Ethiopia is going through a rough patch of political, economic and social realities. The COVID-19 pandemic, locust invasion and the war in the North are just a few of the natural and manmade challenges the country has had to endure. These realities have weighed down on the already grim economic conditions at national and individual level. At the core of the country’s financial troubles is the shortage of foreign currency. To make sense of the seemingly unresolved challenge of foreign currency, The Reporter’s Ashenafi Endale spoke to the Vice Governor and Chief Economist of the National Bank of Ethiopia (NBE), Fikadu Degafe. Fikadu joined the bank as a Researcher and has found his way up the organizational ladder through years of service. He is behind most of the financial policy reforms and directives the bank has been introducing over the past three years. Excerpts:
The Reporter: Apart from prioritizing import items, how does the National Bank of Ethiopia (NBE) inspect forex at the hands of commercial banks?
The issue of inspecting FX allocation by priority is simply down to shortage so that key sectors shall get priority over non-priority sectors. In this case, there is no other intension in controlling FX in the hands of commercial banks. Prioritizing FX allocation by key sectors is carried out in two ways. First, registration for FX is visible to the NBE via its online platform and once a customer is registered, banks cannot alter the queue. The problem here is that banks might refuse to register customers scapegoating on various reasons. So, the NBE has no intension of controlling FX in the hands of banks; all it wants to do is make sure key sectors get the scarce resource fairly as per the directive and check for bias while allocating FX to customers.
The Reporter: Local importers and their suppliers abroad complain that banks request 100 percent upfront payment of the approved LC equivalent in birr. They also complain some banks do not effect the payment even after the shipment arrives in Ethiopia. What is the source of such complications? Does the NBE have minimum and maximum cap on how much birr banks have to request upfront in relation with approved LC?
Our directive says that the manufacturing sector does not need to deposit LC margin during registration while other sectors shall deposit about 30 percent LC margin. During approval of the FX, there is no doubt that the customer must pay full amount at the prevailing exchange rate of the day of payment. The case of no payment after shipment is the problem some banks have faced recently due to shortage of FX and in fact lack of proper cash flow management of the banks. This is the case when banks collect the Birr equivalent before approving the FX and become unable to pay once the shipment arrives; it is an illegal act.
The Reporter: Recently, the NBE suspended a number of banks from approving LC requests. What was the reason? Is the problem solved now?
In fact the NBE did not suspend banks from issuing LC; rather it instructed banks to clear their commitments before they receive additional commitments. There has not been a direct instruction to stop issuing new LC, but an instruction of clearing the existing commitments might imply stopping new issuance. The reason for instructing banks to clear existing commitments before issuing additional LC was failure of some banks to clear their commitments timely, which was followed by many complaints from customers. I think some banks are already clearing their existing commitments by basically stopping new issuance. There are, however, a few banks that are still unable to settle their existing commitments because of very low FX inflow. Currently, the NBE receives complaints against very few banks.
The Reporter: How do you evaluate the impact of devaluation on import, export, as well as imported inflation?
Well, there are established theoretical premises and sufficient empirical evidences on the relationship between exchange rate devaluation/depreciation and current account balance. As per theoretical premises like J-curve theory, exchange rate devaluation initially has down side effect on current account balance but gradually improves current account. In general, exchange rate devaluation/depreciation is believed to encourage exporters and finally improve current account balance maintaining other things constant. However, the effectiveness of this premise depends on various fundamentals. First of all, nominal exchange rate devaluation/depreciation affects international competitiveness to encourage exports through real effective exchange rate depreciation. As real effective exchange rate is a function of both relative prices (domestic and foreign) and nominal exchange rate movements, exchange rate devaluation/depreciation alone cannot be a guarantee to improve current account through improved competitiveness at the international market. Therefore, to see the effect of nominal exchange rate devaluation/depreciation on current account, one needs to see the response of domestic inflation to the devaluation itself. Maintaining other things constant, if the theoretical assumption that devaluation discourages the demand for import holds true and there is less dependency on imported items by the local market on one hand and there are sufficient products to be exported encouraged by the devaluation/depreciation policy, the probability of improved current account will be automatic.
Having this overall theoretical foundation in mind, let us deal with the case of Ethiopia. In our case, there will be several reasons for devaluation/depreciation to be not effective even under the J-curve premise over medium to long term arena. First of all, Ethiopia exports primary products where we cannot compete with other countries price wise and the only way to benefit from devaluation is through increasing the volume of export encouraged by the devaluation/depreciation policy i.e. exporters prefer exporting over domestic market. Practically, however, production and productivity level in Ethiopia are at their lowest level and the possibility of maximizing the benefit of devaluation/depreciation policy by increasing volume of export has not been sufficient enough so far. This is further complicated by huge domestic demand for exportable items at higher price comparable to export prices. Though devaluation/depreciation has positive impact on export, therefore, it must be supported by increased volume of export as our major exports are primary commodity. The other factor is import elasticity to devaluation in the case of Ethiopia. Contrary to the theory that devaluation makes import expensive and its demand will decline at home market, import will not decline in Ethiopia as there are necessity items to be imported like capital goods, fuel and even consumer goods and hence devaluation/depreciation never discourage import in the case of Ethiopia. As there is huge demand for imported items, empirical evidence proved there is a possibility of exchange rate pass through to domestic inflation. In this case, the probability of devaluation/depreciation to improve our competitiveness through depreciating real effective exchange rate is minimal. To sum up, devaluation/depreciation has down side effect on domestic inflation and its capacity to improve real effective exchange rate depreciation is very low, which does not mean that nominal exchange rate over valuation is the solution. The best solution is depreciating the nominal exchange rate gradually and maximizing the gain through enhancing the volume of export and substituting some imports by domestic commodities. This means that instead of keeping nominal exchange overvalued, gradual depreciation supported by enhanced production and productivity in both exportable items and import substituting items could be the best solution to get rid of huge current account balance deficit and imported inflation. Furthermore, gradual deprecation in nominal exchange rate must be supported by prudent demand side management to minimize the effect of exchange rate pass through to domestic price.
The Reporter: How much foreign currency is circulating in the parallel market?
We do not have exact estimates but we do not expect there to be such a huge amount. The main reason for the parallel market to exist is unsatisfied import through the official channel and the amount of FX in the parallel market might be around the amount of underground import.
The Reporter: When do you think Ethiopia’s economy will get back on its pre-COVID 19 track?
Before commenting on the timing of return to pre COVID- 19 period growth trajectory, let we look into the objective of the Home Grown Economic Reform Program launched in late 2019. In the program, one of the key ideas is keeping growth momentum, but in an environment of stable macroeconomic balance. This means that the fast and sustainable growth during the last decade was growth under macroeconomic instability. The Home Grown policy, however, plans to make growth inclusive and broad based under stable macroeconomic environment. Therefore, what is more important is sustainable growth under stable macroeconomic environment; hopefully, there will be significant improvement from this fiscal year onwards supported by huge promising activities in the agricultural sector. The conflict in the northern part of the country will have down side effect to some extent.
The Reporter: The grace period for new entrant banks to be established with ETB500 million capital has phased out. What will happen to banks in the pipeline?
There is clear direction in the directive and banks under formation can be established with Birr 500 million paid-up capital within six months of the directive’s entry into force. In case there are banks under formation that are unable to mobilize the stated amount during the six months, they can still mobilize Birr 5 billion and get the license to become a bank. Therefore, from the NBE’s point of view, new banks cannot be licensed with Birr 500 million minimum capital after the six month grace period, but there is no problem to get a license for a bank under formation even after the grace period as long as it mobilizes the new minimum capital, Birr 5 billion.
The Reporter: Since three years ago, the NBE embarked on reforms and has been reconfiguring most of its directives. Do you see the positive outcomes of the move on the financial industry?
Yes, of course. There have been a lot of positive gains in the financial industry over recent years. One of the key reforms was repealing the 27 percent NBE bill, which has improved the capacity of banks to lend especially to the private sector. As you remember, improving the role of the private sector in the Ethiopian economy was one of the pillars of the Home Grown Economic Reform Program. Private sector credit could be an indicator. Accordingly, private sector fresh loans disbursement during the reform program has increased significantly from around 50 percent pre reform to about 79 percent by June 2021. The other positive achievement is financial sector outreach where banks have increased their branch networks significantly and the number of adults having bank accounts has also increased significantly especially following the currency redemption measure in September 2020. We can also mention improvements in the digital financing sector supported by policy change from the NBE to allow non-bank institutions to offer the financial services. Recent policy change on minimum capital to establish a new bank will also have positive impact on consolidating and enhancing the capacity of banks and economies of scale gradually, which in turn will make banks ready for competition when the sector opens to international investors. The introduction of Islamic Banking service could also be one of the big moves in Ethiopia’s financial sector during the reform period. There is also a policy change on the possible upgrading of micro finance institution to conventional banks during the reform. The decision has already opened the way for some MFIs to be licensed as banks.
The Reporter: Foreign mobile money operators are expected to join the market in the near future. Does this equate to a partial opening up of Ethiopia’s financial industry?
Well, banking business proclamation stipulates that financial service provision is not allowed for non-Ethiopians except people of Ethiopian origin. In this case, if foreign mobile money operators are allowed to provide financial services in Ethiopia, one could definitely say that the sector is partially liberated, albeit the financial sector in Ethiopia is totally dominated by banks and one cannot confidently say that there is partial liberalization with the dominant sector still closed.
