The Federal Democratic Republic of Ethiopia
2007 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Federal Democratic Republic of Ethiopia
Author: International Monetary Fund
Publication Date:
20 Jul 2007
eISBN:
9781451812800
Language:
English
Keywords:
ISCR; CR; debt; GDP; deficit; inflation; U.S. dollar; net present value; trade balance; capital expenditure; public enterprise; Imports; International reserves; Debt relief; Sub-Saharan Africa
Download PDF (445.1 KB)

The Federal Democratic Republic of Ethiopia’s 2007 Article IV Consultation reports on the macroeconomic imbalances and on maintaining medium-term macroeconomic stability while fostering growth potential. Although agriculture continues to be the mainstay of the economy, the expansion has been broad-based, with manufacturing, construction, and services making significant contributions. Expansion of domestic credit has continued to be brisk, reflecting a pickup in private sector economic activity and increasingly negative real interest rates. A critical challenge for Ethiopia is to strike a judicious balance between demand-dampening measures and growth-enhancing structural reforms.

Abstract

The Federal Democratic Republic of Ethiopia’s 2007 Article IV Consultation reports on the macroeconomic imbalances and on maintaining medium-term macroeconomic stability while fostering growth potential. Although agriculture continues to be the mainstay of the economy, the expansion has been broad-based, with manufacturing, construction, and services making significant contributions. Expansion of domestic credit has continued to be brisk, reflecting a pickup in private sector economic activity and increasingly negative real interest rates. A critical challenge for Ethiopia is to strike a judicious balance between demand-dampening measures and growth-enhancing structural reforms.

I. Recent Developments

1. The economy has enjoyed strong and steady growth for the past three years (Table 1). After a significant drought-related contraction in 2002/03, it rebounded with an annual average growth rate of 10.7 percent for 2003/04-2005/06—significantly above the average of 5.8 percent realized in sub-Saharan Africa. As a result, real per capita income increased at an annual average of 7 percent—the fastest rate in Ethiopia’s recent history. Although agriculture continued to be dominant, the expansion has been broad-based, with significant contributions from manufacturing, construction, and services.

Table 1.

Ethiopia: Selected Economic and Financial Indicators, 2003/04–2010/11 1

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

The fiscal year starts from July 8 to July 7.

Including special programs.

Whole series was revised.

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

After enhanced HIPC relief.

A01ufig01

Real GDP Growth and Contribution of Agricultural Sector

(Percent)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

A01ufig02

Real GDP Per Capita

(2000=100)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

2. Unfortunately, as growth rebounded, inflation rose. While inflation was less than 10 percent for most of 2003/04-2004/05, it accelerated in mid-2005 and reached 18.5 percent at the end of 2006. The surge in food prices reflected higher disposable income and some supply-side factors: (i) farmers were able to supply agricultural produce more uniformly over the year (after improvements in access to credit, storage facilities, marketing information, and incomes), which helped avoid excess supply during harvesting seasons; and (ii) the total supply of cereals fell after some donors switched from food to cash aid. Nonfood inflation was also high, 17.3 percent at the end of 2006, because of the continued strong demand associated with large-scale public investment, rapid expansion of domestic credit, and upward adjustments in controlled fuel prices in May and August 2006.

A01ufig03

Consumer Price Indices

(Annual changes in percent)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

3. Public finances deteriorated in 2004/05-2005/06 (Tables 2 and 3). After declining to 0.2 percent of GDP in 2003/04, net domestic borrowing to finance the budget rose to 3.1 percent of GDP in 2005/06 as the domestic revenue effort declined and donors significantly reduced budget support (a shortfall of 2 percentage points of GDP from what was budgeted). Consequently, though expenditures were scaled down from the original budget by postponing large-scale infrastructure projects and constraining recurrent outlays, the overall budget deficit (including grants) was large, about 4½ percent of GDP a year for 2004/05-2005/06.

Table 2.

Ethiopia: General Government Operations, 2003/04–2007/08

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

The fiscal accounts include municipal spending by Addis Ababa starting in 2003/04.

Including the disbursements under the PBS operations starting from 2005/06.

Debt relief from the IMF under the MDRI is recorded in 2005/06. Withdrawal from the special account at the NBE is assumed to take place from FY2006/07 and FY2007/08.

Excluding special programs (demobilization and reconstruction).

Poverty-reducing spending is defined 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.

Demobilization and reconstruction.

Table 3.

Ethiopia: General Government Operations, 2003/04–2007/08

(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 starting in 2003/04.

Including the disbursements under the PBS operations starting from 2005/06.

Debt relief from the IMF under the MDRI is recorded in 2005/06. Withdrawal from the special account at the NBE is assumed to take place from FY2006/07 and FY2007/08.

Excluding special programs (demobilization and reconstruction).

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.

Demobilization and reconstruction.

4. Monetary conditions were accommodative (Table 4). Broad money grew relatively fast in 2005 and 2006, mainly driven by credit expansion to both government and nongovernment sectors. Demand for bank credit rose sharply to finance large-scale investment projects by public enterprises and the rapidly expanding private sector. To some extent, private demand for credit was spurred by the substantial negative real interest rates. With nominal lending rates averaging 8.6 percent, loan demand—especially for housing construction and consumer durables—shot up. At the same time, the excess reserves of commercial banks, which are not remunerated, also fueled the rapid expansion of credit.

Table 4.

Ethiopia: Monetary Survey, 2003/04–2007/08 1

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Sources: National Bank of Ethiopia; and IMF staff estimates and projections.

Year ending July 7. Including commercial bank claims and liabilities to Eritrea.

For 2005/06 government deposits at NBE reflect transfer of IMF MDRI relief into a government account; NBE foreign liabilities have been reduced by a similar amount.

Claims on general government (federal and regional governments and other public agencies) by the banking system less deposits of the general government with the banking system.

A01ufig04

Broad Money and Domestic Credit

(Annual changes in percent)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

A01ufig05

Contribution to Net Dometic Credit Growth

(Annual change in percent of beginning period net domestic credit)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

5. With rising domestic demand, particularly for imported raw material and capital goods, the external current account deficit (after official grants) widened to 10½ percent of GDP in 2005/06. Although there was steady growth in exports of goods, mainly agricultural products, and services, imports rose even faster. Even though the capital account surplus (including substantial errors and omissions suspected to be unrecorded inward remittances) nearly doubled, the overall balance of payments moved from a significant surplus in 2003/04 to a cumulative deficit equivalent to 2 percent of GDP for 2004/05-2005/06, a result in part of the shortfall in donor budget support. Gross official international reserves therefore declined from the equivalent of 3.7 months of imports at the end of 2003/04 to 2.1 months of imports at the end of 2005/06.

A01ufig06

Imports

(Percent of GDP)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

A01ufig07

Gross Official Reserves

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

6. The official exchange rate for the Birr against the U.S. dollar (the intervention currency) was relatively stable despite the widening external imbalances; it stood at Birr 8.78 to the dollar at the end of 2006. The parallel market rate moved within a narrow range.2 With domestic prices rising rapidly, the real effective exchange rate appreciated by 6 percent in 2006. However, because export prices are fixed in foreign currency and relative price shifts take time to influence supply, the appreciation may have only moderated the export growth in recent years though there has been some substitution of imports for domestic goods.

A01ufig08

Nominal and Real Effective Exchange Rates

(2000=100)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

A01ufig09

Daily Exchange Rates at Interbank and Parallel Markets

(Birr per U.S. dollar)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

7. The economy continues to grow relatively fast, with a little easing of pressures on international reserves. Real GDP growth in 2006/07 is projected to hold at about 9½ percent as productivity gains in agriculture continue and nonagriculture activities, especially manufacturing and construction, expand further. Domestic demand has been solid, given major investments in infrastructure and growing private consumption. Inflation is projected to decline only to about 15 percent at the end of 2006/07, despite the completion of the pass-through of fuel price increases and full adoption by farmers of the new pattern for food supply. After a period of relative stability, the depreciation of the birr against the U.S. dollar has in recent months become more pronounced.

8. The fiscal stance in 2006/07 is now expected to be tighter than originally envisaged. The authorities had originally planned for a net domestic borrowing of about 4 percent of GDP but the final budget reduced the amount to less than 3 percent. To help contain pressures on prices and the external position, the authorities are reducing recurrent expenditures, particularly those not affecting the poor, stretching out large capital outlays, and have introduced import surcharges to raise revenues. As a result, the overall deficit is projected at 4.3 percent of GDP, and net domestic financing of the budget would be limited to 2% percent of GDP, which the staff believe to be feasible

Fiscal Balance, 2003/04-2006/07

(Percent of GDP)

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Source: MoFED

Expenditures related to education, health, agriculture, and roads.

Including expenditures under special program.

9. The external position is expected to strengthen somewhat in 2006/07 (Table 5). Export growth, led by coffee and horticulture, is projected to combine with substantial increases in official transfers as relations with donors normalize, reducing the current account deficit by about half, to 5.6 percent of GDP. The overall balance of payments is projected to register a surplus of 2.1 percent of GDP, raising gross official international reserves to the equivalent of 2.2 months of imports by the end of 2006/07.

Table 5.

Ethiopia: Balance of Payments, 2003/04–2006/07 1

(Millions of U.S. dollars, unless otherwise indicated)

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Sources: Ethiopian authorities, and IMF 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).

For 2006/07, incorporates MDRI debt relief.

Public enterprises.

Includes 1997 and 2001 Paris Club rescheduling agreements (including Russia) on Naples terms, 2002 Paris Club topping up to Cologne terms, and HIPC relief (including interim relief including estimates of relief beyond HIPC and relief on non-Paris Club debt under negotiation).

6 Foreign aid is defined as official transfers and inflows of loans to the government.

II. Policies to Address Macroeconomic Imbalances

10. Despite strong growth in recent years, there are significant concerns about inflation and low international reserves. Inflation has risen virtually continuously since early 2006, hitting 19 percent in February 2007 (the latest data available). At the same time, official reserves have been declining, mainly because disbursements of external assistance have been delayed. The authorities concurred with the staff that the impact of inflation, particularly on the urban poor, is very heavy and efforts should be made to bring it down. Their main objective is to consolidate macroeconomic stability while maintaining growth momentum over the medium term; the intention is to reduce inflation to single digits and build international reserves to 10-12 weeks of import coverage. However, the authorities argued that the factors contributing to the high inflation should be studied further before taking additional policy actions. The staff cautioned that action was needed promptly to prevent expectations of high inflation from becoming entrenched. In particular, the staff stressed that remedial actions to address macroeconomic imbalances should be based on prudent fiscal and monetary policies and a more flexible exchange rate.

11. Fiscal policy should help contain pressures on prices and international reserves and crowd in the private sector. There was agreement that fiscal policy should be anchored in net domestic borrowing by the government. The authorities concurred with staff that the appropriate level over the medium term should be 2-2½ percent in order to (i) release resources to the private sector over the medium term, while ensuring a gradual decline in overall money growth to help contain inflation pressures, (ii) contain demand pressures and mitigate impacts on the external position, and (iii) gradually reduce domestic debt, providing the flexibility to respond to shocks, particularly climatic shocks that may call for additional expenditures. To achieve these targets, nonessential recurrent outlays should be further streamlined, with adequate provision for operations and maintenance. Selection criteria for capital projects should emphasize productivity and contribution to growth; noncritical projects with high import content should be avoided. In this context, the authorities noted that expenditures (particularly on capital goods) would be reduced in case of a shortfall in revenue collection. Efforts to mobilize more domestic revenue should complement the expenditure measures. The yield from the new surcharge on imports and other measures under consideration should raise tax revenue from just under 17 percent of GDP in 2005/06 to about 18 percent a year over the medium term, which would be roughly comparable to other countries in the region.3 Nevertheless, vigilance is necessary to prevent the erosion in tax revenue that occurred in the last two years.

12. Monetary policy should be directed to achieving the inflation and international reserves targets, but this will require more effective instruments. Currently, the authorities rely on direct instruments, such as ceilings on domestic credit to the government. The efficacy of indirect instruments like open market operations with treasury bills has been diluted significantly because of structural rigidities, such as the substantial excess cash reserves of commercial banks (see Box 1). There was agreement on the need to rely more on indirect instruments for monetary policy in the medium term; staff recommended reinforcing the recent effort to mop up excess cash reserves through the sale of longer-term securities, facilitating the interbank market (to better allocate the resources to banks in need), and promoting a more efficient and competitive financial sector. The staff also argued that a gradual move to positive real interest rates, starting with a sizeable upfront increase in the minimum deposit rate above the current 3 percent, in combination with the effort to reduce excess reserves, is needed to contain inflationary pressures.

Ethiopia: Excess Reserves in Commercial Banks

As of December 2006, bank reserves exceeded the required level (5 percent of deposits) by about 14 percentage points. The state-owned Commercial Bank of Ethiopia (CBE) holds a disproportionately large amount. Reserves rose sharply in mid-2004, while the overall liquid assets of commercial banks were kept almost constant during 2002-2006. This reflected the shift from issuing treasury bills to central bank financing in 2004/05.

A01ufig10

Excess Reserves of Commercial Banks

(Percent)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

The excess reserves have led to artificially low rates at treasury bill auctions; and precluded the effective use of indirect monetary policy, while enabling banks to expand credit rapidly. The only attempt to reduce excess reserves has been the issuance of short-term treasury bills. This did help reduce excess reserves from 29 percent of deposits at the end of 2005 to 14 percent a year later. However, reserves are still high compared to other countries in the region, and the effect of the issuance of short-term treasury bills on the credit expansion would be limited until the excess reserves have been lowered to a reasonable level.

A01ufig11

Composition of Liquid Assets of Commercial Banks

(Percent of total assets of commercial banks)

Citation: IMF Staff Country Reports 2007, 247; 10.5089/9781451812800.002.A001

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13. continued depletion of international reserves in recent months has prompted the monetary authorities to take measures to defend the level of official reserves. They have issued directives promoting inward remittances and foreign currency deposits, and are enforcing the surrender requirement for receipts from tourists and exports of flowers. Exporters have been given easier access to domestic financing. The staff argued that a more enduring measure would be to allow the exchange rate—which appears to be overvalued—to adjust more rapidly, noting the cumulative real appreciation of about 20 percent since early 2005 (see Box 2). This should be supplemented with restraints to moderate import demand by the public sector, including rephasing large infrastructure projects.