The Federal Democratic Republic of Ethiopia
Staff Report for the 2012 Article IV Consultation

Ethiopia pursues a public sector-led growth strategy that focuses on promoting growth through high public investment supported partly by low nominal interest rates. While the strategy has contributed to robust economic growth in the past, recent developments indicate a buildup of vulnerabilities which need to be addressed in order to sustain this growth performance. While inflation remains high (21 percent at end-2011/12), real GDP growth, which is estimated at around 7 percent in 2011/12 and is projected to decline to 6.5 percent in subsequent years under the continuation of current policies, is still robust.

Abstract

Ethiopia pursues a public sector-led growth strategy that focuses on promoting growth through high public investment supported partly by low nominal interest rates. While the strategy has contributed to robust economic growth in the past, recent developments indicate a buildup of vulnerabilities which need to be addressed in order to sustain this growth performance. While inflation remains high (21 percent at end-2011/12), real GDP growth, which is estimated at around 7 percent in 2011/12 and is projected to decline to 6.5 percent in subsequent years under the continuation of current policies, is still robust.

Background

1. Ethiopia is pursuing a public sector-led development strategy that focuses on promoting growth through high public investment facilitated partly by low nominal interest rates. The strategy calls for government directed economic policy, with a dominant role for public enterprises in infrastructure development. Within this development strategy, the authorities adopted a 5-year Growth and Transformation Plan (GTP) in November 2010, which aims to attain high GDP growth (an average annual rate of over 11 percent) and achieve the Millennium Development Goals (MDGs).1 Among its strategic pillars is an emphasis on agriculture, promotion of industrialization, and investment in infrastructure.

2. The strategy has contributed to lifting economic growth, and Ethiopia has been making significant progress in all areas of the MDGs (Table 1). Robust growth in the recent past and pro-poor focus of the government budget have resulted in significant poverty reduction: the authorities’ preliminary estimates indicate that the poverty head count declined from 38.7 percent in 2004/05 to 29.6 percent in 2010/11.

Table 1.

Ethiopia: Millennium Development Goals

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Source: 2011 World Development Indicators database

3. However, after the second and final Exogenous Shocks Facility review was completed in November 2010, macroeconomic imbalances have resurfaced. Inflation rose above 40 percent in August 2011 from 10 percent in November 2010 and resulted in highly negative real interest rates and an overvalued real exchange rate. Federal government budget execution and monetary policy were tightened later in 2011 and as some special factors contributing to the surge in inflation—including the after effects of birr devaluation in September 2010, international commodity price increases, and drought—began to subside, inflation, though still elevated, is now on a declining path (Figure 1). However, other risks and vulnerabilities related to the financing model of the large public investment projects are now emerging.

Figure 1.
Figure 1.

Ethiopia: Recent Economic Developments

Citation: IMF Staff Country Reports 2012, 287; 10.5089/9781475513233.002.A001

Sources: Ethiopian authorities and IMF staff estimates.

4. The recommendations from the 2011 Article IV consultations have only been partially implemented. The authorities implemented the base money nominal anchor; however, positive real interest rates are yet to be realized and little was done to reinforce liquidity management at the National Bank of Ethiopia (NBE). Similarly, little progress has been made on structural reforms to liberalize the foreign exchange and trade regimes, or improve the business climate. The authorities continue to put much emphasis on improving physical infrastructures such as road and electricity supply, which they believe would help improve business climate.

5. The 2012 Article IV discussions focused on policy options to sustain the robust growth rate and the current disinflation process and to address emerging risks and vulnerabilities in the system. The mission’s recommendations focused on achieving low inflation, appropriate pacing of scaling up public investment, financial sector stability, and increasing the role of the private sector in economic activities.

Recent Developments and Outlook

A. Recent Economic Developments

6. The authorities’ determination to reduce inflation has been paying off, though some challenges remain. Inflation has decelerated to 21 percent in June 2012 from the recent peak of about 40 percent in August 2011, reflecting a tight monetary policy stance and a slowdown in food inflation (Figure 1). Despite this achievement, inflation remains high and nonfood inflation continues to hover around 20 percent. Absent the significant public sector spending to achieve the GTP objectives the pace of inflation decline would have been sharper. According to the authorities, the slow pace of inflation decline reflects instead supply side constraints. Although economic activity has been affected by high inflation, real GDP growth in 2011/12 is estimated at around 7 percent; this is a robust performance given the weakness of the global economy, and is above the average growth for sub-Saharan African countries.2 Domestic credit grew by 41 percent year-on-year at end-April 2012, driven by a sharp rise in public sector borrowing to finance large infrastructure investment projects, contributing to an increase in broad money by 30 percent.

7. The authorities have been implementing their national accounts improvement action plan.3 A recent AFRITAC EAST mission found commendable progress in improving the compilation methodology. Additional efforts by the authorities and the IMF staff are expected to help reconcile the historical differences between official GDP statistics and the staff estimates.

8. Although federal government budget execution has been tight given the objective of supporting inflation reduction, the public sector as a whole has been providing strong fiscal impulse (Figure 1). In the first 10 months of 2011/12, federal government revenue grew by 51 percent while total expenditure including transfers to regional governments grew only by 30 percent; the overall deficit was 0.8 percent of annual GDP compared to 2.3 percent in the budget. However, the public sector (including state-owned enterprises) as a whole has been providing strong fiscal impulse based on its borrowing from the state-owned Commercial Bank of Ethiopia (CBE). A sharp rise in regional government deposits at CBE, a drawdown of excess reserves, and a lowering of reserve requirement in January 2012 contributed to the funding.4

9. Implementation of the base money nominal anchor has been instrumental in reducing inflation. Annual base money growth at end-April 2012 slowed to 1.3 percent as the central bank has ceased providing new direct credit to the government since July 2011 and has been selling foreign exchange (FX) reserves in recent months to achieve a base money contraction target of 4 percent for the fiscal year (Figure 1). However, as some banks significantly drew down their excess reserves and started having difficulty maintaining the required reserves, NBE lowered the reserve requirement ratio in January 2012. The lowering of the ratio from 15 percent to 10 percent has weakened the tightening effect of the base money contraction. Broad money at end-April 2012 grew by 30 percent year-on-year on account of strong credit growth to public enterprises.

10. The real effective exchange rate has been appreciating, an indication of loss of competitiveness and a cause of concern for external stability. After the large devaluation of September 2010, and as a result of high inflation, the real effective exchange rate (REER) in May 2012 reached the highest level since March 2009 and is overvalued in the range of 11–23 percent according to the assessment based on the IMF’s Consultative Group on Exchange Rate (CGER) methodology. Survey-based indicators also suggest that high costs of doing business are undermining competitiveness. (Figure 1 and Annex I).

11. Foreign exchange reserves were significantly run down as a result of foreign exchange sales to sterilize liquidity. Gross official reserves in April 2012 decreased by almost $1.2 billion to 1.8 months of projected imports for 2012/13 from its peak in September 2011. In the absence of an active treasury bill market, FX reserves have been the primary monetary policy tool to affect the level of liquidity. Reserve adequacy analysis indicates that higher months of imports coverage are recommended given the exchange rate regime in Ethiopia (Annex II).

12. The improvement of current account balance in 2010/11 is reversed due to a strong growth of imports in 2011/12. The current account recorded a small surplus in 2010/11 owing to a decline in imports of capital and consumer goods, which appear to reflect some front loading of imports in the previous year. Foreign investors in the targeted sectors that receive government support contributed to a diversification of exports. Despite a continued robust performance in export of goods and remittances in 2011/12, strong consumer goods imports and the deteriorating service balance in the first half of the period, moved the current account into a deficit. Notwithstanding these improvements, large errors and omissions recorded in 2011/12 need to be addressed.

B. Outlook

13. Growth is projected to decelerate in the medium term. This is largely attributed to the limited opportunities for the private sector to leverage the large public investment to further raise growth. In view of these developments, and based on continuation of current policies, staff project real GDP growth to moderately decline to 6.5 percent in the medium term (Box 1 and Table 3). On the external side, solid increases in goods exports are expected, supported by growth of emerging sectors. Vulnerabilities remain, however, as the prospects for the world economy are uncertain and the REER is overvalued.

Table 2.

Ethiopia: Risk Assessment Matrix

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Table 3.

Ethiopia: Selected Economic and Financial Indicators, 2009/10–2016/171

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Sources: Ethiopian authorities and IMF staff estimates and projections.

Data pertain to Ethiopian fiscal year from July 8 to July 7.

Including debt of major public enterprises.

Ethiopia: Growth Accounting

The official statistics registers remarkable economic growth in Ethiopia in the last 8 years. The real GDP growth has remained above 10 percent since 2003/04 when the Ethiopian economy recovered from a severe drought in 2002/03.

A growth accounting applied to Ethiopian data reveals two underlying features (Table below). First, large part of the growth was driven by large capital investment in the public sector. Capital stock grew, on average, by 10.8 percent, which by far exceeds capital growth rates for sub-Saharan Africa in the 1980s (2.0 percent) and even East Asian countries in the 1980s (8.9 percent) where the growth was highly capital intensive.

Second, the official statistics implies long-lasting rapid productivity growth between 2006/07 and 2010/11, the average contributions to the growth are estimated at 2.6 percent from the labor and 3.2 percent from the capital, implying total factor productivity (TFP) growth of 5.2 percent. The estimated TFP growth is high both by the Ethiopian historical standard and the cross-country comparison.

For Ethiopia, existing literature finds TFP growth between 0 to 1.4 percent until the early 2000s. For other countries, studies find TFP growth of 1.6 percent for OECD countries, 0.5–1.6 percent in East Asia and 1.4–4.6 percent in China in 1984–94.

Several factors that normally support high TFP were absent in Ethiopia. These factors include: initial human and physical capital conditions, terms of trade and openness, good macroeconomic environment, such as low inflation, competitive real exchange rate, low government consumption, high international reserve coverage, and low external debt.

High implied TFP productivity growth in Ethiopia seems therefore implausible, suggesting an existence of problems in the official growth estimates. Possible issues include remaining weaknesses in national accounts compilation methodologies and the accuracy of the source data.

With moderate TFP growth, reflecting the factors that are less supportive for Ethiopia, moderate real GDP growth would be expected over the medium term.

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Sources: Ethiopian authorities; IMF IFS database; World Bank’s WDI database; IMF staff estimates.

Average growth for the preceding five years is used for 2009/10 and 2010/11.

The capital stock series is constructed by the perpetual inventory method using the time-series data of gross capital formation from 1981/82. The depreciation rate of 0.10 is used. The capital share of 30 percent is assumed.

C. Risks

14. There are near-term downside risks (Table 2). Key risks arise from the uncertain prospects for the global economy that could lower export prices and from domestic policies. Although the crisis in Europe has had little spillover to the Ethiopian economy to date, a worsening of the crisis could reduce demand for Ethiopian exports and lower export prices and result in shortfalls of aid flows, lower remittances, and limited financing for infrastructure investment in the GTP. On domestic policies, the planned significant domestic financing for large public investment projects of the GTP could result in a further buildup of vulnerabilities. Other key risks include: (i) entrenched inflation expectations and a return to monetary expansion in the context of limited active use of monetary instruments; (ii) weather related shocks, particularly the late onset of the rainy season and possible drought returning to the Horn of Africa; and (iii) a further deterioration of the restrictive business environment.

Policy Discussions: Promoting Growth and Reducing Vulnerabilities

15. Ethiopia aims to sustainably raise growth in line with its goal to reach middle income levels by 2025, while maintaining macroeconomic stability. The government’s objectives for 2012/13 are to sustain the robust economic performance and to lower inflation further to single digits by the end of 2012. For the medium term, the authorities target growth at around 11 percent a year and inflation at single digits in line with the GTP. To achieve these objectives, authorities’ current policies promote high public investment supported partly by low nominal interest rates and a tight monetary policy, which has relied so far on two instruments—FX sales and no NBE financing of fiscal deficit, with the latter planned to be reversed in 2012/13.

16. On the basis of a continuation of these policies, staff baseline scenario expects a deceleration of medium-term growth and a building up of vulnerabilities on both domestic and external fronts. The vulnerabilities relate to: limited use of available monetary policy instruments (securities) to control inflation; low foreign reserve levels; a possible reinforcement of systemic risks associated with the dominant state-owned CBE and its increasing exposure to public enterprises; large accumulation of debt by public enterprises; and crowding out of the private sector—all of these being associated with the authorities’ policy choices. Some adjustments in macroeconomic and financial policies would therefore be needed to mitigate these vulnerabilities as discussed below.

17. The discussions focused on prioritized recommendations which aim at improving macroeconomic performance and mitigating vulnerabilities without fundamentally altering the country’s development model. These include (i) maintaining financial sector stability; (ii) keeping inflation under control to eliminate highly negative real interest rates and exchange rate overvaluation; (iii) creating space for an increased private sector’s role in the economy; and (iv) achieving higher foreign reserve coverage.

18. Given the development model and based on these recommendations, staff developed an alternative scenario that aims at safeguarding macroeconomic stability and reducing vulnerabilities, while preserving strong growth (Table 7). Under staff’s alternative scenario, the growth rate is projected to rise to 8.5 percent in 2016–17 through appropriate pacing of scaling up public investment; a larger private sector participation; inflation would decline further to 6 percent by 2014; real interest rates would turn positive, expanding the deposit base; the exchange rate would become more competitive; and FX reserves would recover to the 3.2 months of imports at the end of the projection period. This scenario assumes that the 27 percent NBE-bill requirement would be modified through a dialogue with private banks (Box 2) and private sector access to credit from the banking system would increase.

Table 4a.

Ethiopia: General Government Operations, 2009/10–2016/17

(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 4b.

Ethiopia: General Government Operations, 2009/10–2016/17

(Percent of GDP)

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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 4c.

Ethiopia: Statement of Government Operations (GFSM2001), 2009/10–2016/17

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Sources: Ethiopian authorities; and IMF staff estimates and projections. The Ethiopian fiscal year ends July 7.
Table 5.

Ethiopia: Monetary Survey and Central Bank Accounts, 2009/10–2012/131

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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. The columns for the authorities reflect NBE’s estimates and targets for end-June.

Claims on the general government by the banking system less deposits of the general government with the banking system.