The Federal Democratic Republic of Ethiopia
Selected Issues and Statistical Appendix

This Selected Issues paper assesses the implications of a significant increase in the flow of external financing and grants on real GDP growth in Ethiopia. The paper presents an analysis of the sources of growth during 1991/92–2003/04, as well as an assessment of potential GDP growth. The paper also seeks to assess the historical relationship between foreign aid and the performance of the external sector in Ethiopia to establish whether foreign aid inflows have had an adverse effect on the tradable goods sector in the past.

Abstract

This Selected Issues paper assesses the implications of a significant increase in the flow of external financing and grants on real GDP growth in Ethiopia. The paper presents an analysis of the sources of growth during 1991/92–2003/04, as well as an assessment of potential GDP growth. The paper also seeks to assess the historical relationship between foreign aid and the performance of the external sector in Ethiopia to establish whether foreign aid inflows have had an adverse effect on the tradable goods sector in the past.

I. Introduction

1. This selected issues paper provides further background information on four issues emerging from the Article IV consultation, namely: an assessment of the attainability of the authorities’ target for real GDP growth under a scenario which includes significantly higher external aid flows for achieving the Millennium Development Goals (MDGs), an assessment of the potential impact of higher external aid flows within the context of pursuing the MDGs on Ethiopia’s tradable goods sector, an overview of the experience with the decentralization of fiscal powers to regions and districts (woredas), and an overview of the development of the financial sector.

2. Real GDP growth averaged 4.0 percent during 1991/92-2003/04, which was significantly higher than that experienced under the military dictatorship (the Derg regime). Most of this growth originated from the accumulation of factors of production (capital and labor), with total factor productivity contributing only 0.7 percentage points. Potential GDP growth during this period is estimated to be about 4½ percent. Raising the level of growth to 7 percent annually, as targeted under the authorities’ medium-term scenario for achieving the MDGs, would therefore represent a substantial improvement over the experience of the past 13 years. Achieving the targeted growth rate in the context of a significant scaling-up of external aid flows would be possible, provided that the increase in resource availability is accompanied by a marked acceleration in the implementation of reforms aimed at supporting agricultural production, private sector development, and exports.

3. According to the “Dutch disease” hypothesis, foreign aid represents a real transfer of tradable goods, which could increase the demand for, and the relative prices of, nontradable goods (a real exchange rate appreciation), causing a relative reduction in the size of the tradable goods sector. There is, however, no evidence that aid flows in the post-1991 period (i.e. following the overthrow of the Derg regime) caused a real appreciation, nor adversely impacted noncoffee exports. However, given that the resource flows required to achieve the MDGs would be significantly higher than in the past, upward pressure on wage and price levels would be expected to cause a real exchange rate appreciation, and it would thus be prudent to implement policies to counter such pressure. There are two main routes through which the demand-driven pressures on the exchange rate can be moderated: channeling part of the increased domestic demand abroad via further opening-up of the economy to foreign trade; and meeting part of the increased demand by increasing the supply of domestically produced goods and services by boosting productivity and cost efficiency.

4. The possibility of significantly higher aid flows to support achievement of the Millennium Development Goals (MDGs), underscores the need to develop the capacity of fiscal institutions in order to improve poverty-reduction outcomes. Advancing structural reforms in the areas of fiscal decentralization, public expenditure management (PEM) and revenue administration will represent key aspects of the broader reform agenda. In addition, pursuing these reforms will support decentralized democratic governance, strengthen budgeting capacity, and build institutions that foster private sector development.