Ethiopia
2010 Article IV Consultation and First Review of the Arrangement under the Exogenous Shocks Facility: Staff Report; Staff Supplements; and Press Release on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
23 Jun 2010
eISBN:
9781455204175
Language:
English
Keywords:
ISCR; CR; ESF arrangement; ESF review; consumer price inflation; central bank; terms of trade; private sector; inflation pressure; debt ratio; Imports
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The Ethiopian authorities have been generally responsive to the policy recommendations from the 2008 Article IV Consultation. To help rebuild international reserves and improve external competitiveness, the authorities made another exchange rate adjustment (a 5 percent devaluation) on January 31, 2010. The overall fiscal balance during July-December 2009 indicates stronger revenue collection than programmed. Ethiopia has been resilient to the ongoing global crisis because remittances have remained stable in 2009/10, FDI has risen 20 percent, and imports are lower.

Abstract

The Ethiopian authorities have been generally responsive to the policy recommendations from the 2008 Article IV Consultation. To help rebuild international reserves and improve external competitiveness, the authorities made another exchange rate adjustment (a 5 percent devaluation) on January 31, 2010. The overall fiscal balance during July-December 2009 indicates stronger revenue collection than programmed. Ethiopia has been resilient to the ongoing global crisis because remittances have remained stable in 2009/10, FDI has risen 20 percent, and imports are lower.

I. Background

1. For the past six years, the economy has enjoyed strong growth, largely owing to government-led development policies—with an emphasis on public investment, commercialization of agriculture, and nonfarm private sector developments. After a significant drought-related contraction in 2002/03, growth rebounded at an annual average rate of 11.2 percent for 2003/04-2008/09—significantly above the average of 6.3 percent realized in Sub-Saharan Africa (Table 1 and Figures 1 and 2). The pace of growth also far exceeds the minimum growth target of 7 percent in the Program for Accelerated and Sustainable Development (PASDEP), and Ethiopia is making significant progress in all areas of the Millennium Development Goals (Table 7). Although initially led by agriculture, the growth has been broad-based, with a rising contribution from the service sectors and industry, resulting in export diversification.

Figure 1.
Figure 1.

Real GDP Growth

(In percent)

Ethiopia has seen strong growth in recent years…

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 2.
Figure 2.

Contributions to Real GDP Growth by Sector

…initially led by agriculture, but increasingly by services.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

2. During this period, pressures on macroeconomic balances, particularly prices and international reserves, heightened. These pressures largely stem from (i) high domestic demand, which exceeded the supply capacity of the economy, and (ii) exogenous shocks during 2008–09, with commodity price surges and the global recession. Inflation rose to 64 percent in the twelve months to July 2008 with food prices rising 92 percent. International reserves fell to one month of imports at end-October 2008. Since late 2008, the authorities have forcefully implemented macroeconomic adjustment policies supported by the arrangements under the ESF, and against a difficult external environment. The global recession has constrained export growth, but the impact on aggregate output has been modest given the central role of subsistence agriculture (Figures 3 and 4).

Figure 3.
Figure 3.

Remittance Inflow

Remittance flows declined in 2009.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 4.
Figure 4.

Exports of Goods

(Annual changes, in percent)

Export receipts, after a drop in late 2008—09, have been recovering.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

3. The Ethiopian authorities have been generally responsive to the policy recommendations from the 2008 Article IV consultation. The authorities adequately implemented adjustment measures, through tightening of fiscal and monetary policies, enhanced flexibility of the exchange rate, and the pass-through of international fuel prices to retail prices. In structural areas (e.g., fostering a deeper foreign exchange market, increasing competition in the banking system), however, only modest progress has been made thus far.

II. Recent Developments and Performance under the Program

4. Pressures on prices and international reserves eased in 2009. Inflation plunged to 7.1 percent, mainly because food prices reversed; nonfood inflation remained in double digits (Figures 5 and 6). Although progress has been made in reducing macroeconomic imbalances, inflation has been rising in recent months and non-food inflation remains near 20 percent.

Figure 5.
Figure 5.

CPI

(annual percent change, average)

A recent inflation trend has reversed…

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 6.
Figure 6.

CPI

(annual percent change)

…largely owing to a reversal of food inflation.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Overall, growth momentum remains healthy despite a modest reduction in the growth rate last summer on account of insufficient rain that affected agricultural production (Figure 7). Helped by strong donor inflows (and Fund resources) and macroeconomic adjustment policies, international reserves rose above two months of imports in February 2010 (Figures 8 and 9). The external current account deficit widened somewhat, but by less than expected, as export volumes were buoyant and the terms of trade improved. Developments under the program are discussed in more detail in the attached Memorandum of Economic and Financial Policies (MEFP).

Figure 7.
Figure 7.

Agricultural Production and Cultivated Area

(Annual changes, in percent)

Agricultural production is expected to slow in 2009/10.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 8.
Figure 8.

International Reserves

(In months of imports)

International reserves are being rebuilt…

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 9.
Figure 9.

Gross International Reserves

(In millions of U.S. dollars, left axis)

…helped by macroeconomic adjustment and donor resources.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

5. To help rebuild international reserves and improve external competitiveness, the authorities made another exchange rate adjustment (a 5 percent devaluation) on January 31, 2010 (Figures 10 and 11). This adjustment, together with previous ones in 2009, and the recent disinflation have brought down the real effective exchange rate to a level close to the equilibrium rate suggested by various methodologies (see paragraph 9).1,2

Figure 10.
Figure 10.

Exchange Rate

(Birr per US$)

A couple of step adjustments have been made in the last 12 months.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 11.
Figure 11.

Effective Exchange Rates

(Index, end-2007=100)

Real effective exchange rate has returned to more acceptable range.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

6. Program implementation is on track (MEFP; paragraphs 2–6). All quantitative performance criteria (PCs) and indicative targets for end-December 2009 were met (MEFP, Table 1), as were all structural benchmarks (MEFP, Table 2).

  • The overall fiscal balance during July-December 2009 indicates stronger revenue collection than programmed, reflecting administrative efforts (including collection of outstanding tax arrears) and the delayed impact of previous high inflation on income taxes (Table 2). On the expenditure side, while maintaining pro-poor spending, other recurrent outlays were contained. As a result, domestic financing was negative during July–December 2009 and the target for the year as a whole has been reduced to 0.7 percent of GDP, about half the targeted amount under the program (Text Table). The continuing large public enterprises’ domestic borrowing is mainly for infrastructure projects in hydro electricity, telecoms, and urban housing.

  • The authorities are implementing a tax reform strategy. The strategy draws significantly on the recommendations of Fund technical assistance on tax policy and administration (Box 1). Specifically, the efficiency of tax collection will be improved by (i) transferring the collections of direct (business and personal income taxes) and indirect taxes (VAT and excise duty) from Addis Ababa City to the Ethiopian Revenues and Customs Authority (ERCA), and (ii) reviewing of all exemptions for economic need.

  • Although annual reserve money growth has declined sharply, excess liquidity remains in the system and bank-by-bank credit ceilings introduced in early 2009 remain in effect (Table 3). Reserve money growth declined to 16 percent in December, and further in early 2010, reflecting the government’s repayment of the NBE’s advances, (Figure 12). A system to control reserve money liquidity is being developed, but is not yet operational. Despite excess liquidity, demand for Treasury bills has declined, as rates remain highly negative in real terms (Figure 13).

  • Ethiopia has been resilient to the ongoing global crisis because remittances have remained stable in 2009/10, FDI has risen 20 percent, and imports are lower (Table 4). The shocks that led to the ESF arrangement request were mainly on large projected declines in remittances and in FDI. As a result, external borrowing, especially on non concessional terms was much lower than expected.

Text Table.

Public Sector Domestic Financing

(In percent of GDP)

article image
Figure 12.
Figure 12.

Contributions to Reserve Money Growth

(Annual changes in percent of beginning period stock)

Reserve money growth declined on restrained financing needs of the government.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 13.
Figure 13.

T-Bill Auction Results

(In percent)

Demand for T-bills has declined steadily, reflecting significantly low yields.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

7. An update safeguards assessment of the NBE was completed in December 2009 (MEFP, paragraph 17). It identified issues related to the oversight of the external and internal audit functions, and controls over monetary data reporting. In response, the NBE established a functional Audit Committee and set up an independent review of monetary data submitted for program monitoring purposes by the NBE’s internal auditors. Over the medium-term, further efforts are called for to address other safeguard risks, through enhancing Audit Committee oversight of the external audit mechanism and strengthening the NBE’s independence concerning the potential scope for unlimited financing of the government and unrealized profit distribution mechanisms. In its response to the assessment, the NBE noted that it had the right to reject any demand for government financing if deemed necessary to maintain macroeconomic stability.

III. Policy Discussions

A. Policies for the Remainder of 2009/10 and 2010/11

8. Key objectives for the rest of FY2009/10 and for FY2010/11 (MEFP, paragraphs 7–8) are to maintain strong GDP growth of 7–8 percent, contain overall inflation to 8–10 percent; and raise international reserves to US$1.9 billion, equivalent to 2.1 months of import coverage by end-June 2010 and 2.3 months by end-June 2011, respectively.3 The authorities—while aiming at real GDP growth of about 10 percent in both years—have agreed to maintain a conservative growth assumption for program purposes and are committed to addressing statistical shortcomings in the national accounts (Box 2).

  • The general government budget for 2010/11 envisages some easing from the tight fiscal balance this year (MEFP, paragraph 10). Tax revenues should rise by about 0.5 percent of GDP, with further implementation of the tax reform strategy, although nontax revenues are expected to decline by 1.2 percent of GDP.4 On the expenditure side, capital outlays would rise while recurrent outlays are maintained in relation to GDP. The budget deficit is set to rise from 2.1 percent to 3.4 percent of GDP, financed by a mix of external and domestic borrowing. Staff would have preferred a somewhat tighter fiscal stance for 2010/11 than proposed by the authorities to support the monetization effort. The increase in the overall deficit reflects lower nontax revenue, from exceptional levels over the past few years and higher public infrastructure investment. The authorities argued strongly that they should reinforce their emphasis on pro-poor and pro-growth public investment outlays. The fiscal stance is also compatible with maintaining the low risk outlook of the DSA. If aid inflows or revenues exceed budgetary projections, the authorities intend to reduce domestic borrowing levels commensurately to support the inflation reduction objective.

  • Monetary policy will support a remonetization of the economy (MEFP; paragraph 12). The NBE intends to introduce active liquidity management, in line with maintaining lower reserve money growth to achieve low inflation, with a view to phasing out the credit ceilings by end-2010. This will require allowing T-bill rates to rise. Staff views the policy response as appropriate and urged determined implementation, to address the adverse consequences of bank credit ceilings on the demand for money and financial deepening and recommended adoption of reserve money as the nominal anchor. For 2010/11, broad money is projected to grow by 22 percent, slightly higher than nominal GDP growth (taking into account prospective monetization). Even after somewhat higher public sector borrowing and the foreign reserve accumulation, growth in credit to the private sector would rise by about 25 percent, a significant increase in real terms.

B. Macroeconomic Policy Challenges

9. Discussions focused on how Ethiopia could sustain high growth, improve resilience to shocks, while further reducing macroeconomic risks and imbalances. Macroeconomic and financial policies should urgently promote monetization and financial deepening. The risk of exogenous shocks is high, given that, for the last decades, Ethiopia has experienced recurring adverse shocks every 5–7 years, stemming from droughts, terms of trade reversals (including high international commodity prices), and most recently the global recession (Figures 14 and 15). Although Ethiopia has made considerable strides in diversifying goods exports and has strong prospects in transportation and electricity exports, it remains highly dependent on primary industry, the level of exports is low, and financial intermediation is severely underdeveloped. Economic resilience would be improved by a strong tax effort, higher domestic savings and investment, and steps to reinforce competitiveness. More generally, an acceleration of the pace of the structural reform agenda would be beneficial. World Bank staff indicate that while modest progress is being made on structural reforms, an increase in the momentum is expected under PASDEP II.

Figure 14.
Figure 14.

Real GDP Growth and Contribution of Agricultural Sector

For the last three decades, Ethiopia has been hit by droughts in every 5–7 years.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 15.
Figure 15.

Terms of Trade and Import Prices

(Annual changes, in percent)

Terms of trade shocks are also frequent, often caused by high international commodity prices.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

  • Monetization and financial deepening (Box 3). The demonetization of the economy is a major cause of concern (Figure 16). Several factors have contributed to demonetization over the last several years, such as significantly negative real interest rates, high reserve money growth; bank-by-bank credit ceilings, introduced to contain inflation; and lack of competition among banks. Staff analysis emphasized the dangers to financial stability and the lost growth from continued demonetization. The authorities concurred with the need to promote monetization and decided to step up their efforts to contain reserve money growth and lower inflation through active liquidity management, thus raising T-bill real rates (Figure 17). The authorities are committed to achieving real positive interest rates, which staff believes is urgently needed to both reverse demonetization and further reduce macroeconomic imbalances.

  • Stepping up revenue efforts to create more fiscal space and substitute for domestic financing (MEFP, paragraph 10). The comprehensive tax reform strategy was finalized in February 2010, based on recent Fund technical assistance. Tax collection is expected to improve significantly by consolidating tax collection, reviewing current exemptions and exemption approval procedures, and increasing resources for the audit and enforcement over large tax payers.

  • Strengthening debt management to ensure public debt remains at low risk (MEFP, paragraphs 11 and 14). Public sector domestic borrowing will continue to at about 3 percent of GDP in the coming years. In line with the assumptions of the DSA the program allows for US$1 billion (3.2 percent of GDP) in the contracting of new nonconcessional borrowing through end-2010-11. Subsequently, new nonconcessional borrowing is projected to decline. Although Ethiopia’s risk of debt distress has been lowered on account of the inclusion of private transfers (see the accompanying DSA), Ethiopia’s debt management capacity is low and lagging behind other countries in the region. However, the adoption of new financial administration regulations is a positive step. Going forward, maintenance of the favorable risk outlook requires continued emphasis on strengthening debt management capacity by closely monitoring the debts of the largest public enterprises and assessing potential contingent liabilities.

  • Enhancing competitiveness (MEFP, paragraph 13). Adjustments to the nominal exchange rate and the recent disinflation have brought the real effective exchange rate to a level close to that suggested by various analytical methodologies (Box 4). However, a continued premium on the parallel market, combined with low external reserve levels suggest caution in assessing whether the exchange rate is at the appropriate level. Reserve coverage is projected to remain low, especially given the agricultural dependence of exports. While remaining vigilant to ensure that the nominal exchange rate is adjusted to avoid overvaluation in real terms, structural reforms to enhance competitiveness over the medium-term are critical. Exchange regime liberalization would benefit the economy through improved access for the private sector, increased confidence in the rate, and reduced economic losses from an active dual exchange market. The privatization program should be carried forward along with implementation of the Common Market for Eastern and Southern Africa (COMESA) external tariff and improvements to the investment climate.

  • Maintaining financial sector soundness: The recent rapid expansion of private banks in an environment of negative real interest rates, declining inflation, and tightening liquidity conditions highlights the importance of strengthened financial sector supervision and regulation. Although financial sector soundness indicators do not point to immediate concerns, continued close scrutiny by supervisors, especially of the dominant government owned Commercial bank of Ethiopia (CBE) and the new private banks will be important (Table 6).5 A slowdown of economic growth, the reduction of excess liquidity in the system, and the recent real estate boom could pose risks that need to be closely monitored. Oversight of the financial system is expected to be strengthened with technical assistances on risk-based supervision provided by East AFRITAC. Staff continues to believe that a Financial Assessment Stability Program (FSAP) evaluation would be beneficial. The recent passage of AML/CFT legislation is an important step forward.6

Figure 16.
Figure 16.

Monetization Indicators

A significant demonetization trend is a major concern.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Figure 17.
Figure 17.

Inflation and Real Interest Rates

Significantly negative real interest rates adversely affect monetization.

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

10. The authorities concurred with the importance of these reforms, except for the increase in the foreign reserves cushion and liberalization of the exchange regime. Ethiopia is targeting international reserves at 10 weeks of imports. In view of repeated large shocks, however, a larger foreign exchange reserve cushion—three months of imports at the minimum—would be advisable. In addition, over time, sustained export growth and import substitution will require vigorous implementation of productivity enhancing structural policies, including raising agricultural productivity, financial sector competitiveness, and improvements in the business climate to raise low private investment rates. The authorities indicated their willingness and ability to move the nominal exchange rate to ensure external competitiveness against the need to maintain higher reserves levels.

C. Medium-Term Outlook

11. The discussions focused on two medium-term scenarios: (i) baseline scenario, in line with the short-term policies as agreed under the ESF-supported program; and (ii) reform policies (with stepped-up reforms described above) to highlight the benefits of further policy reforms.

  • Baseline scenario: This scenario with status quo policies would broadly maintain macroeconomic balances but leave the economy vulnerable to shocks. The scenario envisages: (a) public sector domestic financing unchanged from current year levels (around 3 percent of GDP); (b) implementation of tax reform strategy; (c) reserve money growth maintained in single digits (year-on-year); and (d) gradual exchange rate adjustment in line with inflation differentials. Under this scenario, growth may reach 6–7 percent a year, but, with modest progress in tax reform, resources to finance pro-poor spending may not be boosted significantly. Official international reserves would not reach 2½ months of imports and remain vulnerable to shocks.

  • Stepped-up reform scenario: Reform policy scenario would combine adjustment policies with stepped-up reforms (enhanced tax reform efforts and reaching real positive interest rates sooner) and further exchange rate adjustments (Box 4). Based on the above-mentioned policy reforms, staff projections indicate that the medium-term economic outlook for Ethiopia is favorable. Real GDP growth would average about 7½ percent a year for 20010/11–2014/15, in part under the impact of a monetization of the economy, with private sector credit growing faster, and inflation targeted to stay at 3–5 percent. Based on real exchange rate depreciation over the next two years and structural reforms supporting private development, gradual replenishment of gross official international reserves would bring import coverage to three months by 2014/15 (Table 5). While the domestic debt ratio is slightly lower in the reform scenario on account of higher nominal GDP, the external debt ratio is higher because of the effects of the exchange rate depreciation.

IV. Program Monitoring, Financing, and Risks

12. The program PCs and benchmarks have been updated and modified (MEFP, paragraph 16). Revised quantitative performance criteria for July 7, 2010 are proposed along with new benchmarks for end-September (MEFP, Table 1). The revised criteria at end-June on the NDA of the NBE and on domestic financing of the budget reflect the expected tighter budget outturn for 2009/10 and the tighter monetary profile. The structural benchmarks table has also been extended with three new items that reflect the structural priorities in the period ahead, namely on the need to mark progress on tax reform, the introduction of active liquidity management, and the need to improve the national accounts data for macroeconomic management (MEFP, Table 2 and paragraph 15).

13. The program remains fully financed. Program access phasing remains unchanged. Ethiopia should not have any difficulty meeting its obligations to the Fund (Tables 8 and 9).

14. The risks to the ESF-supported program stem from low external reserves levels, in the face of potential external shocks; from domestic supply shocks reflecting Ethiopia’s dependence on rain-fed agriculture; and from the potential impact of continued demonetization on inflation and macro stability should program reforms on the monetary policy side not be energetically pursued.

V. Staff Appraisal

15. Ethiopia has been successfully implementing policies to reduce inflation and rebuild external reserves as agreed in the ESF-supported program. Public sector domestic borrowing has been reduced significantly in 2009/10 and the nominal exchange rate has been adjusted to improve competitiveness. The negative impact of the global recession has not been as severe as expected, which has allowed for over performance on the external targets. Staff welcomes the sharp reduction in inflation in 2009, reflecting reduced reserve money growth, made possible by lower domestic financing of the budget, and aided by external factors. Further necessary progress on core inflation will require relatively greater effort in controlling domestic liquidity.

16. Real growth has continued strong, under the impulse of government investment spending on social and physical infrastructure. The budget has appropriately focused on poverty reduction and infrastructure expenditure since the Heavily Indebted Poor Countries Initiative (HIPC) completion point. To sustain this growth trend, and further diversify the economy, staff encourages the authorities to adopt policies to promote the monetization and financial deepening of the economy while creating more room for private sector activity to leverage the large public investment outlays on infrastructure. Attention should focus on the business climate, particularly regarding private sector access to foreign exchange and credit, to stimulate private investment, and sustain the high economic and export growth of recent years.

17. The nominal exchange rate adjustments of 2009/10 have helped bring the exchange rate broadly back in line with equilibrium and improved external competitiveness. However, a liberalization of the exchange regime would benefit the economy through improved access and confidence in the foreign exchange market and a unification of the official and parallel markets would free up significant efficiency gains. Staff encouraged the authorities to be vigilant to ensure the nominal exchange rate is managed to guard against overvaluation. The authorities should also give sufficient weight to implementing structural reforms affecting the investment climate, trade liberalization and privatization, to secure durable improvements in competitiveness.

18. Efforts to raise fiscal revenues, a key to lower fiscal financing needs from the central bank, should be sustained. In addition to creating fiscal space, this would relieve pressures on liquidity growth; support a further decline in inflation and a reversal of the demonetization of the economy. Staff welcomes the adoption and initiation of an action plan on tax reform, on the basis of Fund TA, to improve the revenue effort though strengthened administration and policy reforms.

19. Regarding monetary policy, reversal of the demonetization trend is needed urgently. Staff encourages the authorities to significantly strengthen central bank and monetary policy independence from the budget. Maintaining a low reserve money growth policy in 2010/11 is needed to sustain a low inflation environment and support the elimination of the bank-by-bank credit ceilings. Introduction of active liquidity management would also help to achieve positive real interest rates in the short run, and would support monetization, financial deepening, and the mobilization of domestic savings. Allowing nominal interest rates to rise would also help support a liberalization of the exchange regime. Staff welcomes the authorities’ commitments in this area and urges prompt and decisive action. Delay in effecting a reversal in demonetization poses risks to financial stability and the ability of the financial sector to support private sector led growth. Efforts are also needed to strengthen financial sector supervision and regulation, particularly in view of the dominant role of the government-owned CBE and given the sharp rise in the number of new private banks. Staff encourages the authorities to consider the benefits of an FSAP evaluation.

20. While public external debt has risen strongly in recent years, the updated DSA suggests Ethiopia’s risk of debt distress has declined. The improvement reflects in part, the consideration of Ethiopia’s large and stable inflow of remittances as adding to its capacity to repay debt. Access to external resources (both concessional and non-concessional) has helped relieve the financing constraint and can continue to do this given the DSA assessment. Staff encourages the authorities to strengthen further public debt management capacity, particularly regarding public enterprises to maintain this favorable risk outlook. Staff urges a de-emphasis of domestic financing, especially to the extent that it is monetized.

21. The data provided to the Fund are adequate for surveillance and program monitoring purposes, but statistical weaknesses persist, most notably with regard to the national accounts. Staff welcomes the authorities’ commitment to improving the quality of the national accounts, with technical assistance from the Fund.

22. Ethiopia has recently taken action to strengthen AML/CFT and to address the issues raised in the safeguards assessment.

23. Staff recommends completion of the first ESF review. The next Article IV consultation would be held in accordance with the provisions of the Decision No. 12794 of July 15, 2002, on consultation cycles.

Ethiopia: Tax Reform Strategy

A comprehensive tax reform strategy was finalized in February 2010, based on recent technical assistances from the Fund on tax policy and administration. The reform measures comprehensively cover key recommendations from these TA and envisage swift implementation. Specifically, the efficiency of tax collection is expected to be significantly improved by (i) transferring the collection of direct (business and personal income taxes) and indirect taxes (VAT and excise duty) from Addis Ababa City to the Ethiopian Revenues and Customs Authority (ERCA), (ii) reviewing current exemptions and exemption approval procedures, and (iii) increasing the Large Tax Payers Office (LTO) audit and enforcement resources and capacity.

Major Tax Reform Measures

(through 2010)

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Some of the simpler administrative measures have already been implemented. In other areas, the authorities are taking a cautious approach, by first conducting studies in relevant areas (e.g., corrective measures for the investment incentives and its utilization), in order to ensure the government accountability to the public.

  • A review of tax exemptions has started and will be completed by July 2010. Corrective actions will be taken as needed.

  • Increasing the coverage of the cash register system—reducing leakages—has contributed to higher VAT collection. With most large hotels, supermarkets, and restaurants all registered under the system, the number of registers increased 1,330 at end-December 2009 to 2,130 at end-February 2010.

For the effective implementation of these measures, the high-level forum between MoFED and ERCA—established since mid-2009—is expected to play a key role. This forum takes place on monthly basis, monitoring revenue performance and overseeing the implementation of the revenue measures and the tax reform strategy.

Ethiopia: National Accounts Statistics Action Plan

STA mission on national account statistics in March 2010 identified some compilation and estimation deficiencies in the national accounts statistics. A corrective action plan (see below) has been formulated, with a follow-up TA in the pipeline. Some of the weaknesses noted are not unique to Ethiopia. In fact, the compilation system compares quite favorably with the systems of other countries in the region. However, the compilation process should be kept under constant review so that weaknesses could be identified and improvements incorporated into the system on an ongoing basis.

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Ethiopia: Monetary Policy Needs Reform to Promote Financial Intermediation

Ethiopia has experienced a worrying trend of demonetization in the last seven years. Financial intermediation and monetization are a driving force for development and have associated with rapid development success stories in Asia and elsewhere. The level of monetization is very low in Ethiopia. Critically, monetization has been on a downward trend since 2002/03, and Ethiopia is falling behind successful Asian countries at a similar stage of development and regional comparators (Figure 1).

Monetary policy is primarily responsible for this trend. Very high reserve money growth, which in turn reflects unsterilized central bank financing of the budget at effectively zero interest rates, has led to excess liquidity in the financial system. Inflation and low deposit rates (which do not respond to inflation because of commercial banks’ excess liquidity) have resulted in highly negative real interest rates, eroding the real value of deposits, discouraging savings, and dampened demand for broad money (Figure 2). More recently, direct bank by bank credit control (which was introduced in early 2009 as an administrative measure to curb inflation) has contributed to limited money growth despite strong demand for credit.

Monetary policy needs to change to reverse the demonetization trend. Inflation would be difficult to control if low T-bill rates and double digits reserve money growth fueled by central bank direct financing of the budget continue. To stimulate money demand, interest rates would need to be raised to positive levels in real terms and reserve money growth tightly controlled to maintain low inflation while allowing for healthy growth of broad money and credit to support economic expansion. If monetary policy can be reformed as described above, historical comparators (e.g., Korea in the mid 1960s) suggest a rapid and sustained remonetization can be achieved (Figures 3 and 4).

Box Figure 1.
Box Figure 1.

Broad Money/Nominal GDP

(percent)1

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

1 The number after the country names refer to the year (T) of the beginning of the plot.
Box Figure 2.
Box Figure 2.

Ethiopia: Real Deposit Rate and Velocity1

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

1 Real deposit rate is based on nonfood CPI.
Box Figure 3.
Box Figure 3.

Korea: Financial Reform Experience (1)

Percent

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Box Figure 4.
Box Figure 4.

Korea: Financial Reform Experience (2)

Percent

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Ethiopia: External Competitiveness and Exchange Rate Adjustments

The performance of Ethiopia’s exports over the past decade has been strong in US dollar terms but less so in relation to GDP. Since 2003, exports of goods and services have grown by about 19 percent per annum in Ethiopia, exceeded by Rwanda (21 percent), Uganda (25 percent) and Zambia (25 percent) among countries in the region (Box Figure 5). In relation to GDP, the ratio has remained stable in contrast to rises in other countries; this phenomenon is associated with denominator effects since the economy has been growing extremely rapidly. Ethiopia has made considerable strides in diversifying its goods export base (e.g., flowers and oil seeds) but more progress is needed to help boost reserve coverage and the export to GDP ratio (Box Figure 6). This requires some further movement in the real exchange rate.

Box Figure 5.
Box Figure 5.

Exports of Goods and Services

(annual changes, in percent)

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Box Figure 6.
Box Figure 6.

Decomposition of Exports of Goods

(in percent)

Citation: IMF Staff Country Reports 2010, 175; 10.5089/9781455204175.002.A001

Between mid 2004 and end 2008, the real effective exchange rate appreciated by over 60 percent owing to much higher inflation in Ethiopia than in its trading partners. Inflation pressures declined dramatically since end 2008, and, combined with continued nominal depreciation, has led to sharp real exchange rate depreciation. In the first quarter of 2010, the real exchange rate is about 7 percentage points higher than the prediction based on an equilibrium exchange rate model (SM/08/209) but this difference is within standard error margins.

On the other hand, reserve coverage continues to be low, projected to rise only to 2.3 months of imports in 2009/10 and to remain at this level, indicating the need for a 10 percentage point real exchange rate depreciation to secure a reserves target of 3 months of imports. This indicator is a variant on the macro-balance approach in which the objective is a specific reserve target rather than a medium term current account level.

The third methodology for assessing the exchange rate level is based on stabilizing debt. The accompanying debt sustainability analysis shows that Ethiopia is at low risk of debt distress and therefore there is no need for an exchange rate adjustment to improve the debt outlook.

Table 1.

Ethiopia: Selected Economic and Financial Indicators, 2007/08–2013/141

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

Except for data on external sector which is based on July 1-June 30, data pertain to the period July 8-July 7.

Including debt of major public enterprises.

The programmed figure in 2009/10 does not include some public enterprise debt.

After enhanced HIPC and MDRI relief.

Table 2a.

Ethiopia: General Government Operations, 2007/08–2013/14

(Millions of Birr)

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

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

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 after HIPC debt relief from the World Bank and African Development Bank.

Demobilization and reconstruction.

Table 2b.

Ethiopia: General Government Operations, 2007/08–2013/14

(In percent of GDP)

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

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

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 after HIPC debt relief from the World Bank and African Development Bank.

Demobilization and reconstruction.

Table 2c.

Ethiopia: Federal Government Operations, 2007/08–2010/11

(Millions of birr)

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

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

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 after HIPC debt relief from the World Bank and African Development Bank.

Table 3.

Ethiopia: Monetary Survey and Central Bank Accounts, 2008/09–2010/111

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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.

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.