Ethiopia’s latest reform agenda, the ‘Home Grown’ Economic Agenda, claims to achieve “macro-financial stability and rebalance and sustain economic growth.” It emphasizes the necessity of shifting from demand-driven to supply-driven growth models, transitioning from debt financing to savings and equity financing, and moving from public sector to private sector-led growth. It outlines a three-year implementation timeline to address pressing macroeconomic imbalances.
The reform agenda is organized into three pillars: the macro-financial pillar, the structural pillar, and the sectoral pillar. In the macro-financial domain, reforms aim to reduce public debt, mitigate external vulnerabilities, combat inflation, and promote growth, investment, and exports. These objectives will be pursued through actions such as strengthening public finances, transitioning to a flexible exchange rate regime, implementing more direct monetary policy mechanisms, and supporting the development of the financial sector. The structural reforms pillar focuses on addressing obstacles that impede private sector growth, while the sectoral reforms pillar targets reducing market failures, addressing sectoral regulatory challenges, and investment constraints.
In 2019, discussions between the government of Ethiopia and the IMF centered on, among others, progressing towards a market-determined exchange rate. However, tangible progress has not been evident since then. In October 2023, the IMF staff visit resumed the discussions to advance the reform agenda.
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Aspects of the exchange market transition, its macroeconomic implications
The reform agenda attributes the surge in forex demand over the past decade to large-scale public investments, which have failed to generate timely forex returns. Consequently, this disparity is seen as a significant factor contributing to substantial trade imbalances, current account deficits, and a growing shortage of forex reserves. Additionally, the agenda highlights that an “overvalued official exchange rate, coupled with an increasing disparity between parallel and official market rates, has hindered exports”. This has resulted in diminished international competitiveness for Ethiopian exports, as they become less competitive in the global market.
Furthermore, debt servicing has been identified as a significant deterrent and competing priority for forex availability. The reform underscores the growth in external debt servicing, which has surged from 2.5 percent of exports of goods and services a decade ago to 26.6 percent in 2018/19. Although the overall debt level (approximately half of GDP) may not be deemed excessive, its quality and composition pose a strain. Most importantly, the external debt component constitutes half of the total debt, necessitating foreign currencies for servicing these debts.
The reform anticipates that allowing more flexibility in the exchange rate would likely result in nominal depreciation. Consequently, it foresees the need for a tighter monetary policy to counteract inflationary pressures.
Among the macroeconomic imbalance-correcting policy reforms outlined are reducing direct advances from the National Bank of Ethiopia (NBE) to the government, returning to a market-determined monetary policy framework, and enhancing the NBE’s capacity to implement appropriate policies.
The document emphasizes that Ethiopia currently does not intend to label the reform as a transition to a free-floating exchange rate regime. Instead, it aims to eliminate policy distortions in the forex market and allow the exchange rate to be determined based on “economic fundamentals”.
The NBE sets to achieve its exchange rate policy objectives through buying and selling forex in the interbank market, rather than directly setting the going exchange rate. As part of the reform agenda, there are plans to mobilize less costly forex resources to address immediate forex needs, gradually ease forex controls, enhance the availability of forex to the private sector, and strengthen the interbank market.
What awaits Ethiopia on its new pathway?
The decision to transition to a market-determined exchange rate, and the pace of such a transition, hinges on specific contextual factors. Presently, Ethiopia faces a balance of payment crisis demanding urgent attention, with foreign currency reserves covering less than a month of prospective imports over several years.
Establishing the exchange rate—whether rigid, fully flexible, or intermediate—requires robust macroeconomic and financial institutions, alongside credible policymaking.
While Ethiopia’s capital controls and limited currency convertibility to current account transactions may ease the transition, over 27 percent of its government debt is denominated in foreign currencies, putting potential pressure on debt servicing. This poses challenges when the local currency loses value against hard currencies, requiring more local currency for the same amount of foreign dollar debt servicing. The reform agenda acknowledges these risks and aims for a gradual transition over three years. However, this timeline may be insufficient for effective gradualism.
To fully benefit from the transition, Ethiopia needs a functioning interbank money market, currently absent. The optimism of the reform agenda may overlook challenges posed by weak financial sectors and regulatory institutions like the NBE. A well-functioning transition requires active participation from banks in forex transactions and effective central bank intervention. Monetary policy must mitigate effects on price levels, especially in an environment of assumed overvalued nominal exchange rates.
Ethiopia has long maintained a commendable achievement by keeping the budget deficit at bay, typically around or below 3 percent of GDP. However, inadequate control of inflation and excessive exchange rate depreciation could bring additional challenges. High government debt service costs, worsened by currency depreciation, may lead to a vicious cycle of financing through less disciplined measures or excessive borrowing, thereby hindering the envisioned private sector-led growth objectives.
While Ethiopia may not be greatly concerned about international vulnerability due to capital flight, a de facto capital flow outside the formal banking sector remains a concern. Although fiscal smuggling of currencies is currently less prevalent, manipulated trade operations can result in foreign currency remaining outside the country due to illicit financial flows. Without policies to deter participation in the illegal parallel market, the purported “market-determined exchange rate” may fail to reflect economic fundamentals accurately.
Illicit financial flows pose a significant concern, with a notable portion attributed to trade misinvoicing. Ethiopia ranks among the top 10 countries in Africa for illicit financial flows, as reported by the Global Financial Integrity reports. Particularly alarming is the high level of import over-invoicing, estimated at 27 percent of total trade and export under-invoicing, which amounted to 8.1 percent of total trade by 2015.
The country is undertaking additional reforms, including the establishment of a capital market and Ethiopian securities exchange to strengthen the financial system and fostering an environment conducive to implementing market-driven policies. Yet, merely transitioning to a more flexible exchange rate regime won’t suffice to address the foreign currency supply shortage. To effectively increase the influx of foreign currency into official channels, modalities need to be put in place to incentivize parallel market players. These measures could involve encouraging parallel market participants to redirect foreign currency to official channels or exploring avenues to accommodate the parallel market, allowing for its coexistence alongside the official market. In the latter case, the parallel market could indicate whether the official rates are overvalued or undervalued.
This article was submitted exclusively to our magazine by a researcher at Harvard Kennedy School who prefers to remain anonymous. We believe the ideas presented hold significant value for our readers and policymakers and have chosen to publish it accordingly. While we publish it for its informative content, the views expressed here do not necessarily reflect the editorial stance of The Reporter Magazine.
