This Selected Issues paper examines the impact of relief and reconstruction expenditures in Eritrea on the fiscal profile. The paper discusses the principle categories of extraordinary expenditures, which the authorities have undertaken during 1993–96 for relief and reconstruction purposes. It analyzes developments and reforms in the financial system. The paper highlights that Eritrea’s financial system has undergone considerable reform through the mid-1990s, but remains rudimentary and concentrated, and is still largely owned and controlled by the state.

Abstract

This Selected Issues paper examines the impact of relief and reconstruction expenditures in Eritrea on the fiscal profile. The paper discusses the principle categories of extraordinary expenditures, which the authorities have undertaken during 1993–96 for relief and reconstruction purposes. It analyzes developments and reforms in the financial system. The paper highlights that Eritrea’s financial system has undergone considerable reform through the mid-1990s, but remains rudimentary and concentrated, and is still largely owned and controlled by the state.

I. Impact of Relief and Reconstruction Expenditures on The fiscal Profile

A. Introduction

1. A major objective of the Eritrean government during the past four years has been the reconstruction and rehabilitation of the economic and social infrastructure (both physical and human) that was damaged by the prolonged war for independence lasting about 30 years. The state of the economy at the time of independence not only reflected the destruction of infrastructure and the lack of any capital rehabilitation during the war years owing to the insecurity in the region but also the adverse impact of central planning in 1974-91. At independence in May 1993, the Eritrean government inherited an economy characterized by state-owned enterprises, most of which were barely operational; an agricultural and industrial base disrupted by the war; and a damaged and decayed economic and social infrastructure, including health and educational facilities. Thus, there was a massive need for reconstruction and rehabilitation to rebuild the infrastructure and government institutions at all levels--local, provincial, and central.

2. The detrimental effect of the war on society is reflected on the estimated 500,000 people who were forced to became refugees in neighboring countries. In addition, a large number of people left the country and settled overseas in the Arabian Peninsula, Europe, and North America; through their remittances the overseas settlers provided a crucial support to the struggle for independence. Nevertheless, this exodus also left the country with a skill shortage in almost all professions including policy makers, civil servants, teachers, and health professionals. Thus, at the time of independence, the government was faced with a massive task of providing relief to the displaced population and enabling their reintegration—both returning refugees and those displaced internally—and had to deal immediately with the future of the large number of ex-combatants. To contain the medium- and long-term cost of a big army, the government initiated early on a demobilization program, with the aim of reducing the size of the army by at least 50 percent in a short period and reintegrating the demobilized personnel into normal civilian life through various programs.

3. In order to maintain social cohesion and initiate a sustained economic recovery the Eritrean government decided to frontload the expenditures on relief, rehabilitation and reintegration. This broad based effort has contributed to an expansionary fiscal trend particularly in 1994-96, characterized by a few large one-off extraordinary expenditures, consisting mainly of payment to “martyrs’ families” who suffered casualties in the liberation war and for the demobilization of ex-combatants. The emerging fiscal deficits (including grants) of 18 and 16 percent of GNP in 1995 and 1996, respectively, represented a sharp deterioration compared with deficits that averaged 7 percent during 1993-94. The extraordinary relief and reconstruction expenditures, those explicitly itemized in budgetary outlays—demobilization of ex-combatants, payments to martyrs’ families, retroactive salary payments to ex-combatants, and compensatory payments to retrenched civil servants—ranged from 3.2 percent of GNP in 1993 to about 10 percent in 1995 (Table 1). There have been other extraordinary expenditures that significantly impacted on total expenditure but could not be itemized; for example, spending on materials and supplies for rehabilitation, the cost to reintegrate ex-combatants, and capital investment towards reconstruction and rehabilitation. A substantial share of the capital expenditure which increased from 3.8 percent in 1992 to 16.3 percent in 1996, was directed towards reconstruction of damaged and destroyed infrastructure.

Table 1.

Eritrea: Extraordinary Government Expenditures, 1992–97

article image
Sources: Ministry of Finance; and staff estimates.

Excludes retroactive and retrenchment payments.

4. The following section discusses the principle categories of extraordinary expenditures, which the authorities have undertaken during 1993-96 for relief and reconstruction purposes.

B. Types of Extraordinary Expenditures

Demobilization of ex-combatants

5. At the time of independence, Eritrea had an army of ex-combatants estimated at about 96,000. The demobilization program was initiated in 1993 with the reduction of the force by about 26,000 ex-combatants. Most of these ex-combatants were young and without families, who joined the Eritrean Peoples Liberation Front (EPLF) after 1990. Upon demobilization each of them received a lump sum payment ranging from Br 2,500-Br 5,000, which resulted in total costs of Br 99 million (Table 1).1 In 1994, this exercise was followed with a demobilization of another group of about 15,000 ex-combatants, most of whom had served in the EPLF for many years. Each received a lump sum payments of Br 10,000 along with a year of food rations. This resulted in budgetary outlays of about Br 154 million. In 1995, another 3,500 ex-combatants were demobilized and each received about Br 10,000 plus food rations, resulting in budgetary costs of about Br 42 million. In 1996, a much smaller number of just over 1,000 ex-combatants were demobilized at a cost of Br 14 million.

6. During 1993-96, 45,500 ex-combatants were demobilized, entailing a total cumulative cost to the exchequer of about Br 310 million (or 6.1 percent of estimated 1996 GNP), financed entirely from domestic resources, excluding the cost of reintegration which involved additional outlays for rehabilitation and retraining programs (see below). Demobilized soldiers are now active in farming and small business activities and a large number have been successfully reintegrated into civilian life. The size of the army was reduced further by reassigning about 6,000 personnel to various other government ministries. In all, the size of the army was reduced by about 52,000 (54 percent).

Payment to martyrs’ families

7. It was estimated that about 60,000 Eritreans were killed and a large number of ex-combatants and civilians disabled as a result of the war. As part of the government’s social safety net program, the government provided financial compensation to surviving family members of those killed in the war and to the disabled and their families. Available information indicate that about Br 10,000 was paid par family in 1995, to 30,000 such families, for a total cost of Br 296 million (6.4 percent of GNP in 1995 or 13 percent of total recurrent expenditure; Table 1). An additional payment of about Br 30 million to martyrs’ families was made in 1996.

Retroactive salary payments to ex-combatants

8. After liberation, the nondemobilized ex-combatants formed the core of the country’s security forces (military personnel and police), white some 6,000 of them began working in other governmental ministries. They all continued to work for the government without a regular salary during 1992-94. In lieu of regular wages, the government provided them with some nominal pocket money along with food and housing. The government started to pay them on a retroactive basis; the first such retroactive payment to the security forces was made in 1995 totaling about Br 70 million based on the existing pay scale of the ex-combatants and their ranks within the security force. Retroactive salary payments to ex-combatants working in the civilian government amounted to Br 450 per month plus Br 10 for each year of service in the EPLF. These payments to ex-combatants were mainly to cover all back pay dating back to 1994.2 In 1996, another sum of about Br 150 million (2.9 percent of GNP) was paid by the government to the security forces, based on the revised security service structure and a new higher pay scale retroactive to 1994.

Civil service reform

9. At the time of independence, Eritrea inherited a civil service structure that was characterized by too many departments and a deep hierarchial structure. The process of civil service reform was initiated through the setting up of a Presidential Task Force to review government operations.3 The findings of the task force indicated that the civil service was overstaffed, a majority of the staff possessed low levels of skills, and the division of labor, authority, and responsibility were not clearly defined. This organizational structure of ministries led to an overlap of responsibilities across ministries which resulted in inefficient use of resources. According to a comprehensive job assessment conducted by the task force, government operations could be managed effectively by a reduction of the government’s work force by a third to about 20,000 employees in conjunction with the introduction of modern technology and better work practice. Based on the task force’s report, the government embarked on a comprehensive program of civil service reform. The government’s aim was to create a lean, efficient, and effective civil service through a reduction in its size, a redefinition of the priorities of ministries to focus on policy development, regulatory aspects, research, human resource management and training; and decentralization of government operations to the provincial and local levels. Efficiency was gained in many areas through extensive reorganization, computerization, and/or reassignment of responsibilities among the ministries. The structure within ministries was streamlined through a reduction in departments and posts to enable a faster decision making process.

10. Following the recommendation of the presidential task force, the size of the civil service was reduced by 10,000. The redundancies included about 3,500 ex-combatants who had been absorbed into the civil service. In 1995, Br 51 million was paid in compensation to the retrenched civil servants.

11. The task force also recommended that in order to produce an efficient and effective civil service the employees would have to be remunerated competitively. Thus, the salary structure of the civil servants was revised in 1997. The basic pay scale was consolidated to include most allowances and was revised upwards to be comparable to the private sector; the salary of some employees is expected to nearly double. Since the beginning of 1997, most employees in the urban areas have been paid according to the revised higher pay scale, while employees in the rural areas are expected to be paid later in the year, retroactive to the beginning of 1997. At this stage no firm estimate of the revised total government wage bill is available, but it is not expected to be higher than the 1996 total nominal wage payment of about Br 798 million, which included the Br 150 million back pay element to the security forces (Appendix II, Table 16).

Reintegration of ex-combatants and refugees

12. The government has also undertaken a program to reintegrate both ex-combatants and refugees into civilian life. The reintegration has been implemented through agricultural settlement projects, vocational training programs, public works programs, and technical and financial support to help establish independent small-scale enterprises.4 One of the important projects undertaken was the resettlement of about 1,100 ex-combatants in 1994, at the Alighider state plantation located in the Western lowlands. The farm mainly grows cotton and other crops on irrigated land. The cost of this project was reported to be about Br 36 million.

13. It is estimated that between 1991-94, about 80,000 refugees returned to Eritrea without official assistance. In early 1995, the government with the assistance of the United Nations High Commission for Refugees and other donors completed a pilot project—Program for Refugee Reintegration and Rehabilitation of Resettlement Areas in Eritrea (PROFERI). About 25,000 refugees returned under this program. This program cost an estimated Br 88 million (US$14 million) most of which was provided by external donors. Since then preparations have been continuing, along with discussions with bilateral donors, World Bank, and UN agencies, on the technical and financial aspect to repatriate the remaining refugees in phases. Phase 1 is being designed to repatriate about 100,000 refugees which is estimated to entail a cost of about Br 510 million (US$80 million) to be funded mostly by donors.

Expenditure on materials and supplies

14. Expenditure on materials averaged 14.6 percent during 1992-96, peaking at about 18 percent in 1995 (Table 1). Although no firm estimate is available, a major part of this expenditure involved one-off extraordinary expenses. These include rehabilitation of existing government institutions and setting up institutions at the provincial and local levels in line with the restructuring of government operations towards decentralization of most functions. Items in this category of expenditure towards the restocking of supplies in government institutions ranged from basic furniture, office supplies, and computer equipment. In addition, expenses were also incurred towards the rehabilitation of government enterprises, ports, and state farms. For example, new settlers in the state farms were provided with farming tools, seeds, and oxen. Furthermore, expenditure was incurred in restocking of school supplies and improving health facilities which the government had reconstructed and rehabilitated over the past few years. Most of these expenses were oh durable good items, which after initial acquisition will require relatively lower level of expenditures for maintenance.

Capital expenditures

15. Capital formation and maintenance in Eritrea, throughout the war years, was constrained by the prevailing insecurity. Furthermore, the lack of new capital and the war damage led to decay and decline in basic infrastructure, thereby necessitating a major rehabilitation effort at the end of the war. The poor quality and decline in infrastructure was reflected in extensive damages to major roads, key bridges, ports, domestic and commercial buildings, neglect and destruction of most major government enterprises including state farms (Elaberet, Ghinda, and Alighider), and damage to education and health facilities.

16. A large part of the capital’ expenditure during 1992-96 has included expenditure on rehabilitation projects which is not expected to be repeated in the future. Capital expenditure has ranged between 4-16 percent of GNP during 1992-96 (Table 1). Until 1995, the bulk of this expenditure was financed through external resources as donors responded to the large rehabilitation needs of the country. Rehabilitation projects have been undertaken throughout the country, especially in those areas that suffered most in the war, for example, the port city of Massawa. Capital expenditures have encompassed a wide variety of rehabilitation projects including the rebuilding of roads linking major cities, housing, power, schools, health clinics, ports, fisheries, and in the agricultural sector involving rehabilitation of the three state farms and the construction of dams for irrigation. Capital spending on education and health increased from about 1 percent of GNP in 1993 to about 3 percent of GNP in 1996. This involved mostly the rebuilding and construction of schools and health clinics throughout the country.

C. Impact of Extraordinary Expenditures on Fiscal Sustainability

17. The relatively high level of expenditure in 1995-96 was necessitated by the government’s aim to meet urgent one-off payments to rehabilitate the economy and provide social relief. Most of the large one-off expenses have already been undertaken. Total extraordinary expenditure peaked in 1995 at about 10 percent of GNP (Table 1). In 1996, there was a significant decline in extraordinary expenditures of about 6 percentage points of GNP, along with a marked decline in expenses on materials equivalent to about 4 percentage points of GNP (Table 2). Thus, there was a potential for the overall deficit (including grants) to have declined significantly by as much as 10 percentage points of GNP. However, this substantial decline in extraordinary expenditures was almost offset by a combination of a decline in total revenues and grants of 2.4 percent of GNP, an increase in wage and salaries of about 1 percent of GNP (excluding retroactive wage payments), and in particular a sharp increase in capital expenditures equivalent to 4.5 percent of GNP (largely due to a sharp increase in outlays directed towards construction of schools and health facilities). As a result, there was only a marginal improvement equivalent to 2 percentage points of GNP in the overall deficit in 1996.

Table 2.

Eritrea: Annual Changes in Government Operations, 1995–97

(As percent of GNP)

article image
Sources: Ministry of Finance; and staff estimates.

Excludes retroactive and retrenchment payments.

18. Although the government of Eritrea has no formal budgetary process as yet, the broad budget outline which emerged from available information point to a likely sharp decline in the budget deficit (including grants) for 1997. Provisional data on a cash basis through March 1997, also indicates that the budget deficit is expected to decline significantly during the year. A combination of measures could bring about a sharp decline in the deficit in 1997. Revenues are estimated to increase by 1 percentage point of GNP, mostly through better administration and improved coverage and collection.5 Similarly external grants are expected to recover and increase by about 1 percentage point of GNP. The remaining adjustment is likely to come through a decline in total expenditure of almost 6 percentage points of GNP. Almost all extraordinary expenditures have been completed and it is expected that there will be a further decline in such payments equal to 3.6 percentage points of GNP. This would be accompanied with a fall in expenses for materials by about 1 percentage point, as the government’s program of restocking ministries and agencies comes to a close. Additionally, it is likely that capital expenditure will fall by about 3 percentage points of GNP from the exceptionally high level achieved in 1996 to a level more consistent with the outcome in 1995. Overall, total expenditure could be lower by more than 7.5 percent of GNP. However, part of this decline in expenditure is likely to be offset by a rise in other expenditures, particularly wage and salary payments. The total wage bill in 1997 is targeted to not exceed the 1996 level of Br 798 million (including retroactive payment of Br 150 million). Excluding the 1996 retroactive wage payments the basic wage bill for 1997 could increase by about 1.3 percent of GNP, in line with the government’s implementation of the new salary scale for the civil servants as discussed above (Table 2). As a result, total expenditure is expected to fall instead by about 6 percentage points of GNP in 1997. Thus, in conjunction with a rise in revenue and grants of about 2 percentage points of GNP, the overall deficit is expected to decline by half to about 8 percent of GNP in 1997.

II. Recent Developments and Reforms in the Financial System Profile

A. Introduction

19. Eritrea’s financial system has undergone considerable reform through the mid-1990s but remains rudimentary and concentrated, and is still largely owned and controlled by the state. The impact of the latter has been to channel considerable credit to the public sector, particularly the central government at interest rates lower than the prevailing commercial bank rates. While the private sector, mainly the returning Eritreans and those who remain abroad, has been instrumental in building up a considerable deposit base with commercial banks, the sector’s access to bank credit, even though much improved since 1994, has not kept pace with the growth in deposits. In the absence of money and capital market instruments, including government debt securities, this outcome has led the commercial banks to accumulate considerable cash reserves, mostly in deposits at the central bank that have been directed to finance a growing budget deficit. There are indications, however, that private sector demand for credit is growing, and is likely to accelerate with ongoing economic and financial reforms. Against the background of excess bank liquidity, this development posses a serious potential risk of inflationary pressures, at a time when the authorities are planning to introduce a national currency. The means to address this problem, in the context of additional financial reforms to underpin the introduction of the new currency, thus remains a key monetary policy objective.

B. Background

20. The financial system in Eritrea comprises the central bank—the Bank of Eritrea (BE)—, the Commercial Bank of Eritrea (CBER), the Housing and Commerce Bank of Eritrea (HCBE), the Agricultural and Industrial Development Bank of Eritrea (AIDBE), the Eritrean Investment and Development Bank (EIDB), and the National Insurance Company of Eritrea (NICE). Apart from the HCBE, which is owned by the Peoples Front for Democracy and Justice (the ruling and only political party in Eritrea), all the other financial institutions are owned by the government. In terms of size, the CBER dominates the sector, as it accounted for just over 60 percent of the total assets of the banking system at the end of 1996. At the apex of the financial system is the Bank of Eritrea, which through 1996 was still hampered by the lack of a comprehensive legal framework to function as a central bank, and limited resources, particularly skilled manpower. Thus, it had developed only rudimentary instruments of monetary policy.6 Moreover, the de facto currency union with Ethiopia since Eritrea’s independence in 1993—in which the Ethiopian birr is the legal tender—constrains Eritrea’s independence in the conduct of monetary policy.

21. The conduct of monetary policy has been confined largely to encouraging commercial banks to hold reserves (though not legally binding) and through administered interest rates. The focus on the commercial banks’ reserves has been particularly important in light of the large build up in deposits while demand for credit has lagged (Figure 1). The factors that account for the relatively substantial growth in bank deposits include: (i) an increase in confidence in the financial system and the improvement in access to banking facilities;7 (ii) unrecorded (across-the-border) movements of currency, mainly in the form of deposits of Eritreans returning from Ethiopia; (iii) cash deliveries by Ethiopia to meet the deposit liabilities in Eritrea’s banking system at the time of liberation; and (iv) balance of payment surpluses vis-a-vis Ethiopia through 1995; in addition to the recorded transactions, remittances by Eritreans living abroad may underlie this development. On the other hand, the growth in private sector credit demand has been constrained by factors including: (i) cautious banks, which in the absence of established loan service track records and lack of appropriate collateral have been reluctant to provide credit to the private sector; (ii) legal and institutional bottlenecks, particularly the major difficulties in accessing land and legal titles to land for agricultural and construction purposes; and (iii) lack of experience by economic agents in undertaking transactions through the banking system.

FIGURE 1
FIGURE 1

ERITREA SELECTED COMMERCIAL BANKS’ FINANCIAL INDICATORS, 1991 - 96 1/

(In millions of birr)

Citation: IMF Staff Country Reports 1997, 088; 10.5089/9781451811933.002.A001

Source Data provided by the Bank of Eritrea.1/ Net credit to the government provided by the central bank.

22. With the overall high level of liquidity, the commercial banks have maintained a substantial part of their deposits as cash reserves at the central bank; the latter reached birr 2.6 billion by end-1996 and contributed substantially to the commercial banks’ excess reserves—cash reserves in excess of the 20 percent “reserve requirements” imposed by the central bank—equivalent to 43 percent of total bank deposits.8 However, with the government running a substantial deficit and given the constraints imposed by the currency union on the operational aspects of the Bank of Eritrea, the latter used the commercial banks birr deposits to lend to the government. A rediscount window was formally established in 1994 (with an interest rate of 5.5 percent), but the banks have not used this facility given their large cash holdings.

Selected Financial Indicators, 1992-96

article image
Sources: Bank of Eritrea; and staff estimates.

Excluding currency outside of the banking system.

23. Interest rates, which are fully administered by the Bank of Eritrea were streamlined considerably in 1994 by a Bank Directive (No. 5/1994); the latter eliminated the administratively differentiated sectoral lending interest rates (see Appendix II, Table 28). In 1995, the Bank of Eritrea provided greater scope for setting the deposit rates, although the banks kept them in the 6-8 percent range. Lending rates were raised slightly and the spread between the lowest and the highest lending rates increased from 7-9 percent at the end of 1994 to 7-12 percent at the end of 1995. In addition, the Bank of Eritrea introduced a preferential lending rate on central government overdrafts of 2.5 percent, while no interest is paid by the BE on government deposits. However, with a rate of inflation (as measured by the consumer price index of Asmara) of 11 percent at the end of 1995, most interest rates were negative in real terms. Moreover, despite the de facto currency union between Eritrea and Ethiopia, the two countries have pursued somewhat different interest rate policies that have provided for significant interest rate differentials between them.9 However, the potential impact of the resulting differential of about 2-4 percentage points in deposit and lending rates on capital flows between the two countries is difficult to evaluate given the unavailability of data on currency in circulation in either country and the inadequate recording of trade and financial flows between them.

24. Monetary developments over the 1992-95 period reflected the rapid increase in net bank credit to the government and the further growth in credit to the private sector, which together contributed to an accelerating growth in net domestic credit of 46 percent in 1995 (Appendix II, Table 22). However, with increasing pressure on the external sector, the sizeable growth in net foreign assets through 1994 gave way to a decline in 1995,10 and broad money (excluding currency in circulation) growth moderated to about 24 percent in 1995 compared with 50 percent the previous year, thereby leading to a decline in velocity.

C. Recent Developments

25. The developments in the Eritrean financial system during 1996 reflect a continuation of commercial banks reserves build up with the central bank, which in turn channeled the funds to finance the sizable budgetary deficit (some 16 percent of GNP). At the same time, the pace of financial sector reform has accelerated, in part to prepare the ground for the planned introduction of a national currency—the nakfa.

Liquidity buildup, credit, and monetary developments

26. During 1996, commercial banks remained fairly liquid as the growth in the deposit base continued at a rapid pace while lending to the private sector, though growing fast, remained relatively limited. Starting with the partial liberalization of interest rates in 1994, which eliminated the preferential rates for government owned enterprises, the share of credit to the private sector in total bank credit grew rapidly to reach 65 percent in 1996 (20 percent in 1993 and 51 percent in 1994). The sectoral share of credit underwent an equally dramatic shift as trade (domestic and foreign) accounted for 63 percent of the total credit by 1996 (40 percent in 1994), manufacturing for 16.3 percent (9.8 percent in 1994), while the share of agriculture remained static at about 7 percent over the same period and that for building and construction actually declined from 9.8 percent in 1994 to 6.3 percent in 1996 (Appendix II, Table 27). The significant acceleration in the trend of growth in private sector credit since 1994, particularly for domestic and foreign trade (Figure 2) imply that some of the constraining factors mentioned above have weakened over time. Specifically, Eritreans have acquired considerable experience with financing trade through the banking system, partly at the expense of the franco-valuta imports (i.e., those financed outside of the banking system) whose share in total imports declined from 97 percent in 1992 to 53 percent in 1996 (Appendix II, Table 29). This development was reinforced by reforms in the exchange and trade regime and the issuance of business licences; these reforms considerably simplified and liberalized procedures in these areas.11

FIGURE 2
FIGURE 2

ERITREA COMMERCIAL BANK CREDIT BY SECTOR, 1993 - 96

(In millions of birr)

Citation: IMF Staff Country Reports 1997, 088; 10.5089/9781451811933.002.A001

Source: Data provided by the Bank of Eritrea.

27. Overall, monetary developments in 1996 reflected the sustained rapid growth in net domestic credit (44 percent of the beginning-of-period money stock) as a result of higher growth in net bank credit to the government and the private sector. Net foreign assets increased by about 5 percent of the beginning of period money stock, while there was a sharp deterioration in net claims on Ethiopia, which supplied large food imports to drought stricken Eritrea. Against this background, broad money growth decelerated to about 15 percent. With the benefit of considerable reconstruction effort—which has eased supply constraints—and a bumper crop in Ethiopia (Eritrea’s main trading partner), inflation decelerated considerably during 1996 to 3.4 percent, and the deposit interest rates, which remained at 6 percent while lending rates were in the range of 7.5-12 percent, became positive in real terms.

Recent financial sector reforms and developments

28. Recently, the most important financial sector reform pertains to the evolution of a legal framework for the financial system, which provides a basis for the Bank of Eritrea to expand its array of monetary instruments and the means to oversee the financial institutions in order to promote a sound financial system. The other reforms, including those affecting individual institutions, should contribute to greater competition and efficiency.

29. In March 1997, the government enacted the Bank of Eritrea Proclamation (No. 93/1997) and Financial Institutions Proclamation (No. 94/1997) to establish a comprehensive legal framework for the financial system. The Bank of Eritrea Proclamation supersedes the 1993 Proclamation that established the central bank, and provides for an independent Bank of Eritrea, with considerably expanded powers to issue a legal tender, conduct monetary policy with a much broader set of instruments and to licence, regulate, and supervise the financial institutions (see Box 1). The Financial Institutions Proclamation is the first such law in Eritrea, and provides for a comprehensive definition of the role and obligations of financial institutions, which are also tailored to the functions of the Bank of Eritrea, to facilitate an effective and efficient regulation of a modern and sound financial system (see Box 2). The broader powers of the Bank of Eritrea have been designed to facilitate the introduction of the new currency. As further preparations for the introduction of the nakfa, the authorities have undertaken work on the legal, administrative and technical aspects of the conversion to the new currency, including the strengthening of the skills at the central bank and the preparation of more timely and improved data.

Bank of Eritrea Proclamation (No. 93/1997)

The key elements of the Bank of Eritrea (BE) Proclamation, which was enacted in March 1997, spell out that:

  • The objectives of the BE is the management of money and credit and the safeguarding of the value of the national currency.
  • The BE is empowered to issue, manage and retire the legal tender—the nakfa—and is tasked to collect and publish economic data of the financial and other sectors for research and policy purposes.
  • The BE shall be independent from and not subject to instructions by the government in performing its functions.
  • The capital of the BE shall be equivalent to US$10 million.
  • The Board, consisting of seven members, is responsible for the management and administration policy of the BE but the Governor, the Deputy Governor (both appointed by the President), and three members appointed by the Governor will comprise the Policy Committee of Experts responsible for monetary and related policies.
  • The BE has the responsibility to manage international reserves and is empowered to conduct open market operations with the issue, purchase, sell, discount, and rediscount of government or its own securities.
  • The BE is now able to impose mandatory reserve requirements for deposit banks.
  • Limits on government borrowing from BE comprise 25 percent of the estimated government revenue in the relevant fiscal year (repayable not later than six month after the end of the fiscal year) and 10 percent of government revenue for the current fiscal year on holdings by the BE of government securities with maturities exceeding two years.
  • The contents of the Proclamation are fully coordinated with those of the Financial Institutions Proclamation.

Financial Institutions Proclamation (No. 94/1997)

The Proclamation which was enacted in March 1997 provides for:

  • The licensing, regulation, and supervision of financial institutions, comprising depository and non-depository entities, by the Bank of Eritrea (BE).
  • The maintenance of adequate capital base, accounts and records, and the appointment of independent auditors by all depository financial institutions and for the BE to issue regulations to enforce these requirements and, as necessary, to have similar or relevant requirements for non-depositary institutions.
  • The prudential regulations of financial institutions by the BE, including exposure limits (20 percent of capital and reserves to any borrower and 10 percent ownership of any company, including its subsidiaries), information requirements, and limits on insider loans.
  • The monetary supervision of financial institutions by the BE, including mandatory reserve requirements for depository institutions.
  • The off-site monitoring and on-site inspection and other supervision by the BE to ensure compliance with regulations, while promoting a sound financial system.
  • The fiduciary functions by financial institutions as well as remedial measures required by the BE to promote a sound financial system.

30. The government enacted in late May 1997 a Land Proclamation (No. 31/1997), which once implemented is expected to facilitate access to land, and may promote demand for private sector credit, particularly in the agricultural and construction sectors. Moreover, the availability of land titles or leases as collateral should make it easier to administer loans. At the same time, the government has announced a program to privatize 39 public enterprises during 1997, a factor that is likely to contribute to further growth in private sector credit demand.

31. The Housing Bank of Eritrea, which from inception in 1994 has been very heavily involved in real estate development (as of 1996, 66 percent of its assets were in the form of investment in housing projects), was restructured in early 1997.12 As part of a major reorganization to concentrate fully on banking activities by spinning off its development activities in real estate, the bank changed its name to Housing and Commerce Bank of Eritrea. As of May 1997, the accounts of the two emerging entities have been separated and discussions are ongoing to finalize the division of assets and the capitalization of the new real estate company. Meanwhile, HCBE is undertaking steps to become a full service bank specializing in mortgage finance and commercial banking and, to this end, is in the process of opening three new branches in different parts of the country to diversify its activities. This reorganization will not only broaden financial activities in Eritrea, but will also enable the new bank to comply with the prudential guidelines; the latter are under preparation by the central bank in order to implement the provisions of the new Proclamations.

32. In other developments, in October 1996, the Eritrean Investment and Development Bank was established by Proclamation (No. 91/1996) with paid up capital of birr 45 million, to provide medium to long-term credit. During 1996, the CBER opened a branch in Barentu to bring the total number of branches to 13.

D. Conclusion

33. The special factors that have contributed to a significantly liquid commercial banking sector in Eritrea and which have hitherto facilitated government borrowing from the central bank—even within the context of a currency union—appear to be receding fast. The underlying economic trends are likely to work in tandem with certain economic reforms, notably the Land Proclamation, the privatization program and the broader provision of financial services, to set the stage for accelerated private sector credit growth. To accommodate this growth, while tightening the stance of monetary policy to provide a conducive macroeconomic setting for the introduction of the nakfa, a priority would be for the authorities to coordinate monetary and fiscal policies with the objective of substantially reducing the size of the budget deficit and government recourse to domestic bank financing. In addition, the Bank of Eritrea will have to act expeditiously to develop and deploy the requisite monetary instruments, provided under the new legal framework, to play a more active and effective monetary policy role than in the past.

III. The Exchange and Trade System13

Exchange arrangement

34. The provisional legal tender of Eritrea is the Ethiopian birr, which is issued by the National Bank of Ethiopia. Prior to April 1,1997, an official exchange rate (determined in the weekly foreign exchange auctions conducted by the National Bank of Ethiopia) and a preferential exchange rate prevailed in Eritrea. The official exchange rate at end-March 1997, was Br 6.64 per US$1. Effective April 1, 1997, the official and the preferential exchange rates were unified at the prevailing preferential exchange rate of Br 7.2 per US$1.

35. Prior to the unification of the preferential and the official exchange rates, the official rate applied to transactions between Eritrea and Ethiopia (oil refinery services, port transactions), to government imports, and all aid-funded imports. The preferential exchange rate was used for most private imports, all exports, and the conversion of foreign exchange remittances by Eritreans living abroad. The Bank of Eritrea (BE) undertakes transactions with authorized dealers, who in turn carry out transactions with the public on its behalf. There are also a limited number of unofficial, but sanctioned, dealers who buy and sell foreign exchange.

36. Exchange rates for currencies other than the U. S. dollar14 are communicated daily by the BE to the authorized dealers on the basis of previous day’s late afternoon cross quotations in the London market against the U.S. dollar. For all foreign currency transactions, except transactions involving foreign currency notes, the BE prescribes a commission of 0.25 percent for purchases of foreign exchange and 0.75 percent for sales of foreign exchange. The authorized dealers are permitted, but not obliged, to levy a service charge for their own account and, for currencies other than the U.S. dollar, to include a margin charge that is applied by the correspondents abroad. There are no taxes or subsidies on purchases or sales of foreign exchange, and no forward cover is provided in foreign exchange by the BE or the authorized dealers.

Administration of control

37. The BE is working to ensure that all foreign exchange transactions are effected through the authorized dealers who were licensed in accordance with the Monetary and Banking Proclamation No. 32/1993. Foreign exchange transactions are now governed by the Bank of Eritrea Proclamation No. 93/1997, enacted on March 10, 1997. Under this proclamation, the BE may license and restrict, suspend, or revoke licenses of authorized dealers and may from time to time issue regulations, directives, and instructions on foreign exchange matters. Comprehensive foreign exchange regulations to enforce the provisions of the Proclamation are being prepared.

38. The Foreign Exchange Department of the BE issues permits only for those imports that require foreign exchange from the banking system. The Business Licensing Office issues licenses for importers, exporters, and commercial agents, while the Ministry of Trade and Industry has authority to regulate foreign investments (Investment Proclamation No. 59/1994) and issues certificate of origin for exports; it vets and licenses technology transfer agreements, as well as investment projects (including joint ventures) that are eligible to take advantage of the incentives and concessions of the Investment Proclamation.

Prescription of currency

39. Settlements may be made in currencies quoted by the BE or in any other convertible currency it deems acceptable. All transactions with Ethiopia, except for those related to the imports of spare parts for the refinery in Assab, are settled in Ethiopian birr.

Trade and payments with Ethiopia

40. Under the agreement of friendship and cooperation, signed by the Heads of State of Eritrea and Ethiopia in September 1993, the two countries undertook to cooperate closely and develop common policies concerning a wide range of issues, including matters pertaining to their exchange and trade systems. A joint ministerial commission is entrusted to ensure the implementation of the provisions of the agreement, notably Article 9, which calls for mutual consultation on the use of the Ethiopian birr and the exploration of the possibilities of adopting a common currency by both countries. An agreement with the objective of establishing a free trade area (FTA) between Eritrea and Ethiopia was signed on April 4, 1995.

41. Payments are generally made in Ethiopian birr, although the Government of Ethiopia has required payments in foreign currencies for Eritrea’s purchases of some of Ethiopia’s traditional exports, as well as for goods that are in short supply in Ethiopia. Under an intergovernmental agreement between Eritrea and Ethiopia, Eritrea pays Ethiopia in birr for its domestic requirements of petroleum products. The refinery in Assab is reimbursed in birr for the costs of refining the derivative products consumed by Ethiopia, except that the portion corresponding to the depreciation of equipment is paid for in foreign exchange.

42. As stipulated under an intergovernmental transit and port services agreement as well as a customs arrangement (amended annually), the port of Assab is a free port for Ethiopia, with its own Ethiopian customs branch office, and goods shipped to or from Ethiopia remain exempt from the Eritrean customs duties and related charges. Procedures for the clearing of goods and the exchange of documentation are to be coordinated, and the port and shipping charges are paid in Ethiopian birr.

Foreign currency denominated accounts

43. With the approval of the BE, nonresidents may open accounts denominated in U.S. dollars or in Ethiopian birr with the Commercial Bank of Eritrea and the Housing and Commerce Bank of Eritrea. The BE has authorized the maintenance of interest-bearing accounts denominated in U.S. dollars for Eritreans residing abroad since November 1, 1993. Effective May 9, 1995, all residents are allowed to maintain foreign currency accounts in Eritrea. Nonbank residents may not open accounts abroad, except where they are specifically authorized by the BE.

Imports and import payments

44. All importers must possess a valid trade license issued by the Business Licensing Office. These licenses must be renewed each year at a fee of Br 200-500. Import payments made through the banking system require permits that are issued by the BE upon presentation of pro forma invoices providing information as to type, quantity, unit price, and freight cost (where applicable). A commission of 2 percent is collected on imports that do not require official foreign exchange and are not aid funded. The BE ensures full collection of franco valuta commissions by requesting the display of a payment document to customs at the time of the import declaration. Imports of cars and other motor vehicles require prior permission from the Ministry of Transport to ensure their suitability for existing infrastructure and other similar considerations.

45. In 1995, the BE introduced a negative list for imports that are financed through the banking system; however, goods included in this negative list can still be imported through the franco valuta system. As of March 30, 1996, the BE does not provide foreign exchange for the import of goods in the following categories: perfumes and cosmetics; hair wigs and dyes; toys and games; plastic shopping bags; jewelry and other ornaments; dishes and similar kitchen equipment, except for hotels; ready-made clothing; biscuits and confectionery items; fresh fruit, fruit juices and vegetables, except for hotels and duty-free shops; live animals, except for reproduction; fresh or tinned meat, eggs, and fish; liquor and soft drinks, except for hotels and duty-free shops; salt; articles of decoration and Christmas trees; postcards, Christmas or other greeting cards, and collectors’ postage stamps; ivory and smoking articles.

46. As a further import restriction, a public enterprise producing tobacco and matches continues to hold a monopoly over the import of these products. Imports requiring official foreign exchange are effected under letters of credit or on a cash-against-documents basis. Suppliers’ credits must be registered by the BE. Effective November 11,1995, importers are no longer required to submit customs declarations to the BE for discharging purposes.

47. Imports prohibited for health, environmental, and security reasons are: old or used clothing, asbestos and construction materials made of asbestos, ivory, second grade alcohol, arms and weapons, and narcotics.

Payments for invisibles

48. With a foreign exchange permit, which is issued free of charge by the BE, payments for invisible transactions could be made to any country. Effective May 9, 1995, the limits on travel allowance for business trips outside the birr area was raised from US$50 a person a day for up to 20 days to US$250 a person a day for up to 30 days. In bona fide cases, these limits may be exceeded with the approval of the BE. Also, exporters may freely use their foreign currency denominated retention accounts for this purpose. For personal travel, the limits on the allowance has remained at US$100 a person (adult or minor) for up to two trips a year. The limits on the allowance for medical treatment outside the birr area was raised from US$2,000 to US$10,000 upon the recommendation of the Medical Board of the Ministry of Health. Residents may remit premia on life insurance policies that were taken out before May 1991. Generally, the BE gives approval in all bona fide cases that exceed these limits for invisible transactions. Effective November 11, 1995, the requirement to submit bills of settlement by authorized dealers of foreign exchange (e.g., hotels, duty-free shops) has been suspended, and the BE notified the general public that all Eritrean nationals could purchase air travel tickets in local or foreign currency.

49. Following the 1994 Investment Code, foreign investors may freely remit net profits and dividends accrued from investment and fees and royalties in respect of any technology transfer agreements. Foreign employees may remit per contract of employment without limit their net earnings each month, and of their cumulative earnings upon completion of their term of service in Eritrea.

Exports and export proceeds

50. Exporters must be licensed by the Business Licensing Office. The annual licensing fee is Br 275 for manufacturers, Br 500 for private limited companies and partnerships, and Br 1,000 for share companies, associations, and government agencies. All exports require documentation by the BE, which examines the sales contracts as to type of product, quantity, and unit price. Certain commodities may require clearance from specific government bodies (e.g., the Eritrean Institute of Standards). In particular, livestock and cereals require the permission of the Ministry of Agriculture, and marine products require the permission of the Ministry of Marine Resources. Exports of unprocessed hides and skins have been suspended since mid-1993 in an attempt to improve the supply to domestic tanneries and processors.

51. Exports may be made under a letter of credit or on an advance payment basis; in some cases, exports can be permitted on a consignment basis. All export proceeds must be repatriated to an authorized bank within 90 days of shipment; where justified, this deadline can be extended by another 90 days. Exporters may retain up to 100 percent of the sales proceeds.

Proceeds from invisibles

52. Travelers are not required to declare their foreign exchange holdings at the point of entry into Eritrea, and they are allowed to reconvert their balances back into foreign currency upon departure, provided that documentation can be provided that the foreign exchange has been converted into birr through a licensed foreign exchange dealer.

Capital

53. Foreign exchange proceeds representing capital inflows must be registered at the BE in order to ensure the smooth transfer of profits, dividends and interest, amortization of principal, and proceeds of the sale of shares to residents or from the liquidation of investments.

54. Direct foreign investments (including joint ventures) in Eritrea are governed by the provisions of the Investment Code (Proclamation No. 59/1994). Foreign direct investment is permitted in all sectors, except that domestic retail and wholesale trade, and import and commission agencies are open to foreign investors only when Eritrea has a bilateral agreement of reciprocity with the country of the investor; the latter condition may be waived by the Government. Under the foreign exchange regulations submitted to the Government, foreign investors may freely remit proceeds received from liquidation of investment and/or expansion, and payments received from the sale or transfer of shares. Petroleum contractors and subcontractors may freely transfer abroad funds accruing from petroleum operations and pay subcontractors and expatriate staff abroad.

55. Foreign borrowing by residents in Eritrea has to be registered with the BE. Authorized banks are permitted to purchase and hold foreign bank notes. With the approval of the BE, authorized banks may borrow abroad or overdraw their correspondent accounts abroad. They may acquire securities under similar conditions.

Gold

56. Residents may own gold jewelry without restrictions. Beyond this, ownership or possession of gold or other precious metals or ores requires the authorization of the Ministry of Energy and Mines.

Eritrea: Selected Issues
Author: International Monetary Fund