A. Background

1. Eritrea attained independence from Ethiopia in 1993, after a civil war that lasted for about 30 years and led to the destruction of infrastructure and the displacement of the Eritrean people. The economy was devastated by the combined effects of the protracted war and recurrent droughts, and at independence it required substantial rehabilitation and reconstruction of the physical and social infrastructure. Moreover, the government had to demobilize the ex-combatants and resettle large numbers of displaced people. At the same time, it began the task of transforming the previous central planning regime¹ into a market-based economic system that could support a thriving private sector. The authorities have implemented significant reforms to establish central and local governments and financial institutions, privatize a large number of previously nationalized entities, and deregulate the economy; they have also undertaken a massive expenditure program to jump-start broad-based economic activities. Eritrea elected to join Ethiopia in a temporary currency union, using the Ethiopian birr as legal currency; moreover, in 1993 the two countries signed an agreement to establish a free trading area. However, the envisaged development of common monetary, exchange, and trade policies was not realized as there were divergences in the implementation of these policies.

2. With Fund technical assistance, the authorities enacted the Bank of Eritrea (BE) and Financial Institutions Proclamations in April 1997 and subsequently issued several regulations, that together provide a comprehensive legal financial framework. In November 1997, Eritrea introduced its own currency, (the nakfa, abbreviated as ERN), to replace the birr on a one-to-one parity, but Eritrea and Ethiopia have yet to agree on the treatment of the birr notes retired in Eritrea. Following the introduction of the nakfa and despite strong reservations by Eritrea, Ethiopia introduced a requirement to use hard currencies and letters of credit for payments in excess of ERN 2,000. More recently, the bilateral relations have worsened owing to a border dispute and have led to an outbreak of an armed conflict between the two countries.

B. Recent Developments

3. Since the early 1990s, the Eritrean economy has recovered considerably, thanks to the rebuilding of the infrastructure and the improved availability of essential imports following major trade reforms in 1994. During 1993–96, real GDP growth averaged about 4 percent annually² (Appendix Table 1), ahead of the estimated population growth rate of about 3 percent. However, annual growth was erratic over the period mainly because of the drought conditions in 1993 and 1995, whereas the weather was exceptionally favorable in 1994. In 1997, the economy continued its strong recovery, and real GDP growth is estimated to have been 8 percent. The expansion in the economy was mainly supported by growth in the construction and manufacturing sectors, as agricultural output was adversely affected by inclement weather.³

4. Annual end-of-period inflation averaged about 8 percent during 1993–96, based on a commodity price index for Asmara (Appendix Table 11),⁴ despite the elimination of significant price controls in 1994. While the substantial domestic supply response and low-priced food imports from Ethiopia had contributed to the slowdown in inflation to about 3 percent in 1996, the reduced food production in 1997, together with the disruption of trade with Ethiopia, led to an increase in inflation of 10.6 percent.

5. The fiscal outcome during 1993–96 was determined mainly by the massive expenditure programs undertaken to rehabilitate and reconstruct the economy, as well as by the reforms in the public sector.⁵ The government also undertook measures to increase revenue collection during this period, including revising the tax structure in 1994. The overall deficit (including grants) doubled in 1995 to about 19 percent of GNP before moderating slightly to 16.4 percent in 1996 (Appendix Table 14). However, in 1997, the fiscal deficit was sharply reduced to 5.5 percent of GNP, as the ambitious expenditure program was completed and total revenue increased by 43 percent. As in the past, the overall deficits (including grants) were financed largely by recourse to Bank of Eritrea credit.⁶

6. Total revenues, which had averaged about 26 percent of GNP over 1993–96, increased to about 33 percent of GNP in 1997, mostly owing to a sharp increase in nontax revenues (Appendix Table 15). The sharp increase in nontax revenues to 16.9 percent of GNP was due to the growth in surpluses and dividends of public enterprises—including the payment of arrears accumulated during previous years—and significantly higher receipts from port fees and charges. These developments were also underpinned by the improved efficiency of the public enterprises and the port authorities. During the year, continued efforts were made to improve tax collections, particularly custom duties. Progress was made in simplifying administrative procedures for clearing of goods and training customs officers, and the Customs Proclamation was drafted. As the impact of these reforms is likely to take time, overall tax revenues remained at about 16 percent of GNP in 1997.

7. Recurrent expenditure which had averaged about 38 percent of GNP over 1993–96, declined sharply to about 24 percent of GNP in 1997 with the completion of expenditures on rehabilitation and reform programs (Appendix Table 16). There were in particular, sharp declines in the wage bill, outlays on materials, and externally financed expenditures. Notwithstanding the significant wage increase awarded to civil servants in 1997, the overall wage bill declined because of an offsetting reduction in outlays, reflecting the completion of payments for retrenchment (of about 10,000 civil servants) and for wage increases for the security forces in 1995–96. Moreover, the wage bill was significantly boosted during 1995-96 because part of the security forces pay increase had been back dated to 1994. Part of this steep decline in recurrent expenditure in 1997 was offset by an increase in capital expenditure, as externally financed recurrent expenditure was shifted to the capital budget.

8. Monetary developments over 1993-96 were characterized by rapid expansion of credit to the government and private sector borrowing; overall net domestic assets over this four-year period grew on average by 32 percent of the beginning-of-period money stock (Appendix Table 19). This credit expansion, together with an average increase in net foreign assets of 18 percent of beginning-of-period money stock, resulted in an average increase of 38 percent in bank deposits over 1993-96, the only indicator of broad money (as data on currency in circulation is unavailable for that period)⁷. However, in 1997, net domestic assets grew by only 6.8 percent of beginning-of-period money stock, reflecting sharply smaller financing requirements of the government along with a lower level of private sector borrowing. The modest domestic credit expansion facilitated a sharp gain in foreign reserves of 25.7 percent, which contributed to a further increase in bank deposits of 11.4 percent. The commercial banks continued to build up unremunerated excess reserves at the central bank; in order to bolster its earnings, the Commercial Bank of Eritrea increased lending rates for certain sectors while leaving the deposit rates unchanged (Appendix Table 26). Importantly, Eritrea introduced its own currency, the nakfa, in November 1997 and took steps to further develop the financial sector (see Section II).

9. Eritrea’s external current account (including official transfers) weakened from a surplus of 19.4 percent of GNP in 1993 to a deficit of 6.7 percent in 1996,⁸ owing in part to the large increase in the fiscal deficit and reflecting mainly investment-related import growth (Appendix Table 27). With the improvement in public finances and a 43 percent increase in private transfers, the current account recorded a surplus of 0.6 percent of GNP in 1997. However, the trade balance weakened slightly as a decline in exports—partly as a result of the new trade arrangement with Ethiopia—was offset only somewhat by a decline in imports. The surplus position in the services account showed only a modest increase as both receipts and payments rose sharply—the former on account of higher collection of port fees and charges, and the latter because of increased construction fees (mostly for the housing complexes in Asmara and Massawa) and travel expenditure. A decline in official grants was almost offset by higher loan disbursements, mostly related to the Hirghigo power project in Massawa. Finally, foreign direct investment recorded a marginal increase, partly owing to investments associated with the privatization program. However, with large errors and omissions,⁹ the overall balance of payments deficit increased to 13.4 percent of GNP in 1997 from 9.9 percent in 1996. As the Commercial Bank of Eritrea’s use of external financing more than offset the overall deficit, gross international reserves of the BE increased to US$260 million, the equivalent of 4.9 months of imports of goods and services, from 4.1 months in 1996.

10. Until April 1997, the official exchange rate was determined in weekly auctions conducted by the National Bank of Ethiopia and, at end-March 1997, was Br 6.64 per U.S. dollar. The auction exchange rate applied to transactions between Ethiopia and Eritrea (oil refinery services and port transactions) as well as to all aid-funded imports. In Eritrea, a more depreciated preferential exchange rate (buying and selling rates of Br 7.05 and Br 7.20 per U.S. dollar, respectively) was used for all other transactions, including remittances from Eritreans living abroad, export proceeds, and import payments not funded by foreign assistance. Eritrea unified the official exchange rate (which had depreciated to Br 6.8 per U.S. dollar) and the preferential exchange rate at Br 7.20 per U.S. dollar on April 1, 1997. When the nakfa was introduced its exchange rate vis-à-vis the U.S. dollar was initially set at the unified rate, pending establishment of a mechanism to determine the exchange rate (see below). In real effective terms, calculated using an average of the auction and preferential rates through April 1997 and the price index for Asmara, the nakfa appreciated by about 5 percent from end-1996 to end-1997 (Appendix Table 33).

11. Effective May 1, 1998, after 15 foreign exchange bureaus were licensed to join the two commercial banks as dealers in the market, the authorities put in place a mechanism to provide a market determination of the exchange rate. The dealers are required to report their prevailing exchange rates to the BE daily, and the midpoint of the reported rates is used to set a daily reference rate. These developments completed the transitional period that began with the introduction of the nakfa, when the exchange rate remained unchanged at ERN 7.2 per U.S. dollar. As of June 10, the nakfa had depreciated to ERN 7.40 per U.S. dollar.

12. At independence, Eritrea did not inherit any external debt. Since then, particularly in 1994 and 1997, it has contracted mostly concessional loans to finance investment projects. The stock of disbursed external public debt reached US$75.6 million at end-1997 (about 9 percent of GNP), while that on a commitment basis was US$318 million (Appendix Table 32). In 1996, the authorities established a unit in the Ministry of Finance to improve the monitoring and management of public debt.

A. Introduction

13. Since independence in 1993, the financial system in Eritrea has undergone considerable reforms, most notably in 1997 with the enactment of the Bank of Eritrea (BE) and Financial Institutions Proclamations—establishing a comprehensive legal financial framework—and the introduction of a national currency (the nakfa).¹¹ Prior to introducing the nakfa, Eritrea was in a de facto currency union with Ethiopia, which limited the scope of an independent monetary policy thus, monetary management by the BE was largely confined to aspects of interest rate management. With its own currency, Eritrea will henceforth pursue an independent monetary policy. Notwithstanding efforts to diversify the financial system, including the creation of new institutions, the financial sector is still fairly rudimentary and is dominated by the state-owned Commercial Bank of Eritrea (CBE).

B. Structure of the Financial Sector

14. Eritrea’s financial system consists of the BE—the central bank—the CBE, the Housing and Commerce Bank (HBE), the Agriculture and Industrial Development Bank of Eritrea, the Eritrean Development and Investment Bank (EDIB), and the National Insurance Corporation of Eritrea. The EDIB was established through a legal proclamation in October 1996 to fill the gap in the market by providing medium-and long-term loans (maturities of 5-7 years and 7-15 years); however final arrangements for its establishment with a capital base of ERN 50 million were completed only recently, and it was expected to be operational by June 1998. The HBE has also just completed a major restructuring in the past year to allow it to concentrate on commercial banking operations while relinquishing its role in real estate development projects.¹² Except for the HBE, which is owned by the ruling party (People’s Front for Democracy and Justice), all these financial sector institutions are owned fully by the government.

15. In addition to the above mentioned institutions, a number of more specialized financial entities have recently emerged or are in the planning stage. These include the 15 foreign exchange bureaus that were licensed and—in most cases—commenced operations during the first half of 1998 as part of the new framework for the incipient foreign exchange market. Discussions are ongoing with the World Bank to set up a revolving credit fund that would provide credit to small and medium-scale enterprises as part of the effort to promote private sector activity. In addition, a microcredit scheme (Box 1) for individuals (based on the Grameen Bank approach) was initiated as a component of the Eritrean Community Rehabilitation Fund.

16. Until March 1997, the BE functioned as a central bank on the basis of a temporary Proclamation No. 32/1993, enacted in 1993. This limited legal framework, which took account of the de facto currency union with Ethiopia, did not give the BE much leeway to develop a monetary framework or undertake measures to manage liquidity. Thus, during 1993–97, the BE primarily focused on basic capacity building at the central bank—mainly hiring staff and organizing itself into a functional institution. It also devoted a great deal of its time to drafting the central bank and financial institution proclamations, and preparing for the introduction of the national currency. The conduct of monetary policy by the BE was thus confined to a limited set of tools comprising: (a) the informal arrangement it had with the commercial banks to maintain—without remuneration—a 20 percent margin of their deposits plus any excess reserves with the BE; (b) administered interest rates; and (c) a rediscount window, which was established in 1994 (with an interest rate of 5.5 percent) but not utilized by the banks, given their large cash holdings.

17. The enactment of the Bank of Eritrea Proclamation and the Financial Institutions Proclamation in April 1997 substantially transformed the role of the BE.¹³ The Bank of Eritrea Proclamation supersedes the 1993 temporary proclamation and provides for the establishment of an independent Bank of Eritrea, with considerably expanded powers to issue legal tender and conduct monetary policy with a much broader set of instruments, as well as to license, regulate, and supervise financial institutions. The Financial Institutions Proclamation provides for the first time a comprehensive definition of the role and obligations of the financial institutions and—in a complementary role to the Bank of Eritrea Proclamation—facilitates an effective and efficient regulation of a modern and sound financial system. During the remainder of 1997 and through early 1998, the BE took initial steps to establish the framework for monetary policy, the foreign exchange market and the means to improve its regulatory and supervisory capacity. To these ends, the BE has enacted regulations on legal reserve requirements and the licensing and operations of foreign exchange dealers (including bureaus), and it has prepared drafts of a number of regulations to establish a money market, including on credit facilities and the issuance of treasury bills. Internally, the BE established a Monetary Policy Committee—comprising the Governor and the Vice Governor of the BE, and three senior officials, including a representative from the Ministry of Finance—to oversee and coordinate the various functions involved in directing monetary policy. It also set up a Bank Supervision Department. However, substantial scope still exist for the BE to build its capacity further so that it can effectively carry out all its central bank functions.

18. With only two commercial banks, Eritrea’s financial sector is lacking in diversification and competition. The CBE, currently with 14 branches nationwide, is the dominant commercial financial institution in the country; as of end-December 1997, it accounted for about 88 percent of total bank assets and about 87 percent of the total deposit base in the country. A large portion of the CBE’s deposits are kept at the BE, in the form of excess reserves (see below). With the opening of a new branch, the HBE saw a more than 50 percent growth in its deposit base in 1997 to ERN 633 million (Figure 1), and it hopes to increase its deposits base further with the introduction of three more branches in 1998. Both the CBE and HBE are under-capitalized, despite the doubling of capital subscription of the CBE to ERN 100 million in 1997. The authorities reported that while both banks have minimal nonperforming loans, they have each made provisions for bad debt, amounting to 3 percent of outstanding loans at the HBE and 1.5 percent of the capital base at the CBE.

C. Monetary Developments, 1995–97

19. Broad money expansion—as measured by the change in deposits in the absence of reliable estimates of currency in circulation—moderated over 1995–97 from about 24 percent of beginning-of-period money stock to about 11 percent (Appendix Table 19).¹⁴ The underlying developments were characterized by a strong growth in net credit to the government and private sector credit through 1996, followed by sharp declines in 1997. Net credit to the government averaged 16.5 percent of GNP in 1995–96, (owing mainly to the impact of an ambitious expenditure program) but dropped to about 2 percent in 1997 when government expenditure was sharply curtailed. Private sector credit expanded by an annual average of about 57 percent in the three years ended 1997, thanks to the improvement in infrastructure and other measures to promote private sector activity. Overall net domestic credit expansion averaged about 137 percent per annum in 1995–96 before declining to about 8 percent in 1997. At the same time, the broad trend in the external accounts—a steadily deteriorating trade balance with Ethiopia, which partly offset an improving overall position of the BE in 1996–97—slowed monetary growth in 1996 while providing an impulse on broad money growth in 1997. On the demand side, deposits grew steadily, including a size-able shift from cash holdings, as the level of confidence in the banking system improved over time. The growth in deposits averaged about 17 percent during 1995–97 and contributed to an increasingly liquid banking system; commercial bank excess reserves reached 61 percent of deposits in 1997 (see Table below).¹⁵ Financial deepening in Eritrea in the last three years is evidenced by the increase in the various ratios of money to GDP; for example, the ratio of quasi money to GDP increased from 59 percent at end-1995 to 62 percent at end-1997 (Figure 2).

Eritrea Commercial Banks’ Deposits, 1992-97 ^1/

(In millions of nakfa)

Citation: IMF Staff Country Reports 1998, 091; 10.5089/9781451811940.002.A001

Source: Bank of Eritrea.^1/ Commercial Bank of Eritrea (CBE) and Housing and Commerce Bank of Eritrea (HBE).

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Eritrea Commercial Banks’ Deposits, 1992-97 ^1/

(In millions of nakfa)

Citation: IMF Staff Country Reports 1998, 091; 10.5089/9781451811940.002.A001

Source: Bank of Eritrea.^1/ Commercial Bank of Eritrea (CBE) and Housing and Commerce Bank of Eritrea (HBE).

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Eritrea Commercial Banks’ Deposits, 1992-97 ^1/

(In millions of nakfa)

Citation: IMF Staff Country Reports 1998, 091; 10.5089/9781451811940.002.A001

Source: Bank of Eritrea.^1/ Commercial Bank of Eritrea (CBE) and Housing and Commerce Bank of Eritrea (HBE).

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Commercial Banks’ Excess Reserves, 1993–97

(In millions of nakfa, unless otherwise indicated; end of period)

Commercial Banks’ Excess Reserves, 1993–97

(In millions of nakfa, unless otherwise indicated; end of period)

		1993	1994	1995	1996	1997
Reserves		1,227.5	1,780.3	2,113.6	2,591.5	3,822.1
	Net claims on the birr area	949.5	1,009.5	717.6	97.6	…
	Deposits with the BE	278.0	770.9	1,396.0	2,493.9	3,822.1
Deposits		1,925.3	2,924.9	3,630.8	4,158.3	4,698.1
	Demand	866.8	1,258.4	1,295.8	1,677.0	1,649.9
	Savings and time	1,058.5	1,666.5	2,335.0	2,481.4	3,048.2
Reserve requirements (20 percent)		385.1	585.0	726.2	831.7	939.6
Banks excess liquidity		842.4	1,195.4	1,387.4	1,759.8	2,882.5
	(as a percent of deposits)	43.8	40.9	38.2	42.3	61.4

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Commercial Banks’ Excess Reserves, 1993–97

(In millions of nakfa, unless otherwise indicated; end of period)

		1993	1994	1995	1996	1997
Reserves		1,227.5	1,780.3	2,113.6	2,591.5	3,822.1
	Net claims on the birr area	949.5	1,009.5	717.6	97.6	…
	Deposits with the BE	278.0	770.9	1,396.0	2,493.9	3,822.1
Deposits		1,925.3	2,924.9	3,630.8	4,158.3	4,698.1
	Demand	866.8	1,258.4	1,295.8	1,677.0	1,649.9
	Savings and time	1,058.5	1,666.5	2,335.0	2,481.4	3,048.2
Reserve requirements (20 percent)		385.1	585.0	726.2	831.7	939.6
Banks excess liquidity		842.4	1,195.4	1,387.4	1,759.8	2,882.5
	(as a percent of deposits)	43.8	40.9	38.2	42.3	61.4

20. The strong growth in domestic credit in 1995–96, reflected both a government recourse to domestic credit in the face of deteriorating public finances and a surge in private sector activity. To finance its large fiscal deficits (averaging 18 percent of GNP), mainly caused by large outlays on infrastructure rehabilitation and expansion, as well as by major one-off extraordinary expenditures, government borrowing rose by an average of 23 percent of beginning-of-period money stock during 1995–96.¹⁶ Government borrowing was entirely from the BE, which, in turn, was able to lend by accessing the significant excess reserves deposited by the commercial banks. However, with the completion of most extraordinary expenditures and a sharp recovery in revenue, government borrowing declined sharply in 1997 to about 4 percent of beginning-of-period money stock. There was a small decline in credit to public enterprises in 1996–97, owing to financial discipline, including the hard budget constraint that had been imposed on them by the government since 1994, the impact of liberalization measures—including the lifting of price controls—and the effects of the privatization program.

Eritrea Selected Indicators of Financial Deepening, 1992-97

(In percent of GDP)

Citation: IMF Staff Country Reports 1998, 091; 10.5089/9781451811940.002.A001

Sources: Bank of Eritrea; and staff estimates.

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Eritrea Selected Indicators of Financial Deepening, 1992-97

(In percent of GDP)

Citation: IMF Staff Country Reports 1998, 091; 10.5089/9781451811940.002.A001

Sources: Bank of Eritrea; and staff estimates.

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Eritrea Selected Indicators of Financial Deepening, 1992-97

(In percent of GDP)

Citation: IMF Staff Country Reports 1998, 091; 10.5089/9781451811940.002.A001

Sources: Bank of Eritrea; and staff estimates.

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21. Credit to the economy increased by an average of about 84 percent annually over 1995–96, albeit from a relatively low base, before moderating to an annual growth of about 5 percent in 1997. Accordingly, over 1995–96, private sector credit from the CBE significantly increased to almost all sectors (Appendix Table 25), before slowing in 1997. The lower level of private sector borrowing in 1997 reflected the sharp increase in access to external resources (notably private transfers, which increased by US$100 million in 1997—Appendix Table 27)¹⁷ and the increase in certain lending rates by the CBE (see next paragraph). The largest percentage increase in credit from the CBE went to the export sector, followed by the manufacturing sector. However, in terms of the share of total outstanding credit from the CBE, the domestic trade and services sector continued to account for over 40 percent of total outstanding credit at end-1997, followed by the manufacturing and import sectors (at about 20 percent and 14 percent, respectively). The HBE also participated in the rapid credit growth during 1995–96, as it partly met the demand for building and construction finance. It advanced considerable credit to clients to enable them to purchase property in the Sembel housing and office complex in Asmara. At the same time, credit from the CBE to the building and construction sector grew at a slower rate in 1997 than in 1995–96, accounting for about 6 percent of the CBE’s outstanding loans. Overall, during 1995–97 net outstanding credit to the private sector from the CBE and the HBE almost doubled. Correspondingly, the private sector’s share of net outstanding credit extended by the CBE rose to about 75 percent in 1997.

22. Interest rates continue to be administered by the BE, but they have been considerably streamlined. In 1994, a BE directive eliminated the differentiated lending rates between the public and private sectors, but interest differentials across economic sectors was maintained (Appendix Table 26). In practice, commercial banks adjust lending and deposit rates in consultation with the central bank. In 1997, against the background of continued growth in its deposit base and a cautious lending policy that increased its excess (but unremunerated) reserves at the central bank, the CBE raised several sectoral lending interest rates by ½–3½ percentage points. This move increased the lending rates to 8–12 percent per annum and led to a significant increase in the spreads as deposit rates remained unchanged. A notable exception was the CBE lending rates for housing purchases, which declined from 12 percent to 8½–11 percent.¹⁸ Meanwhile, although the central government continued to pay a preferential interest rate of 2.5 percent on its overdrafts from the BE, it received no interest on its deposits with the BE. The interest rate paid by the CBE and the HBE on deposits remained unchanged at about 6 percent; in order to gain market share, the HBE continued to offer a deposit rate of ½ of 1 percentage point higher than the CBE on its savings account. With the pickup in inflation to about 11 percent at end-1997, most interest rates were negative in real terms.

D. Monetary Management

23. The legal framework established through the 1997 Bank of Eritrea Proclamation provides the BE with several monetary instruments, including the use of reserve requirements on commercial banks’ deposits, the sale and purchase of securities in open market type operations, and the lender-of-last resort window. It also provides powers to regulate and supervise financial institutions which must be now developed together with a framework to conduct monetary policy, while promoting a sound financial system.

24. The BE has issued regulations to commercial banks to formalize the 20 percent reserve requirement on total commercial banks’ deposits. This reserve requirement is applicable to each type of deposit at the commercial banks, that is, demand, savings, and fixed deposits (including foreign currency deposits). The CBE easily met this requirement and in fact, continued to hold unremunerated excess reserves with the BE, amounting to about ERN 2,891 million at end-1997 (Appendix Table 24). Some of the factors that account for the large buildup in deposits include an increase in confidence in the financial system combined with an improvement in access to banking facilities; balance of payments surpluses vis-à-vis Ethiopia through 1995; and remittances from Eritreans living abroad. Additionally, by end-1997, foreign currency deposits had grown to an estimated ERN 185 million, reflecting in part the expansion of certain types of foreign currency deposits offered by the HBE to depositors. Moreover, Eritreans were encouraged in 1997 to deposit cash with banks to facilitate the introduction of the nakfa, as the cash exchange was limited to Br 5,000 per individual.

25. There is an urgent need to develop instruments to absorb this substantial excess of commercial banks’ reserves. To this end, Eritrea is making arrangements to develop a primary market by auctioning treasury bills in the near future; eventually, the BE aims to conduct monetary policy with the sale and purchase of these bills in the secondary market. The issuance of treasury bills would introduce an important new instrument of monetary policy that, in addition to absorbing the excess bank liquidity, would help influence interest rates through market forces. A sizable initial stock of treasury bills could be provided by securitizing the existing stock of government domestic debt held by the BE, equivalent to about ERN 1.8 billion.¹⁹ This approach would also help the BE satisfy the requirement in the 1997 Bank of Eritrea Proclamation that limits its direct advances to the government to within 25 percent of estimated annual revenue for the relevant fiscal year.²⁰ The stock of treasury bills could then be traded at market interest rates and, if sold to the commercial banks, would help absorb part of their excess reserves. However, as the commercial banks’ excess liquidity (ERN 2.8 billion) exceeds the outstanding stock of government debt (ERN 1.8 billion), more treasury bills or other instruments would have to be issued to commercial banks to fully absorb their excess liquidity. Alternatively, and as the money market is likely to take time to develop the BE may have to increase reserve requirements²¹ and/or rely on credit ceilings to prevent the banks from extending credit beyond prudent levels in the near-term. The cost of the open market operations would be borne directly by the budget (if only government securities are used) so as not to compromise the BE’s financial position in pursuing an appropriate monetary policy.

26. The reduction in the level of excess bank reserves through auctions of treasury bills would help to stimulate the development of both the interbank market and a secondary market in treasury bills. Furthermore, if the number of banking institutions were increased with the issuance of new banking licenses, the scope of the interbank market would be widened and overall competition in the sector promoted. To help deepen the market, treasury bills of several different maturities should be introduced over time. In turn, the development of the secondary market will enable the BE to use open market operations as the key instrument of monetary policy.²² More specifically, the development of the money market will require supporting steps, including (a) improving the interbank settlement system for large payments; (b) moving toward a delivery-versus-payment basis for the settlement of transactions; and (c) ensuring appropriate market organization and trading arrangements. The introduction of treasury bill auctions would enable the market to determine a benchmark interest rate, which the BE in turn could use in its operation of a discount window to signal the market (see next paragraph).

27. Once the financial system has developed adequately, the BE could eventually also influence credit growth through its lender of last resort window. It is drafting new regulations to implement this facility with provisions for discounting securities, as it is envisaged that credit extended through this facility will be suitably collateralized (e.g., with treasury bills). To encourage the development of the interbank market, this facility should primarily be used for genuine short-term liquidity support (overnight to one week). The BE would use the market interest rate emerging from the money market to set the discount rate, which would include a premium to discourage banks from accessing the facility before exhausting alternative sources.

E. Development of Prudential Oversight

28. The financial sector which is growing, both in size and sophistication, will increasingly require effective supervision and regulation; thus, it is critical for the BE to rapidly build its capacity in this area. The newly created Bank Supervision Department within the BE needs to be quickly staffed with qualified personnel who can conduct the necessary supervisory and regulatory tasks of a central bank, including off-site surveillance and on-site examinations. In line with the BE’s objective of developing a modern financial sector in Eritrea, it would need to issue prudential regulations that meet international standards

F. Conclusion

29. The BE must build on initial steps and quickly develop a framework and instruments to conduct monetary policy. This task is likely to require close coordination with fiscal policy, as government debt instruments are expected to play a key role in managing credit growth. The introduction of treasury bills will allow the BE to securitize the outstanding credit to the government and thus comply with the limit on advances to the government required under the Bank of Eritrea Proclamation while sales of treasury bills to commercial banks would mop up most of their excess liquidity. The initiation of treasury bill auctions and subsequent trading of government securities would help to develop the money market and establish a market rate of interest. To develop further an efficient money market, the BE should promote competition and foster the development of the financial sector. Finally, to safeguard the soundness of the financial system, the central bank should expedite the issuance of the appropriate prudential regulations and speed up steps to effectively monitor compliance with these regulations by financial institutions.

A. Introduction

30. This paper reviews the progress made with privatization in Eritrea since the early 1990s. In the first stage, during 1993–94, the government adopted a case-by-case approach to privatization, focusing on small-scale retail businesses and the tourism sector. In the second, ongoing stage, the emphasis has been on the large enterprises with a view to, inter alia, attracting foreign investment and technology.

B. Background

31. Prior to independence in 1993, Eritrea was part of Ethiopia, which the Marxist Derg regime (1974–91) had ruled with a highly controlled command economic system. After gaining power, the Derg nationalized all major industrial and financial enterprises and virtually all small-scale operations, while heavily regulating the remaining private sector activity. Even agriculture did not escape, as land and the three large farms—which accounted for virtually all private commercial farming—were nationalized. The regime imposed strict price controls and introduced import restrictions, which further reduced the scope for efficient business operations. The dismal economic situation and the poor performance of the public enterprises was compounded by the protracted war for independence (1961–91), which not only resulted in a large number of displaced people and other war victims, but also exacerbated the shortage of skilled manpower and the inadequacy of institutional capacity.

32. Against this background, the public enterprise sector in Eritrea—comprising about 69 medium- and large-scale enterprises, utilities, and a large number of small firms, which as a group employed an estimated 15,000 people—was in virtual collapse at the time of independence.²⁴ The industrial sector consisted of 42 working factories and about 700 small-scale workshops, all controlled by the state. The average age of the plants and machinery was about 40 years, and most plants were operating considerably below capacity because of a lack of maintenance and new investment, and poor infrastructure. Private sector activity was almost nonexistent.

33. The new government quickly focused on reconstructing the postwar economy and putting it on a sustainable growth path by reducing the role of public sector. Thus privatization (and development of the private sector in general) became an integral part of the country’s economic policies at an early stage. Privatization in Eritrea is a part of a broader program that aims at increasing the role of the private sector in the economy, accelerating the adoption of new technology and production techniques, and improving overall efficiency, competitiveness, and product quality.

C. The Early Stages, 1993–94

34. In the early stages, the government approached privatization on a case-by-case basis. To a certain extent, the process was demand driven. Examples are the tourism sector and small-scale enterprises, where there were ready investors, including a large number of Eritreans who were returning to civilian life or from exile, as well as those in the diaspora. In the tourism sector, the Nyala Hotel was sold in 1994 to a foreign investor for US$5 million. Meanwhile, the Ambassador hotel was returned to its previous owner, and management of several other hotels was leased to private companies.

35. The sale of state-owned small and medium-scale firms to private entrepreneurs began in 1993, and by year’s end all 700 small-scale shops were already privately owned (see Table below). The government faced a more difficult position with regard to larger enterprises in the industrial sector, particularly those with monopoly positions or considered strategically important. In the meantime, decisions were taken to have all larger industrial public enterprises operate on a commercial basis, including making independent decisions about management, wage, and employment policies, access to imports, the setting of prices, and the imposition of hard budgets, which ruled out budgetary support.²⁵ The government kept its intervention only in the area of capital investment as part of its plan of rehabilitating the industrial enterprises through the updating of machinery and new construction. The government initially focused on industries with domestic sales, such as textiles, cement, glass, and brewing in order to alleviate supply constraints.²⁶ In addition, the Ministry of Industry began preliminary discussions with potential foreign investors who had shown an interest in three enterprises (textiles, soft drinks, and tobacco).

Selected Data on Public and Private Enterprises, end-1993

Source: World Bank, 1994.

Selected Data on Public and Private Enterprises, end-1993

		Public Employment			Private Employment
Industry		Number of firms	Total employed	Average	Number of firms	Total employed	Average
Food		6	960	160	419	1,424	3
Beverages		3	940	313	8	185	23
Tobacco		2	337	169
Textiles		5	4,397	879	98	964	10
Leather and shoes		5	1,569	314	27	492	18
Metal products		10	934	93	147	603	4
Printing		3	341	114	15	99	7
Nonmetallic minerals		4	631	158	41	449	11
Chemicals		4	746	187	38	468	12
	Total	42	10,855	258	793	4,684	6

Source: World Bank, 1994.

View Table

Selected Data on Public and Private Enterprises, end-1993

		Public Employment			Private Employment
Industry		Number of firms	Total employed	Average	Number of firms	Total employed	Average
Food		6	960	160	419	1,424	3
Beverages		3	940	313	8	185	23
Tobacco		2	337	169
Textiles		5	4,397	879	98	964	10
Leather and shoes		5	1,569	314	27	492	18
Metal products		10	934	93	147	603	4
Printing		3	341	114	15	99	7
Nonmetallic minerals		4	631	158	41	449	11
Chemicals		4	746	187	38	468	12
	Total	42	10,855	258	793	4,684	6

Source: World Bank, 1994.

D. Developments Since 1995

Privatization procedures

37. The initial step in this second ongoing phase of privatization process was the preparation of brief profiles (audits) of the enterprises, including their legal obligations.²⁸ To do this, ONASPPE made contracts with outside consultants. The profile usually included a brief assessment of the financial situation of the enterprise, but the responsibility of carrying out a thorough financial audit rested with the potential investor. To simplify the process, most liabilities, especially those incurred as a result of transactions with Ethiopia before independence, were written off by the government. All enterprises remaining on the privatization list are audited every year.

38. After the profiles were completed (in the second half of 1996), the intended sale of the 39 enterprises was advertised to Eritreans by publishing the list of enterprises and their respective activities in the local papers. In addition, a series of seminars was given at the Chamber of Commerce of Asmara. The interested parties were provided free access to the factories. Advertisement to potential foreign investors was undertaken by providing the list of enterprises and their profiles to Eritrean diplomatic missions abroad, as well as to foreign diplomatic missions in Eritrea. Invitations for bids were then formally issued in March 1997 and advertised in all official domestic papers, as well as in some foreign papers. Each invitation contained information on a firm’s activities and financial situation and the rules of the bidding process. However, this passive form of advertisement has not been combined with a more active approach under which ONASPPE would seek out the most suitable investors.²⁹

39. Typically, the enterprises are advertised for two months; during this period the potential investors are required to submit a bidding fee. After that, the bidders have up to 45 days to submit final bids, consisting of price (including method of payment) and business plan. The weights attached to these two factors differ, depending on the circumstances of the enterprise, but they are announced to potential buyers in advance. The main factor considered in the business plan is the investment and training of the workers that the buyer intends to undertake. ONASPPE then selects the winning bidder, taking into account the offered price and business plan.

40. Once the winning bidder is selected, the final contract between the buyer and the government is signed. Sometimes during this process the winner attempts to renegotiate the contract, in particular to lower the price; this was the case, for example, in the sale of Mereb Textile Factory (Box 2). The buyer is usually required to immediately pay the agreed cash price in the contract, but exceptions have been granted (see Table below). This postponement of payment is another way of renegotiating the contract. However, since only eleven enterprises have been privatized so far—and only very recently—and four of them paid the price in full immediately upon signing the contract, it is too early to assess the impact of delayed payments.

Box 2.

Privatization of Individual Enterprises

In interviews with the three newly privatized firms listed below, none of the owners mentioned serious difficulties during the privatization process itself but rather talked about general impediments to private sector development. The main obstacle faced by the enterprises after the privatization seems to be lack of skilled workers, followed by inadequate infrastructure. Unlike in other countries, none of the enterprises stated identified in obtaining credit or high taxation as an impediment to their operations.

The Gash Cigarettes Company was purchased for ERN 52 million by Rothmans Cigarettes (United Kingdom) at the beginning of 1998; the price was fully paid at purchase. Currently, the factory produces 140 million cigarettes a year; for the local market. At the time of purchase of the factory, the owner was granted a monopoly right (for 13 years) and, hence, is now the sole producer of cigarettes in Eritrea. Protection from competition from abroad comes through high import taxation, although the authorities intend to further reduce the external tariff. The company also intends to produce a new brand of cigarettes for export in a year. The company was first considered for privatization in 1994. However, at that time, no privatization law existed and procedures were not clear, so it was not actually offered for sale until the second half of 1997. Between 1994 and 1997, the company was restructured. In particular, about 10 percent of the workers were laid off, the entire structure of the organization was streamlined, and all liabilities were paid off. The main obstacle for operation reportedly is the lack of skilled workers. As the company is preparing to start production for export, it is retraining all its workers. The factory uses locally produced tobacco and faces a sector-specific obstacle in the form of inadequate land irrigation.

The Mereb Textile Factory specializes in processing cotton fabrics and garment production; it produced 5 million yards of cotton fabrics in 1997, and it intends to double production in 1998. Only 15-30 percent of the output is for the domestic market; the rest is for export to Ethiopia, Somalia, Congo, and Italy. The company was first advertised for privatization in June 1997; the bid was submitted in August; and the process was completed in December. Some postcontract negotiation over the price occurred; in the end the company was sold for ERN 12 million, which has been fully paid. As agreed in the business plan (and the privatization contract), the company is undertaking investment to replace the outdated machinery (about US$6 million is to be spent on investment in 1998). The owner did not report any problems in the privatization process itself, but rather general impediments to private sector development, such as poor roads and telephone networks, and the lack of skilled workers.

The Eritrea Shoe Factory was also privatized at the beginning of 1998. About 70 percent of the output is exported. Shortly after privatization, the new owners replaced or repaired some of the machinery. At the moment, the factory is operating at only 30 percent of its production capacity because of the lack of skilled workers, but production is expected to increase as more workers are trained to operate the updated machinery. In addition to the lack of skilled workers, the owners reported unreliable supply of electricity as one of the difficulties they currently face.

41. The privatization process in Eritrea to date has not benefited fully from technical assistance, especially from the experience of other countries. At the same time, ONASPPE does not provide a public record of the privatization progress, which hinders public access to information in this important area.

Public enterprises privatized as of May 1998.

Source: Eritrean Authorities

Public enterprises privatized as of May 1998.

Enterprise	Output	Date	Employment	Sale price (millions of nakfa)	Paid so far (millions of nakfa)
National Soft Drinks	coca cola, fanta	1/20/97	176	21.9	n/a
Red Sea Soap	soap, detergents	8/12/97	60	14.8	14.8
Eritrea Shoe	leather shoes	8/9/97	118	5.4	5.4
Himbold Household	cooking pots	2/17/98	59	5.1	1.6
Gejeret Carton Sil.	cartoon containers	3/10/98	80	6.5	2.0
Gash Cigarette	cigarettes, tobacco	3/2/98	129	52.7	53.7
Mereb Textile	cotton, fibre cloth	3/26/98	542	12.0	12.0
Eri-Bus Assembly	bus body building	3/26/98	63	2.4	1.2
Barka Wood/Plastics	furniture	5/8/98	n/a	7.5	4.5
Fana Oxygen/Aceton	oxygen	5/8/98	16	2.7	0.7
Eritrea Steel Sheets	steel sheets	5/8/98	n/a	12.1	1.2
Total			1,243	143.1	97.1

Source: Eritrean Authorities

View Table

Public enterprises privatized as of May 1998.

Enterprise	Output	Date	Employment	Sale price (millions of nakfa)	Paid so far (millions of nakfa)
National Soft Drinks	coca cola, fanta	1/20/97	176	21.9	n/a
Red Sea Soap	soap, detergents	8/12/97	60	14.8	14.8
Eritrea Shoe	leather shoes	8/9/97	118	5.4	5.4
Himbold Household	cooking pots	2/17/98	59	5.1	1.6
Gejeret Carton Sil.	cartoon containers	3/10/98	80	6.5	2.0
Gash Cigarette	cigarettes, tobacco	3/2/98	129	52.7	53.7
Mereb Textile	cotton, fibre cloth	3/26/98	542	12.0	12.0
Eri-Bus Assembly	bus body building	3/26/98	63	2.4	1.2
Barka Wood/Plastics	furniture	5/8/98	n/a	7.5	4.5
Fana Oxygen/Aceton	oxygen	5/8/98	16	2.7	0.7
Eritrea Steel Sheets	steel sheets	5/8/98	n/a	12.1	1.2
Total			1,243	143.1	97.1

Source: Eritrean Authorities

E. Conclusions

47. The first phase of privatization (1993–94) was ad hoc and largely demand driven. The program was successful in privatizing several hotels and about 700 small-scale shops, thus providing employment and business opportunities for war veterans and Eritreans returning from abroad. During this period, the government realized the importance of a systematic approach to privatization and utilized the experience to establish a formal framework to guide the second stage, which has focused on the large industrial enterprises.

48. At the end of 1997, Eritrea began implementing a more formal privatization program; eleven industrial enterprises have been sold through end-May 1998, and the process is under way for three others. In most of the privatized enterprises, new investment was undertaken and training programs for the workers set up. It is too early, however, to assess the impact of privatization on enterprise performance.

49. Privatization has so far attracted only limited foreign investment, partly because of a lack of aggressive advertisement. The other impediments to foreign investment in the country—which could also be constraining the development of the private sector in general—include poor infrastructure (roads, facilities for generating and transmitting energy, telephone services, and financial services) and the lack of skilled workers; potentially, the small Eritrean market could also be a limitation. Finally, the lack of formal unemployment insurance, although not a major constraint, could undermine the support of the general population for privatization. On their part, the authorities could strengthen their expertise by taking advantage of the considerable experience elsewhere, including accessing technical assistance as needed. They could also provide a public record of the privatization process to promote transparency.