Guest bloggers Basil Oberholzer and Dawit Ayele Haylemariam argue for maintaining Ethiopia’s developmental financial system and implementing economic reforms to address inflation, currency shortages, and slowing growth while promoting green development.
Ethiopia, Africa’s second-most populous country, has experienced twenty years of high economic growth and great success in poverty reduction. This growth has been fuelled by substantial public investment in critical infrastructure and social development programs. To continue on this path, the challenges emerged in past years, such as slowing growth, high inflation, foreign exchange shortage, and harmful climate change impacts must be addressed quickly. How can Ethiopia get out of these constraints by fostering green growth and development while avoiding austerity and more instability, which jeopardize development success? Answers can be found in the analysis of Ethiopia’s banking system and its key role in sustaining macroeconomic and monetary stability.
Ethiopia’s banks feature a high share of public ownership, which has effectively served the government’s successful developmentalist strategy driven by public investment. At the same time, the country conducts monetary policy in a rather monetarist fashion where banks are subject to minimum reserve requirements while the growth of reserves is the main policy target. Restricting the supply of reserves thus sets an upper limit to money growth. Additionally, interest rates are also controlled by setting a minimum deposit rate. Commercial banks are obliged to purchase treasury bonds to cover the government’s budget deficit at least partially. Moreover, banks face requirements to surrender large shares of foreign exchange earnings to the National Bank of Ethiopia (NBE). The currency is pegged to the US Dollar, capital controls limit currency convertibility, and the banking system is closed to foreign banks.
Misleading analysis of macroeconomic challenges
Several analyses, notably by international financial institutions, identify the roots of Ethiopia’s macroeconomic problems as follows: money supply growth due to public budget deficits financed by advances from the NBE drives inflation; government interventions in the financial sector lead to inefficiencies in resource allocation; government dominance creates finance shortage and crowds out the private sector; negative real interest rates discourage saving; the fixed exchange rate leads to a loss in international competitiveness due to inflation while capital controls keep away foreign capital, thus intensifying the lack of finance in the economy. The recommendations of those analysts are clear: reduce the government’s budget deficit, adopt market interest rates, liberalize capital flows by removing controls and exchange rate pegging, and open the market to foreign banks. As a result, inflation will come down, resource allocation will be more efficient, the current account will improve, and the financing constraint lifted.
The above perspective would possibly be useful if money was as a scarce commodity where a limited amount of savings is available to finance investment. Yet, in the world we are living in, money is created via the issuance of loans, meaning that every loan creates a deposit of an equal amount. Savings are not a precondition of investment but, instead, the result of investment. Hence, money is driven by demand for credit and associated to economic production, which means that money is elastic. The quantity of money is neither limited by an external force nor does it say anything about the causes of inflation.
Once capital expenditures are excluded from Ethiopia’s government budget, i.e. when comparing total government revenue and government recurrent spending, the public finance exhibited a surplus in the last 20 years. Distinguishing between current and capital expenditures is relevant because the former create new output and income and hence should be financed via new loans much like private investment. Moreover, government expenses involving payments abroad for external debt servicing and specific military spending amounted to more than 20 percent of the total budget deficit. Such payments involve a drainage rather than an increase in the amount of money. Explaining inflation via the growth of the domestic quantity of money, which is itself supposedly driven by the government budget deficit, does not work. There are enough other factors that can explain inflation in Ethiopia: currency devaluation, global commodity price spikes, urbanization, domestic supply-side shocks such as in agriculture due to conflict and climate change. As a result, more money is required to deal with higher prices of everything but that does not mean that money causes inflation.
The consequences of restricting money supply
Crowding-out of the private sector via government deficit financing is a possibility in Ethiopia because of the monetary authority’s endeavor to control the growth of reserves and, by extension, money supply. This is more evident in the National Bank’s recent policy to cap credit expansion at 14% in inflation fight. In this situation, restrictions to commercial banks’ balance sheets combined with their obligation to purchase treasury bonds may leave an insufficient space for credit to the private sector. Yet, this is a policy choice rather than a necessity. It is the monetarist idea of restricting money supply that leads to this crowding-out. This is economically harmful while not even addressing the causes of inflation. If the central bank accommodates demand for loans, crowding-out can be avoided without the government cutting down its spending, which would have negative economic and social consequences (which does not mean that expenses should not be reviewed and checked for their social benefits before making them).
In this context, there is an additional driver of inflation, which has not yet been mentioned: due to overall inflation, wealth holders store their wealth in real estate, which drives up their prices, thus contributing to more cost-push inflation in the rest of the economy. Data show that real estate prices in Ethiopia’s capital, Addis Ababa, have risen at a much faster rate than consumer prices and also house rent prices. This points to the possibility of a speculative bubble in the making. Moreover, due to imposed restrictions on money growth, real estate investment leaves less space for real productive and green investment. It is likely that speculative investment is the much more relevant source of crowding-out real private investment than the government deficit. Yet, productive investment is more than ever required to address the economy’s supply-side constraints, particularly in agriculture, industries, and post-conflict reconstruction. While money supply control is not able to tackle inflation, it is an obstacle to an investment-driven, growth-enhancing, and climate-friendly anti-inflation strategy.
Simple reforms for stability and green growth
Financing constraints can also be addressed without devaluing the exchange rate or removing capital controls. Obviously, foreign exchange is essential to pay for imports. Yet, financial account liberalization will most likely intensify forex shortage rather than easing it. Capital flight will set in with devastating and self-enforcing consequences including severe inflation spikes. If the trade deficit improves, it will mostly not do so due to adjusted prices thanks to currency devaluation, but due to shrinking import demand arising from the shock effect on the Ethiopian economy.
Instead of dismantling the government’s developmentalist strategy that could trigger additional instability, the Ethiopian banking system should take a few key steps towards a growth-led and green framework. First, the NBE should accommodate commercial banks’ demand for reserves to remove financing constraints to productive green investment. Second, speculative investment should be restricted by instruments such as, for instance, limits to mortgage volumes or higher reserve requirements than for productive investment. What matters is not the fixation on the quantity of money but ensuring that finance flows to investment with green and social benefits rather than inflation-driving speculative investment. In this way, structural change can be enforced to reduce import dependence, promote exports, and grow out of foreign exchange shortage.
The views expressed in this post are those of the author and do not reflect those of the International Development LSE blog or the London School of Economics and Political Science.
Featured image credit: Addis Ababa, snapped by Gideon Abate via www.ethiopia-insight.com.
