The Federal Democratic Republic of Ethiopia
2005 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for The Federal Democratic Republic of Ethiopia

The Federal Democratic Republic of Ethiopia’s 2005 Article IV Consultation reports that domestic credit growth has accelerated, driven by strong demand from the government, public enterprises, and the private sector. High import content, particularly from public infrastructure investments, together with higher oil imports, has translated into widening trade and current account deficits, and emerging pressures on international reserves. Inflation pressures are rising, driven by both demand pressures and higher import costs. The real effective exchange rate has appreciated moderately.

Abstract

The Federal Democratic Republic of Ethiopia’s 2005 Article IV Consultation reports that domestic credit growth has accelerated, driven by strong demand from the government, public enterprises, and the private sector. High import content, particularly from public infrastructure investments, together with higher oil imports, has translated into widening trade and current account deficits, and emerging pressures on international reserves. Inflation pressures are rising, driven by both demand pressures and higher import costs. The real effective exchange rate has appreciated moderately.

I. Background and Recent Developments

1. Following the cessation of hostilities with Eritrea in 2000, Ethiopia embarked on a PRGF-supported program, which ended in October 2004. The program helped to restore macroeconomic stability, and supported the authorities’ Sustainable Development and Poverty Reduction Program (SDPRP). Donor assistance rose rapidly, and Ethiopia reached the completion point under the enhanced Heavily Indebted Poor Country (HIPC) Initiative in April 2004 and qualified for debt relief under the Multilateral Debt Relief Initiative (MDRI) in December 2005. Initially, higher aid flows were largely saved and reflected in higher international reserves, but over the last two years imports have risen sharply.

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Ethiopia: Imports, Aid and Gross Reserves

(US$ million)

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

2. Ethiopia’s largely agricultural economy remains vulnerable to climatic shocks, which have resulted in wide swings in output, with severe adverse effects for the poor (Box 1). Average growth over the five years to 2004/05 of 4.6 percent has not been fast enough to significantly reduce poverty. World Bank reports suggest that the incidence of consumption poverty has not declined between 1990 and 2004.1

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Ethiopia: Actual and Trend Growth in Real GDP

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

Food Security

While major crop producing areas are expected to see improvements in food security in 2006, pastoral areas of southern and southeastern Ethiopia are suffering from the effects of drought. The 2006 Humanitarian Appeal is seeking emergency assistance for 2.6 million people. After two successive years of good harvests, and favorable prospects for 2005/06, the number of people requiring emergency assistance is the lowest in over a decade. However, the Food Security Coordination Bureau has indicated that the total number of people needing humanitarian assistance will rise from 9 million in 2005 to 11 million in 2006, or around 15 percent of the population. In addition to those requiring emergency assistance, this includes 8.3 million people who are now considered chronically food insecure and are expected to receive assistance through the Productive Safety Net Program (PSNP). The PSNP—a multi-sectoral and multi-year program which implements intensive public works schemes using both cash and food for work mechanisms—has undergone a retargeting exercise that has raised the number of beneficiaries from 4.8 million in 2005.

3. In the last two years, growth has been strong but there are emerging pressures on prices and, more acutely, the balance of payments.

  • In 2004/05, the economy grew by 8.8 percent, the second year of rapid expansion after the recent drought.2 At the same time, inflationary pressures have risen. Although domestic petroleum prices were last adjusted in December 2004, non-food inflation rose to a 12-month average of 7.9 percent in December 2005. Special factors explain some of this increase, including higher imported and domestic prices for construction materials, but underlying demand pressures appear to be contributing to the highest nonfood inflation rate in a decade.

  • Government’s domestic borrowing rose to 3.5 percent of GDP in 2004/05—2 percent of GDP higher than budgeted—as a result of shortfalls in revenues and aid inflows, and the stock of government’s domestic debt remained high at 35 percent of GDP. Capital spending rose sharply as the government began to scale up domestically-financed spending on infrastructure, which was also reflected in an increase in overall poverty spending.

  • During 2004/05, broad money grew more or less in line with nominal GDP. However, this growth was entirely due to an expansion of net domestic assets (NDA), including sharp increases in credit to the private sector and public enterprises. At the same time, commercial banks’ excess reserves rose to over 30 percent of deposits as the National Bank of Ethiopia (NBE) met government’s domestic financing needs, and the dominant Commercial Bank of Ethiopia (CBE) sharply reduced its holdings of treasury bills.

  • Ethiopia’s terms of trade improved by 11 percent in 2004/05, reflecting surging coffee prices. However, the external current account deficit (after official transfers) widened by 4 percent of GDP, in spite of export growth of 36 percent. Imports—which are now almost four times larger than exports—rose by 40 percent or about US$1 billion, but only about a third of this increase reflected higher fuel costs. The overall balance moved into deficit, as reflected by the decline in net foreign assets of the banking system.

  • Although the birr continued to depreciate gradually against the US dollar, the recent trend of real depreciation reversed during 2004/05, reflecting a relative strengthening of the US dollar and the pick up in Ethiopia’s inflation.

  • Following four years of reserve accumulation through 2004/05, NBE has begun to draw down its foreign reserves, and import cover has dropped to around 3 months during the first half of 2005/06.

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Nonfood inflation

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

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Ethiopia: Imports US$ million

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

4. The mission took place against a tense political background. The results of the May 2005 election remain in dispute. The main opposition party, the Coalition for Unity and Democracy (CUD), which officially won 109 of the 547 seats, boycotted the new parliament that was sworn in on October 10, 2005, although some opposition parliamentarians have since taken their seats. In November, violent unrest erupted again and the leaders of the CUD were jailed, and face charges that include treason. Donors have reacted by suspending their budget support. Future disbursements and aid modalities are under review;3 donors have stressed that governance and human rights issues will be central to Ethiopia’s future partnership with the international community. They have also expressed concerns that a prolonged period of political uncertainty could have adverse consequences for the business climate, investment, and private sector development. Tension has also mounted on the disputed border with Eritrea.

5. The authorities place a high priority on maintaining macroeconomic stability and have welcomed past Fund advice in this area. However, they have consistently argued for higher revenue projections and greater domestic financing, arguing that the latter would not jeopardize macroeconomic stability. The authorities are, for the most part, following Fund advice in strengthening revenue and customs administration, and expenditure management. The authorities remain unconvinced by the Fund’s policy advice on the need for greater financial sector liberalization.

II. Prospects and the Policy Stance for 2005/06

6. After two years of strong agricultural expansion, the staff expects the overall growth rate to ease to just over 5 percent. This mainly reflects an expected slowdown in crop production growth to 6.8 percent, and the likely adverse impact of recent political unrest. The agricultural assessment assumes modest growth in area under cultivation, and yield growth in line with the average rate seen in the last 14 years. However, the authorities considered that agricultural production would be stronger, noting the recent rapid increase in fertilizer imports and early crop forecasts for the main season harvest, and projected GDP growth of 7 percent for 2005/06.

7. Food prices are expected to decline during 2005/06 from the high levels that prevailed in 2004/05 despite good harvests. However, taking into account the impact of the expected phased pass through of world market petroleum prices, the non-food index is projected to remain higher, bringing the average increase in consumer prices to 10.8 percent in 2005/06. The authorities noted that they were projecting an average inflation rate of 9.5 percent.

8. The initial focus of discussions was on the policy response to emerging pressures on the balance of payments. The authorities agreed that such pressures reflected a higher oil bill, large public infrastructure investments and, since November 2005, lower donor support. Initial projections in October suggested that full implementation of the budget—including an increase in capital spending of over 4 percent of GDP—and the investment programs of public enterprises, would contribute to import growth of at least 24 percent in 2005/06. Although export growth was expected to remain strong, given the small size of the export base, export receipts would finance only a small proportion of this import growth and the trade deficit would widen by around US$630 million (4.9 percent of GDP). Staff initially identified a financing gap of around US$390 million (3 percent of GDP), assuming import cover was maintained at 3 months. This was later revised up to US$600 million (4.6 percent of GDP) to reflect lower donor support.

9. Against this background the mission saw an urgent need to tighten the policy stance, while protecting basic services. The authorities confirmed their intention to pass on higher oil prices to consumers during 2005/06 although the timing would depend on the availability of external support for a targeted social safety net (Box 2). The focus of discussions was on containing import growth stemming from public infrastructure investments. In December 2005, the authorities indicated that for 2005/06 public enterprise imports would be lower by US$240 million (2 percent of GDP) than initially envisaged, as a result of agreed cuts in the investment programs of the electricity and telecommunications corporations (EEPCo, ETC) which could be made without breaking contractual obligations (Box 3). Consistent with these steps, planned domestic bank financing of these public enterprises would be correspondingly reduced.

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Overall CPI

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

Poverty and Social Impact Assessment (PSIA) of Removing Fuel Price Subsidies

Work undertaken by the World Bank, and supported by the Fund’s PSIA Unit, has concluded that there is a strong case for removing fuel subsidies as they are not pro-poor, and tie up funds which could be used for other purposes. Analysis has shown that petroleum product subsidies, including kerosene, are captured disproportionately by the rich. The lowest income quintile receives less than 10 percent of total subsidies, while the top (richest) quintile receives about 44 percent.

Retail prices for petroleum products have not been adjusted since December 2004, leading to an increasing subsidy during 2005. Removing this subsidy would not immediately affect the budget, as it is currently financed from domestic bank borrowing by the Ethiopian Petroleum Enterprise (EPE) following the depletion of the Fuel Stabilization Fund in 2004/05. Nonetheless, this debt will have to be paid out of government funds, reducing that available for other purposes.

Actual and Unsubsidized Prices for September 2005

(Birr/Litre)

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Source: World BankNote: The annual cost of the subsidy is running at around 2 percent of GDP. This is currently being financed by EPE domestic borrowing, incuring a large contingent liability for the government.Annualized, the estimated amount of subsidies currently going to the top quintile is Birr 760 million. This amount could fund an additional 2.1 million people under the Safety Net Program, or 50,000 additional nurses, 3.5 times the current total.

Public Investment Program

A key element of Ethiopia’s medium-term growth strategy is to rapidly scale up infrastructure investment. This involves substantially higher on-budget capital spending for roads, food security and rural electrification. In addition, the power and telecom companies (EEPCo and ETC) have embarked on ambitious programs to expand access to basic services. Table 1 illustrates that on-budget capital spending is increasing sharply across a range of sectors. Moreover, the domestically-financed share of capital outlays has increased significantly since 2002/03.

Table 1.

Ethiopia: On-budget Capital Spending

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Fiscal and macro policy risks are mounting as the main public utilities domestically finance large infrastructure investments. The increase in import demand fueled by these investments has contributed to significant pressure on the balance of payments. The government has also guaranteed bonds in 2004/05 issued by ETC and EEPCo totaling 3.1 percent of GDP, exposing the budget to potentially large contingent liabilities. Even after agreed cuts in 2005/06, planned large recourse to domestic financing could squeeze private sector credit and stoke inflationary pressures.

Table 2.

Ethiopia: Major Public Enterprise Investment Programs

(as a share of GDP)

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Sources: EEPCo, ETC, NBE, and Fund staff estimates.

Expressed relative to 2005/06 GDP. The full cost of EEPCo’s program covers the 2005/06-2009/10 period. The ETC program covers the 2005/06-2008/9 period, and assumes imports of about $250-300 million per annum.

10. Most of these cutbacks would take place off-budget. However, staff also identified a financing gap of 4.5 percent of GDP in the 2005/06 budget. The authorities intend to cover this through cutting federally financed capital spending on rural electrification in the budget by Birr 1.25 billion (1.1 percent of GDP); a budgeted one-off transfer of accumulated profits from the NBE totaling 2.2 percent of GDP, and increased recourse to domestic financing to 4 percent of GDP. However, after including MDRI relief from the Fund, which was not approved when discussions concluded, domestic financing would be held to just over 3 percent of GDP.4 In addition, they noted that any shortfall in regional revenue collection would lead to an equivalent cut in their expenditure. Staff welcomed the decision to contain capital spending, and recognized that raising domestic financing was, in principle, an appropriate response, provided the decline in aid flows was temporary. However, staff noted that higher domestic financing from the NBE and the profit transfer would involve issuing base money. To address this concern, as well as to help reduce excess reserves in the banking system, the authorities indicated that they would rely predominantly on issuing treasury bills to commercial banks to fund the budget deficit.

Ethiopia: General Government Operations, 2002/03-2005/06

(In percent of GDP)

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Sources: Ethiopian authorities; and Fund staff estimates and projections. The Ethiopian fiscal year ends July 7.

Reflects the authorities’ measures to address staff’s identified financing gap, and receipt of Fund MDRI relief.

Poverty-reducing spending is defined consistently with the SDPRP to include total spending on health, education, agriculture, roads and food security

11. Based on five months of import data, the authorities also revised down the 2005/06 oil bill by US$200 million over that projected in October 2005, to US$700 million. This reflects an exceptional increase in oil import volumes in 2004/05, and results in projected oil imports which are around 5 percent higher than the previous three-year average. Taking all these elements into account, they considered that reserves would be held at over 3 months of import cover, and macroeconomic stability maintained.

12. Staff was of the view that the authorities’ revised scenario still involved significant risks for the balance of payments. Oil imports may be higher than projected, particularly if fuel prices are not raised. In addition, despite the proposed cuts in public enterprise spending, sustained rapid domestic credit growth could have adverse implications for the balance of payments, prices and public domestic debt levels. In this connection, staff noted the combination of higher domestic financing of the budget deficit, the planned recourse to domestic bank credit by public enterprises in 2005/06, and continued strong growth in credit to the private sector credit. Moreover, without the assumed pass through of higher oil prices, credit to the EPE to fund the subsidy would crowd-out financing for the private sector.

13. The authorities stressed that they would take additional measures as necessary to defend the reserve position at 3 months, and noted their success in doing so during past difficult times. Staff welcomed this commitment, but cautioned that recourse to administrative controls should be avoided to prevent any adverse impact on the private sector.

III. Baseline Medium Term Scenario

14. Discussions on medium term prospects and policies took place around two scenarios, which were drawn from the preliminary frameworks presented in the authorities’ draft Plan for Accelerated and Sustained Development to End Poverty (PASDEP).5 6

  • Staff’s baseline scenario, which is not explicitly geared to attaining the MDG, assumes that growth averages just over 5 percent, consistent with the low case scenario in the PASDEP, and slightly above the trend rate in the last ten years; an annual average inflation of 6 percent, and the restoration of reserve cover to around 3.4 months of imports. While prospects for aid flows remain highly uncertain, the baseline scenario assumes that aid flows begin to rise again in 2006/07, and return to the levels originally budgeted for in 2005/06. Thus, the baseline implicitly assumes sufficient progress is made in addressing donors’ concerns to allow such a resumption in aid flows.

  • The MDG scenario draws upon the Needs Assessment, which estimated the costs of reaching the MDGs. In addition to incorporating faster growth of 7 percent on average—required to halve poverty by 2015—the scenario includes a large expansion in spending on key services and infrastructure, and a corresponding increase in aid. The key elements of this scenario, and the policy framework to support it, are summarized in Box 4.7

A. Fiscal Policy

15. Staff noted that the baseline scenario in the PASDEP entailed significant financing risks. These stemmed from planned increases in expenditure, especially capital spending (by nearly 9 percent of GDP between 2004/05-06/07) and very ambitious revenue projections, which entailed risk that recourse to domestic financing would increase over the already high levels planned (as occurred in 2004/05).

16. Staff recommend that the authorities develop a fiscal framework which shows how expenditure will be prioritized on the basis of likely resource availability and in line with the growth strategy. Although such a prioritization is not yet available, staff’s baseline scenario presented here assumes lower expenditure than in the PASDEP to produce a fully financed medium-term fiscal framework that allows for increased pro-poor spending, and is consistent with declining domestic debt levels. Thus, while the PASDEP shows financing gaps needed to be filled to support planned expenditures (Tables 2, 3, 4), staff’s baseline scenario8 reflects the authorities’ commitment to cut nonpriority spending (and maintain reserve cover). The path of domestically financed capital spending thus reflects the available fiscal space, including shifts in NBE profit transfers and assumed increases in tax revenues. The latter reflects buoyant international taxes, a recovery in business income taxes, and expected administrative improvements.

An MDG Scenario

Discussions on strategies for achieving the MDGs formed an integral part of the 2005 Article IV consultation, and served to update work started on an MDG scenario during the 2004 consultation. The updated scenario incorporates the lower bound estimate of total public sector costs (US$58 billion), presented in the MDG Needs Assessment Synthesis Report prepared by MOFED, and an annual expenditure framework guided by simulations produced by the World Banks’ MAMS model, which provides for a front-loading of infrastructure investments in line with the authorities strategy.

Discussions with the authorities focused on the policies and macroeconomic framework to accommodate higher aid inflows and promote faster growth. Key challenges identified included:

  • 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.

UN and World Bank Assessment of Progress Towards the MDGs

An assessment by the government, United Nations Country Team, and World Bank considers that a sub-set of the MDG Goals 1, 3 and 7 are likely to be achieved under current trends, while Goal 2 could be achieved even before 2015. Achievement of all MDGs by 2015 will require improved policies to strengthen institutions and support efforts to raise real GDP growth in a sustainable manner, as well as significantly higher aid flows.

Ethiopia: Millennium Development Goals - recent trends, and required growth

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1995-2000;

Source: World Bank Development Indicators, April 2005; Millennium Development Goals Report: Vol. 1, Ministry of Finance and Economic Development and United Nations Country Team, March 2004; and staff calculations

17. The mission argued that the medium-term fiscal projections, including under the MDG scenario, should be anchored by the need to ensure domestic debt sustainability. Ethiopia’s domestic debt is high compared with other countries in sub-Saharan Africa although, as a result of very high levels of excess reserves in the banking system, interest rates are negative in real terms, and therefore servicing this debt does not place a heavy burden on the budget. However, over the medium term, it would be prudent to expect interest rates on government debt to become positive in real terms as excess reserves decline and competition in the financial sector increases. In addition, targeting a gradual reduction in the domestic debt stock is important to provide the flexibility to respond to unforeseen shocks, particularly climatic shocks that call for additional expenditures and adversely affect revenue performance.9 The baseline thus projects a decline in domestic financing of the budget from 4 percent of GDP in 2005/06 to 3 percent by 2008/09, allowing a small reduction in the debt stock to about 32 percent of GDP by 2009/10.

Regional Comparisons of Revenue Performance

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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 is 2004/05.

18. The mission and authorities agreed that the lower tax ratio resulting from the upward revision to GDP provides a more realistic picture of Ethiopia’s revenue effort. This underlined the need to improve the buoyancy of the tax regime, both through strengthening tax administration, and a review of tax policy. In addition, large revenue increases will be required to match increases in recurrent spending on infrastructure, as well as a potential increase in service delivery related to the MDGs, in order to provide for an orderly exit from potentially higher aid inflows. In this context, the authorities have requested technical assistance from the Fund to review tax policy.

19. Regarding tax administration, the mission recommended a focus on the following areas:

  • strengthening the functional organization and capacity of revenue administration;

  • encouraging regions to centralize revenue administration;

  • further strengthening of customs administration; and

  • avoiding future tax amnesties to avoid undermining taxpayer compliance, and maintain equitable burden sharing across taxpayers.

B. Monitoring Public Enterprises

20. The mission noted that fiscal reporting should include the activities of major public enterprises. The budget has on-lent significant external financing to key public enterprises, and has guaranteed substantial new domestic financing from the banking system. To account for these heightened fiscal risks, and to better measure the impact of public investment on the broader economy, key public enterprises could be consolidated into fiscal reporting and the budget. Alternatively, the budget could include a detailed annex outlining the activities of the largest public enterprises, including an overview treatment of new borrowing guaranteed by the government.

21. The authorities did not support the proposal of consolidating public enterprises into the budget. They agreed that monitoring public enterprises was important and noted that this was already undertaken by various government agencies, principally on the basis of audited reports. In response, staff stressed that what was needed was more than just monitoring individual enterprises. Their operations need to be pulled together and placed within a broader macroeconomic context so as to allow for an assessment of their macroeconomic consequences – the recent import pressure stemming from the operations of EEPCo and ETC attested to the importance of such work.

C. Strengthening Public Expenditure Management

22. The mission reiterated the importance of reforms to strengthen public expenditure management and reporting.10 Key steps include:

  • rolling-out the budget disbursement and accounting system;

  • implementing performance-based budgeting, and undertaking regular and timely reconciliation of the fiscal and monetary accounts.

23. In addition, the Fiscal Decentralization Strategy poses particular challenges, in that subnational governments are responsible for executing the bulk of social spending. Given their key role in providing essential services, the adequacy of federal transfers should be carefully assessed to avoid any unfunded mandates in pro-poor sectors.

24. The mission stressed that timely fiscal reporting is essential for fiscal and macro policy management, and to enable budget appropriations to be linked to past performance. Priority measures include:

  • Prompt dissemination of quarterly budget execution reports, and clearing the backlog of federal fiscal accounts to be finalized and audited by end-2005/06.

  • Strengthening assistance to regional governments in order to expedite the clearing of the average 2-year backlog of sub national accounts.

  • The regular inclusion in fiscal reports of all the extra budgetary funds, and more timely consolidation of budget reporting by woredas and regions.

The authorities concurred on the importance of strengthening PEM, and have requested technical assistance from the Fund.

D. Monetary and Exchange Rate Policy

25. Discussions on monetary policy focused on the risks posed by a sustained rapid increase in domestic credit growth to public enterprises and the private sector. The mission noted that some restraint appeared necessary to moderate import demand and inflationary pressures. In this context, high levels of commercial bank excess reserves were a particular concern. As well as precluding the effective use of indirect monetary instruments, these excess reserves enabled banks, particularly the CBE, to expand credit rapidly, particularly to public enterprises.

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Ethiopia: Excess Reserves & NBE Credit to government

(Birr millions)

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

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The structure of interest rates remained unchanged, and T-bill yields low, reflecting excess bank liquidity.

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

26. Against this background, the mission proposed that, despite the risks that it could give rise to distortions, imposing a direct ceiling on the credit operations of CBE provided the most reliable means of guarding against excessive credit expansion. At the same time, staff recommended that government’s domestic borrowing requirement be met principally through recourse to commercial bank financing, rather than the NBE, to avoid adding to excess reserves. The large infrastructure financing plans of public enterprises also argued for a closer coordination and monitoring of such activities with fiscal and monetary policy to ensure monetary stability. In this context the staff recommended that adoption of the Integrated Monetary Data Base (IMD)11 should be a priority.

27. The authorities acknowledged the emerging pressures in the economy, and agreed with the proposed shift to commercial bank financing of the budget. However, they felt that the proposed cuts in public infrastructure investments were sufficient, and that there was no need to introduce credit ceilings at CBE. Further they stressed that they would use all applicable measures to maintain monetary stability and reserve targets, if and when necessary.

28. The recent modest appreciation of the real exchange rate does not appear to be affecting competitiveness. Annual export volume growth averaged close to 20 percent during 2003/04-04/05, and is projected at 16 percent in 2005/06. The authorities are actively pursing a policy of export diversification which is yielding results, and of strengthening infrastructural support for industry and agriculture in general. In addition, Ethiopia’s terms of trade have improved. While rising imports are a concern, they currently mainly reflect the activities of public enterprises and higher oil prices.

29. The mission noted that the exchange rate remained tightly managed, and that its recent evolution appeared more representative of a crawling peg against the US dollar than the official policy of a managed float. In addition, de facto intervention had increased in recent months as the NBE had made foreign exchange available for imports; gross reserves declined by US$320 million in the first half of 2005/06, to around 3 months import cover. Following recent political unrest a premium averaging around 4 percent, has also emerged in the parallel market.

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Birr per U.S. Dollar Rates

(End of period)

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

30. These developments raised questions about the desirability of maintaining such tight exchange rate management. In this context staff argued that, although the current level of the exchange rate did not appear to be presenting immediate competitiveness problems, the rigidity of the exchange rate policy did involve considerable risks for the balance of payments in a forward looking perspective. Staff argued that greater flexibility was therefore needed to allow the exchange rate to reflect balance of payments developments, and avoid the risk of an unsustainable real appreciation. The authorities agreed that greater exchange rate flexibility could play a role in responding to balance of payments developments, and indicated that the exchange rate would be allowed to adjust during 2005/06 as part of a coordinated response to any additional balance of payments pressures that may emerge.

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Ethiopia: Daily Interbank and Parallel Market Exchange Rates

(Birr per U.S. dollar January 2005-February 2006)

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

E. Financial Sector

31. The authorities confirmed that they are continuing to implement the financial sector strategy as outlined in 1998. This aims to direct resources through the state dominated banking system to priority sectors, primarily through the Development Bank of Ethiopia; to link the financial sector to the strategy of Agricultural Development Led Industrialization—principally through development of the MFI sector—and to develop a sound financial system that can sustain liberalization in due course. In the meantime, market forces will play a limited role in setting interest and exchange rates, and foreign bank entry will not be allowed. The authorities also confirmed that they view excess reserves of commercial banks as “savings” which can, and should, be mobilized in support of public infrastructure development.

Banking Sector Soundness

The banking sector continued to show signs of improvements during 2004/05. Reported NPLs showed a steady decline as a percentage of total loans, and all banks reported capital adequacy ratios (CAR) above the minimum required ten percent, except the state owned Construction and Business Bank (CBB) at 9.7 percent. The authorities indicated that a decision was pending as to how to deal with CBB’s capital shortfall, including a possible sale of the bank.

Bank Soundness Indicators

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(see Table 8 for additional data and sources).

The CBE continued to implement its financial restructuring program and met the plan’s NPL and CAR targets for 2004/05. The plan aims to reduce the NPL ratio to 15.6 percent by end 2006/07 through a combination of cash collection, rescheduling/renewals and foreclosures, and to maintain a CAR above 10 percent.

CBE Financial Restructuring Plan

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While welcoming the encouraging performance, the mission cautioned that the rate of increase in bank credit to the non-government sector raises some concerns, particularly if sustained. Although the NPL ratio has declined, there has been some increase in the nominal stock of NPLs of private banks. Efforts are needed to preserve bank’s asset quality, and NBE should look to undertake comprehensive examinations for loan quality and risk management practices at all banks on a more timely basis.

(i) Does not include data for DBE or the Cooperative Bank, which commenced operations in March 2005.

32. The mission recommended that further financial sector reform be considered over the medium term, and reiterated that increasing competition in the banking system, along with a reduction in the relative size of CBE, remains central to improving the environment for the implementation of monetary policy. Further, without a clear strategy, there is a risk that the gains from a potential scaling up of expenditure will not translate into a sustained private sector response. The forthcoming World Bank Financial Sector Capacity Building Project,12 will help prepare the ground for broader policy reform in due course, and in support of this, the Fund is providing technical assistance in the areas of bank supervision and payment systems.

F. Infrastructure Spending, Productivity, and Private Sector Development

33. The mission agreed with the authorities that improving Ethiopia’s infrastructure was essential to enhance growth prospects. Substantial investments would be required to bring key indicators of Ethiopia’s infrastructure even to average levels seen in sub-Saharan Africa. However, the beneficial effects of such investment—including the “crowding-in” of private investment and a lagged improvement in total factor productivity consistent with higher growth performance—would depend on the choice and quality of the investments, as well as a policy environment conducive to private sector development.

Ethiopia: Infrastructure Gap Indicators

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Source: World Development Indicators.

34. The mission also noted that the economic contribution of the private sector remains limited. Recent positive developments, such as the resumption of the privatization program, an easing the regulatory burden, and the introduction of a competition policy, are welcome, but further reforms are needed. A comparison of the business climate in Ethiopia with that in Vietnam (see Box 7)—which shares some elements of the growth strategy that Ethiopia is following—confirms that the business environment remains difficult. In addition, there is a risk that recent political developments may impede private sector development, and adversely affect private investment, including foreign direct investment (FDI).

Investment Climate: Ethiopia and Vietnam: A Comparison

A comparison of the two countries’ business environments reveals some significant differences. Ethiopia is rated 106th out of 117 countries by the World Economic Forum’s 2004/05 Global Competitiveness Report; Vietnam is rated 81st. While Ethiopia compares relatively well in terms of providing a supportive regulatory environment, it is much more costly to start a business, and gain access to credit than in Vietnam. Ethiopia also compares unfavorably on most governance indicators, and in the supply of skilled labor and infrastructure services. These factors may help explain why FDI in Vietnam – typically in the form of a joint venture between foreign partners and a state owned enterprise - has played a larger role than in Ethiopia.

Figure 1.
Figure 1.

Governance Indicators: 2004

(Percentile rank)

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

Table 1.

The Cost of Doing Business, 2004

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The index range from 1-10, with higher value indicating that collateral and and bankruptcy laws are better designed to expand access to credit.

Index ranges from 0-6, with higher value indicating that more credit information is available from either public registry, or private bureau to facilitate lending decisions.

Index ranges from 0-7, with higher value indicating more disclosure.

Source: World Bank-http://rru.worldbank.org/doingbusiness/.
Table 2.

Supply of skilled labor and infrastructure

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Source: World Bank, World Development Indicators 2005.

35. While admiring of Vietnam’s performance, the authorities indicated that their interventionist strategy was guided more by the East Asian experience of the 1970s,13 and noted that this involved less liberalization than currently pursued by Vietnam. They restated their view that the export sector would not develop without state intervention, and noted priority sectors—horticulture, floriculture, textiles, garments and leather. Support for these sectors is being provided through the establishment of training institutes, access to land at reduced prices, long term credit, tariff exemptions, and tax holidays. However, the authorities also stressed that work was underway, supported by the World Bank, to improve private sector development, including efforts to improve government service delivery, and address issues around access to credit.

36. Staff noted that historically, growth in agricultural production has been driven by increases in cultivated land, rather than improvements in productivity. Given pressures on land, sustaining higher rates of growth in agriculture production will require substantial improvements in productivity.

G. Trade Policy

37. Trade policy discussions focused on tariff structure and exemptions. Ethiopia’s average tariff rate of 17 percent is just above the average for sub-Saharan Africa. However, the top bands of 30 and 35 percent apply to about half of all imports and provide higher rates of protection to the manufacturing sector. In addition, a “second schedule” grants almost 700 partial or full exemptions to selected industries. Staff recommended that the authorities consider lowering, or merging at a lower level, the top two tariff bands, noting that the resulting revenue losses could be significantly reduced by removing the exemptions covered by the second schedule which gives rise to widespread distortions. The authorities recognized the importance of such issues, and confirmed their willingness to review such trade policy, while noting their desire to use trade instruments to achieve industrial policy objectives.

38. The mission noted that a tariff reduction would also ease the move towards the COMESA FTA. However, the authorities indicated that they are not yet ready to join due to concerns over the impact on revenue and competitiveness. They also expressed a reluctance to alter the trade regime just as the Memorandum on the Foreign Trade regime is about to be sent to the WTO.

uA01fig12

SSA average tariff on imports based on the Fund’s Trade Policy Database

Citation: IMF Staff Country Reports 2006, 159; 10.5089/9781451812787.002.A001

H. External Outlook and Debt Sustainability

39. Prospects for the balance of payments depend crucially on levels of external assistance and timely policy responses to any pressures. While export prospects are positive, they remain vulnerable to exogenous shocks. In addition, managing a timely slowdown in import growth commensurate with available foreign exchange may be a challenge, putting the projected level of reserve cover at risk.

40. Staff updated the joint Fund-Bank debt sustainability analysis (see Annex 1), and included Fund14 debt relief under the MDRI. While the external ratios have improved with the delivery of debt relief—and will do so further once MDRI relief from the World Bank and African Development Fund is approved—the analysis implies a moderate risk of debt distress, and highlights the necessity of securing grant financing and containing domestic borrowing. In this context, staff stressed that development of a comprehensive public debt management strategy, to specifically include public enterprise debt and contingent liabilities, remains a priority.

IV. Technical Assistance, Data Issues, and Article VIII

41. Recent assistance has focused on fiscal and monetary policy formulation, strengthening bank supervision, and improvements in the quality and timeliness of core data that are considered key for surveillance purposes. As well as previously mentioned requests in the fiscal area, the authorities expressed interest in technical assistance in the areas of the consumer prices index15 and measurement of FDI. The authorities indicated that the IMD will be adopted during 2006, and the move to the balance of payments manual five reporting finalized.

42. The mission enquired about the status of remaining current account exchange restrictions which the Fund considers to be inconsistent with Article VII I, Section 2(a) of the IMF’s Articles of Agreement (see Appendix I, IX). The authorities maintained their position that these measures did not, in their view, constitute current account restrictions, and expressed interest in further discussion and clarification of these issues between NBE and the Fund’s legal department.

V. Future Relationship with the Fund

43. The authorities expressed their desire to maintain a close dialogue and relationship with the Fund. They noted that access to Fund financing was not the main consideration, but that they needed the Fund’s signal to donors on the suitability of their macro-framework for an effective use of a scaling up of aid. In this context they considered the Fund as a partner in their efforts to reach the MDG’s with donor support. The authorities indicated that they would consider the various options open in terms of future relations with the Fund, including the new Policy Support Instrument.

VI. Staff Appraisal

44. Ethiopia’s recent growth performance has been encouraging, but sustaining this at levels needed to meet the MDGs will be difficult without an acceleration of reforms. In particular, agricultural growth has been driven by increases in area under cultivation, not yields, highlighting the need address constraints to productivity gains. In addition, the focus on public enterprises and state determined priority sectors, risks thwarting the emergence of a dynamic private sector needed to provide incomes and boost growth.

45. Achieving the MDGs will require significantly higher levels of external assistance. Such inflows could be facilitated by a resolution of both the current domestic political tensions, and the border dispute with Eritrea, as well accelerated structural reforms and strengthened public expenditure management. Introducing timely fiscal reporting is particularly important ahead of scaling up public spending. External support should also largely be in the form of grants to ensure debt sustainability is maintained.

46. The current strategy of scaling up domestically financed infrastructure, including through drawing on CBE’s excess reserves, risks jeopardizing macro economic stability, and in particular the balance of payments position. The authorities should thus look to manage the pace and level of such domestically financed spending within a broader macroeconomic and fiscal framework that ensures stability. In the current context, this requires some initial scaling back, as well as greater recourse to external funding.

47. Even with proposed cuts in infrastructure imports, pressures on official reserves could remain high. While the authorities commitment to take remedial measures is welcome, it would be preferable to act sooner rather than later to forestall any drop below 3 months import cover. If a large rebuilding of reserves becomes necessary, this will squeeze the room for non-inflationary domestic bank credit growth, dampening growth prospects.

48. Fiscal policy should be anchored by the need to avoid adverse macroeconomic consequences from large recourse to domestic bank finance, and to ensure debt sustainability. The adjustment measures introduced this year are welcome, but the resulting policy stance still involves significant risks for the balance of payments. Beyond 2005/06, planned recourse to domestic borrowing should be reduced to contain debt levels and provide room to respond to shocks, as well as mitigate any pressures on reserves. At the same time efforts are needed to improve the buoyancy of the tax regime to ensure revenue growth keeps up with recurrent expenditures. Staff thus welcome the authorities’ request for technical assistance from the Fund in the area of tax and customs policy, including on the structure and level of tariff exemptions. Staff also highly recommend that the activities of key public enterprises be closely monitored, and ideally consolidated into fiscal reporting.

49. The proposal to pass through higher oil prices is welcome, and staff recommend that this be implemented as a priority during 2005/06, followed by the reintroduction of the automatic pricing mechanism. Given the limited impact on the poor and the mounting costs, delays in securing additional external support should not detract from moving ahead with domestic price increases.

50. Monetary and exchange rate policy will need to be geared to preserving international reserves and containing inflationary pressures. In the absence of effective indirect instruments, direct controls on the operations of CBE may be the most effective way to curb excessive credit growth. Staff consider that external competitiveness does not seem to be an immediate problem. However, looking forward, greater flexibility is needed to allow the exchange rate to reflect balance of payments developments and avoid the risk of an unsustainable real appreciation. Moreover, the authorities should follow through on the option of allowing greater flexibility as part of a timely and coordinated response to additional balance of payments pressures that may emerge.

51. Differences of view remain over financial sector reforms. The authorities’ MDG scenarios entail a significant private sector response to reforms and infrastructure development, which staff consider will need to be supported by a more dynamic and market orientated financial sector than currently envisaged. In the meantime, the Fund will collaborate with the forthcoming World Bank Financial Sector Capacity Building project and will provide targeted technical assistance consistent with the aim of advancing broader policy reforms in due course.

52. Data provision to the Fund remains adequate for surveillance purposes, but shortcomings affect the analysis of key areas. In particular, in light of their increasing role in infrastructure investment, the authorities are encouraged to consolidate key public enterprises in fiscal reporting and the budget. The adoption of the IMD is also a priority.

53. It is recommended that the next Article IV consultation with Ethiopia take place on the standard 12-month cycle.

Table 1.

Ethiopia: Selected Economic and Financial Indicators, 2002/03-2005/06 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 relief and Fund relief under the MDRI. Exports of goods and services used.

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

After enhanced HIPC relief and Fund relief under the MDRI; in percent of exports of goods and nonfactor services.

Table 2.

Ethiopia: General Government Operations, 2002/03-2009/10

(In millions of birr)

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Sources: Ethiopian authorities; and Fund staff estimates and projections. The Ethiopian fiscal year ends July 7.

The fiscal accounts include municipal spending by Addis Ababa beginning from 2003/04.

Excluding special programs (demobilization and reconstruction).

Demobilization and reconstruction.

The consolidated budget column presents an estimate based on the actual federal budget and projections for subnational governments.

The domestic debt series has been revised starting from 2000/01 to reflect gross rather than net debt. The non-interest bearing component is approximately Birr 9.4 billion, of which Birr 8.7 billion reflects NBE advances maturing in 2030 to finance expenditures in connection with the Eritrea conflict.

Poverty-reducing spending is defined consistently with the SDPRP to include total spending on health, education, agriculture, roads and food security.

External interest and amortization are presented before HIPC debt relief from the World Bank and African Development Bank up to 2007/08 for comparability with the authorities’ medium-term fiscal framework.

Debt relief from the IMF under the MDRI is recorded in 2005/06. Pending discussion with the authorities, additional MDRI-funded expenditures are not included in the baseline projections.

Table 3.

Ethiopia: General Government Operations, 2002/03-2009/10

(In percent of GDP)

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Sources: Ethiopian authorities; and Fund staff estimates and projections. The Ethiopian fiscal year ends July 7.

The fiscal accounts include municipal spending by Addis Ababa beginning from 2003/04.

Excluding special programs (demobilization and reconstruction).

Demobilization and reconstruction.

The consolidated budget column presents an estimate based on the actual federal budget and projections for subnational governments.

The domestic debt series has been revised starting from 2000/01 to reflect gross rather than net debt. The non-interest bearing component is approximately Birr 9.4 billion, of which Birr 8.7 billion reflects NBE advances maturing in 2030 to finance expenditures in connection with the Eritrea conflict.

Poverty-reducing spending is defined consistently with the SDPRP to include total spending on health, education, agriculture, roads and food security.

External interest and amortization are presented before HIPC debt relief from the World Bank and African Development Bank up to 2007/08 for comparability with the authorities’ medium-term fiscal framework.

Debt relief from the IMF under the MDRI is recorded in 2005/06. Pending discussion with the authorities, additional MDRI-funded expenditures are not included in the baseline projections.