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.

IV. Exchange Rate Policy and Management16

A. Introduction

38. The purpose of this section is to describe and analyze Eritrea’s exchange rate regime, placing special emphasis on a comparison of the de jure regime, as it is officially stated, and the de facto regime, as it is reflected by actual exchange rate market developments. In addition, the implications of the current exchange rate regime for macroeconomic and microeconomic stability and efficiency are discussed, and the potential gains from switching to an alternative regime are examined. To put the analyses in their historical context, a brief overview of recent events is also provided.

B. Brief Historical Overview

39. Following Eritrea’s proclamation of independence from Ethiopia in May 1993, the Eritrean authorities introduced on November 22, 1997 a national currency, the Eritrean nakfa (ERN), replacing the Ethiopian birr, which had previously served as the legal tender. According to the IMF’s 1998 Exchange Arrangements and Exchange Restrictions Annual Report (AREAER), the Ethiopian authorities intended to pursue a managed floating exchange rate regime.

40. In its Foreign Exchange Regulation dated May 1, 1998, the Bank of Eritrea (BE) allowed banks to “set their own exchange rates,” thereby establishing a mechanism for market determination of the foreign exchange rate, hi connection with a separate Regulation for the Licensing and Operation of Foreign Exchange Bureaus dated May 1, 1998, the regulation set out the process of obtaining a license for operating a foreign exchange bureau. At that time, the foreign exchange market consisted of two commercial banks-the Commercial Bank of Eritrea (CBE) and the Housing and Commerce Bank of Eritrea (HCBE)–and twelve foreign exchange bureaus.

41. Immediately after the Foreign Exchange Regulation came into force, the nominal exchange rate increased to ERN 7.34 per U.S. dollar in May 1998 (up from ERN 7.13 per U.S. dollar in April 1998) and continued to depreciate further afterward. However, during extended time periods, the free float was interrupted, and the exchange rate remained at fixed levels (at ERN R. I per U.S. dollar during April-October 1999 and at ERN 9.6 per U.S. dollar from November 1999 through November 2000, in spite of mounting upward pressures stemming from the border war with Ethiopia, lasting from May 1998 to December 2000.

42. In connection with the border war, on July 1, 2000 the authorities imposed restrictions on foreign exchange transactions and gold in order to curb “the possible adverse impact of the current speculative activities in the foreign exchange market” (Legal Notice 44/2000). These restrictions authorizing the BE to fix of the foreign exchange rate, and allowing foreign exchange bureaus to sell foreign exchange only to the BE.

43. In August 2001, Legal Notice No. 49/2001 repealed the foreign exchange restrictions that had been imposed during the war with Ethiopia, allowing the exchange rate to “be determined by market forces, depending on the supply of and demand for foreign currency.” Foreign exchange bureaus and banks were free again to buy and sell foreign currency without restrictions, and to adjust rates of exchange in response to changing market conditions, and they were no longer required to surrender their foreign holdings to the BE- After freeing the foreign exchange market, the nakfa immediately depreciated by almost 35 percent in September 2001 to around ERN 13.8 per U.S. dollar. Since then, the official exchange rate has remained virtually unchanged, further depreciating only slightly to ERN 14.1 per U.S. dollar in mid-2002.

44. A new exchange rate directive (No. 01/2003) was issued on January 8, 2003. It explicitly allows exchange rate bureaus to set their own buying and selling rates of exchange and is also otherwise consistent with the Foreign Exchange Regulation and the Regulation for the Licensing and Operation of Foreign Exchange Bureaus that were issued in May 1998. The new directive, however, puts special emphasis on the requirement that bureaus explicitly and openly display their buying and selling rates and that they issue receipts for both purchases and sales.

C. Official (de jure) Structure of the Foreign Exchange Market

45. The formulation and enforcement of exchange rate policy and management lie with the BE. In particular, Section III.5.1.b of the Bank of Eritrea Proclamation No. 93/1997 states as one of the principal objectives of the BE to “maintain sound exchange rate policy to promote a healthy balance of payments and a sustainable foreign exchange reserve position.”17 However, the precise type of exchange rate regime is not written into BE law; rather, it is up to the BE to determine the appropriate regime.

46. In a recent paper by the authorities, “Transitional Growth and Poverty Reduction Strategy 2001-2002,” Eritrea’s official exchange rate policy is described as a managed floating exchange rate regime. Although The BE may influence exchange rate movements by buying or selling foreign currency in the foreign exchange market, using the U.S. dollar as the intervention currency, the authorities emphasize that they do “not want to use [the BE’s] limited foreign exchange reserves to defend a fixed exchange rate.”

47. Under a flexible, or floating, exchange rate regime, the domestic money supply can be controlled to contain domestic sources of inflation and to influence fluctuations in the current account balance. In this vein, the main objective of the BE, as described in the above-mentioned Eritrea strategy paper, is the use of its monetary policy instruments to maintain price stability while leaving the determination of the exchange rate to the market.

48. Within this framework, regular foreign exchange transactions were to be executed by commercial banks and foreign exchange bureaus, all of which require licensing by the BE. By September 2001, 22 licenses had been issued and two commercial banks were operating, as well as 14 foreign exchange bureaus in the foreign exchange markets.

49. As detailed in the Regulation for the Licensing and Operations of Foreign Exchange Bureaus, any individual, partnership, or company without a prior history of fraud or embezzlement may apply for a license. There are only a few requirements for obtaining a license, although some of the financial prerequisites are likely to be enormous for Eritreans. As of January 2003, these included a minimum paid-up capital of US$5,000 (or its equivalent in nakfa), an ERN 300 application fee, an ERN 700 initial license fee, and recurring annual renewal fees equal to ERN 500. On the operational side, obtaining a license requires a fixed business location and the necessary infrastructure to maintain appropriate records.

50. Officially, then, Eritrea’s foreign exchange regime and market structure constitute a highly liberal and open system with few rigidities. Also, the BE’s declared strategy of using its monetary policy instruments mainly for maintaining price stability is consistent with the official policy of a market-determined foreign exchange rate.18

D. Actual (de facto) Structure of the Foreign Exchange Market

De facto exchange rate regime

51. Following the restrictions imposed on foreign exchange in July 2001, Eritrea’s de facto exchange rate regime was reclassified in the IMF’s 2001 AREAER from “independently floating” to a “conventional pegged arrangement,” and this classification has been maintained henceforth.19 Although the authorities have officially declared themselves to be pursuing a managed floating exchange rate regime, the current regime is best described as a failed fixed exchange rate regime.

52. As seen in Figure IV.1, the official nominal exchange rate is fixed, over long time periods, with virtually no month-to-month movements, and adjusted only infrequently in small, discrete steps. However, because the de facto fixing of the exchange rate is not supported by corresponding monetary policies, upward pressures on the exchange rare and an increasing shortage of foreign exchange at the official rate have led to the development of a parallel foreign exchange market in which the exchange rate differs markedly from the official rate.20 The large exchange rate spread, over 60 percent in August 2002, indicates that the official exchange rate significantly overvalues the nakfa.

Figure IV.1.
Figure IV.1.

Eritrea: Nominal Exchange Rates, 1998-2002

(In Nakfa per U.S. dollar)

Citation: IMF Staff Country Reports 2003, 166; 10.5089/9781451811971.002.A004

53. Under this market structure, official transactions (and other “priority” needs) are conducted at the official exchange rate and through official channels, while the vast majority of private transactions, including bona fide transactions on the current account, as well as official transaction that could not be financed through official channels are executed in the parallel market.21 The volume of transactions in the parallel market has drastically increased since 1998 and has led to a widening spread of the parallel exchange rate over the official rate. The exclusion of many current international transactions from access to foreign exchange at the official rate and the large exchange rate spread give rise to an exchange restriction under the Fund’s Articles of Agreement (Article VIII, Section 2(a)). The current exchange system also constitutes a “multiple currency practice” under Article VIII, Section 3.

Institutional arrangements

54. The absence of monetary policies that would support the official exchange rate implies that the official rate is maintained through channels other than market forces. The persistence of dual exchange rates is to a large extent explained by the institutional structure of the foreign exchange market. Although foreign exchange bureaus are, in principle, free to choose their own rates according to market forces, they have in the past effectively taken as given the rates set by Himbol, the largest foreign exchange bureau, which is owned by the ruling party (PFDJ) and accounted for over 90 percent of all foreign exchange purchases by bureaus in 2001. Himbol’s strong position dates from the independence war, when it channeled the diaspora’s financial contributions to the armed struggle. In Eritrea, Himbol purchases foreign currency at the official rate. Outside the country, where it has several branches, it purchases foreign exchange from the diaspora at a higher rate. Currency transfers on behalf of foreign organizations (such as nongovernmental organizations (NGOs)) operating in the country are also carried at a rate somewhat higher than the official one (about ERN 17 per U.S. dollar as of January 2003). Himbol does not appear to sell foreign exchange, except to party enterprises and to other “preferred” clients (i.e., those deemed to be of essential importance to the domestic economy). It is this monopolistic market structure, as well as Himbol’s selective trading policy, that helps to keep the official market rate at its essentially fixed level. However, the authorities claim that Himbol’s position has considerably weakened because of the proliferation of parallel market operators.

55. The policy of favoring “essential” companies and transactions, as well as the recent Proclamation on Unfair Trade Practices indicates that party-owned Himbol is acting on considerations other than economic or commercial interests in selling foreign exchange and setting exchange rates.22 However, given the large spread between official and parallel exchange rates and the implied profit potential, it is unclear why other foreign exchange bureaus still find it in their interest to follow Himbol’s lead, and why more bureaus have not entered the market in pursuit of these apparently unexploited profits.23

56. Part of the answer lies in the costs of obtaining a license to operate an official foreign exchange bureau. A US$5,000 start-up capital requirement, plus other initial and recurring fees (see the previous subsection), are remarkably high when considering that Eritrea’s per capita GDP at market prices was about US$150 in 2002 (using the official exchange rate). These financial costs therefore constitute a significant barrier to entry, thereby reducing pressures for a more market-based exchange rate that would arise from increased competition.

57. More important, however, there are indications that even officially licensed bureaus now increasingly operate in the parallel market at parallel market exchange rates, even though their published rates are always at the official one. Apparently, official foreign exchange bureaus do exploit the above-mentioned arbitrage opportunities by buying foreign currency at the official rate and selling it in the parallel market at the higher parallel rate. However, all the transactions in their books are recorded using the official rate, in order to hide their nonlegal operations and to avoid paying business taxes. This market behavior and bookkeeping practices might also explain the government’s recent reissuing of prior foreign exchange regulations with an added emphasis on the proper posting of, and accounting for, actual exchange rates.

58. One reason given by Himbol for maintaining the current regime, apparently shared by Eritrean officials, is the belief that increasing or freeing the official exchange rate would merely lead to an equal increase in the parallel market while leaving the existence of dual markets and the size of the exchange rate spread unchanged. Although there are signs that even the parallel market rate may overvalue the nakfa,24 the previously mentioned arbitrage opportunities would make it difficult for a dual exchange rate regime to persist over an extended period in the absence of any exchange rate restrictions. Also, a more freely operating official market would reduce the need to acquire foreign currency in the informal market, thereby lowering informal market demand and mitigating upward pressures there. The likeliest outcome of a more flexible exchange rate structure, therefore, is a reduction or elimination of the currently large exchange rate spread at a higher unified exchange rate.25

59. Other exchange rate operators are the BE and commercial banks. Accounts in foreign currency at commercial banks have recently been allowed. Eritrean expatriates can send money through these accounts, which are then exchanged with the commercial banks at the official rate. It appears to be more common practice, however, for foreign currency account holders to withdraw their hard currency from the bank and then sell it in the parallel market in order to secure the better parallel rate, thereby circumventing the official rate.

60. Official external operations are conducted by the BE. In particular, when its own foreign reserves are insufficient, the BE acquires the necessary foreign currencies from officially licensed foreign exchange bureaus (particularly Himbol) and from commercial banks. When none of these sources are available, the BE sometimes obtains foreign currency from unofficial dealers at rates closer to the parallel market rate.

E. Macroeconomic and Microeconomic Implications

Macroeconomic Implications

External Competitiveness

61. The policy and management of exchange rates in Eritrea have widespread implications on both the macroeconomic and microeconomic level. Among the macroeconomic implications is the negative effect of the exchange rate regime on external competitiveness. The strong overvaluation of the nakfa at the official rate raises the real exchange rate and thus reduces competitiveness for those exports transacted at the official rate.26 Reduced export competitiveness, in turn, translates into smaller export volumes than could otherwise be realized.

62. The following empirical analysis illustrates quantitatively some of the potential benefits that could be obtained from freeing the exchange rate.27 Reflecting the lag at which changes in economic variables work their way through the economy, quarterly export volumes (EXP) were regressed on lagged logs of the real effective exchange rate (REER) and a trade-weighted real GDP growth index of the main trading partners of Eritrea (FGDP), as well as on a dummy variable (D) to control for the effects of the border war with Ethiopia.28 Using quarterly data for the period 1992-2001, the following results were obtained (standard deviations are in parentheses):29

EXPt=11.85(4.5).81Dt2(.14)1.85REERt2(.99)+3.68FGDPt2(1.63)(R2=.52).

63. Using these estimates, it is possible to calculate what level of exports could have been realized if the exchange rate had been determined by the market. Although not perfectly so, the parallel exchange rate is a possible proxy for the “true” exchange rate. As only a few data points are available, the parallel exchange rate time series is a combination of data obtained from the authorities and staff estimates.30 Nominal and parallel exchange rates are shown in Figure IV.1.

64. According to Figure IV.1, the parallel market exchange rate started to deviate from the official one in 1998. To the extent that the parallel rate reflects the market valuation of the nakfa, starting in 1998, exports would have been higher than realized if the exchange rate market had been fully market based. By substituting the parallel exchange rate values into the export equation estimated above, one obtains a quantitative estimate of the benefits (or costs) of the current exchange rate regime.

65. Figure IV.2 shows how exports would have differed from actual exports if the parallel exchange rate, instead of the official one, had been used in all transactions. On average, quarterly exports would have been 55.2 percent higher, with a total export gain over the time period 1998-2001 equivalent to over US$300 million. According to these estimates, in 2001 alone exports would have been more than twice as high as the actual figures, corresponding to over a one-fourth of total nominal GDP in 2001, and thus raising Eritrea’s GDP growth potential by over 25 percentage points.

Figure IV.2.
Figure IV.2.

Eritrea: Actual and Hypothetical Exports, 1998-2001

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2003, 166; 10.5089/9781451811971.002.A004

66. These estimates are subject to several important qualifications. First, the estimates reflect the relationship between export volume and the exogenous variables in equilibrium, which is determined simultaneously by export supply and demand. During much of the time period under consideration, Eritrea’s war with Ethiopia put severe constraints on supply. To the extent that supply constraints will be less important as war effects diminish over time, projections using the above parameters must be interpreted with caution.

67. Second, while a depreciating exchange rate makes exports more competitive, it also makes import goods more expensive. If there are limited domestic substitutes for imported production inputs, domestic production using imported inputs will suffer. However, the already large volume of franco valuta imports (see below for more details on the franco valuta system), which are presumably executed at exchange rates closer to the parallel exchange rate, suggests that a move toward a unified exchange rate structure will have only a small effect on imports, as they already reflect the higher rate.

68. Lastly, and most important, the estimated benefits from removing the current exchange rate restrictions are based on the assumption that all export transactions have been executed at the official exchange rate. This is unlikely to have been the case in light of the increasingly active parallel market over the last year or so. The benefits of fully liberalizing exchange rate markets will, therefore, be more limited than suggested by the above regression. However, this exercise does illustrate the significant economic benefits that potentially flow from choosing an appropriate exchange rate regime.

Trade and payments channels

69. The scarcity of foreign exchange has reinforced the use of alternative payments systems. An informal funds transfer scheme known as the franco valuta system has been used and is rooted in the strong kinship ties of Eritreans with its large diaspora. The functioning of this scheme is illustrated by the following example. An importer contacts a person abroad to pay for the import goods in the exporting country. Instead of repaying the foreign contact person directly, the Eritrean importer repays the foreign contact person’s domestic relative, friend, or business partner in nakfa at the agreed exchange rate (which typically is significantly higher than the official exchange rate). This system thus circumvents the domestic scarcity of foreign exchange and is estimated by the BE to have been applied to almost two-thirds of goods imports during the first half of 2001.31

Scarcity of foreign exchange

70. The current exchange rate regime affects the scarcity of foreign exchange in two ways. First, the lack of adjustment of the overvalued official foreign exchange rate implies that the exchange rate is stuck below the market equilibrium, leading to excess demand for foreign exchange. Second, on the supply side, the shortage of foreign exchange is exacerbated by the reduction in exports discussed above, which thus generates a smaller inflow of foreign exchange.

71. The decline in Eritrea’s foreign reserves has sharply reduced the country’s capacity for imports, including those that may be important inputs into production. Moreover, the low level of reserves, combined with an overvalued fixed exchange rate, undermines credibility regarding exchange rate stability and has the potential to trigger financial crises.

Foreign direct investment (FDI)

72. As is evident from the discussion above, the current exchange rate regime in Eritrea is very complex and opaque. The “semilegal” nature of a substantial part of foreign exchange transactions and the authorities’ occasional crackdowns on the parallel market also introduce uncertainty regarding the availability of foreign currency and the rate of exchange. All of these factors create an environment that is unfavorable to investment and deter FDI. Lower FDI, in turn, reduces growth, lowers exports, and makes foreign exchange scarcer (because of both smaller capital inflows and lower exports). Low FDI is particularly harmful because Eritrea’s long-term growth prospects depend on imported technology.

Microeconomic implications

73. In addition to the macroeconomic effects of a dual exchange market and an overvalued exchange rate, Eritrea’s management and structure of the foreign exchange market also have negative implications at the microeconomic level.

Allocative efficiency

74. In a market-based allocation with flexible prices, only those firms will obtain foreign exchange whose use for it is at least as productive as its costs. With productivity as the key criterion for obtaining resources, scarce foreign exchange is allocated to those uses that have the strongest impact on the productivity and growth of the economy.

75. In contrast, in the absence of price adjustment, like in Eritrea, a shortage of foreign exchange emerges and available foreign currency must be rationed. That is, it must be allocated through mechanisms other than price. In the current foreign exchange market structure, this may be party affiliation, random luck, or other noneconomic criteria. This allocation mechanism leads to inefficiencies and distorted competition by implicitly subsidizing those firms that obtain foreign exchange at the lower official rate.

76. In addition, the opacity of the system and its semilegal character involve high information and transaction costs that undermine competitiveness and distort competition. Finally, firms are required to account for foreign exchange transactions using the official rate, irrespective of the actual rate at which the foreign currency was obtained. This inflates profits and increases profit taxes for those firms that have to resort to the parallel market and thereby puts them at a further disadvantage. However, worst hit are those firms that have no access to foreign exchange for importing necessary production inputs.

Rent seeking and fraud

77. By allocating resources by criteria other than profitability, rationing creates incentives for rent seeking, thereby diverting resources away from productive activities toward those aimed at obtaining foreign exchange at a favorable rate. Counter to the system’s intentions, it creates the potential for fraud and bribery and raises general governance issues. These risks are exacerbated by a lack of transparency and the uncertainty costs the system imposes on firms and individuals. The current system, therefore, puts at risk the reputation of the Eritrean people hardworking, honest, and free from corruption by raising the rewards for “bending” the rules.

78. A similar potential for fraud is created by forcing all firms to report costs and profits based on the official exchange rate. Private companies that must purchase their foreign currency in the parallel market thus face the unappealing choice of either following the rules and incurring an elevated tax rate or committing fraud through misreporting of profits.32 Neither option constitutes an adequate basis for a healthy and sustained development of the private sector.

F. Conclusions

79. Although Eritrea’s official exchange rate regime and foreign exchange markets are extremely liberal, the actual implementation involves considerable open and hidden rigidities that keep the foreign exchange system from reaching a market equilibrium. Although the authorities maintain that the exchange rate restrictions are required because of the scarcity of foreign exchange, in order to keep foreign exchange affordable and available to meet the economy’s priority needs, this section’s discussion shows that, in stark contrast to the authorities’ intentions, the current regime actually exacerbates the scarcity of foreign exchange as well as allocates the existing foreign exchange inefficiently. The current regime thus keeps the exchange rate from playing a positive role in Eritrea’s economic development. The effects of these rigidities and distortions are far-reaching, extending from a loss in external competitiveness to allocative inefficiencies, which, in turn, lower exports and reduce macroeconomic growth.

80. Reforms of the foreign exchange regime are complicated by the extremely low level of foreign reserves and the high official demand for foreign exchange in connection with priority needs of the government, including, in particular, the management of the drought. Policy measures will, therefore, have to follow a well-sequenced and well-paced reform agenda, at the end of which a greater degree of exchange rate flexibility should be permitted in a unified market based on underlying supply and demand conditions. In principle, this would imply no more than a return to the official system of a “managed float” introduced in 1998. To achieve this objective, reforms will also be needed in the exchange markets to ensure that market conditions are not undermined by dominant institutions and noneconomic allocation criteria.

ANNEX I: Diagrammatic Analysis of Exchange Rate Determination

81. This appendix provides a diagrammatic description of recent exchange rate developments in Eritrea, as well as an analysis of the implications of removing existing exchange rate restrictions. As Figure IV.1 in the main text shows, the parallel foreign exchange market came into full existence only after 1998. Until then, both exchange rates were essentially identical, suggesting that the official exchange rate closely reflected a market equilibrium. In Figure IV.3, this situation corresponds to the intersection of Do and So with eo as the resulting equilibrium exchange rate.

Figure IV.3.
Figure IV.3.

Eritrea: Exchange Rate Determination

Citation: IMF Staff Country Reports 2003, 166; 10.5089/9781451811971.002.A004

82. After 1998, a parallel market began to emerge because the demand for foreign exchange by the private sector was no longer met in full by the supply at the official rate. In Figure IV.3, this situation is shown as the result of an outward shift in demand from Do to D1.33 The lack of adjustment in the official exchange rate created excess demand equal to AE in the official market and thus led to the formation of a parallel market, in which supply is given by Sp. For a number of reasons, the supply curve in the parallel market is likely to be steeper than the supply curve in the official market. First, parallel market dealers typically demand a risk premium in compensation for the risk of legal prosecution, given their illegal status. In addition, dealers may also be able to exploit informational imperfections in the highly non-transparent parallel foreign exchange market in Eritrea. Finally, transactions costs are often high because many parallel market dealers operate on a small scale. Requests for larger amounts of foreign currency are then often channeled through several layers of traders, each of whom requires a fee.

83. The parallel market rate ep is determined by the intersection of Sp and D1 resulting in an exchange rate premium equal to epeo The volume of foreign exchange traded in the parallel market at ep is equal to AB, while that traded in the official market at eo is equal to 0A. The total traded volume of foreign exchange is, therefore, equal to 0B.34

84. Lifting restrictions on the exchange rate in the official market will remove the need for a parallel market. In the absence of restrictions, So becomes the relevant supply curve in all markets. In the parallel market, at ep there will therefore be excess supply of foreign currency equal to BD, putting downward pressure on the parallel exchange rate. Similarly, if the official exchange rate is allowed to adjust, excess demand in the official market exerts upward pressure on eo Eventually, both exchange rates will converge to the unitary market equilibrium rate, e*. The total volume traded is equal to OC; this is higher than the total volume of foreign currency traded under the dual market structure, illustrating the point that the current exchange restrictions reduce the available amount of foreign exchange.

16

This section was prepared by Martin Schindler. Valuable input was provided by Klaus-Walter Riechel and Benoît Mercereau.

17

The other two main objectives of the BE are to pursue price stability and to foster economic growth and development. See also the companion paper, “Monetary Policy and Management.”

18

See, however, the companion paper on the actual implementation of monetary policy (Seetion III).

19

See the 2002 AREAER.

20

Monetary financing of the fiscal deficit, which has contributed to a large current account deficit and double-digit inflation rates, is likely to have contributed significantly to the rising exchange rate pressures.

21

The nature of the parallel market has changed over the recent months. According to a World Bank assessment in early 2002, the parallel market was an informal market consisting of a large number of unlicensed dealers. Recently, licensed bureaus (buying and selling) and the BE (only buying) also have participated in the parallel market.

22

See the footnote in the subsection on microeconomic implications.

23

A foreign exchange bureau seeking to make a profit could offer a purchasing rate above the official exchange rate and a selling rate below the rates in the parallel market, implying a potentially large profit margin. Because this would also attract a larger share of the market, such a bureau should have little problem in acquiring the foreign currency necessary to run its operations. This will be particularly so if individuals and companies have a preference for acquiring foreign exchange legally over having to resort to the (illegal) parallel market.

24

There are reports of foreign currency shortages also in the parallel market, which would not be the case if exchange rates fully adjusted. These shortages persist most likely because informal traders, having been tolerated by the authorities in spite of being unlicensed, may be hesitant to deviate too much from the official rate lest they incur stricter enforcement of the requirement to obtain a license. In fact, street traders have at times been arrested, resulting in a sharp reduction in the availability of foreign exchange to the private sector.

25

The appendix illustrates some of these issues diagrammatically.

26

Let e denote the nominal exchange rate (expressed in Eritrean nakfa per U.S. dollar) and P and P* the domestic and foreign price indices, respectively. Then the real exchange rate can be expressed as ɛ = P/(eP*), the nominal exchange rate corrected for movements in relative price indices. Hence, domestic inflation pressures relative to external pressures lead to an increase in the real exchange rate, making domestic goods less competitive abroad.

27

As discussed below, several qualifications imply that this analysis should be interpreted as merely an Illustrative exercise, rather than a firm quantitative prediction of the effects of removing Eritrea’s exchange restrictions.

28

A lag structure of two quarters was used, ensuring a high R2, as well as statistical significance of all variables (at the .05 level), particularly the real effective exchange rate.

29

Given an F-statistic of 12.41, the overall regression, as well as all of the variables, are statistically significant at the .05 level. The high value of the D coefficient relative to the REER coefficient (in absolute terms) and its high statistical significance suggest that war-related effects, including supply-side effects, dwarfed the influence of other economic variables.

30

Although the authorities officially compile parallel exchange rate statistics, only data for 1999 and 2002 have been made available to IMF staff. The remaining values were constructed by interpolation.

31

Other examples of franco valuta transactions include remittances sent from abroad into Eritrea in the form of foreign currency, remittances channeled through foreign exchange bureaus, or those transferred via foreign currency accounts with commercial banks. Cash remittances, often via intermediaries, have been an important channel for foreign currency transfers from the diaspora into Eritrea. The official level of remittances channeled through exchange rate bureaus is very low, although some transfers seem to take place in this way at the unofficial rate of exchange. Foreign currency accounts with commercial banks have only recently been allowed; their usage for foreign currency transfers will depend on the extent to which individuals can withdraw foreign currency from these accounts and exchange it in the parallel market.

32

Alternatively, firms may attempt to recover higher costs of foreign exchange through higher sales prices. However, the scope for price adjustments is limited by the recent Proclamation No. 125/2003 on Unfair Trade Practices. This proclamation empowers the Ministry of Trade and Industry to subject goods or services to price controls if their prices are deemed “too high,” and the determination of “fair prices” is presumably based on valuing imported inputs at the official exchange rate.

33

The exchange rate premium could also have been caused by a reduction in the supply of foreign currency. The analysis and the diagram would, however, be very similar, with identical implications for the effects of removing exchange rate restrictions on exchange rate developments.

34

Demand in the diagram encompasses both private and official demand, although official demand and selected private demand for “priority needs” are given preference at the official rate, e0. As a result, demand in the parallel market is mostly private. However, as discussed in the main text, there have recently been cases where the supply of foreign currency in the official market was insufficient to satisfy even official demand, thus temporarily forcing some official demand into the parallel market.

Eritrea: Selected Issues and Statistical Appendix
Author: International Monetary Fund