Eritrea: Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix examines the sustainability of the public finances in Eritrea. The paper analyzes monetary policy and management. It points out that the period since gaining independence in 1993 has not been long enough for the authorities in Eritrea to gain a full understanding of the functioning of the economy and develop the necessary skills and expertise to successfully implement the complex mix of economic, financial, and development policies needed to strengthen growth and reduce poverty. The paper also analyzes the determinants of inflation in Eritrea.

Abstract

This Selected Issues paper and Statistical Appendix examines the sustainability of the public finances in Eritrea. The paper analyzes monetary policy and management. It points out that the period since gaining independence in 1993 has not been long enough for the authorities in Eritrea to gain a full understanding of the functioning of the economy and develop the necessary skills and expertise to successfully implement the complex mix of economic, financial, and development policies needed to strengthen growth and reduce poverty. The paper also analyzes the determinants of inflation in Eritrea.

II. Sustainability of the Public Finances1

A. Introduction

7. Following a promising start after independence in 1993, the war with Ethiopia during 1998-2000 drastically changed the performance of the Eritrean economy: GDP declined, inflation rose, the external current account worsened, international reserves were nearly depleted, and banking assets were severely compromised. However, the most significant change was the sharp deterioration of the public finances and rapid increase in domestic and external public debt, as a result of both war-related factors and policy decisions.

8. Against the backdrop of these developments, the purpose of this section is to examine developments in Eritrea’s public finances with respect to their sustainability. Problems with sustainability could arise as the direct result of fiscal policies or indirectly through the changes in key variables or behavioral responses that government policies might induce. This section will give considerable attention to the identification of these responses.

9. The section is organized as follows: In the next subsection, the sustainability of the public finances will be more formally defined and explained. In Subsection C, developments in key indicators affecting sustainability will be described and analyzed against the background of the economic policies of the authorities and developments in exogenous variables. Subsection D attempts to identify endogenous responses to developments in the variables that directly affect sustainability, and inferences will be drawn about the prospective responses under unchanged policies. Finally, possible policy adjustments to restore sustainability are discussed.

B. The Importance of Fiscal Sustainability

Definition of sustainability

10. In the most general terms, sustainability is said to exist when the present value of budget constraint (PVBC) is satisfied without a major and abrupt correction having to be made in the balance of income and expenditure to avoid solvency and liquidity problems. Solvency, in turn, is ensured when the present value of current and future primary expenditure is not greater than that of current and future streams of income, net of any initial indebtedness, that is,

Σi=0Et+iΠj=1i(1+rt+j)Σi=0Yt+iΠj=1i(1+rt+j)(1+rt)Dt-1,(1)

where Et is the primary expenditure (i.e., total expenditure minus interest payment) at period t, Yt is the income (GDP for a country), Dt-1 is the beginning-period stock of debt at period t-1, and rt is the nominal interest rate. Liquidity exists when liquid assets and available financing are sufficient to meet or roll over maturing liabilities, regardless of whether the solvency condition is satisfied.

11. On the basis of this general definition, fiscal sustainability can be said to exist when government policies satisfy the PVBC, which is defined as follows:

Dt=Σi=0PBt+iΠj=0i(1+rt+j)=Σi=0Zt+iΠj=0i(1+rt+j)Σi=0Et+iΠj=0i(1+rt+j),(2)

where Dt is the beginning-period stock of government debt at period t, PBt is the primary balance, Zt is government revenue (including grants), Et is the primary expenditure (i.e., total expenditure minus interest payment), and rt is the nominal interest rate. Equation (2) states that the value of today’s government debt must be matched by (or smaller than) an excess of future primary surpluses over primary deficits in present value terms. Temporary deficits can, therefore, be accepted as long as they are eventually offset by the sum of future primary surpluses.

12. If equation (2) is expressed in terms of the ratio of the variables to GDP, the PVBC becomes

dt=Σi=0Πk=1l(1+nt+k)Πj=0t(1+rt+j)pbt+i=Σi=0Πk=1i(1+nt+k)Πj=0i(1+rt+j)zt+iΣi=0Πk=1i(1+nt+k)Πj=0t(1+rt+j)et+i,(2a)

where lower letters correspond to the ratio of the variables to GDP and nt is the nominal growth of GDP. In this formulation, the critical influence on sustainability of the performance of the economy (growth of GDP) becomes clear.

13. Equation (2) can be modified to take account the situation of both domestic and external debt as follows:

Dt=DDt+εtDEt=Σi=0((1λt+i)Πj=0i(1+rt+j)+λt+iεtΠj=0i(1+qt+j)Πj=0i(1+rt+i*))PBt+i,(3)

where DDt is the beginning-period stock of government domestic debt denominated in local currency at period t, DEt is the beginning-period stock of government external debt denominated in foreign currency, εt is the nominal exchange rate (local currency per foreign currency), λt is the share of external borrowing in financing the primary balance, qt is the rate of appreciation of the nominal exchange rate, and rt* is the nominal interest rate on external debt. Expressed in terms of the ratio of the variables to GDP, equation (3) becomes

dt=ddt+εtdet=Σi=0((1λt+i)Πj=0i(1+rt+j)+λt+iεtΠj=0i(1+qt+j)Πj=0i(1+rt+l*))Πk=1i(1+nt+k)pbt+i.(3a)

14. Equations(3) and (3a) indicate that the key variables determining the sustainability of the public finance (debt sustainability) are government revenue, primary expenditure, the domestic/external debt stock, the domestic/foreign nominal interest rate, the nominal exchange rate, real GDP growth, and the inflation rate. For the assessment of sustainability, it will, therefore, be necessary to understand the importance of these variables and the factors, including government policies, that affect their values.

Discussion of key variables influencing sustainability

Revenue

15. In the case of Eritrea, revenue Z consists of tax and nontax revenue T, exceptional revenue ER, such as receipts from privatization and external grants from donors and the Eritrean diaspora G.2 Total revenue therefore is

Zt=Tt+ERt+Gt.(4)

Tax revenue is a function of tax rate t and the tax base TB, which in the general terms is a function of GDP. Thus,

Tt=tTB(Yt).(5)

16. Unless domestic tax rates are raised or tax administration improves, GDP growth determines the level of tax revenue, and policies to enhance growth are therefore critical for fiscal sustainability. Customs revenue and port fees and charges, which are very important in Eritrea, are determined by trade activities and relations, and an increase in trade would not only raise domestic revenue but also relieve the foreign reserve constraint. Progress in privatization is the dominant factor affecting exceptional revenues. Finally, external grants are primarily influenced by the relationship with donors and the diaspora and by special factors, such as development programs, drought, and other calamities.

Primary expenditure

17. Primary expenditure E can be broken down into three types of components: primary current expenditure, excluding interest payments, C; capital expenditure (investment) I; and spending under special programs SP. Accordingly,

E=C+I+SP.(6)

18. In the case of Eritrea, primary current expenditure is mainly composed of wages and materials and services (defense and nondefense), as well as government grants and contributions (for ex-soldiers and for food assistance). At present, the amount of defense spending depends significantly on the progress with demobilization. Capital expenditure is dominated by the government’s reconstruction efforts and donor-financed development projects. The latter will not influence the fiscal balance, but they will affect sustainability if debt financed. Special program spending consists of spending on the Emergency Reconstruction Program (ERP), demobilization, and humanitarian assistance, and is entirely donor financed, including by grants.

Domestic/external debt stock

19. The total debt of Eritrea consists of domestic and foreign debt, and can be defined as follows:

Dt=DDt+εtDEt=(1+rt)DDt1(1λt)PBt+εt(1+rt*)DEt1λtPBt,(7)

where rt is the interest rate on domestic debt and r*, is the interest rate on foreign debt, and the primary balance PBt is financed either domestically or externally. The debt stock in every period is therefore equal to the stock at the end of the preceding period and interest payments on this debt, plus any primary deficit in the current period. Apart from the primary balance, the debt stock is also affected by exchange rate and interest rate developments, which are, in turn, affected by fiscal policies and the sustainability of public finance itself, as much as by economic activities and external developments and the expectations they generate.

Nominal interest rate

20. Equations (3) and (3a) indicate that sustainability is critically dependent on the domestic and foreign interest rates on public debt. In particular, the higher these are interest rates, the larger the primary surplus must be to repay the initial debt stock. The domestic interest rate on government securities is administratively fixed in Eritrea, and no market mechanism functions as to government borrowings. The real interest rate is, therefore, often negative as a result of high inflation. The domestic interest rate is currently clearly below equilibrium, and, correspondingly, a substantial debt-service cost would emerge were the rate to be raised or freed. While this fact may be seen as an argument against freeing the domestic interest rate, it must be judged against the efficiency gains to be realized from market-determined interest rates. The interest rate on external debt is by and large the concessionally fixed donor rate, while borrowings from non-Paris club members and the diaspora entail different rate profiles and more closely reflect market risk.

Nominal exchange rate

21. The exchange rate plays a critical role in the determination of the external debt and debt service burden, as well as the sustainability of both, first because of its direct effect on their size and, second, because of its effect on competitiveness and growth. The equilibrium exchange rate generally reflects macroeconomic policies and developments, including fiscal policies and their sustainability, and is also a function of investors’ confidence. The current exchange rate system in Eritrea is close to that of a conventional peg, at least as far as official transactions are concerned. Although the rate is allowed to respond to market forces, the current arrangement bears a substantial risk of depreciation, especially because of the large external deficits and low level of official reserves. Should such an adjustment occur, the foreign-currency-denominated debt would swell unless debt relief could be secured. At the same time, a market-determined exchange rate would strengthen the country’s exports and growth.

Real GDP growth

22. Real GDP affects not only the ratios to GDP of a number of variables of sustainability but also the development of key constituent variables of fiscal sustainability, for example, tax revenues, inflation, and the exchange rate. The behavior of GDP is, therefore, critical for the maintenance of fiscal sustainability, and all economic policies affecting the growth of GDP therefore simultaneously affect fiscal and external sustainability. In the current situation, the growth of real GDP depends in large measure on the pace of demobilization, reconstruction efforts by the government, structural reforms conducive to private sector growth, developments in the foreign exchange markets and the financial sector, and macroeconomic stability.

Inflation

23. Inflation would have no impact on the real economy if markets functioned properly, that is, the nominal interest rate and the exchange rate kept their real rates unchanged by reflecting inflation developments. However, inflation does have an impact on fiscal sustainability, positively in the short term if nominal rigidities prevail and prevent those variables from regaining their equilibrium values. In particular, while ratios of debt to GDP decline when the nominal interest rate and exchange rate are administratively fixed, as in the case of Eritrea, the related rigidities impair economic growth.

Links between fiscal and external debt sustainability

24. As described above, any primary deficit needs to be financed either domestically or externally. When one source of finance is insufficient, the other must expand. External borrowing directly reduces external sustainability. At the same time, an expansion in domestic credit will increase imports and thereby reduce the amount of foreign exchange available to the domestic economy. Domestic financing may also cause a rise in inflation and increase pressure for an exchange rate depreciation. Domestic financing is, therefore, no panacea for the problems of external sustainability.

25. For a country like Eritrea, the external budget constraint is more likely to be binding than the domestic financing constraint because the country does not issue a convertible currency and its access to foreign lending is limited. It is, therefore, particularly important to assess the linkage between fiscal and external debt sustainability.

26. External debt sustainability is generally defined as the following:

Ft=Σi=0Πk=1i(1+qt+k)Πj=0i(1+rt+j*)CAt+i,(8)

where Ft is the gross foreign liabilities of a country denominated in foreign currency terms and CAt is the (primary) current account balance in domestic currency terms. Equation (8) indicates that today’s external debt must be matched by the present value of future (primary) current account surpluses (excess of surpluses over deficits). The large and chronic current account deficit in Eritrea suggests a violation of external debt sustainability and the need for major and abrupt corrections in imports in the absence of large and stable flows of official and private transfers.

27. Equation (8) can be explained further by reference to the national income identity:

CAt=PBt+StPItP,(9)

where StP

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is private saving at period t and ItP is private investment. The equation indicates that the external current account balance is equal to the sum of the saving-investment balance of the public sector and that of the private sector. Because the public sector saving-investment balance is equal to the primary deficit, the link between fiscal sustainability and external sustainability becomes clear.

C. Public Finances: Developments and Trends

Key fiscal indicators

28. Developments in government revenue, expenditure, and financing, as well as different concepts of fiscal deficit in Eritrea, are reported in Table II.1. The key factors that affected fiscal variables and sustainability of the public finances over the period of observation were the following:

Table II.1.

Eritrea: Key Fiscal Indicators, 1993-2002

(In percent of GDP, unless otherwise indicated)

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Sources: Ministry of Finance; Bank of Eritrea; and staff estimates.

Including privatization receipts.

Excluding privatization receipts.

In percent of total loans of the banking system.

In percent of net domestic credit.

In percent of total expenditure, excluding special programs.

  • The war with Ethiopia during 1998-2000 dominated developments in the fiscal sector: revenues declined and expenditure increased sharply, and fiscal deficits reached extreme proportions.

  • Total revenue (excluding grants), which until 1998, had averaged some 35 percent of GDP, plummeted to some 25 percent of GDP in 2000, driven entirely by the sharp decline in nontax revenue; this revenue consisted mainly of port fees from Ethiopia as a result of the cessation of transshipments through the port of Massawa and Assab by landlocked Ethiopia. After the war, total revenue did not recover because the surtax collected during the conflict was gradually lifted, leading to a loss of revenue of some 5 percent of GDP. On the basis of the current revenue system, no major recovery of revenue to prewar levels can be expected. However, external grants for reconstruction and humanitarian purposes sharply increased following the cessation of hostilities in 2000, keeping total revenue and grants at about the same level as in the previous years.

  • Total expenditure, which had fluctuated between 43 percent of GDP in 1994 and 66 percent in 1995, exceeded 90 percent of GDP in 1999 during the height of the war with Ethiopia. At the same time, primary current expenditure increased from 30 percent of GDP to more than 50 percent.

  • All measures of fiscal balance worsened markedly with the onset of war in 1998. In particular, the overall deficit (excluding grants and special programs) widened to 58 percent of GDP in 1999 and remained above the prewar levels of 12-30 percent of GDP. The same pattern applies to the primary balance, the major determinant of fiscal sustainability.

  • The deficit financing of the Eritrean government is characterized by the large recourse to domestic credit and diaspora financing during the war, and by the substantial increase in external assistance for reconstruction thereafter. Financing of the government from domestic sources reached 43 percent of GDP in 1999 and amounted to a cumulative total of 106 percent of GDP during 1998-2000. Moreover, in 1999, credit to the government accounted for more than 100 percent of the increase in domestic credit of the banking system. This development sharply reduced excess liquidity in the financial system and crowded out private sector credit demand, which, in turn, impaired private sector growth and development.

29. On balance, then, fiscal indicators deteriorated substantially as a result of the war. Their impact on fiscal sustainability was aggravated by the deterioration of conditions for growth, as well as the weakening of confidence, including among investors and donors.

Indicators of fiscal sustainability

30. Developments in key debt and debt-service ratios affecting fiscal sustainability are presented in Table II.2. On balance, they suggest the following broad conclusions:

Table II.2.

Eritrea: Indicators of Fiscal Sustainability, 1993-2002

(In percent of GDP, unless otherwise indicated)

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Sources: Ministry of Finance; Bank of Eritrea; and staff estimates.

Three-year-average of exports of goods and services used.

Domestic revenue excludes exceptional revenue. Maturity is six months, while principal has never been repaid.

In months of imports of goods and services.

  • Debt indicators have worsened significantly since 1998. As a result of the large fiscal deficits discussed above, the overall public debt-to-GDP ratio jumped from less than 10 percent in 1994 to 42 percent in 1997, and 77 percent in 1998, before reaching some 200 percent of GDP in 2002. The increase in debt was driven mainly by the accumulation of domestic debt. However, external debt and debt-service ratios also increased sharply, not only because of new external borrowing but also because of the depreciation of the exchange rate of the nakfa.3

  • The net present value (NPV) of external public debt also increased sharply in 1999 and 2000 in terms of both exports of goods and services and domestic revenue, owing largely to new external borrowings but also because of the significant decline in exports and domestic revenue. Because of the largely concessional nature of loans to Eritrea, its NPV amounted to only 44 percent of GDP in 2002, while the external debt stood at 79 percent of GDP.

Government assets and liabilities

Debt and debt-service ratios give an incomplete picture of the sustainability problems they raise. To obtain a more accurate picture, these ratios need to be examined with respect to the uses of the financing on which they are based. Clearly, for the same debt ratios, sustainability is more of a problem if the financing has been used for consumption rather than investment. It is, therefore, important to examine whether, and to what extent, the increase in indebtedness of government has financed investment in both physical and human capital. This assessment is critical because such investments strengthen the productive capacity of the country and thereby improve sustainability through their effect on potential output. To assess these issues for the case of Eritrea, an attempt has been made to measure changes in the country’s physical and human capital stock since independence in 1993 (Table II.3). In the estimation, the government assets are assumed to consist of three kinds: physical capital, human capital, and government deposits.4 Physical and human capital stock is calculated based on the annual investment flow net of depreciation and war damage. The major findings are follows:

Table II.3.

Eritrea: Assests and liabilities of Government, 1993-2002

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Sources: Ministry of Finance; Bank of Eritrea; and staff estimates.

End-year stock. Initial capital stock at end-1992 is assumed to be none. No depreciation is assumed for human capital.

Assumed at 3 percent of the current period capital stock.

Total damage is estimated from the study in July 2000 by the University of Asmara, Assumed at 2 percent of capital stock in 1993 and 1999 acid the rest in 2000.

Including ERP-related capital spending.

Only current expenditure. Including externally financed spending up to 1999.

Positive numbers indicate that the borrowing for consumption in the year was higher than that for investment, while the negative numbers indicate the opposite.

Not adjusted for exchange rate movement

  • Following independence in 1993, Eritrea’s physical and human capital stock increased dramatically, reaching a cumulative level of 147 percent of GDP in 1999, despite increasing war damage. This substantially increased the growth potential of the country and strengthened fiscal and external sustainability.

  • Following the eruption of hostilities with Ethiopia in 1998, net assets of the government declined substantially because new borrowing largely surpassed the increase in assets, resulting in a negative net worth of government by 2000.5

  • The drastic change in the net asset position of the government reflects in good measure the shift in the use of borrowings from investment to consumption, notably for defense spending, which reached 20 percent of GDP in 2000.

31. On balance, then, the productive capacity of Eritrea and the related sustainability of its public finances and external debt, which had improved significantly until 1997, deteriorated substantially during the war years and have yet to recover.

Key macroeconomic developments and policies

Apart from the fiscal variables discussed above that influence sustainability directly and indirectly, the equations on fiscal and external sustainability point to other key economic variables that can have a substantial impact on sustainability measures. These include, above all, economic growth and inflation, as well as external competitiveness and export performance; also important are changes in monetary and exchange rate policies that may become necessary to “correct,” offset, or accommodate the impact of fiscal policies. In addition, special factors, such as drought or the war, have a key impact on the economy and sustainability. Developments and influences of these variables are reported in Table II.4 and discussed below.

Table II.4.

Eritrea: Key Economic Development, 1993-2002

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Sources: Ministry of Finance; National Statistics Evaluation Office; and staff estimates.

Decline in cereal production in 1995 was due to severe locust infestation.

Consumer price index in Asmara; average.

Average inflation is only during 1999-2000.

In percent of net domestic credit.

Growth and inflation

32. Growth performance over the last ten years was mixed, and no clear trend emerged. On average, real GDP grew by 5 percent, driven by the expansion in the nonagricultural sectors. Industry experienced the highest growth among major sectors, reaching 13 percent on average, and its share in GDP rose to 25 percent by 2002. By contrast, the growth of agriculture fluctuated significantly year by year, largely owing to the weather conditions, and, on the whole, Eritrea’s food security did not improve. In U.S. dollar terms, GDP per capita remained basically unchanged over the last ten years at a very low level by international standards. Inflation, which had remained manageable during the four years following independence, has been consistently high since 1998, mainly reflecting the war, drought conditions, monetary expansion for deficit financing, and the depreciation of the nakfa since 1998.

External performance

33. Information on the external accounts of Eritrea suggests that, particularly because of the war, the country has become more dependent on foreign assistance. Since 1998, current account deficits have widened mainly as a result of the loss of the traditional export market of Ethiopia, a surge in food and defense imports, and the decline in service receipts and private transfers. Capital inflows were not sufficient to cover the widened current account imbalance, and gross foreign reserves dropped to 1.4 months of imports of goods and services in 1998 from 5 months in the previous year, and declined further to less than 1 month in 2002. Together with the external debt developments discussed above, these changes in external performance, which are in good measure the result of fiscal policies, suggest that external sustainability cannot be achieved without major support by donors and improvement in economic growth and export performance.

Monetary policies and aggregates6

34. Monetary policy influences fiscal sustainability directly via credit to government and indirectly through the availability and conditions of credit to the private sector and the stability of the financial system. The latter can substantially affect the functioning of the economy and its capacity to grow out of debt. Since the introduction of a separate national currency in 1997, the Bank of Eritrea, the central bank, has been subordinating its objectives to fiscal policy objectives and cannot independently pursue its statutory objectives. This fact is especially evident from the large share of credit to government in total credit (Table II.4). In addition, the rate of interest on government securities is administratively fixed at 2.5 percent. These significant rigidities hamper the implementation of an effective monetary policy and prevent the financial sectors from playing an intermediation role. In this environment, monetary policy has not been able to contribute to economic growth and sustainability.

Exchange policy and developments7

35. As discussed above, exchange rate movements exercise a very important influence on fiscal and external sustainability. The choice of an exchange rate regime is, therefore, important for sustainability. At the same time, the regime has a critical effect on external competitiveness and growth. Experience in other countries demonstrates that a wrong exchange rate policy may temporarily support sustainability but will eventually undermine growth to such an extent that sustainability is damaged. For an assessment of the effects of exchange rate policy on fiscal sustainability, it will be important to examine these factors, as well as the functioning of foreign exchange markets and their influence on private sector activity. Mainly in order to limit the fiscal costs of foreign payments, including external debt service, the Eritrean authorities have kept the official nominal exchange rate of the nakfa essentially unchanged. This has supported “nominal” sustainability. However, the present exchange rate system and its management have resulted in a dual exchange rate regime with a strong parallel market and are marked by a high degree of rigidity that not only undermines transparency and competitiveness, but also hampers domestic growth.

Influence of special factors

36. As can be seen from Table II.4, special factors such as droughts and war, have had a significant influence on economic performance and fiscal and external balances. Drought conditions have affected Eritrea for six years out of the last ten years. They have mainly caused large swings in agricultural productions but have otherwise not affected so much the performance of other sectors and macroeconomic balances. By contrast, the effects of the 1998-2000 war are reflected clearly in every key variable of the economy: growth has declined, inflation has risen, public expenditure has increased, the current account deficit has widened, and foreign reserves have nearly been depleted.

D. Responses to Fiscal Policy and Management

37. As in most other developing countries, fiscal policy in Eritrea has a comprehensive and profound influence on the economy because directly or indirectly it affects virtually all economic agents and sectors through the financial impact of revenue and expenditure measures, as well as by influencing incentive structures and expectations. For a full evaluation of sustainability, it is, therefore, important to examine the channels through which these influences work and to assess the endogenous responses they entail. A full discussion of these issues lies outside the scope of this paper. References will, therefore, be made only to those variables that are of particular importance in Eritrea. They include, above all, the following: GDP growth, private initiative, financial sector stability, confidence in government policies, and diaspora and donor financing. The discussion is then extended to examine the effects on sustainability of endogenous responses to nominal rigidities in interest rates, exchange rates, and prices.

Key response variables and their effect on sustainability (Figure II.1)

Figure II.1.
Figure II.1.

Eritrea: Fiscal Policies and the Sustainability of Public Finances

Citation: IMF Staff Country Reports 2003, 166; 10.5089/9781451811971.002.A002

38. The principal interdependences between fiscal policy and endogenous variables that affect fiscal sustainability are depicted in Figure II.1. The chart shows the main elements through which fiscal policies and developments influence the behavior of key actors and variables in the economy, and how their responses, in turn, affect fiscal sustainability.

Growth of GDP

39. Conventional growth theory posits that the growth of an economy depends on three factors: capital, labor, and total factor productivity (TFP). Fiscal policy typically influences all of these factors. First, Eritrea’s capital stock is directly affected by the authorities’ investment in economic and social infrastructure, as discussed above. Additional influences work through tax policies and income transfers that affect incentives and resources for private sector saving and investment. In support of sustainability, it will therefore be necessary to examine these influences and correct policies where they are seen to undermine capital formation.

40. Second, both the active volume and the productivity of labor matter. At present, demobilization policies dominate the availability of labor inputs into productive activities in the private and public sectors in Eritrea. The mobilization of combatants during the war severely impaired private sector activity and the functioning of public administration, not least because it affected skilled and managerial personnel most.8 It also significantly reduced the availability of labor in the rural areas and for agricultural production. Following the cessation of hostilities in 2000, demobilization has been slow so far, and an acceleration would, no doubt, increase economic activity and improve the public finances. At the same time, the Eritrean authorities have given substantial attention to investments in human capital through training and increases in spending on education and health. These actions should eventually increase labor productivity.

41. Finally, TFP in Eritrea is primarily influenced by imports of capital goods and know-how that result in technological advances and general efficiency gains in production. An open trade regime and adequate access of the private sector to foreign exchange are, therefore, critical. While good progress has been made in Eritrea in liberalizing trade and reducing tariffs, the precipitous decline in foreign reserves and the selectivity of their use have severely undermined private sector growth, and thereby reduced fiscal and external sustainability.

Private sector initiative and development

42. In most successful economies, the private sector has been the driving force for employment creation and economic development. Private sector initiative is particularly effective when the sector is offered an environment conducive to its development in an open and liberal organization of the economy. In Eritrea, most of these fundamental conditions were introduced after independence but have recently been rolled back in a number of areas, such as finance, foreign exchange, utility services, petroleum products, and trade. More generally, the authorities’ dissatisfaction9 with the private sector has resulted in an increased role of the government in the economy, including its intervention into markets — a practice that may stifle private initiatives and could endanger fiscal sustainability by lowering growth prospects.

Financial sector stability and development

43. In Eritrea, as elsewhere, fiscal policies affect financial sector stability and development mainly through the volume and the terms and conditions of domestic deficit financing of the government. In addition, private saving, the source of private investment, is strongly influenced by interest rate policies and expectations about financial sector stability. In Eritrea, the large increase in deficit financing and the setting of interest rates at hugely negative levels in real terms carry the risk of reducing private savings; they may also undermine the stability of the financial sector and thereby constrain private investment. Such an outcome would substantially reduce the prospects of fiscal sustainability and undermine the country’s prospect of growing out of its poverty trap.

Expectations and confidence

44. Given their central role in Eritrea’s macroeconomic policy, fiscal policies not only constitute its principal tool but also are the key determinants of expectations and confidence in the economy. In particular, the large fiscal deficits and increases in government debt have raised doubts about the sustainability of the public finances and have prompted both domestic and foreign investors to take protective measures. If not corrected in time, the country may enter into a vicious circle of self-fulfilling expectations, which would further undermine fiscal sustainability.

Diaspora financing

45. In the past, Eritrea benefited substantially from diaspora financing, which brought the country much-needed foreign exchange. This support has been mainly guided by family relationships and patriotism, but has increasingly also been viewed as an investment in the country. As the latter element increases in importance, the soundness of government policies and the performance of the economy will increasingly condition the preparedness of the diaspora to make savings available to the country and influence the sustainability of the public finances. The importance of the diaspora for the public finances and foreign exchange is demonstrated by the fact that the level of bonds issued to the diaspora reached 3.1 percent of GDP in 1999 and grants amounted to 3.2 percent of GDP in 2000. On the external account, private transfers from the Diaspora are the largest single source of foreign currency inflows into the country, with the ratio of these transfers to GDP averaging 37 percent over the last ten years. These levels of diaspora financing are clearly exceptional; but even lower levels are achievable only if confidence and trust in government policies and economic developments are maintained and contracts are honored. Both fiscal and external sustainability depend critically on the continued support of the diaspora.

Donor financing

46. Generous donor financing is indispensable for Eritrea’s economic development and the sustainability of its public finances and external deficits. Following independence, donor assistance became the largest engine of economic and social development. Similarly, following the conflict with Ethiopia, total assistance from donors, including net official loans and external grants, reached 31 percent of GDP in 2001, when the reconstruction and humanitarian support effort intensified. Since then, not only disputes over political governance but also concerns about fiscal and other economic policies have caused donors to hold back on new commitments, except for demobilization and humanitarian assistance. For sustainable economic development, a resumption of to budgetary and balance of payments support will be needed, and this will require a normalization of relationships with donors10.

Influence of nominal rigidities and policies taken to minimize endogenous effects

47. Mainly with a view to keeping budgetary costs low, the authorities have taken a number of actions to prevent market mechanisms from playing out. While these actions have temporarily avoided undesired consequences for the public finances, the external accounts, and the exchange rate, they are likely to result in compensatory action on the part of economic agents that are costly and undermine the responsiveness and development of the economy. This applies, in particular, to the measures taken on interest rates, exchange rates and foreign exchange allocation, and price controls11. It is, therefore, important to review the need for these policies and to determine their long-term effect on incentives and growth.

E. Restoring Sustainability

Sustainability gap indicators

48. The various sustainability indicators calculated all indicate that fiscal policies over the last ten years have significantly moved away from sustainability, and that large adjustments in the balance of government revenue and expenditure are necessary for stabilizing the public finances.12 Gap indicators are summarized in Table II.5 where a negative number indicates how far away the indicator is from the balance needed for stabilization and sustainability. The indicators are all negative except for 200113, indicating that the debt-to-GDP ratios could not be stabilized with the primary balance in the respective years because revenue was too low or expenditure too high. In the peak year of 1999, the gap indicators reached -52 percent of GDP, when grants and special programs are excluded, and -46 percent of GDP, including grants and special programs. These outcomes suggest that, in order to stabilize debt ratios at the 1999 level, total revenue and grants would have had to be raised to 88 percent of GDP, against the actual 42 percent, or total primary expenditure, including special programs, would have had to be cut to 46 percent of GDP, against the actual 92 percent.

Table II.5.

Eritrea: Sustainability Indicators, 1993-2002

(In percent of GDP, unless otherwise indicated)

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Sources: Bank of Eritrea; and staff estimates.

The “primary/tax/expenditure gap indicator” measures how much adjustment a country needed in primary balance/tax revenue/expenditure relative to its actual level to keep the debt-to-GDP ratio constant, if positive, the primary balance/tax revenue/expenditure in a calculated period was enough to keep the debt-to-GDP ratio constant. If negative, the primary balance/tax revenue/expenditure was not enough to keep the ratio constant. See also Annex.

Based on the assumption that grants are provided with special programs.

Based on the assumption that grants are not provided without special programs.

Based on the assumption that all the necessary adjustment is done to either primary current or capital expenditure.

49. Three factors suggest that even these large adjustments underestimate the actual correction now needed to move toward sustainability. First, the debt-to-GDP ratio climbed above 200 percent of GDP in 2002, and just maintaining this level is hardly enough. Setting more ambitious targets for debt reduction is, therefore, imperative. Second, the administratively fixed domestic interest rate for public debt underestimates the real costs of interest payments and thereby underreports the intrinsic size of gap indicators. Under an administratively fixed interest rate, inflation improves the gap indicators because nominal GDP growth, nr, goes up, while rt stays the same in the gap indicator formula.14 Third, the fixing of the official exchange rate at an overvalued rate underestimates the underlying size of the external debt stock and debt-service burden, and thereby underreports the sustainability gaps.15

50. To illustrate the dependence of changes in the sustainability gap and the need for adjustment on the two critical variables, GDP growth and interest rate, a matrix based on these two variables has been calculated for the situation observed in 2002 (Table II.6). The upper matrix indicates the size of the primary deficit needed to stabilize the debt-to-GDP ratio at its 2002 level of 201.8 percent. If it is assumed that the domestic nominal interest rate on government debt remains fixed at 2.5 percent, and taking the average annual GDP growth rate of 3.5 percent projected for the baseline scenario in the staff report, the primary deficit needed for stability of the debt-to-GDP ratio is 14.7 percent of GDP, compared with the level of 26.1 percent of GDP lower than actually observed in 2002. The adjustment needed for stability could, therefore, have been 11.5 percent of GDP (see bottom matrix). By contrast, in the case of the more optimistic scenario, under which demobilization advances speedily and donor assistance increases, average GDP growth is projected at 6 percent, hi this case, the primary deficit needed for stabilization would be 19.1 percent of GDP under an unchanged interest rate on domestic public debt, implying an adjustment need of 7 percent of GDP. In turn, any increase in the interest rate to strengthen savings and banks’ balance sheets would lower the “equilibrium primary deficit” again and require a stronger adjustment from either or both government revenue and expenditure to achieve the reduced deficit objective.

Table II.6.

Eritrea; Minimum Primary Balance and Adjustment Required — Status Quo

(In percent of GDP, unless otherwise indicated)

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Sources: Ministry of Finance; Bank of Eritrea; and staff estimates.

Historical weighted average.

Based on a medium term projection.

Historical average for advanced economies.