants from the Federal Government to the States will continue to be substantial. As a result, the budget process would need to encompass the full range of capital expenditures, including those financed directly by donors, to ensure a balance with regard to the development of key infrastructure, the implementation of national standards for public health and education, and sufficient allocations for operations and maintenance. In this context, the consolidation of the strategies and policies of the various States and those of the Federal Government into a single document could provide an appropriate basis for future allocations of both domestic and external resources, within a framework that ensures continued macroeconomic stability.

The increased scope for state policies with regard to both revenues and expenditures underscores the importance of defining the mechanisms for adjusting in a timely manner any discrepancies between budget allocations and actual revenue receipts and outlays. Because the allocation of revenues indicated in the Constitution is not readily alterable, the main source of flexibility for offsetting revenue shortfalls or expenditure overruns is in the allocation of the joint revenue pool and external assistance. Simultaneously, the expanded scope for policymaking at the state level has heightened the difficulty in projecting revenues and expenditures. In this context, the advancing federal structure emphasizes the importance of adequate institutional capacity at the state level for providing an appropriate basis for policy determination, and for meeting the need for accurate projections for budget preparations, as well as later revisions.

The potential for destabilizing competition among the States is largely limited by the allocation of revenue responsibilities: the Federal Government retains authority over import tariffs and related exemptions, while the taxation of corporations is the joint responsibility of the State and Federal Governments. Nevertheless, the movement to a Federal Government emphasizes the role of coordination between state and federal policies so as to avoid an undue burden on some revenue sources to offset shortfalls in other areas. In a similar manner, the allocation of responsibility to the States and Federal Government to adjust to economic developments will be important for the stability of Ethiopia’s macroeconomy.

Appendix I

Table I.

Ethiopia: Gross Domestic Product by Sector at Constant 1980/81 Factor Cost, 1990/91-1994/95

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Source: Data provided by the Ethiopian authorities.
Table II.

Ethiopia: Expenditure on Gross Domestic Product at Current Market Prices, 1990/91–1994/95

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Source: Data provided by the Ethiopian authorities; and staff estimates.
Table III.

Ethiopia: Estimates of Agricultural Production and Cultivated Area of Major Crops, 1990/91–1994/95

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Source: Central Statistical Authority.

In thousands of hectares.

In thousands of quintals.

Preliminary estimates.

Table IV.

Ethiopia: Estimates of Coffee Production, Marketing, and Stocks, 1990/91–1994/95 1/

(In thousands of metric tons)

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Source: Ministry of State Farms and Coffee and Tea Development.

Estimates (except for exports) based on Coffee Sector Survey.

As recorded on loading at port rather than at customs stations.

Represents, among other factors, unofficial exports and handling losses.

Table V.

Ethiopia: Monthly Export and Arrival Volumes, and Coffee Prices, January 1992–December 1995

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Source: Data provided by the Ethiopian authorities.

Auction price less estimated transport and handling costs.

For unwashed and washed coffee combined (mostly unwashed) at Addis Ababa, weighted by same month’s arrivals.

Domestic retail price in Addis Ababa.

Excess of the domestic price over the auction price in percent.

ICO, International Coffee Organization; U.S. cents per pound.

Table VI.

Ethiopia: Summary of Investment Projects, July 1992-April 8,1995 1/

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Source: Investment Office of Ethiopia.

Data do not include projects approved by the Tigray Investment Office.

As stated in the project application, in millions of birr.

Thousands of birr per employee.

Table VII.

Ethiopia: Ex Refinery and Retail Prices of Petroleum Products, 1989–55 1/

(In birr per liter)

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Source: Ethiopian Petroleum Corporation.

Retail prices vary across country depending on transportation costs.

Table VIII.

Ethiopia: Addis Ababa Retail Price Index (Excluding Rent)

January 1992 - December 1995

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Sources: Central Statistical Authority; and National Bank of Ethiopia.