The Federal Democratic Republic of Ethiopia
Selected Issues and Statistical Appendix

This Selected Issues paper on The Federal Democratic Republic of Ethiopia highlights that accelerating private sector development is the key to increasing and sustaining growth, and providing employment opportunities to raise incomes. Private sector development remains in its infancy, reflecting the slow transition to a market economy, and the contribution of industry to GDP has not changed significantly. The World Bank has identified some key areas to improve the investment climate, which include deeper financial sector reform and acceleration of the privatization program.

Abstract

This Selected Issues paper on The Federal Democratic Republic of Ethiopia highlights that accelerating private sector development is the key to increasing and sustaining growth, and providing employment opportunities to raise incomes. Private sector development remains in its infancy, reflecting the slow transition to a market economy, and the contribution of industry to GDP has not changed significantly. The World Bank has identified some key areas to improve the investment climate, which include deeper financial sector reform and acceleration of the privatization program.

I. Ethiopia: An MDG Scenario

A. Introduction

1. Discussions on strategies for achieving the Millennium Development Goals (MDGs) formed an integral part of the 2005 Article IV consultation, and served to update work started on an MDG scenario during the 2004 Article IV consultation. Thus together with the baseline medium term projections presented in the staff report, an updated alternative MDG scenario was also prepared which draws upon the results of the authorities’ recently completed MDG Needs Assessment Synthesis Report.1 The Synthesis Report itself draws on two separate but complementary strands of work by the government, developed with support from the UN Millennium Project, and the World Bank based on their Marquette for MDG Simulations (MAMS) model.2 In particular, work on the MAMS was used to help estimate different costings for achieving the MDGs and to include costed interventions, particularly in infrastructure, which are not directly related to an MDG, but are needed as part of an integrated strategy to support reaching the MDGs, and particularly that of halving the poverty head count. While the UN work provided a sectoral bottom-up cost assessment, the MAMS uses a different approach, including the incorporation of some second round effects in labor markets and on productivity growth, to provide a possible lower bound to the costs of an MDG strategy. For the Synthesis Report, the authorities developed their own model along similar lines to, and incorporating results from, the MAMS to come up with lower and upper bound public sector costs of achieving the MDGs.

2. The total costs of achieving the MDGs are estimated at US$101 billion, with an upper and lower bound public sector cost of US$76 billion and US$58 billion respectively. The MDG scenario considered here incorporates the lower bound estimate of total public sector costs (US$58 billion), implying a six fold increase in per capita aid flows to US$64 in 2015. The magnitude of aid flows required to attain the MDGs is thus comparable to those included in the illustrative scenario for the 2004 Article IV consultation in which aid flows doubled as percent of GDP. However, while still illustrative, the current scenario is more robust in that it is drawn from sectoral costs identified by the authorities on the basis of the completed needs assessment and guided by work using the MAMS.

Table 1.

Ethiopia: MDG Synthesis Report—Projected Sectoral Costs 1/

(in millions of constant 2005 US dollars)

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Notes:

Includes treasury and donor financed components only. The lower bound scenario incorporates cross-cutting efficiency savings that reduce total costs by over 20 percent.

3. These total costs must be broken down into annual expenditures to develop a macroeconomic framework. In their new Plan for Accelerated and Sustained Development to End Poverty (PASDEP) the authorities have developed an initial five year Macroeconomic and Fiscal Framework (MEFF) which identifies projected government expenditures from the lower bound MDG cost estimate presented in the Synthesis Report. However, while the MEFF shows the estimated on-budget component of spending needed to achieve the MDGs, it does not capture the large infrastructure expenditures by public enterprises that are required. Nor does it include some significant off-budget programs to be supported by local communities and NGOs. In view of this, and the shorter time frame of the 5-year MEFF, the scenario presented here includes the costs incurred by non financial public enterprises to support achievement of the MDGs by 2015, and is consistent with the total lower bound cost estimates. These have been converted into an annual expenditure framework through 2015, based on simulations produced by the MAMS model which provides for a front loading of infrastructure investments in line with the authorities’ strategy. The financing needs in the MDG macroeconomic scenario are shown as being met through external grants.

B. Macroeconomic Framework and Policies

4. The scenario assumes that increased aid flows are both spent and, through increases in the external current account, absorbed. A key element of the growth strategy is a frontloaded increase in public investment to reduce the country’s severe infrastructure gap. In addition to increasing annual growth to around 7 percent as proposed in the Synthesis Report, the framework aims to contain annual inflation to 7.5 percent, to build up gross international reserve cover to 5.5 months of imports, and to protect domestic and external debt sustainability. Given the lack of information in the PASDEP or Synthesis Report on the balance of payments impact of MDG expenditures, the scenario presented has had to make assumptions on the import content of expenditures and their phasing, drawing particularly on the infrastructure investment plans of public enterprises. In addition, the baseline assumptions on the contribution of exports to GDP have been maintained. Given that GDP is higher under the MDG scenario, but external demand and international prices remain unchanged, an assumption of increased competitiveness has thus been built in.

5. Discussions with the authorities on a scaling-up scenario focused on the macroeconomic framework to accommodate higher inflows and policies to promote faster growth. Key issues included fiscal sustainability and addressing shocks; public expenditure management, exchange rate policy; the identification of priority policies in agriculture and the private sector to realize the required large improvement in productivity, and the role of infrastructure in promoting growth.

Growth, infrastructure, factor productivity and private sector response

6. As with the 2004 exercise, the MDG scenario includes a growth target of 7 percent, which the authorities consider necessary to halve poverty by 2015. This would represent a significant improvement over past growth trends. An updated growth accounting framework, extending the analysis that was presented in the last Article IV consultation, indicates that attaining this would require a sharp rise in annual total factor productivity (TFP) growth to around 1.5 percent as well as large increases in investment (to over 37 percent of GDP)—see Table 2. While government spending and higher external support would play a key role in improving the delivery of services and infrastructure, the scenario calls for an increased contribution from the private sector. Private investment is assumed to be “crowded in” by infrastructure investment, and market-based reforms would remove obstacles to private sector development to yield faster growth in TFP.

Table 2.

Sources of real GDP Growth

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Source: Ethiopian authorities, and staff estimates and calculations.

7. In support of such growth projections more work has gone into assessing the potential impact of increases in infrastructure investment, and of policy-based improvements in the environment for private sector development, on growth.

  • The impact of infrastructure on growth. Empirical studies suggest that each additional 1 percent of GDP spending on infrastructure can add between 0.5 to 1 percent to the growth rate after 5 years, but that the relationship is non-linear, since diminishing returns may soon set in. In Ethiopia’s case, the low starting point of very poor infrastructure and the desire for a balance between e.g., road construction and electrification which tend to have a more positive impact, give some support for assuming a growth response at the upper end of the range found in empirical studies. Scenarios developed with the MAMs include assumptions of improvements in private sector TFP growth of one percentage point in response to improved infrastructure, and show that in an aid constrained environment, a focus on infrastructure investment produces more rapid GDP growth, allowing the MDG income poverty target to be met. Such scenarios assume a significant private sector productivity response to improved infrastructure provision starting in 2009. Central to this response is the view that infrastructure links producers and consumers to national and international markets and information flows, raising returns to private investment. However, the estimates cannot be entirely empirically based: the unanswered question is whether infrastructure investments would be sufficiently well-designed and implemented to yield a private sector response.

  • Improving agricultural performance lies at the heart of growth prospects and poverty reduction. Raising real output growth in agriculture from a historical average of 2.9 percent to the 7 percent required to accelerate real GDP growth is key. Historically, growth in agriculture production has been driven by increases the area cultivated, rather than improvements in productivity; specifically, yield growth during 1991/92-2004/05 has been flat at around 0.2 percent per year. Given significant pressure on land, sustaining higher rates of growth in agriculture production over the medium term will therefore require substantial improvements in productivity. The authorities’ strategy to achieve this is based on changing the structure of current production (which is mostly subsistence-based) to commercially-oriented small-scale production, including for export. Such a strategy must address many issues including “connectivity”, security of tenure, inefficient input and output markets, access to credit, improved extension services and irrigation. If these can be resolved, the World Bank estimates that with better soil and water management, combined with wider adoption of existing technologies (seeds and fertilizer), Ethiopia could achieve a doubling of cereal yields in food secure areas, and an increase of 50 percent in food insecure areas.

  • Accelerating private sector development is also key to increasing and sustaining growth, and providing employment opportunities to raise incomes. However, private sector development remains in its infancy, reflecting the slow transition to a market economy, and the contribution of industry to GDP has not changed significantly over the last 13 years. There is thus a need to accelerate reforms in order to allow for the assumed strong positive private sector response. The World Bank has identified some key areas to improve the investment climate including; deeper financial sector reform; acceleration of the privatization program, and further urban land reform. In addition, emphasis is needed on providing public goods3 that foster the development of the private sector.

Private savings and financial sector development

8. The MDG scenario entails a significant private sector response to reforms and infrastructure development, as described above. In addition, although not clearly enumerated, the PASDEP implies a substantial amount of financing for planned public enterprise spending will be sourced domestically, both from internally generated resources, and from recourse to domestic bank borrowing. While currently commercial banks, most particularly the state owned Commercial Bank of Ethiopia (CBE), hold excess reserves (see below), it is clear that private savings and their intermediation will need to rise over time to support higher private investment and the financing needs of public enterprises. This highlights the need for financial sector reform over the medium term even if, over a horizon of three years or so, such reforms would not be expected to yield significant gains. There is a risk that without a clear strategy in this area, the gains from scaling up will not translate into a sustained private sector response. If the financial system were to remain an obstacle to the effective mobilization of domestic savings, increasing foreign direct investment (FDI) could be an alternative. While there has been some emphasis given to FDI in the new PASDEP, the MDG scenario does not factor in a large increase in inflows, so that FDI remains low in relation to total private investment.

A consolidated MDG fiscal framework

Coverage of fiscal activities

9. The coverage of fiscal operations in the MDG scenario is broader than the definition of general government used by the authorities and presented in the staff report. A significant share of infrastructure investments would be undertaken by the largest public enterprises, including the Ethiopia Electricity and Power Company (EEPCo), the Ethiopia Telecommunications Company (ETC). The aim of these programs is to extend electricity coverage from 16 to 50 percent of the population during the next five years, and improve telecommunications and Internet connectivity rates. These social development investments are not solely commercially oriented, and if tariffs are not permitted to rise sufficiently to cover the higher operating costs then the budget might need to absorb these quasi-fiscal costs through explicit transfers, or implicitly through lower dividends and tax concessions. In addition, a significant share of these investments is to be financed by government-guaranteed bond sales to the major state-owned commercial bank. Given the potential for these contingent liabilities, the fiscal presentation for the MDG scenario consolidates the full costs of achieving the MDGs, including the off-budget social development mandates of public enterprises.

Infrastructure composition

10. The fiscal strategy is driven primarily by the relative frontloading of infrastructure investments. Figure 1 compares the phasing of recurrent and capital spending during the first and second five-year periods leading up to 2015.4 Although infrastructure investments do not contribute directly to the MDGs, the relative frontloading of this spending is projected to lessen the cost of recurrent social service delivery over the medium term while “crowding in” private savings and investment. In this manner, higher public and private productivity growth will mitigate the risk of Dutch Disease by enabling the economy to more effectively absorb higher public spending with a relatively higher domestic content. The scaled-up level of capital spending would require a dramatic 6.5 percent of GDP increase in external assistance to 20.4 percent of GDP in 2006/07 (Table 2), compared to that projected for 2005/06 under the baseline scenario. However, the 2005/06 projections do not include the off budget spending and financing needs of public enterprises. For a better comparison, if the estimated off-budget expenditure plans of ETC and EEPCo are included in the 2005/06 fiscal projections, then the required increase is reduced to around 5 percent of GDP.

Figure 1.
Figure 1.

Ethiopia: Phasing of Capital and Recurrent Costs to Achieve the MDGs

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

Sources: Staff calculations and World Bank MAMS simulation.
Expenditure composition

11. The medium-term fiscal framework involves a significant shift in expenditure composition (Tables 2 and 3).5 Total infrastructure spending on roads, power, telecommunications and the railroad increases by 12.2 percent of GDP between 2005/06 and 2010/11. Capital spending on roads is the largest cost in the public investment program with an increase of about 6.3 percent of GDP between 2005/06 and the peak in 2010/11. In contrast, recurrent pro-poor spending increases steadily to reach 10.7 percent of GDP by 2015/16, or 5.3 percent of GDP higher than 2005/06. Defense outlays continue to adjust as a share of GDP to create additional fiscal space for pro-poor expenditures. Pro-poor spending peaks in 2010/11 at 37 percent of GDP but remains steady at about 75 percent of total spending throughout the scenario (Figure 2). Between 2005/06 and 2015/16, pro-poor expenditures increase by almost four times in per-capita dollar terms.

Table 2.

Ethiopia: Fiscal Operations in MDG-LOW Scenario, 2006/07–2015/16 1/

(in millions of birr)

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Sources: Authorities and staff estimates.

Fiscal year ending July 7.

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

Domestic balance defined as own-source revenue less total spending excluding earmarked donor aid and external interest payments.

Beginning from 2004/05, external interest and amortization are presented net of HIPC debt relief.

Table 3.

Ethiopia: Fiscal Operations in MDG-LOW Scenario, 2006/07–2015/16 1/

(as a percent of GDP)

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Fiscal year ending July 7.

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

Domestic balance defined as own-source revenue less total spending excluding earmarked donor aid and external interest payments.

Beginning in 2008/09, external interest and amortization are presented after debt relief.

Figure 2.
Figure 2.

Ethiopia: Expenditure Composition of the MDG Scenario

(as a percent of GDP)

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

12. The public sector wage bill increases in line with the scaling up of recurrent social spending. The wage bill is projected to increase by 3.2 percent of GDP between 2005/06 and 2015/16 consistent with the findings in the initial 2004 Article IV MDG scenario. However, these projections are based on annual sequencing generated by the MAMS model. As a result, the projections depend on the success of investments in the education system in producing sufficient skilled workers to alleviate pressure on economy-wide wages.

Domestic revenue and the exit strategy

13. Domestic revenue needs to increase dramatically to enable an orderly exit from heightened aid dependence. Following the 2015 target to achieve the MDGs, donors could revert to previous ODA levels. As a result, the exit strategy from aid dependence should aim to raise domestic revenue during the next ten years so that at least recurrent spending can be financed from own resources. In this manner, the government can avoid recourse to unsustainable domestic borrowing to offset declining external assistance. Consistent with this objective, the MDG scenario targets an increase in the revenue ratio to around 22½ percent of GDP from under 17 percent of GDP in 2006/07. The higher level of domestic revenue would cover both the scaled-up level of recurrent spending at 19 percent of GDP, and a portion of the public investment program (Figure 3). Real GDP growth will play an important role in defining the scope for expanded real government spending in the context of fiscal sustainability and an acceptable level of aid dependency. Given this, and to safeguard the exit strategy, spending plans would need to be carefully reassessed over the medium term in light of the growth effects of the initial expansion in infrastructure spending, accelerated private-sector development, and other growth-promoting reforms.

Figure 3.
Figure 3.

Ethiopia: Formulating an Exit Dtrategy from Aid Dependency

(as a share of GDP)

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

14. The large revenue increase would need to be supported by both strong structural reforms in revenue administration and improved tax policies. Structural reforms need to focus on strengthening the large taxpayer office, and institute the functional reorganization of tax administration. In particular, the audit, compliance and taxpayer service functions need to be significantly enhanced to support a more effective revenue administration. Reforms in the customs administration should aim to strengthen post-release verification, anti-smuggling efforts, and modernize human resources. The distortionary system of commodity- and industry-specific exemptions from import tariffs should be reviewed to broaden the tax base and lower the average effective tariff rate, which is currently high at almost 20 percent. In addition, tax policy reforms should aim to bolster buoyancy given the envisaged pick-up in growth. Figure 4 illustrates that achieving the ambitious domestic revenue target would place Ethiopia on the high end of current revenue ratios among sub-Saharan African countries. Tax policy reforms also need to avoid regressive taxation that would run counter to the pro-poor objective of the MDG strategy.

Figure 4:
Figure 4:

Regional Comparisons of Domestic Revenue Effort

(as a share of GDP)

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

Source: IMF staff estimates and country authorities. Revenue ratios are calculated on the basis of data for 2003/04 for Kenya, Tanzania and Uganda and calendar year 2004 for Mozambique and Zambia. Ethiopia data correspond to 2004/05.
Public Expenditure Management

15. Strengthening public expenditure management and capacity building will be vital to support implementation of the MDG scenario, especially at the subnational level where the scaled-up resources to enhance social services will ultimately be spent (see Box below). In addition, the large role to be played by public enterprises, and their substantial impact on macroeconomic developments—including domestic and external borrowing levels, and import demand—argue for their consolidation into the budgetary accounts, or, at a minimum, enhanced monitoring of their activities. Timely fiscal reporting based on double-entry accounting data will be a priority to improve fiscal transparency and accountability, and to reassure the public and donors that the scaled-up aid flows are being well utilized. In addition, timely preparation and auditing of the fiscal accounts will be priorities to ensure that actual spending accords with budget appropriations.

Reforming Public Financial Management (PFM)

Ethiopia is pursuing a comprehensive reform of its public financial management (PFM) systems under the umbrella of the Civil Service Reform Project (CSRP). Enhancing administrative capacity is essential to improve the efficiency of public spending and to effectively absorb scaled-up donor assistance. In this context, accelerated implementation of reforms in budgetary management is especially critical.

  • Budget preparation: To improve the link between policy objectives, appropriations and performance indicators, the government is embarking on a transition towards program-based budgeting. The government may proceed on a pilot basis with a number of line departments during 2005/06. In support of this initiative, the medium-term expenditure framework will also require strengthening.

  • Budget execution: More timely reconciliation of financing and fiscal accounting data with banking statements and the monetary accounts of the central bank are critical to enhance accountability and transparency.

  • Budget reporting: Timely reporting of the consolidated government outturn is essential to better manage macroeconomic and fiscal policy. As an urgent step, the authorities should clear the backlog of annual fiscal accounts to be finalized and audited so that current budget planning can be based on an assessment of recent performance rather than incremental costing. The authorities should also re-double efforts to include the extra budgetary funds in fiscal reporting. Consolidated monthly reporting based on double-entry accounting data should become more readily available once the Budget Disbursement and Accounting system has been fully rolled out to budget users across all levels of government by end-2006. As an interim step, local governments should submit monthly fiscal reports to the federal consolidation department as well as the regional ministries of finance.

  • Public investment program: The public investment program requires strengthened project selection, prioritization and project management. The infrastructure program of the major public enterprises is reportedly integrated into the project planning of line departments. Nonetheless, the rapid scaling up of large investment programs would need to be very carefully managed.

Resource gaps and the need for external financing

16. Despite the large increase in targeted revenue, scaled-up spending would result in large annual financing gaps. Figure 5 illustrates that the fiscal deficit excluding grants increases sharply, peaking in 2010/11 at almost 30 percent of GDP. MDG-related expenditure is the driving factor behind the widening fiscal deficit, however domestic resources would be clearly inadequate to finance higher spending by 20 percent of GDP between 2005/06 and 2010/11. The resulting annual resource gaps are met by a projected increase in external assistance reaching over US$6 billion in 2015/16, an increase in per capita terms from about US$11 in 2004/05 to almost US$65 by 2015/16.

Figure 5.
Figure 5.

Ethiopia: Assessing Aid Dependency

(as a share of GDP)

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

17. The composition of scaled-up aid in this MDG scenario is more heavily weighted towards earmarked project support than in the initial 2004 Article IV exercise. The principal aid modalities in this scenario include project grants tied to infrastructure and road investments, and direct budget support to cover higher recurrent pro-poor spending and related capital spending in the health and education sectors. This represents a shift in the projected composition of aid compared to the earlier model that presumed scaled-up ODA would be largely delivered as untied direct budget support.

Debt Sustainability

18. In addition to meeting priority spending, fiscal policy should be geared to protecting public debt sustainability and enabling an orderly exit from higher aid in due course. Although the growth strategy underlying the MDG scenario seeks to lower vulnerability to climatic shocks through reducing the reliance in rain-fed agriculture, a significant risk will remain. In addition, a greater reliance on external budget support may add an further vulnerability. The MDG scenario thus assumes a declining domestic debt path to around 22 percent of GDP (see Annex).

19. Given the magnitude of the resources needed under the MDG scenario, required external financing is assumed to be predominantly in the form of grants to ensure external debt sustainability. Under this assumption, the projected NPV of debt-to-exports ratio, after assumed full delivery of MDRI relief, is maintained at between 60–80 percent. Sensitivity analysis highlights the risk of contracting new debt, even on concessional terms.

Replacing a third of the currently assumed inflow of grants with concessional loans, results in an increase in the projected NPV of debt-to-exports ratio to 150 percent.

A01ufig01

Ethiopia: NPV of debt-to-exports ratio

(in percent)

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

Note: The MDG scenario DSA results are not comparable with those presented in the staff report as the GDP, exports, and external financing projections, are different.

Aid absorption, spending,6 and “Dutch Disease”

20. The assumption that higher public spending is matched by increased foreign aid in the MDG scenario, raised questions about the potential of “Dutch Disease”, and policies to mitigate this. To date, aid inflows have not resulted in an appreciation of the exchange rate or pressures on real interest rates (see the 2004 The Federal Democratic Republic of Ethiopia: Selected Issues and Statistical Appendix, Series: Country Report No. 05/28). However, past experience may not be a reliable guide to future developments. Increasing aid flows since 2000, particularly in the form of budget support, took place when there was a pressing need to reestablish macroeconomic stability, and a significant proportion of aid was effectively saved, resulting in a large accumulation of international reserves. Thus, potential pressures for an appreciation were mitigated by a policy under which part of the inflows were neither spent nor absorbed.

21. This approach is not envisaged in the MDG scenario which assumes aid is absorbed and spent, with a corresponding increase in the fiscal and current account deficits (excluding grants). In this context, a heavy front loading of infrastructure spending with a high import content could limit pressures for an appreciation of the exchange rate in the initial years of scaling up. However, after the initial surge in infrastructure spending, the pattern of spending would shift toward recurrent expenditure that is expected to have a lower import content. At this time, some real exchange rate adjustment may be necessary and appropriate in response to the sustained higher level of aid. This is reflected in the MDG scenario in a modest real exchange rate appreciation in the second half of the projection period. While this should help stimulate absorption, the scenario assumes some build up of reserves to cushion the impact of potentially unpredictable and lumpy aid disbursements, particularly post 2015, when levels of aid flows are likely to decline. The scenario also takes into account the authorities’ aim, as outlined in the Needs Assessment, to move towards a sustainable trade and current account deficit that can be financed through foreign borrowing, remittances and foreign investment inflows.

22. Projections adopted by the authorities, influenced by simulations conducted using the World Bank’s MAMs model7 suggest that the envisaged levels of spending would have a modest impact on the relative price of non-tradables. Nevertheless, it also recognized that care was needed to ensure that training activities in the non-tradables sector, particularly in health and education, were geared to projected demands to avoid undue pressure in wage rates. The MDG scenario thus assumes that this potential labor market constraint is addressed through investment in the education system to increase the availability of skilled labor, thereby easing pressure on economy-wide wages from higher social spending. In practice, nontraditional hiring practices are also being pursued, such as training semi-skilled health extension workers. Moreover, productivity gains derived from increased infrastructure spending during the first five years of scaling-up could subsequently mitigate any adverse impacts on competitiveness from an real appreciation .

23. Overcoming absorptive capacity constraints will be critical to the effective implementation of the MDG scenario, and the avoidance of Dutch Disease. While there are clearly major challenges involved, Ethiopia has already made a good start in many areas. Large scale infrastructure programs are already underway underpinned by comprehensive sectoral assessments and plans. In particular, import heavy investments in telecommunications, energy and roads are currently being implemented, and plans are in place to accelerate them. Thus, while the MDG scenario presented here is illustrative, there is a strong foundation to its assumption of an absorption of aid through large scale imports in the early years. Key to implementing it will be managing the required aid flows and investment operations.

24. In another key area, education, Ethiopia is also well advanced offering good prospects that planned investments in training and facilities will ease labor market constraints at a later date. Assessments by the UN8, suggest that Ethiopia will probably meet the MDG goal of achieving universal primary education even before 2015. Over the last 5 years enrollment rates have been increasing by about 13 percent per annum. In addition, during the first Sustainable Development and Poverty Reduction Program (SDPRP) covering 2000/01-03/04, a major Technical and Vocational Education and Training (TVET) initiative was launched, and an expansion of the university system undertaken. Both these initiatives are already yielding results: to date enrolment in TVET has risen from 25,000 to 102,649 and university intake capacity from 42,132 to 172,111.

Exchange rate policy

25. Given the scenario described above, Dutch Disease may not be a major concern. Nonetheless there could be periods when the authorities would need to sterilize the liquidity impact of the aid-related spending. More generally, the management of potentially large and lumpy aid inflows will be a challenge that will require a mix of policy responses depending on the specific circumstances, including a temporary accumulation of reserves, until the aid flows can be productively spent. In present circumstances, there is limited scope for the Ethiopian authorities to use market-based domestic instruments to sterilize such liquidity. In the presence of significant excess reserves in the banking system, NBE efforts to reduce liquidity through treasury bill sales tend to be ineffective as the direct effect on bank lending and economic activity in general is very weak. Against this background, foreign exchange sales would be expected to play a dominant role in sterilization, at least until steps have been taken to develop the financial system in a manner that reduces the dominance of the CBE, which continues to militate against the efficacy of market-based instruments of monetary policy. The already high level of public domestic debt, at over 30 percent of GDP, also argues against reliance on domestic sterilization measures. The management of the exchange rate will thus have to be much more flexible under an MDG scenario than is currently the case.

Monetary policy and excess reserves

26. The authorities tend to view excess reserves as “savings” that should be mobilized to help fund higher MDG related infrastructure spending. In this manner, promoting an increase in credit to public enterprises would both provide extra-budgetary funds for infrastructure development, and also alleviate the problem of chronically high excess reserves. However, such credit expansion would need to be effected cautiously and monitored carefully. Planned recourse to large scale domestic bank financing by public enterprises carries risks for monetary and price stability, and a potential crowding out of the private sector. Further, such activities would need to be pursued within the context of a broader macroeconomic and fiscal framework that includes the activities of public enterprises, so as to be able to asses the potential risks.

Ethiopia: A History of Excess Reserves

Chronic excess liquidity remains a major obstacle to financial market development and monetary policy implementation, as well as posing a risk to macroeconomic stability. Although all banks hold excess reserves, the CBE accounts for the vast majority of these excess reserves which have recently surged, and stood at Birr 11.3 billion in December 2005, equivalent to 34.7 percent of deposits.

A01ufig02

Ethiopia: Excess Reserves 1998/99-November 2005

Citation: IMF Staff Country Reports 2006, 122; 10.5089/9781451812770.002.A001

Past efforts to reduce excess reserves have had only temporary success. During the conflict with Eritrea in 1999–2000, a number of factors, including a surge in NBE credit to the government and administrative restrictions on foreign exchange which curbed imports, caused excess reserves to rise to 30 percent of deposits. The authorities issued Birr 3.2 billion in two years bonds in November 2000 to reduce this excess liquidity - of which CBE purchased Birr 3 billion - and started to conduct regular treasury bill auctions. The emphasis since then has been on a cautious withdrawal of excess liquidity with the ultimate objective of tightening overall liquidity sufficiently to move treasury bill rates (currently 0.05 percent) up to a level where the 3 percent minimum savings deposit rate can be safely removed. However, after an initial decline, excess reserves continued to rise – mainly reflecting large external inflows, and a compression in commercial bank non-government credit through 2002/03 – and on maturity the two-year bonds were rolled over into 91-day treasury bills by CBE. More recently CBE has allowed these treasury bill holdings to mature, and NBE has stepped in to meet the government’s domestic financing needs, leading to a sharp rise in excess reserves.

27. Too rapid domestic credit growth could result in a large injection of liquidity with its attendant inflationary risks. While such risks will be dampened to the extent that the increased spending goes on imports (and thus also helps absorb aid inflows), the impact on domestic liquidity, on top of the expected aid-funded fiscal injection, will need to be carefully managed. In this context it will be essential to ensure policies are in place to accelerate growth so as to allow for a non-inflationary expansion in money supply. In addition to the broader growth agenda, effectively managing the expected increase in liquidity will require improvements in coordinating and monitoring fiscal and monetary policies, ideally including the consolidation of the operations of major public enterprises into the budget. Given the undeveloped nature of the financial sector, in the short run monetary policy will have to continue relying on direct instruments. Nonetheless, efforts are needed to improve the ability of the NBE to use indirect instruments, and in this light additional work is needed on better liquidity forecasting, and the development of the interbank money and foreign exchange markets. In addition, the prospect of sustained strong credit growth emphasized the importance of improving bank supervision to ensure banking sector soundness.

Concluding remarks

28. The finalization of the MDG Synthesis Report is an important step in working towards achievement of the MDGs. However, as the scenario discussed above illustrates, there are still considerable challenges in translating these costings into an operational framework. The rapid scaling up of additional donor support and expenditures will require concerted actions on behalf of both the authorities and donors, with a vital first step being the resolution of the current political tensions and concerns over governance issues. Other key challenges to be met include:

  • increasing agricultural productivity, and ensuring that supporting policies are in place to achieve the expected private sector productivity response to improved infrastructure provision, necessary to raise GDP growth rates;

  • raising fiscal revenues by over 5 percentage points of GDP in order to cover the recurrent costs of higher spending, and allow for an exit strategy from high aid dependence;

  • strengthening public expenditure management and capacity building to ensure the effective implementation of expenditure plans, including infrastructure investments of public enterprises;

  • addressing potential labor market constraints through appropriate investment and training in order to ease pressures on wages;

  • managing the sequence of spending to mitigate potential pressures on the real exchange rate through an initial focus on import heavy infrastructure investment which results in productivity gains, and eases labor constraints at a later date when the emphasis shifts to recurrent spending.

Table 1.

Ethiopia: MDG Scenario Selected Economic and Financial Indicators, 2006/07–2015/16 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.

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

After enhanced HIPC relief.

Table 4.

Ethiopia: Balance of Payments, MDG Scenario

(In millions of U.S. dollars, unless otherwise indicated) 1/

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

Data pertain to the period July 8-July 7.

Assuming an import content of 50 percent except for ETC (65 percent).

From 2005/06, incorporates debt relief under HIPC (including topping up) and additional bilateral voluntary cancellations.

Public enterprises.

Assumes full delivery of MDRI. The MDG scenario DSA results are not comparable with those presented in the staff report as the GDP, exports, and external financing projections, are different.