IMF Policy Paper: The Federal Democratic Republic Of Ethiopia: Staff Report For The 2017 Article IV Consultation
Author: International Monetary Fund. African Dept.
Publication Date:
24 Jan 2018
eISBN:
9781484338506
Language:
English
Keywords:
ISCR; CR; center; authority; fiscal policy; current account; balance of payments; broad money; foreign exchange; central bank; IMF staff; Imports; Monetary base; export diversification
Download PDF (2.8 MB)

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for The Federal Democratic Republic of Ethiopia

Abstract

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for The Federal Democratic Republic of Ethiopia

Background And Recent Developments

1. Growth was resilient in 2016/171 amid continued weak global prices for commodities and re-emergence of drought in pastoral regions. Output is estimated to have grown 9 percent (Figure 1)2, owing to the recovery in the agriculture sector and 16 percent industry growth (power generation, construction), amid strong investment in infrastructure and manufacturing. Improved rainfall in the major Meher season saw agricultural production expand strongly by 8.8 percent, offsetting below-average rainfalls in the Belg season. The re-emergence of drought in the south and east did not halt the recovery: their GDP contribution is small and substantial past investments have enhanced the productivity and resilience of agriculture. However, the drought’s budgetary and social costs remained high with 8.5 million people requiring food assistance.

Figure 1.
Figure 1.

Real GDP Growth and Contribution by Sector

(Percent)

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Sources: Ethiopian authorities; and IMF staff calculations.

2. The 2016/17 external current account deficit narrowed due to lower imports, but exports remained stagnant. The current account deficit fell by one percentage point of GDP to 8.2 percent of GDP in 2016/17 as imports of goods and services declined, driven by lower drought-related food and public sector capital imports. The latter reflects the authorities’ policy actions aimed at reducing external imbalances and ensuring debt sustainability, consistent with Fund advice. However, export revenue rose only 2.9 percent, well below expectations, reflecting delays in key export-oriented projects—now completed or near completion (Hawassa industrial zone, Djibouti railway, power transmission). On the upside, coffee export volumes surged after recent supply-enhancing market reforms. Foreign Direct Investment (FDI) grew strongly by 27.6 percent, driven by investor interest in new industrial parks and privatization proceeds. Overall, international reserves declined to US$3.2 billion, equivalent to 1.8 months of prospective imports of goods and services (2.5 months on the authorities’ preferred measure3).

3. In October 2017, the National Bank of Ethiopia (NBE) devalued the birr by 15 percent to improve competitiveness and substantially tightened monetary policy—broadly in line with Fund advice. The interest rate floors on time and savings deposits were increased from 5 to 7 percent, and planned base money growth (the NBE’s main monetary policy instrument) was lowered from 22 percent to 16 percent. The NBE also liberalized some exchange control regulations, allowing exporters to access foreign credit and to retain up to 30 percent of their export proceeds in foreign currency (previously 10 percent), which, should lessen difficulties in procuring foreign exchange when needed for their inputs and capital imports. These measures are intended to address the external imbalances by supporting net exports and alleviating foreign exchange shortages, while minimizing potential inflationary effects from the devaluation. Prior to the devaluation, there had been an upward drift in inflation which exceeded the authorities target of about 8 percent, driven by food inflation; and significant growth in monetary and credit aggregates in 2016/17 (Figure 2 and Table 4). Inflation was 13.6 percent in November 2017, partly reflecting inflation momentum and the impact of the devaluation.

Figure 2.
Figure 2.

Inflation, Monetary and Credit Developments

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Source: Ethiopian authorities.
Table 4.

Ethiopia: Monetary Survey and Central Bank Accounts, 2013/14-2021/22

article image
Sources: NBE and IMF staff estimates and projections.
1

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

4. Since October 2016, the authorities appropriately adopted a restrictive stance on both government and public enterprises (SOEs) borrowing policies. The 2016/17 general government budget deficit was 3.4 percent of GDP including the supplementary budget, slightly below the budgeted 3.5 percent of GDP. While expenditure remained unchanged relative to 2015/16 (in percent of GDP), revenue underperformed (Table 1) mainly due to a shortfall in import levies. The January 2017 supplementary budget (1.1 percent of GDP) allowed for a moderate increase in public wages to increase retention, as suggested by a World Bank (WB) study, and social assistance, including drought-related spending. However, the supplementary budget was funded without additional borrowing by privatization receipts and fuel price stabilization fund surpluses. Also from October 2016, the Ministry of Finance and Economic Cooperation (MOFEC) implemented strong controls on external borrowing by public enterprises. As a result, the NPV of outstanding external obligations stabilized, and non-concessional commercial borrowing was reduced substantially.

Table 1.

Ethiopia: Fiscal Operations, 2015/16-2016/17

(Millions of birr, unless otherwise specified)

article image

5. Political context. Civil unrest since early-2015, rooted on regional and ethnic tensions, led to the introduction in October 2016 of a 9-month state of emergency, now lifted. The economic fallout, which affected mainly horticulture, tourism, and investor sentiment, seems to have been limited and short-lived. After the initially stern security response, the authorities took steps to enhance inclusiveness and compensated private investors for damages. However, instances of civil unrest continue. In October 2016, the cabinet was reshuffled, including appointment of a new Minister of Finance and Economic Cooperation and other senior economic policymakers. The new cabinet has substantially intensified implementation of GTP II4 policies aiming to increase privatization and private sector participation in the economy, introduction of a modern Public-Private Partnerships (PPPs) legal framework, and State-Owned Enterprises (SOEs) financial and governance reform.

Outlook And Risks

6. Output growth is expected to remain high at 8.5 percent in 2017/18, and only slowly decelerate over the medium term (Table 2). In the short term, ongoing recovery from droughts and the expected pick-up in exports are expected to offset the impact of the restrictive macroeconomic policy stance announced by the authorities. Medium-term real GDP growth is expected to converge to 8 percent, supported by strong private investment, continuing investment in infrastructure, and improving productivity—as FDI and export-oriented industries expand. In the immediate term, inflation is likely to remain above the 8 percent target due to price momentum from earlier months and the pass-through from devaluation. Nevertheless, the announced restrictive monetary and fiscal policy stances should bring inflation back to target in 2018/19.

Table 2.

Ethiopia: Selected Economic and Financial Indicators, 2013/14-2021/22

article image
Sources: Ethiopian authorities and IMF staff estimates and projections.
1

Based on data from Central Statistical Agency (CSA), except for the current account balance, which is based on BOP data from National Bank of Ethiopia (NBE).

2

Non-financial public sector debt.

7. Export growth is expected to pick up as key supporting projects come online, but the current account deficit will only gradually decline (Tables 5a and 5b). Exports of goods and services are envisaged to pick up substantially in the medium term, reflecting the completion of key infrastructure (electricity generation and transmission, railway to Djibouti and other logistics, industrial parks) and pay-offs from domestic investment and greenfield FDI. Nevertheless, this pickup is unlikely to reach its full extent immediately: time may be needed for testing, installation and training of newly-hired industrial workers before production facilities can operate at full capacity. Import growth will remain moderate in 2017/18, premised on continued public sector restraint, as announced in the recent budget speech. However, imports will gradually accelerate over the medium term since expanding manufacturing activities will entail substantial importation of inputs until alternative local sourcing, where feasible, develops. Thus, the current account deficit is projected to remain wide and decline only gradually.

8. Medium-term policies will remain framed by the GTP II strategic objectives. The GTP II allocates a major role to the public sector for public goods provision and anti-poverty and developmental programs. However, the strategy emphasizes private sector development and FDI, particularly in export-oriented manufacturing, through wide-ranging structural reforms and infrastructure improvements.

9. The external debt and debt service burden pose the main identifiable risk to macroeconomic stability (Annex I and Debt Sustainability Analysis, DSA). In particular, liabilities acquired in past years (Figure 4) coupled with export supply delays have resulted in a deterioration of DSA indicators, warranting a reclassification to high risk of debt distress. Under the baseline, both the net present value (NPV) of public and publicly guaranteed external debt and debt service ratios relative to exports breach the standard cross-country thresholds calling for reclassification to high risk of debt distress. Current debt service is becoming significant: Ethiopia faces about US$1.5 billion in external public debt service payments5 coming due during 2017/18 and significant obligations over the medium term. Given thin reserves (Annex II) and uncertainty in the timing and profile of the export pick-up, adverse shocks could pose debt servicing risks. This in turn, could force an undesirably abrupt import compression and undermine confidence, potentially compromising, at least temporarily, Ethiopia’s successful growth trajectory. In addition, further delays in the export take-off could also put growth projections at risk. The authorities have adopted appropriate decisive policy initiatives to forestall the emergence of debt stress episodes. These include restrictive public sector external borrowing policies, devaluation of the birr, a tight policy stance to increase domestic savings and contain demand spillovers through the balance of payments, and fast-track adoption of initiatives to mobilize private sector resources for infrastructure and public goods provision. Ethiopia remains vulnerable to climate-related risks, including droughts. The authorities have strengthened their safety net and humanitarian response mechanisms, which have been commended by donors, and are developing plans for preventive mitigation with assistance from the WB.

Figure 4.
Figure 4.

Net Accumulation of Liabilities and Debt Outstanding of the Non-Financial Public Sector

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Source: Ethiopian authorities.

Authorities’ Views

10. The authorities have placed the highest priority on policies to correct external imbalances and curb the debt burden, but disagreed with the change in DSA assessment to high risk of debt distress. There was no disagreement of substance between the authorities and staff as to the appropriate policy response, which the authorities are decisively implementing. The authorities considered the recent increase in the debt burden relative to exports as temporary, resulting from an unexpected delayed response of exports, and being effectively addressed by current policies. Also, they expressed concern that a DSA reclassification to high risk could hinder remedial policies by limiting their capacity to tap concessional financing (to replace commercial loans) and negatively affecting investor sentiment and public perceptions of the reform efforts.

Policy Discussions

11. There was agreement that after more than a decade of sustained public sector-led growth, the lead needs to be transferred now to the private sector—as envisaged in the authorities’ GTP II strategy. Should the public sector continue undertaking on its own a broad array of public projects, even if highly productive in the long term, it would risk aggravating external imbalances in the short term. These imbalances in turn would undermine the very objective of the public projects: the development of a vibrant private sector and dynamic markets able to lead the economy into its next growth phase. Thus, the timing and sequence of public investment and other public sector activities needs to be reprofiled to a pace commensurate with actual export revenue increases, and with progress in mobilizing domestic savings. In 2016/17, the authorities appropriately curbed accumulation of external debt, but the protracted export supply response to past investment requires additional actions. Thus, the more restrictive macroeconomic policy stance adopted by the authorities, including after the birr devaluation, is appropriate. Staff also supports the reforms in tax administration and financial management of SOEs—which will enhance domestic resources and their effective use. The envisaged private sector development reforms, such as the roll-out of a financial market and improvements in the business climate should be accelerated. Use of PPPs (with adequate safeguards), private concessions, and privatizations, as envisaged by the authorities, will preserve public resources while helping private sector development.

A. Fiscal Policy

12. Budget implementation in 2017/18 is expected to remain appropriately restrictive. Staff projects a below-budget government deficit outturn of 2.5 percent of GDP (Table 3b), based on the strict borrowing policies announced in the budget speech, particularly on capital projects financed by external loans. That said, social needs remain large, and staff supports the authorities’ intention to protect pro-poor spending. In this area, the social safety net is well-designed and has proven effective in delivering timely assistance to drought victims (Box 1). Continued progress on investment efficiency would also create fiscal room—staff encouraged participation in a Fund-WB Public Investment Management Assessment (PIMA).

Table 3b.

Ethiopia: General Government Operations, 2013/14-2021/221

(Percent of GDP)

article image
Sources: Ethiopian authorities and IMF staff estimates and projections. The Ethiopian fiscal year ends July 7.
1

Government financial statistics are reported by the authorities based on GFSM 1986.

2

Excluding special programs (demobilization and reconstruction).

3

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

4

External interest and amortization are presented after HIPC debt relief from the World Bank and African Development Bank.

The Social Safety Net in Ethiopia

Ethiopia has dealt with multiple droughts since the 1980s that have resulted in significant social costs.

The most recent drought in 2015/16 was managed through organized and coordinated action by the government with support from development partners. In addition to pledges from donors, the government mobilized reserve resources through drought recovery schemes. These mitigate the effects of the drought through imports and distribution of wheat and edible oil, and distribution of cattle feed to drought-stricken areas. The government’s goal is to reduce dependence on donor funding and assume greater responsibility for its social safety net system.

Since 2005, the Productive Safety Net Program (PSNP) has been assisting rural families facing chronic food insecurity. The program, now in its fourth phase, is funded by the budget and multiple donors. It reaches about 8 million beneficiaries, about half of whom are in drought-affected areas. Since the PSNP’s inception, the government has progressively increased its support, pledging US$500 million for the fourth phase. Of this. US$285 million constitutes cash grants, with the remainder offered as in-kind contributions (office space, employees, etc.). The PSNP aims to contain the negative effects of food shortages, support the rural transformation process, encourage families to engage in production and investment, and increase their purchasing power. Able-bodied beneficiaries must participate in productive activities aimed at uplifting community infrastructure and rehabilitating water and land resources. Participation (attendance) is recorded in the Urban Payroll Attendance Sheet System (UPASS), based on which PSNP beneficiaries receive food allocations or cash payments, the latter transferred into individuals’ bank accounts. Participants are also encouraged to save and can be referred to microfinance institutions to finance business ventures upon graduation from the PSNP.

To reduce urban poverty, the Urban Productive Safety Net Project (UPSNP) was established with support from the World Bank. The UPSNP is a 5-year project targeting some 604,000 people living below the poverty line in 11 urban centers. The total allocation to the program is US$450 million, with the government contributing US$150 million through cash and in-kind transfers. The project applies PSNP mechanisms that have proven to be effective in the past, combining direct support with engagement in public work, and relies on community-based targeting for nomination of beneficiaries, all of whom are registered in UPASS and receive payments through their bank accounts. UPSNP beneficiaries are also encouraged to save a portion of their earnings. After a period of three years, they can graduate from the program and receive a lump sum to establish their own small-scale enterprises, with assistance from microfinance institutions.

13. Stepping up revenue mobilization is urgent (Figure 3). Staff welcomed initiatives to expedite tax administration reforms with technical assistance (TA) from development partners, including the Fund (Box 2). Additionally, staff encouraged steps to reduce the scope for tax officials’ discretion and opportunities for rent-seeking. Staff suggested banking-intermediated payments and small-taxpayer taxation based on standardized presumptive-income indicators (e.g., shop surface) indexed to inflation. A stocktaking of existing tax incentives is near completion, with WB and Fund support. As a subsequent step, staff recommended establishing a regular cost-effectiveness review of existing incentives—a tax expenditure report—as part of the budget cycle.

Figure 3.
Figure 3.

Tax Revenue

(Percent of GDP)

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Domestic Revenue Mobilization in Ethiopia

Ethiopia has a low tax ratio compared to other low-income countries. Administrative bottlenecks and weak tax compliance have been the main obstacles to revenue administration. Given the current low collection rate, achieving the target of 17.2 percent of GDP by 2019/20 will be challenging. Some countries in the region have successfully implemented reform programs aimed at improving tax compliance and strengthening effectiveness and efficiency in revenue administration (e.g. Mozambique, Congo Republic, Cabo Verde and Liberia). Reforms have focused on strengthening core operational processes, improving organizational structures, better use of data and information technology, and enhanced human resource management.

The authorities are pursuing an ambitious revenue administration reform agenda. The income tax and tax administration laws approved in 2016 aimed at improving tax collection, broadening the tax base and setting up a more efficient tax system overall. The authorities designed the strategy in collaboration with development partners and established a Tax Policy Directorate under the MOFEC. Also, the Ethiopian Revenue and Customs Authority is implementing strategic measures in human resources, data management, large-taxpayers’ compliance, tax auditing, arrears, automation, and public outreach.

Although some progress has been achieved to date, much more remains to be done. Reforms have strengthened integrity and enforcement, with significant improvements in taxpayer assistance and service. However, compliance risk management improvements are slow. The authorities plan to clean up the taxpayer register and strengthen monitoring and management of exemptions with Fund assistance. An updated Integrated Tax Administration System software is also needed. Further legal reforms may be required to support revenue mobilization. A review of the Ethiopian tax system would also be useful in this regard, particularly as it could shed light on the underlying causes of the recent poor VAT performance.

uA01fig01

Tax Revenue in LIDCs

(2016, percent of GDP, general government)

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Source: WEO, Fiscal Monitor Note: LIDC (low income developing countries) average weighs individual country by annual nominal GDP converted to US dollars at average market exchange rates as a share of the group GDP.

14. SOEs governance reform and privatization aim at improving efficiency in public delivery while alleviating financing constraints. The recent National Tobacco Company privatization, divestment plans of non-strategic SOEs, and the ongoing audit of Ethio-Telecom are important steps. They should be accompanied by strengthened public oversight, based on timely audited International Financial Reporting Standards (IFRS) compliant financial statements for all public companies, and financial disclosure.

15. Improvements in fiscal reporting would facilitate macroeconomic policy formulation and accountability. Adoption of current Government Finance Statistics Manual (GFSM) standards remains an urgent task (Annex IV). Public debt reporting is accurate and comprehensive, and other public indicators from MOFEC and NBE are also appropriate. However, adherence to different methodologies make them difficult to integrate and result in inconsistencies. Policymaking and public understanding of policies would benefit from a more consistent and comprehensive fiscal reporting, encompassing extra-budgetary accounts. Also, a budget annex with the non-financial public sector summary consolidated accounts would allow monitoring of the broader financial and macroeconomic implications of public policies.

Authorities’ Views

16. There was agreement on the need to continue the tight policies and control on external borrowing implemented by the authorities during 2016/17, aiming at reducing the debt burden. While the authorities project substantially higher export and output growth than staff, there was also agreement that strong policies would need to be maintained until actual export performance improves. On structural fiscal reforms, including domestic revenue mobilization (Box 2), the authorities intend to continue intense technical assistance collaboration with development partners, stressing that this support is an important component in implementing their reform agenda. The authorities intend to continue strengthening the oversight of public enterprises with a view to improving their performance and, where appropriate, exploring options for strategic divestment.

B. Exchange Rate, Monetary, and Financial Sector Policies

17. In recent years, the exchange rate has been rigidly managed to achieve a nominal depreciation path of 5-6 percent annually relative to the U.S. dollar, which resulted in an overvaluation of the real exchange rate (Annex II). This exchange rate policy implicitly aimed at maintaining the real effective exchange rate stable, assuming that the inflation differential with trading partners was about 5-6 percentage points and the U.S. dollar value remained stable relative to Ethiopia’s trading partners’ currencies. However, the birr became increasingly overvalued in real effective terms after the strengthening of the U.S. dollar in 2014-15. In addition, persistently higher-than-expected inflation differentials with trading partners added to the overvaluation—even when allowing for high productivity gains in Ethiopia. While the predictable depreciation path reduced uncertainty, the increasing overvaluation encouraged import demand, hampered export diversification into higher-value export lines,6 exacerbated foreign exchange scarcity in the market.

18. The October 2017 devaluation of the birr and subsequent monetary tightening will help address exchange rate overvaluation. Staff estimates that the real effective exchange rate was overvalued by about 20 percent during 2016/17 based on a variety of approaches (Annex II)— resulting in widespread foreign exchange shortages. Thus, the October devaluation eliminated on impact most of the accumulated overvaluation, leaving it at about 7 percent.7 The substantial reduction in base and broad money growth targets for 2017/18 are appropriate to contain second-round and pass-through inflationary effects (Box 3). Going forward however it will be key to maintain a flexible exchange rate to preserve competitiveness and facilitate export diversification (Box 4). Staff advised against an excessively rigid birr-USD depreciation path and argued for making it more responsive than in the past to the evolution of the USD and inflation differentials relative to trading partners.

Exchange Rate Pass-Through in Ethiopia

Inflation pass-through in Ethiopia has historically been significant, but not complete. Staff’s analytical work has sought to explore empirically the exchange rate pass-through from the nominal effective exchange rate (NEER) to domestic prices. A univariate vector autoregression model was estimated using 2003-2017 data. The model controls for international oil and food prices, but it was statistically unfeasible to control for policy variables. Thus, results must be interpreted as applying when policy settings are at their (generally accommodative) historical levels for earlier depreciations.

The results show that a 1 percent movement in the NEER has historically been associated with a cumulative 0.43 percent movement in the Consumer Price Index (CPI) over 3 years, with most of the impact occurring within the first 18 months. A smaller effect is observed with the food basket in the CPI where a 1 percent NEER depreciation is expected to produce a cumulative increase of 0.23 percent in food prices over 3 years. These results suggest that, with policies at their historical settings, the recent 13-percent devaluation (measured in USD/birr) should raise domestic prices by approximately 5.6 percent over the next 18 months, or roughly 3.7 percent in the first year. Alternative estimation methodologies yielded broadly similar results. These should be interpreted as an upper bound: the restrictive policies announced by the NBE can be expected to result in substantially smaller pass-through.

uA01fig02

1% NEER Depreciation, Effect on Overall CPI

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Infrastructure Investment, Exchange Rate Policies, and Export Diversification: CrossCountry Analysis

Ethiopia has a small export base—its exports-to-GDP ratio in 2015 was the fifth lowest in the world—highly concentrated in primary products. This raises two risks: (i) Ethiopia lacks the export diversification needed to raise growth through a broad base of production technologies,1 spreading risk and reducing aggregate output volatility;2 and (ii) primary products are vulnerable to global price volatility and weather-related shocks. The GTP II aims to increase both the level and diversification of exports to support resilient growth.

Efforts to diversify exports are ongoing. Two key obstacles identified in surveys are the paucity of trade-related infrastructure, and the overvaluation of the exchange rate and associated shortages of foreign exchange.

Cross-country analysis validates these perceptions: an overvalued real exchange rate hinders export diversification, while good infrastructure improves it. A real depreciation of 20 percent (in line with the 2016/17 estimated misalignment, Annex II) is associated with an export diversification of 6 percent (to Ghana’s level) holding all other factors constant. Similarly, an improvement in the quality of trade-related infrastructure by 25 percent (to Chile’s level) is associated with an export diversification shift of 31 percent (to Russia’s level). Moreover, the analysis shows that diversification is associated with higher growth and structural transformation, two key strategic goals of the Ethiopian authorities. Export diversification is associated with value added, particularly in manufacturing and services. These results reinforce the conclusions of earlier analyses3 showing cost considerations are critical in entering new markets, particularly for manufactures.

uA01fig03

Quality of Trade and Transport-related Infrastructure, 2015

(1 = Low; 5 = High)

Citation: IMF Staff Country Reports 2018, 018; 10.5089/9781484338506.002.A001

Source: WorldDevelopment Indicators, World Bank

Export Concentration, Real Exchange Rate and Growth

article image
Estimates based on a seemingly unrelated regression model using a cross-country panel of 42 African countries between 1995-2015. The results are robust even after controlling for trade openness, FDI, public investment, public debt and political stability.Standard errors in parentheses.
***

p<0.01,

**

p<0.05,

*

p<0.1.

RER is real exchange rate.PPP GDP per capita is Purchasing Power Parity GDP per capita.
1 Romer, P. M., 1990, Endogenous Technological Change, Journal of Political Economy, Vol. (98)5, pp. 71-102.2 Acemoglu, D. and F. Zilibotti, 1997, Was Prometheus Unbound by Chance? Risk Diversification and Growth, Journal of Political Economy, Vol. 105(4), pp. 709-751.3 2016 Article IV Consultations with Ethiopia (IMF Country Report No. 16/322).

19. The ongoing financial deepening calls for a strategic approach to reforming the monetary policy framework to ensure its continued effectiveness. Direct monetary instruments may be appropriate at an early stage of financial development.8 However, over time, base money is expected to shrink relative to overall monetary aggregates as the financial sector deepens. In such a case, direct monetary instruments lose their effectiveness as the relationship between base and broader money aggregates weakens. Thus, the NBE should gradually move towards indirect monetary policy instruments and reduce direct budget financing, letting other financial agents and markets play a larger role. The role of the market in setting interest rates will become important, including to promote secondary market trading. Although real rates remain negative, the recent increase in interest rates is a positive step. Also, the rapid process of financial inclusion and deepening suggests that over the medium term, a slower expansion of base money than currently targeted by the NBE would be more consistent with a neutral monetary stance.

20. The obligation for banks to purchase NBE bills equivalent to 27 percent of their loan issuance remains in place. The proceeds are used to fund the Development Bank of Ethiopia (DBE). Staff argued that the current system penalizes short-term working capital financing; and that the bills’ low remuneration (3 percent) makes them unsuitable for trading in the planned secondary market. Instead, DBE expansion could be funded through retained profits. If additional funding were deemed necessary, raising market financing or direct budgetary capitalization would be preferable on governance, accountability, and transparency grounds. While the current system may have initially spurred banks’ deposit expansion, as the authorities argued, this objective would be better served by increasing competition through the (possibly initially limited) presence of international banks, which would result in know-how and technological spillovers.

21. Financial stability indicators do not indicate emerging vulnerabilities (Table 6). In June 2017, system-wide non-performing loans (NPLs), at 2.59 percent, remain below the statutory ceiling of 5 percent, while banks overall appear profitable, well-capitalized, and liquid. Nevertheless, rapid credit growth merits vigilance by banks and the NBE. In contrast, NPLs in the DBE have increased substantially to well above their separate statutory limit (15 percent). While the DBE is not a deposit-taking institution (and hence not part of the commercial banking system), the high NPL level constitutes a contingent fiscal liability. Staff welcomed plans to address this issue, including by taking decisive recovery measures, such as foreclosing and seizing collateral on NPLs related to projects that are not viable. An objective assessment of future viability of the affected loans is crucial to ensure that only profitable projects are supported.

Table 6.

Ethiopia: Financial Stability Indicators of the Commercial Banking Sector, 2012-17

(In percent, unless otherwise indicated)

article image
Source: National Bank of Ethiopia
1

The average capital used to calculate the ROE execludes retained earning and profit & loss.

2

Total income comprises gross interest income and gross non-interest income.

3

Gross income comprises net interest income and total non-interest income.

4

Customer deposit includes time, current and saving deposits.

22. Difficulties in maintaining reliable correspondent banking relationships (CBRs) by smaller non-systemic banks raises concerns. The CBR losses appear related to high compliance costs for the correspondent banks and small business volume. The NBE, together with the Financial Intelligence Center, is making progress in strengthening Ethiopia’s Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) framework, and implementing the action plan agreed with the Financial Action Task Force (FATF), which could help forestall additional CBR losses. Also, the NBE is encouraged to examine additional options, including encouraging banks to expand or consolidate, and engage home supervisors of the correspondent banks.

Authorities’ Views

23. The NBE largely agreed with staff’s assessment on the exchange rate and monetary policy stance, and has taken decisive actions consistent with Fund advice. The authorities are considering staff’s advice on a more flexible depreciation path. They are also taking actions to address bad loans in the DBE. Regarding the banks’ obligatory purchase of NBE bills, the authorities consider that it has provided crucial incentives for banks to expand deposits and branches, without any detrimental effects on profitability—while providing the DBE with cost-effective funding and draining prior excess liquidity from the system.

C. Supporting the Emerging Private Sector

24. Efforts to spur industrialization are showing positive results. The strategic orientation of industrialization policy—a focus on labor intensive light manufacturing such as in leather, apparel, textiles, agro-processing and electricity—capitalizes on Ethiopia’s competitive advantages. This is buttressed by the promotion of industrial parks, which circumvent business climate impediments through simplified procedures, tax advantages, and easy access to financial services. Wider reforms aim at addressing other bottlenecks, most notably power supply and transport links. In this regard, the imminent start of operations of key projects such as the railway to Djibouti and transmission lines from Gibe III are welcome developments. Staff encouraged the authorities to expedite the process of World Trade Organization (WTO) accession to enhance export prospects.

25. Other reforms to the business climate are necessary to elicit increased investment. Businesses consider foreign exchange shortages and onerous tax administration and licensing requirements the main impediments to investment. The package of measures around the October 2017 birr devaluation discussed above will help in this regard. The authorities’ commitment to improving key business environment rankings (e.g., WB’s Doing Business, World Economic Forum’s Competitiveness Index) is a positive step. The Financial Inclusion Strategy has the potential to ease the cost of doing business and support domestic investment. The authorities have intensified anti-corruption initiatives, which resulted in a number of high-profile arrests and legal prosecutions. Progress in strengthening the anti-corruption regime will also contribute to improve the investment environment.

26. New PPP legislation, with the appropriate fiscal safeguards, can help private sector development and fund public infrastructure. The Council of Ministers recently endorsed PPP legislation, soon to be approved by parliament. The creation of a PPP Directorate within MOFEC tasked with the centralized management and oversight of PPPs is welcome. Staff encouraged the authorities to work with development partners on the implementation of a PPP framework that strikes the appropriate balance between eliciting private participation and minimizing fiscal risks.

27. Ethiopia is leveraging participation in the G20’s Compact with Africa to make progress on reforms and attract FDI. The authorities have integrated their strategic goals, as outlined in the GTP II, with policy commitments aimed at maintaining macroeconomic stability, strengthening domestic revenue mobilization, upgrading public investment management, and improving the business climate.

Other Issues

28. With participation of the IMF Legal Department, staff assessed the operation of Ethiopia’s foreign exchange system, including the foreign exchange legal framework and market practices, against Article VIII, Sections 2(a), 3 and 4 of the IMF’s Articles of Agreement. Staff has assessed that one of the four exchange restrictions in existence in 2002 (when the last assessment was conducted) has been eliminated, while the scope of another restriction has been expanded. Also, the recent bank regulations on foreign exchange prioritization and rationing give rise to a new exchange restriction.9 Staff encouraged the authorities to remove these restrictions and recommended moving toward eventual acceptance of obligations under Article VIII. The authorities’ view is that all existing restrictions affect exclusively the capital account, and that there are no exchange restrictions on current account payments; consequently, they do not intend to request their approval.

29. The NBE continues to address recommendations in the 2009 Safeguards Assessment. Following changes on the NBE board, a new audit committee has been formed, and a Risk Management Unit has started operations. A full set of audited financial statements has now been published on the NBE’s website, in accordance with the safeguards policy. The NBE is also soliciting bids from consultants to transition to IFRS. Notwithstanding these developments, some recommendations focused on strengthening the external audit process, and legal amendments to address safeguards weakness in the Central Bank Law remain outstanding. The NBE did not see its full legal independence as a pressing issue, noting that it was already operationally independent in practice. They stressed that the NBE’s monetary policy goals informed its operational decisions, including on the amount of credit extended to the government, and annual limits on the latter were strictly observed. The NBE also did not consider the distribution to the government of unrealized gains on foreign assets to be a significant risk in the context of predictable nominal birr depreciation (Informational Annex).

30. Improvement of economic statistics would strengthen policymaking and support investors’ confidence. The authorities are rebasing the national accounts, which is expected to yield a significant improvement in the accuracy of estimates. Nevertheless, the national accounts remain confined to the supply side complemented by a few expenditure-side aggregates. Sectoral and income accounts or higher frequency indicators are not produced. Further, Ethiopia does not provide monetary and financial data in the Standardized Report Forms. Improvements in economic statistics and their upgrading to current international standards are urgent tasks. This would yield high returns by informing the policymaking process as well as by minimizing investors’ uncertainty and enhancing the public understanding of policies.

31. The Fund’s TA strategy is aligned with the identified structural reform priorities (Annex III). Capacity building efforts are especially focused on strengthening domestic revenue mobilization, upgrading the quality of economic and financial statistics, introducing secondary financial markets, modernizing monetary policy implementation, and strengthening financial supervision.

Staff Appraisal

32. The preconditions for an export take-off and associated transition to private sector-led growth are in place. Ethiopia has invested in trade-enhancing infrastructure, and private investors are responding positively to these efforts. With key projects coming online, a significant improvement in exports is expected over the medium term. The ongoing shift from traditional activities to higher value added tradeable products can support continued strong growth, offsetting fiscal and monetary restraint.

33. Stagnant exports in 2016/17 have raised debt sustainability risks, but the authorities have taken decisive actions to address the underlying external imbalances. The DSA now indicates that the risk of debt distress has increased from “moderate” to “high”. Staff advised steadfast implementation of ongoing policies, especially strong control of public external non-concessional borrowing, to lessen the chance of adverse outcomes. As the export take-off becomes entrenched, risks should subside, providing scope to revisit external financing of critical future projects. In the meantime, creating more room for private sector participation in investment projects is advised. Staff assesses the external position to be moderately weaker than the level consistent with medium-term fundamentals and desirable policies.

34. The October devaluation and adoption of a tighter monetary policy stance will help to reduce the external current account deficit and associated risks, while the budget execution needs to be tightened this year. Monetary policy however may need further tightening if inflationary pressure does not abate over the next few months, including further interest rate hikes. Tight budget implementation as announced in the budget speech, targeting a return of the budget deficit to 2½ percent of GDP, and stringent monetary targets will help contain import demand and inflation. Staff supports the October devaluation of the birr which corrected a large part of its overvaluation. Going forward, adopting a more flexible exchange rate policy that responds to movements in the U.S. dollar and actual inflation differentials with respect to trading partners will be key to retain the achieved competitiveness gains and ease foreign exchange shortages. The authorities did not request and staff does not recommend approval of the exchange rate restrictions maintained inconsistently with Article VIII obligations.

35. Pressing ahead with key structural reforms is key to medium-term growth prospects. The authorities’ emphasis on improving the efficiency of revenue administration and policy is crucial to create fiscal room and improve the business climate. Rolling out, as planned, a secondary market for government securities will deepen financial intermediation and improve savings allocation. It will require, however, higher real interest rates and public savings to accommodate the attendant financing costs. It will also require reforms to the compulsory purchase by banks of low-yielding NBE bills to fund the DBE.

36. Data are broadly adequate for surveillance, but further efforts to address gaps and delays would improve the policymaking process and transparency. Efforts to improve economic, fiscal, and financial statistics are welcome but there remain weaknesses in accuracy, coverage, and adoption of current standards. The upcoming national accounts rebasing is an opportunity to step up collaboration with international experts to improve the quality of statistics. The adoption of Standardized Report Forms for monetary and financial statistics is also an urgent task. Greater transparency on granular financial stability indicators and SOEs financial reporting would enhance policymaking and transparency. Staff encourages the authorities to implement the enhanced General Data Dissemination System (e-GDDS).

37. Staff recommends that the next Article IV consultation with Ethiopia be held on the standard 12-month consultation cycle.

Table 3a.

Ethiopia: General Government Operations, 2013/14-2021/221

(Millions of birr)

article image
Sources: Ethiopian authorities and IMF staff estimates and projections.
1

Government financial statistics are reported by the authorities based on GFSM 1986.

2

Excluding special programs (demobilization and reconstruction).

3

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

4

External interest and amortization are presented after HIPC debt relief from the World Bank and the African Development Bank.

Table 5a.

Ethiopia: Balance of Payments, 2013/14-2021/22

(Millions of U.S. dollars)

article image
Sources: Ethiopian authorities and IMF staff estimates and projections.
1

Includes net borrowing by state-owned enterprises and NBE time deposits

2

The NBE definition for import coverage excludes food-aid and franco-valuta imports.