The Federal Democratic Republic of Ethiopia
2004 Article IV Consultation and Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility—Staff Report; Staff Statement; and Public Information Notice and Press Release on the Executive Board Discussion

This paper examines Ethiopia’s 2004 Article IV Consultation and Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF). The PRGF program remains on track. All the quantitative performance criteria under the PRGF for end-March 2004, the structural performance criteria for end-June 2004, as well as all the benchmarks for these test dates have been met. In particular, the implementation of the Commercial Bank of Ethiopia (CBE) restructuring plan has progressed as planned. The 2004/05 federal budget requires substantial domestic financing as spending initiatives outpace revenue growth.

Abstract

This paper examines Ethiopia’s 2004 Article IV Consultation and Sixth Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility (PRGF). The PRGF program remains on track. All the quantitative performance criteria under the PRGF for end-March 2004, the structural performance criteria for end-June 2004, as well as all the benchmarks for these test dates have been met. In particular, the implementation of the Commercial Bank of Ethiopia (CBE) restructuring plan has progressed as planned. The 2004/05 federal budget requires substantial domestic financing as spending initiatives outpace revenue growth.

I. Introduction

1. On July 14, 2004, the IMF Executive Board extended through October 31, 2004 the arrangement under the Poverty Reduction and Growth Facility (PRGF) approved on March 22, 2001, to allow time for the completion of the sixth review under the arrangement. The attached letter from the Minister of Finance and Economic Development of Ethiopia and the Governor of National Bank of Ethiopia (NBE), dated August 12, 2004 (Appendix I), indicates that the performance criteria under the third annual program (covering fiscal year July 8, 2003-July 7, 2004) supported by the PRGF arrangement were achieved, and requests the final disbursement under the arrangement.

2. The Article IV consultation discussions focused on the conclusions of the draft ex post assessment report (EPA) and on the authorities’ macroeconomic policies and structural reform strategy to achieve an acceleration of economic growth and the Millennium Development Goals (MDGs). During these discussions, in line with the conclusions of the EPA, the staff strongly encouraged the authorities to pursue a more ambitious reform strategy than in the past. Section II describes economic performance in 2003/04. Section III reports on the discussions, and Section IV presents the staff appraisal.

3. Ethiopia continues to face political uncertainties, which are partly related to the unresolved dispute with Eritrea on boundary demarcation and partly to the preparations for the June 2005 elections. The Eritrea-Ethiopia Boundary Commission ruling (April 2002) that the town of Badme would be located within Eritrea has ignited strong opposition to it in Ethiopia, leading to protracted delays in the official demarcation of the border. However, the Ethiopian government has said it will not go to war over Badme. The international community’s efforts, including a recent U.N. initiative, have not succeeded so far in resolving the impasse. Meanwhile, the Development Assistance Group (DAG) in Ethiopia has underscored that the Government of Ethiopia should avoid escalating defense expenditures while the border dispute remains unresolved. The DAG ambassadors have also encouraged the Ethiopian authorities to invite international observers to the upcoming June 2005 election, and allow all political parties to participate on an equal footing in the public debate prior to the election.

4. Ethiopia ranks towards the bottom (170 out of 177 countries) in the 2004 Human Development Index ranking, an assessment combining life expectancy, adult literacy, primary school enrollment, and per capita income. The poverty reduction strategy paper (PRSP) indicates that the poverty headcount index was 44.2 percent in 1999/2000 for the country as a whole, down from 45.5 percent in 1995/96

II. Economic Performance in 2003/04

5. Ethiopia’s real GDP growth rebounded strongly (to 11.6 percent) during 2003/04, as agricultural production recovered fully from the drought-affected levels of 2001/02-2002/03. Growth in the nonagricultural sectors was also stronger (6.8 percent) than earlier estimated, primarily reflecting the impact of higher agricultural output on industrial production and services activities.

Selected Indicators, 2001/02-2003/04 1/

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Sources: Ethiopian authorities; and staff projections

Fiscal year ending July 7.

6. The average annual inflation rate (about 11 percent as of May 2004) has fallen much less sharply than earlier projected (5.5 percent), mainly because both food and nonfood prices have declined at slower rates than expected. The announcement of floor prices for cereals under the cereal price support scheme operated by the Ethiopian Grain Trading Enterprise (EGTE) is likely to have had a signaling impact on the prices at which cereals have been traded in the markets, and in addition, a shift by some local aid agencies from imports to domestic purchases of cereals may also have prevented food prices from falling in line with earlier seasonal patterns. The introduction of warehousing facilities for farmers, moreover, has allowed them to store a part of their crop after the harvest instead of having to sell it when prices are subject to downward pressures. The nonfood inflation rate (4.2 percent in May 2004) is higher than earlier expected, mainly because of the nominal effective depreciation of the birr on the exchange market, as well as the rise in import prices of selected inputs.

7. Although the exchange rate vis-à-vis the U.S. dollar has remained highly stable through 2003/04 declining only slightly from Birr/$ 8.60 in June 2003 to 8.63 in May 2004, the exchange rate has depreciated in nominal and real effective terms quite noticeably (by about 8 percent and 5 percent, respectively through end-March 2004). Consistent with their policy of avoiding a real appreciation, the authorities indicated that they have been content to follow the U.S. dollar and allow the birr to depreciate against the euro. As a result, the nominal and real effective exchange rates of the birr also depreciated. Given the challenge of stimulating more rapid growth, the authorities indicated that the depreciation of the real effective exchange rate was appropriate1. This policy has allowed the NBE to build up its net foreign asset position above the programmed level to take advantage of a normal harvest year and establish a stronger reserve cushion for coping with future exogenous shocks.

A01ufig01

Exchange Rate Developments, January 2002-March 2004

Trade-Weighted Exchange Rates (Indices, 1998=100)

Citation: IMF Staff Country Reports 2005, 025; 10.5089/9781451812718.002.A001

Sources: Ethiopian authorities; and staff calculations

8. The expansion of broad money through end-March 2004 (7.2 percent) was considerably less than programmed (12.4 percent). Since the Government reduced its net indebtedness to the banking system much more than programmed, the NBE was able to reduce its net domestic assets (NDA) well below the program estimate and overall NDA of the banking system recorded a small decline. As the NBE did not fully offset the decline in its NDA with its buildup of net foreign assets (NFA), it was able to sharply limit the increase in reserve money. Reflecting the economic recovery, bank credit to the nongovernment sectors expanded strongly, both to the public enterprises (in telecommunications and power) and the private sector. The NBE also allowed the commercial banks to reduce their excess reserves by a modest amount to support this credit expansion. In the last quarter of the fiscal year, the authorities indicated that they expect the full use of programmed domestic credit which, combined with stronger than programmed growth in NFA, leads to projected broad money growth for 2003/04 beyond the programmed level.

Monetary Survey, 2001/02-March 2004

(Percentage change since the end of the previous fiscal year)

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Sources: Ethiopian authorities; staff projections.

9. The structure of interest rates has remained unchanged during 2003/04. The NBE’s monetary policy committee considered increasing the minimum saving deposit rate, which is the only interest rate directly set by the NBE, in line with core inflation. However, it decided to postpone a decision on this matter to later in the year, when it would have a clearer picture of whether or not the pick up in nonfood inflation is temporary. The yield on 91-day Treasury bills has remained low, reflecting the excess liquidity in the banking system, and liquidity management remains a major challenge for the authorities due to the underdeveloped nature of domestic financial markets2.

Interest Rate Structure, 2001/02-March 2004

(In percent; end of period)

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Source: Ethiopian authorities.

10. Based on updated estimates, in 2003/04 the fiscal deficit (including grants) is likely to be lower (4.8 percent of GDP) than targeted (7.1 percent of GDP) reflecting lower external project loans as donors shifted to grant financing given the vulnerable debt situation. Relative to GDP, the deficit excluding grants (12.6 percent) was also below the program target (14.1 percent) as the share of recurrent expenditure was contained below that of domestic revenue. In nominal terms, revenue surpassed the program target because of strong indirect tax receipts stemming from buoyant import growth and improved customs administration, which more than offset lower-than-programmed direct taxes that reflected weak corporate profits following the drought of 2002/03. However, the tax base could not keep pace with the unexpectedly strong rebound in GDP, which was driven by the lightly taxed agricultural sector. Consequently, tax revenue fell short of the program target by 0.7 percent of revised GDP. Similarly, recurrent and capital spending were largely in line with the nominal program targets, but fell short as a share of GDP. Defense spending (Br. 2.4 billion) is expected to be held to the nominal program estimate, while poverty-reducing expenditure is anticipated to slightly exceed the nominal target owing to higher-than-planned capital spending in the education sector. The government has also implemented most of the planned expenditure for food security, without recourse to any domestic credit in the first nine months of 2003/04. However, the authorities anticipate a decompression of expenditures in the final quarter that will fully utilize the available domestic credit under the program.

General Government Operations, 2001/02-2003/04 1/

(In percent of GDP)

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Sources: Ethiopian authorities; and staff estimates and projections.

Fiscal year ending July 7.

Including special programs (demobilization and reconstruction).

Excluding special programs (demobilization and reconstruction).

11. The external current account deficit (including grants) is estimated to show a smaller deficit than earlier projected, due to higher net inflows of official and private transfers and a larger surplus in nonfactor services. The additional official grants reflected a shift away from long-term lending by donors. In the capital account, although there was a shortfall in disbursements of official long-term loans, this was offset by other unclassified inflows (recorded under net errors and omissions), and net capital inflows were broadly in line with the program estimate. Thus, the lower-than-programmed external current account deficit was the primary factor contributing to an overall surplus in the balance of payments. Under these circumstances, the NBE was able to build up its foreign reserves beyond the program level.

12. All the quantitative performance criteria for end-March 2004, the structural performance criteria for end-June 2004, as well as all the benchmarks for these test dates have been met, as shown in Appendix I, Tables 1 and 2.

13. The implementation of the restructuring plan for the NBE was begun in January 2004. Most of the recommendations made by KPMG, which covered all aspects of the restructuring plan except job grading, salary scales, and review of manuals for policies and procedures, were approved by the Board of the NBE. However, a number of key recommendations aimed at increasing the autonomy of the central bank were rejected by the NBE Board.3

14. Almost all the recommendations under the safeguard assessments have been implemented. The suggestion to strengthen the internal control system is planned to be completed as part of the overall organizational restructuring, in particular, of the internal audit department.

III. Report on Discussions

15. Since the Fund emphasized the need for structural reforms to support sustainable growth and poverty reduction in previous Article IV consultations, the discussions also covered key areas of such reforms including liberalization of the external sector and interest rates, the reorientation of spending to poverty alleviation, the speeding up of tax reform, privatization, and the strengthening of the financial sector, including by removing barriers to foreign bank entry (see sections IIB-IIIE below). Most of the immediate and distortionary policies identified in previous consultations have been gradually overhauled, but the authorities have remained cautious of greater market orientation in some key areas (see EPA section II). In particular the authorities continue to believe that allowing foreign bank entry would be premature (see paragraph 33 below). On the macroeconomic front, the authorities have, on the whole, pursued fiscal, monetary, and exchange rate policies that have been prudent and broadly in line with the Fund’s advice.

16. The discussions focused on the staff’s EPA and on its implications for developing a sound framework of macroeconomic policies and structural reforms that could help to achieve the MDGs by 2015. The EPA calls for the adoption of prudent debt management; realistic projections for real growth, government revenues and foreign grants in developing macroeconomic programs; more ambitious structural reforms; and programs that explicitly incorporate policies to help cope with exogenous shocks.

17. In responding to the conclusions of the EPA, the authorities welcomed the opportunity to revisit performance under past programs. They suggested, however, that the report should give greater recognition to significant recent reforms (e.g. in civil service reform and agriculture). They also considered it important for the Fund to give thought to alternative approaches to achieving development, and to avoid overemphasizing “liberalization”. They acknowledged that Fund programs had been beneficial, and that without them the outcomes would have been different. Looking forward, they indicated that they would continue to take appropriately sequenced measures at their own pace, and based on their own concrete analysis. They recognized that to make better progress towards the MDGs and ensure that both the public sector and the private sector contributed to higher growth, it would be important to focus not only on strengthening public expenditure management and external aid mobilization efforts, but equally strongly concentrate on supportive macroeconomic policies, and institutional and structural reforms.

18. In line with the recommendations of the EPA, the staff developed a baseline medium-term scenario based on recent trends and/or realistic projections of external assistance and real GDP growth. At the authorities’ request, the staff also prepared a more ambitious “Doubled Aid” scenario, which projected significantly higher external aid flows and somewhat higher GDP growth than under the staff’s baseline. Regarding any future arrangement, the authorities noted that while they considered high access to be appropriate, Fund financing was relatively minor, and the key benefit of a Fund-supported program was the policy framework and the seal of approval.

A. Achieving Higher Growth and the MDGs

19. The baseline scenario for 2004/05 and beyond takes into account four basic objectives. First, the projections for the real GDP growth rate (5.7 percent in 2004/05 and an average of 5.3 percent per year for the period up to 2015) are somewhat less ambitious than that of the authorities’ projections, because the projected increases in the ratios of investment and savings to GDP, and agricultural productivity, and the pace at which these gains would be realized are relatively more cautious than those of the authorities (Box 1)4. Second, the annual inflation rate would be contained to 3 percent consistent with the base case of the APR of the PRSP. Third, foreign reserves would be maintained at a level that covers at least four months of imports. Fourth, the ratio of total (domestic and foreign) debt to GDP would be reduced gradually over time. To achieve these objectives, the targeted path of fiscal deficits and the accompanying policies would play a central role in achieving the necessary degree of monetary restraint, containing pressures on the price level and the external current account, and achieving debt sustainability.

20. In contrast, under the doubled aid scenario, the authorities expect a marked acceleration of real GDP growth that is needed to achieve the income poverty goal of halving the number of people living in poverty by 2015. To this end, based on estimates of the income elasticity of poverty and strong implementation of their reform program, the authorities are targeting an average annual growth rate of about 7 percent, compared with 4.0 percent achieved during 1991/92-2003/04. This would require significant increases in agricultural productivity, and the ratios of savings and investment to GDP. The authorities, however, expect that as a result of the envisaged intensity and implementation of supporting structural and institutional reforms, these critical variables would increase well above historical trends.

21. The path of annual fiscal deficits (excluding grants) under the baseline would need to be contained to about 10 percent of GDP over the medium term, based on recent trends in official aid receipts (9 percent of GDP) and on a policy of containing new domestic borrowing as a share of GDP (to about 1 percent of GDP). Over the longer term, the ratio of revenues to GDP is expected to rise gradually, reflecting ongoing capacity building and improved revenue buoyancy as non-agricultural growth picks up, allowing scope for increasing the ratio of total expenditures to GDP, and eventually for reducing the dependence on aid. Under this fiscal scenario, the government would be able to reduce gradually the currently high ratios of its domestic and foreign debt to GDP to more sustainable levels. Moreover, by limiting its domestic borrowing, it would provide scope for adequate annual increases in bank credit to the nongovernment sector within annual targets for monetary expansion that are consistent with holding the annual inflation rate at about 3 percent. A significant risk in successfully implementing the baseline scenario is the reoccurrence of a severe drought, which strikes about every third year on average, as noted in the ex post assessment discussion.

22. The baseline scenario assumes new external borrowing over the medium term to be limited consistent with the baseline scenario presented at the HIPC initiative completion point, with increased grants allowing total assistance to remain broadly at their current levels as a share of GDP. While the envisaged lending program will keep the debt stock elevated for some time, the debt-service ratios are projected to remain manageable over the projection horizon reflecting the long maturity periods on existing debt and projected future financing.

23. In contrast to the baseline, the “doubled aid” scenario entails a rapid expansion in poverty-reducing expenditure financed by an inflow of external grants (Box 2).5 The budget deficit (excluding grants) would balloon to over 20 percent of GDP to finance higher poverty-reducing spending by 15 percent of GDP by 2015/16. In contrast, the deficit including grants would decline gradually to just 2.3 percent of GDP by 2015/16 as domestic fiscal effort steadily improves6. Expenditure would need to focus on recurrent items in light of the high wage component of addressing the shortage of teachers and medical staff that will be essential for achieving the MDGs in health and education7. Consequently, the government sector wage bill would increase by 4½ percent of GDP by 2015/16. The domestic public debt would decline and inflation would be contained (to 6 percent) by limited recourse to domestic financing at less than 1 percent of GDP per annum8. However, assumed donor assistance would increase by $5 billion per annum by 2015/16, before shifting to a downward trend. Under this scenario, the staff stressed the importance of containing any emerging wage pressures and maintaining adequate monetary restraint consistent with the inflation target, and noted that the scaling up of aid inflows also required aid coordination efforts to ensure predictability and firm forward-looking commitments from donors, as well as simplification and harmonization of donor conditionality and aid delivery practices.

Assumptions Underlying the Medium-Term Growth Projections

Ethiopia’s PRSP (the SDPRP) indicates that real GDP growth should average about 6 percent per year in order to achieve the MDG income poverty goal of halving the number of people living in poverty. The authorities believe that average annual real GDP growth of 7.0 percent could be achieved over the medium term.

Achieving growth of this magnitude on a sustainable basis would, however, require a significant improvement on the experience of the past 13 years. Annual real GDP growth during 1991/92-2003/04 averaged 4.0 percent, while potential growth is estimated at about 4.4 percent (Table 1). The staff’s baseline scenario assumes implementation of a reform program and higher agricultural productivity than in the past, which yields higher GDP growth, averaging about 5.5 percent annually.

The following are the main differences between the staff baseline projection and that of the authorities:

  • the authorities’ projection is based on a doubling of official aid flows as a share of GDP;

  • regarding agricultural production, the staff projects crop yields to improve by an average of 4 percent per year, compared with the authorities’ projection of 9 percent – this compares with an average increase of 1.4 percent per year during 1993/94-2003/04;

  • applying a growth accounting framework, and taking into account projections for gross domestic investment and labor, the staff’s projection implies a contribution from total factor productivity (TFP) of 1.1 percentage points; in the authorities’ projection, this would imply a TFP contribution of 1.7 percentage points; and

  • the authorities’ projection implies a further substantial increase in the ratio of investment to GDP. Compared with the staff’s projection of an increase in the ratio to an average of 22 percent during 2004/05-2020/21, the authorities’ growth projection implies a ratio of 31.4 percent of GDP. The staff projects an improvement in gross domestic savings to about 8 percent of GDP from 2.3 percent during 1991/92-2003/04, compared with the authorities’ projection of about 11 percent of GDP. The authorities’ projections thus imply a significant resource gap, averaging about 23 percent of GDP during 2004/05-2020/21.

Table 1.

Potential Real GDP Growth and Sources of Growth

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Source: Authorities; and staff estimates and projections.

Hodrick-Prescott Filter

This approach models output as a function of capital, labor, and total factor productivity.

This approach models output as a function of the capital stock based on an assumption that output in developing countries is fundamentally constrained by a lack of infrastructure and capital.

Achieving the Millennium Development Goals (MDGs) in Ethiopia.

Ethiopia is confronting pressing social deficits with respect to achieving universal primary education, addressing gender disparity, enhancing basic health care coverage, and reversing the spread of major diseases.

Health: Only 62 percent of the population enjoy access to basic health care services, while the prevalence of HIV/AIDS is estimated to impact about 2 million people;

Education: Completion rates in primary education are low with over half of students dropping out by grade 3, while enrollment in secondary schools is only 14 percent;

Population dynamics: Large investments will be required just to maintain the currently low level and quality of public service given an estimated fertility rate of 5.9 children per woman of childbearing age that will boost the population by 50 percent within 20 years;

Water: Just one quarter of the population has access to safe drinking water, and only 15 percent has access to sanitation services; and

Transport, telecommunications and power: Ethiopia has low road density at just 27 km/1000km3, compared to 50 in sub-Saharan Africa (SSA). Telecommunications and internet connectivity are also low with just 4 telephone lines per 1,000 people, compared to an average of 14 in SSA.

Achieving the MDGs will require a substantial increase in donor assistance. Aid flows presently amount to just $13 per capita compared to the SSA average of $23. In light of this, and guided by the pattern of expenditure in the “extended PRSP” scenario detailed in the World Bank’s Public Expenditure Review, the fiscal impact of doubling foreign assistance as a share of GDP is assessed relative to a baseline scenario that incorporates prudent revenue forecasts, existing expenditure priorities and current trends in donor support. The “doubled aid” scenario assumes that the increase in required resources over the baseline is disbursed in the form of higher grants, reflecting Ethiopia’s tight external debt position. Consistent with this scenario, donor support would increase gradually through 2015/16 to reach about $6 billion, enabling poverty-reducing spending to attain $78 per capita compared to just $20 in 2003/04. The wage bill also increases significantly as higher social spending is allocated to recurrent spending needs in education and health care, which entail large wage components. The budget deficit excluding grants increases sharply to over 20 percent of GDP by 2015/16, raising concerns about the sustainability of donor financing after 2015/16.

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3/ Statistics are from the World Bank’s 2002/03 Public Expenditure Review and CAS.

B. The 2004/05 Budget

24. The authorities’ 2004/05 federal budget requires substantial domestic financing as spending outpaces revenue growth. Although the consolidated government budget will not be available until September, the staff project a slight decline in the general government fiscal deficit by 0.1 percent of GDP, assuming that the authorities secure additional grant financing or undertake fiscal measures totaling 2 percent of GDP to fill the gap. In the absence of higher grant financing, or new measures, the authorities will require domestic financing of 3.5 percent of GDP to finance a general government deficit that would rise to 6.7 percent, jeopardizing a sustained decline in both the inflation rate and the ratio of public debt to GDP.

General Government Operations, 2003/04-2005/06 1/

(In percent of GDP)

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Sources: Ethiopian authorities; and Fund staff estimates and projections.

Fiscal year ending July 7.

Including special program (demobilization and reconstruction).

Excluding special programs (demobilization and reconstruction).

Authorities’ expenditure is higher by 0.9 percent as external interest is presented gross of HIPC relief.

Total financing in 2004/05 and 2005/06 is consistent with the staffs baseline scenario, thus leaving a gap to be financed either through higher domestic financing, or measures to be identified.

25. With respect to the revenue projections for 2004/05, nongrant revenue is projected by staff to decrease by 0.2 percent of GDP after incorporating prudent projections for receipts from corporate profit taxes and indirect taxes on imports, and recognizing the authorities’ envisioned downward path in nontax revenue. The former was based on a less substantial jump than assumed by the authorities and the previous staff projection, which reflects a more cautious forecast in the recovery of financial and industrial sector profits from currently depressed levels. In the staff’s estimates, the large overperformance in import duties during 2003/04 is only partially carried forward into the 2004/05 projection, reflecting lower projected import growth.9 The authorities explained that they had taken into account the full-year impact of the revenue measures implemented in the course of 2003/04, notably those relating to the strengthening of both customs administration and tax enforcement procedures.

26. The authorities project higher spending in 2004/05 by 0.6 percent of GDP, led by a doubling of the Food Security Program (FSP) and higher defense and poverty-reducing expenditure. The authorities envision defense expenditure returning to the nominal level (Br. 3 billion) initially budgeted in 2003/04 after compressing military spending this year in light of an expected revenue shortfall. Poverty reducing expenditures increase as a share of GDP (to 18.4 percent). The staffs’ revised projection entails lower recurrent spending on “other” items to contain spending growth, as the authorities expressed optimism that a switch to performance-based budgeting in 2004/05 would contribute to securing additional savings in this area. The mission also suggested that the scaling-up of FSP outlays be phased in with concurrent steps to ensure greater accountability in the use of transfers by regional governments, preferably through more timely external audits of achieved outcomes. There is also a need to address the lack of capacity to absorb additional FSP transfers in several regions. The staff also noted that these efforts to contain spending in light of tighter financing could be facilitated if the authorities reconsidered the proposed increase in defense spending as a share of GDP.

27. Taking into account the expected net foreign financing, the staff urged the authorities to limit the government’s domestic borrowing requirement to 1.5 percent of GDP in 2004/05, with a view to achieving a decline in the inflation rate and in the ratio of domestic debt to GDP. Additional measures to reduce the deficit by about 2 percent of GDP would be required to bring the domestic borrowing requirement to a level consistent with achieving the objective of reducing the public debt, and containing monetary expansion in line with the government’s inflation target10. In view of this and the expected near term deterioration of the external debt situation, the strategy should be to significantly reduce domestic debt as a share of GDP, and set total public debt on a downward path over the medium term. To this end, the staff stressed the importance of developing and publicizing a comprehensive debt management strategy covering all public debt (both domestic and external). The strategy should articulate clear limits to the acceptable level of borrowing with appropriate steps to ensure that all government borrowing decisions are only approved if consistent with its public debt strategy.

28. The authorities considered the staff’s tax revenue projections to be too cautious. They agreed, however, that it was important to continue to seek additional donor grants to support the expansion of the food security program. They stressed that they would continue to monitor budget developments closely ensuring that government borrowing remained consistent with medium-term sustainability, and that private borrowing and investment was not crowded out.

29. Structural fiscal reforms in tax and customs administration will continue after making significant progress during 2003/04. Tax collection and enforcement procedures are being improved by putting in place effective tools to collect tax arrears, including applying liens on property and account balances, and preparing auctions for seized property next year (the non-filing rate has improved from over 35 percent of taxpayers to under 20 percent since the new procedures were established this fiscal year). Customs administration is also being substantially improved by recruiting college graduates to bolster human capital, providing enhanced training and streamlining clearing procedures for goods and facilitating collections. As the authorities’ attention shifts increasingly to revenue administration from tax policy, the mission suggested making efforts to improve the value-added tax (VAT) refund mechanism in light of low refund requests by international standards, possibly as a result of overly stringent auditing and enforcement procedures.

30. Reform priorities in public expenditure management in 2004/05 will focus on bolstering local government capacity after two waves of major fiscal decentralization. The authorities identified reform priorities for 2004/05 consistent with the key recommendations of the second Assessment and Action Plan (AAP) for tracking poverty-reducing spending, which include (i) improving budget reporting to facilitate timely general government consolidation by revising and extending the chart of accounts to all regions; (ii) automating budget accounting systems, networking regional governments and rolling out double-entry cash accounting to all regions; (iii) clearing the backlog of unaudited accounts to under one year from over five years; (iv) continuing the civil service overhaul; (v) enhancing cash management; and (vi) improving budget formulation and reporting by reaching agreement with donors on a standardized reporting form to more accurately estimate all inflows and their destination, including grant-financed project spending.

C. Monetary Policy and Financial Sector Reforms

31. The authorities have targeted monetary expansion to be in line with their projection of nominal GDP growth. This assumes a somewhat higher GDP growth than the staff projection and a small decline in the income velocity of money that is not assumed in the staff projection. The staff explained that in the present environment of stronger inflationary pressures and financially weak banks, it would be prudent to avoid projecting a decline in velocity. As the authorities plan to build up foreign reserves at a slower pace than last year, their monetary target for 2004/05 allows for a substantial increase in credit to the nongovernment sector in addition to the planned increase in credit to government. The staff explained that such a stance of monetary policy carried serious risks of magnifying the current inflationary pressures. To avoid this risk, the staff recommended the adoption of more moderate targets for the expansion of money and credit to the government.

32. While progress is being made to address the restructuring needs of financial institutions, further efforts are needed to resolve the structural problems facing the CBE, the CBB and the DBE, and to strengthen the capacity for bank supervision. 11 The staff noted that by exploiting the restructuring and reform of state-owned banks and ensuring that they become financially viable, they would be better able to expand their financial intermediation role. While the implementation of the CBE restructuring plan has progressed as planned (Box 3), a continued full implementation of the plan is essential in 2004/05. As the privatization of the CBB has been postponed again due to a delay in preparing up-to-date audited accounts, completing this task as quickly as possible would help move the privatization process forward. Since the financial situation of the DBE has remained weak despite the financial restructuring implemented in 2003, a comprehensive audit will need to be conducted to provide the basis for developing a new financial restructuring plan for the DBE. The staff noted that the supervision department of the NBE had conducted on-site inspections (30 in total) and developed corrective actions that the banks subsequently implemented. Nonetheless, since the inspections have not been as frequent as required (once in every year), and the supervision department has suffered from a loss of experienced staff, due in particular to insufficient remuneration, the mission suggested that steps be taken to address these issues.

Restructuring of the Commercial Bank of Ethiopia (CBE)—Update

Restructuring of the CBE has been implemented as planned so far. A comprehensive financial restructuring of the CBE started in November 2003 with a view for the CBE to becoming a sound and profitable bank. The CBE instituted a policy to limit rescheduling/renewal of nonperforming loans (NPLs) to two iterations in January 2004, as a prior action of the PRGF fifth review, and two structural performance criteria for end-June 2004 have been implemented: (i) removal of the maximum annual write-off limit of Br.100 million in May 2004 through the approval of a revised write-off policy by the CBE Board; and (ii) transfer of cofinanced loans (Br. 1,029 million) in June 2004 from the CBE to the DBE in exchange for a government-guaranteed bond (Br.392 million) with discount factor equivalent to the amount of the provisions already constituted on these loans (Br.637 million). According to the Memorandum of Understanding (MOU) co-signed by the CBE, the DBE, and the MOFED in June 2004, the government-guaranteed bond will be repaid out of state dividends by the CBE during 2003/04-2004/05 (projected to be Birr 189 million in 2003/04 and Br.524 million in 2004/05). Following the removal of the annual write-off limit, the authority to write-off loans was transferred in June 2004 from the Board of the CBE to management.

From end-June 2003 through end-March 2004, NPLs declined, while capital increased. The ratio of NPLs to total loans at end-March 2004 declined to 46 percent (including the Djibouti branch loans) from 54 percent at end-June 2003 through a combination of cash collection, rescheduling/renewals, and foreclosures. The ratio is estimated to have declined further by end-June 2004, with the transfer of cofinanced loans to the DBE and the write-off by Br.20 million already implemented as planned. The capital adequacy ratio rose to 13.2 percent at end-March 2004 (before state dividend payment) from 10 percent at end-June 2003. The financial restructuring plan envisages the NPLs to decline to 37 percent of total loans by end-June 2004, while the risk-weighted capital adequacy ratio will remain above 10 percent. Audited accounts are expected to become available in October 2004

33. The staff believes that financial sector reform should be accelerated. Over the medium term, financial sector reforms should aim at promoting financial intermediation and the growth of savings and investment, and at providing the NBE with the necessary instruments for actively controlling reserve money and influencing market-determined interest rates. The staff noted that by allowing foreign bank entry and addressing the near monopoly status of the CBE, competition in the banking sector and efficiency could be enhanced. By ensuring that access to financial services—savings and credit—is fully extended to the rural sector, a significant constraint to agricultural production could be alleviated. To meet the credit needs of small- and medium-size enterprises, it would help to extend the range of lending instruments beyond short-term, collateral-based credit. The savings mobilization effort could be strengthened by introducing appropriate savings instruments that carry positive real interest rates. The staff also stressed that prudent monetary policies would have to be pursued by containing any inflationary domestic bank financing to the government, and when necessary, by sterilizing the monetary impact of any excessive external inflows and contain inflationary pressures. The authorities indicated that they will continue their efforts to enhance efficiency in the financial sector. They consider, however, that they are not yet ready to allow foreign banks to enter the financial sector, and that priority should continue to be given to strengthening the domestic banks and enhancing supervision by the NBE. The staff and the authorities agreed on the importance of fostering microfinance institutions.

D. Other Structural Reforms

34. As noted in the EPA, accelerating growth will require an accelerated implementation of structural reforms in collaboration with the World Bank. While the authorities have made significant progress during the past year with the implementation of such reforms in support of rural and private sector development, a number of important challenges remain.

  • The staff stressed that significantly accelerating growth in agricultural production would require rapid progress in improving (a) the functioning of input and output markets, (b) access to rural financing, (c) security of land tenure, (d) technical support and capacity building, and (e) the pursuit of vigorous risk management mechanisms.

  • With regard to private sector development, it would be important to achieve significant progress in privatizing the remaining public enterprises, removing the impediments to private sector development and foreign trade identified in the Diagnostic Trade Integration Study (DTIS).12 Equally important would be implementing the Industrial Development Strategy and current initiatives to integrate Ethiopia’s economy into the global economy (including accession to the WTO, participation in the COMESA FTA, and the EU EPA).

  • Finally, the authorities were also encouraged to press ahead with their ongoing efforts to enhance the efficiency of the Customs Authority, revise the federal urban land lease law, revise the recently adopted Competition Policy to clarify that regulations are intended only to limit anti-competitive behavior, further strengthen dialogue with the private sector, and to improve access to telecommunications services, including through the partial liberalization of the sector.

E. External Projections and Policies

35. Over the period 2004/05–2006/07, the external current account deficit (excluding official grants) is projected to narrow progressively as a percent of GDP. With export volume growing more strongly than import volume and some improvement in the terms of trade over the outer years, the trade deficit is also forecast to narrow somewhat. Despite the recent expansion of Ethiopian Air Lines’ (EAL) fleet of aircrafts, the net inflows of services as well as private transfers are projected to decline relative to the exceptionally high levels of 2003/04. Nonetheless, this weakening in the balance on services and private transfers is not expected to offset the improvement in the trade balance. However, with the projected decline in inflows of official transfers, the current account deficit (including grants) is likely to widen over the projection period. As a result, despite a substantial increase in net capital inflows (largely long-term loan disbursements) in 2004/05 and lower debt service payments resulting from recent debt relief under the HIPC Initiative and bilateral debt cancellations, the overall balance of payments is expected to shift to a large deficit. Moreover, as the capital account surplus is projected to decline over the outer years, the overall balance will continue to be in substantial deficit. Consequently, the foreign reserves cover of imports is likely to decline, though remaining within a comfortable range of 4.5-5 months of imports.

Medium-Term Balance of Payments

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Source: Staff projections

Fiscal year ending July 7.

36. The current level of the exchange rate does not suggest a competitiveness problem. Services and noncoffee exports have been growing strongly and coffee export volume has also risen over the past year, despite a decline in prices. Nonetheless in the staff’s view, a significant real appreciation should be avoided going forward. The speedy implementation of measures to (i) further liberalize the foreign trade regime, (ii) eliminate any remaining exchange restrictions,13 (iii) streamline customs procedures, (iv) improve access to credit, land availability, competition policies, and infrastructure would go a long way towards achieving this objective.14 Moreover, the suggested stance of monetary restraint and the implementation of proposed measures that increase productivity and cost efficiency would help to strengthen competitiveness further. With the increased openness of the economy to foreign trade and monetary policy geared towards achieving the inflation objective, the staff recommended that the exchange rate be allowed to be fully market-determined, with NBE’s interventions in the foreign exchange market being limited only to smoothing out fluctuations and reducing the volatility of the exchange rate. While broadly agreeing with this approach, the authorities noted that that they intend to avoid any real appreciation of the currency. They furthermore noted that while they have implemented a number of the structural reforms to improve competitiveness, they were at this stage not considering further trade liberalization as this might adversely affect domestic industries.

37. The authorities indicated that they are negotiating with Paris Club creditors the bilateral agreements resulting from the recent agreement to provide debt relief, including topping-up at the completion point under the HIPC Initiative (Box 4). They will also seek comparable treatment from all other official bilateral and commercial creditors. They indicated that they are preparing, with the help of the World Bank and Debt Relief International (DRI), a public debt strategy that will cover both external and domestic debt, although they expressed a view that the focus of external debt sustainability should be on expanding exports rather than constraining borrowing. Similarly, on domestic debt, they noted that the burden on the budget was low (due to low or negative real interest rates), and that they would rely on future revenue growth to contain it, particularly if domestic interest rates were to rise to positive levels in real terms.

Summary of the Paris Club Agreement on the Provision of Debt Relief Under the Enhanced HIPC Initiative

The representatives of the Paris Club creditor countries met in May 2004 and agreed (with one creditor still in the process of taking the necessary legislative steps to join the consensus) on a recommendation to their governments to implement their share of the debt relief effort (including topping-up) approved by the Boards of IMF and IDA at the completion point under the enhanced HIPC initiative. According to the terms of the agreement, the following principal amounts will be cancelled: (i) 100 percent of non-ODA pre-cutoff government and government-guaranteed debt; (ii) 100 percent of the consolidated loans from the 1992 and 1997 Paris Club consolidation agreements; (iii) 22 percent of non-ODA consolidated loans under the Debt Reduction option from the 2001 consolidation agreement (as amended in 2002; and (iv) (74 minus eDR13/05/04) percent of non-ODA consolidated loans under the Debt Service Reduction option from the 2001 consolidation agreement (as amended in 2002) where eDR13/05/04 is a ratio calculated to achieve a comparable debt reduction between creditors who chose the Debt Reduction option and creditors who chose the Debt Service Reduction option in the previous consolidation agreements. The terms of the agreement are therefore more favorable than assumed by the staff under the completion point, and will provide Ethiopia with debt relief of about $83 million more in NPV terms than assumed by the staff. In addition to the agreed terms of treatment, most of the Paris Club creditors committed on a bilateral basis to grant additional cancellations of up to 100 percent of their claims.

F. PRSP Process

38. In May 2004, a multiagency mission of major donors, assessed progress with SDPRP actions and indicators as the basis for providing new financing for SDPRP implementation. The agencies intending to provide direct budget support (DBS) indicated an intention to streamline and harmonize the budget support process. During discussions, the authorities indicated the intention to prepare a second annual progress report (APR) by December 2004 and to take into account the issues raised by the staff in the joint staff assessment of the first APR.

G. Statistics and Technical Assistance

39. The authorities continued to make progress with the implementation of initiatives to improve the quality and comprehensiveness of macroeconomic data, and the timeliness of dissemination. While the Medium-Term National Statistical Plan (MTNSP) has not yet been approved by the Office of the Prime Minister, the Central Statistical Authority (CSA) has started implementation of initiatives aimed at broadening the coverage of macroeconomic data.15 To this end, the CSA conducted a Census of Economic Establishments in March 2004, and technical assistance was requested through the GDDS Initiative for the compilation of a production price index and an index of manufacturing production. Regarding the rebasing of the national accounts, the authorities have decided to establish 1999/2000 as base year, rather than the previously planned 1995/96--the authorities expect this work to be finalized by August 2004. In the area of monetary data, a follow-up STA technical assistance (TA) mission is planned for September 2004 to continue efforts at improving the classification of the data.

40. The government has made some progress in addressing the previously identified deficiencies in external debt management. The Credit Administration Department of the Ministry of Finance is in the process of upgrading its debt management software and providing training to staff with the support of UNDP and UNCTAD. In addition, a Debt Management Committee is soon to be established at a technical level to strengthen the coordination among the various departments of the ministry and the NBE. Furthermore, to facilitate aid delivery and interagency coordination, the government is in the process of launching the centralized Aid Management Platform which would allow both the government (federal and regional) and donors to get a better grip on the amount of foreign assistance delivered and its timing, modalities, recipients, and end use.

41. Efforts aimed at improving data on poverty and social indicators include plans to conduct the Household Income, Consumption and Expenditure Survey (HICES), and Welfare Monitoring Survey during 2004/04–the latter also will include a number of indicators relating to HIV/AIDS.

IV. Staff Appraisal

42. Performance under the three-year PRGF-supported program has been good. Despite the impact of the recent drought, price stability has been maintained, and significant progress has been made with key structural reforms, in particular the commencement of the restructuring plan for CBE and the strengthening of public expenditure management. All the quantitative and structural performance criteria required for the completion of the final review have been achieved. Reaching the HIPC Initiative completion point has also allowed Ethiopia’s external debt to be reduced and brought scheduled debt service obligations to more manageable levels.

43. Ethiopia nonetheless remains highly vulnerable to external shocks, and poverty indicators continue to be among the highest in the world. Achieving faster growth and the Millennium Development Goals will require higher levels of external aid, but also improvements in the capacity to effectively absorb and use such assistance through accelerated implementation of financial sector and other structural reforms (largely to support rural and private sector development). Higher inflows of external aid could be facilitated by a peaceful resolution of the border dispute with Eritrea and the continued reorientation of public resources to poverty related expenditures.

44. Achieving the MDGs will require significantly greater levels of external assistance, and this will need to be largely in the form of grants if debt sustainability is to be maintained. It will be important for the authorities to develop a comprehensive and prudent public debt management strategy which clarifies the rules for containing future domestic and external borrowing to sustainable levels. Consistent with any scenario involving a significant increase in external assistance as a share of GDP, the authorities’ medium-term fiscal framework needs to involve a rebalancing of expenditure to recurrent items, given large gaps in the required number of teachers and medical personnel. The staff strongly supports the authorities’ plan to develop their own fiscal scenarios aimed at achieving the MDGs, but recommends continued close consultation with donors and the Fund, to identify the challenges early and mitigate any potential adverse effects on the broader macro framework arising from a substantial scaling-up of inflows of donor assistance. Significantly higher external assistance would necessarily imply a large deterioration in fiscal and external balances (excluding grants), leaving Ethiopia even more dependent on foreign aid than it is today.

45. Fiscal policy should continue to focus on strengthening expenditure management and enhancing revenues, while containing inflationary domestic financing and reducing the public debt burden. In view of the projected higher level of domestic borrowing needed to finance the 2004/05 budget and the recent pickup in nonfood inflation, however, it will be important to take additional measures to achieve the desired reductions in the debt and the inflation rate. While the staff welcomes the food security program, its implementation should be supported by adequate efforts to strengthen the capacity of local governments to absorb the substantially higher federal transfers, and seek additional donor grants. The latter could be facilitated if the authorities prepared timely external audits of the achieved outcomes. The staff would caution the authorities against institutionalizing the scheme to guarantee the minimum price for maize, wheat and sorghum, to avoid any direct budgetary costs resulting from the scheme, and instead to address the underlying causes of price volatility by improving performance in the agricultural sector and tackling market fragmentation.

46. Significant progress has already been achieved with fiscal structural reforms. Improving public expenditure management remains a critical priority, especially for bolstering the capacity of local governments, given their new expenditure mandates following fiscal decentralization. It is crucially important to continue to progress with consolidating the general government accounts in a timely manner, including regular reporting. Moreover, efforts to consolidate the gains made in improving customs administration should continue, and the VAT refund mechanism should be carefully reviewed along with other audit and enforcement guidelines, to avoid imposing an overly restrictive tax environment that discourages investment and growth.

47. Monetary and exchange rate policies will need to focus on achieving the authorities’ inflation and international reserve targets. The case that the exchange rate should be weaker is not compelling. Nonetheless the staff considers that a significant real appreciation of the exchange rate going forward should be avoided. The authorities should seek to safeguard external competitiveness through structural reforms that improve productivity and efficiency. Measures to further liberalize foreign trade, eliminate remaining exchange restrictions, streamline customs procedures, and implement the recommendations in the DTIS would support these objectives. Moreover, the exchange rate should be allowed to be fully market-determined, with NBE’s interventions in the market being limited only to smoothing out fluctuations.

48. In order to lay firm foundations for achieving a sustained increase in long-term growth compared with the recent past, it will be essential to expedite the implementation of the government’s structural reform agenda. Necessary reforms focus on agriculture (especially enhancing land tenure security), food security, capacity building, export promotion, privatization, and strengthening the legal and regulatory framework. In the financial sector, while progress has been made with strengthening bank supervision and implementing the restructuring plan of the CBE, it will be important to fully implement these initiatives. Regarding the NBE, the staff welcomes the commencement of the restructuring plan, but there is a need to work towards increasing the operational autonomy of the NBE, and the staff would urge the authorities to consider the recommendations of the consultants aimed at strengthening the NBE’s independence. The staff also urges the authorities to open up more of the financial sector to the private sector, including by allowing foreign bank entry.

49. Data provision to the Fund remains adequate for surveillance purposes, and the staff welcomes the development of a comprehensive Medium-Term National Statistical Plan and efforts to improve data on poverty and social indicators.

50. The staff recommends that the final review under the PRGF be completed. It is proposed that the next Article IV consultation with Ethiopia be held within 24 months, subject to the provisions of Decision No. 127 94–(02/76) on Article IV consultation cycles, as amended.

Figure 1.
Figure 1.
Figure 1.

Ethiopia: Selected Economic Indicators, 1999/2000-2006/07 1/

Citation: IMF Staff Country Reports 2005, 025; 10.5089/9781451812718.002.A001

Sources: Ethiopian authorities; and staff estimates and projections.1/ All data pertain to the period July 8-July 7. Shaded area indicates program period.2/ In months of imports of goods and nonfactor services of the following year.3/ Excluding special programs.4/ In percent of deposits.5/ Change in percent of beginning-of-period broad money.6/ Includes credit to public enterprises and the private sector.
Figure 2.
Figure 2.

Ethiopia: Exchange Rate Developments, January 1998-March 2004

Citation: IMF Staff Country Reports 2005, 025; 10.5089/9781451812718.002.A001

Sources: IMF, Information Notice System; National Bank of Ethiopia; and staff estimates.1/ Until September 2001, the marginal rate at the foreign exchange auction conducted by the National Bank of Ethiopia; thereafter, the transaction-weighted foreign exchange interbank market rate.
Table 1.

Ethiopia: Schedule of Disbursements and Repayments Under the PRGF Arrangement, 2004-05

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Source: Fund staff calculations and projections.

With Board-approved HIPC Initiative assistance

Quota of SDR 133.7 million.

Table 2.

Ethiopia: Proposed Schedule of Remaining Disbursements and Conditions for Disbursement Under the PRGF Arrangement, 2004

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Table 3.

Ethiopia: Selected Economic and Financial Indicators, 2002/03-2008/09 1/

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Sources: Ethiopian authorities; and Fund staff estimates and projections.

Data pertain to the period July 8-July 7.

Excluding special programs.

Whole series was revised.

After enhanced HIPC Initiative relief. Exports of goods and services used.

After enhanced HIPC Initiative relief. Revenues exclude grants.

Before debt relief; on an accrual basis; in percent of exports of goods and nonfactor services.

After enhanced HIPC Initiative relief.

Table 4.

Ethiopia: General Government Operations, 2002/03-2008/09 1/

(In millions of birr)

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Sources: Ethiopian authorities; and Fund staff estimates and projections.

Fiscal year ending July 7.

The revised projection is based on current policies and identified financing. The medium-term baseline reflects staff-recommended adjustment based on identified financing consistent with the inflation target and sustainable public debt.

Excluding special programs (demobilization and reconstruction).

Demobilization and reconstruction.

Figures for external financing and grants are provided by donors, and differ in some cases from government estimates.

External interest payments are presented after traditional debt relief up to 2003/04, but following the completion point in 2003/04 are presented after HIPC Initiative relief starting in 2004/05. HIPC Initiative relief below the line becomes zero beginning in 2004/05 following the completion point. The authorities after 2003/04 continue to provide figures gross of debt relief.

Unidentified financing is assumed to be filled from above the line, either as additional grant financing or through measures to be identified.

In cases of unidentified financing, the balance excluding grants is calculated assuming that additional measures are taken to close the gap, rather than higher grants.

Table 5.

Ethiopia: General Government Operations, 2002/03–2008/09 1/

(In percent of GDP)

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Sources: Ethiopian authorities; and Fund staff estimates and projections.

Fiscal year ending July 7.

The revised projection is based on current policies and identified financing. The medium-term baseline reflects staff recommended adjustment based on identified financing consistent with the inflation target and sustainable public debt.

Excluding special programs (demobilization and reconstruction).

Demobilization and reconstruction.

Figures for external financing and grants are provided by donors, and differ in some cases from government estimates.

External interest payments are presented after traditional debt relief up to 2003/04, but following the completion point in 2003/04 are presented after HIPC Initiative relief starting in 2004/05. HIPC Initiative relief below the line becomes zero beginning in 2004/05 following the completion point. The authorities after 2003/04 continue to provide figures gross of debt relief.

Unidentified financing is assumed to be filled from above the line, either as additional grant financing or through measures to be identified.

In cases of unidentified financing, the balance excluding grants is calculated assuming that additional measures are taken to close the gap, rather than higher grants.