By- Fahad Garba Aliyu
Ethiopia has reached a critical juncture, closing its currency at a surprisingly pivotal moment, a decision rooted in decades of economic choices. Over the past twenty years, Ethiopia has financed its development primarily through heavily leveraged capital from international markets. While borrowing in itself is not inherently problematic, the issues arose from how this capital was utilized. Ethiopia’s impressive growth, driven by public investment funded through international capital markets, including bonds, has been marred by inefficiencies and corruption. These challenges have plagued the completion of public sector projects, preventing them from generating the necessary economic returns and leading to significant public sector debt.
When the current Ethiopian government took power in 2018, it inherited an external debt stock of $28 billion, against export earnings of just $3 billion. Various reform initiatives were launched to address this imbalance, but external shocks, including the COVID-19 pandemic, the Russia-Ukraine war, and internal conflicts, have hampered progress. These challenges have contributed to severe inflation, wide budget deficits, and misaligned payments, leading to a critical decision to close the currency and implement a modern, interest-based monetary policy.
This policy shift represents a significant change for Ethiopia, as it moves away from its previous approach to managing the economy. However, the large informal sector and limited financial inclusivity pose substantial obstacles to the effectiveness of these reforms. For interest-based monetary policies to succeed, a significant portion of the economy must operate within the formal sector. Currently, a large amount of money circulates outside the banking system, undermining the impact of these policies.
In the face of these challenges, Ethiopia’s currency devaluation has added to the economic uncertainty. The exchange rate has seen a significant jump in volatility. This radical move, while necessary, shocked many economists and has led to speculation about further depreciation in the coming months. The government’s ability to stabilize the currency and manage the market’s reaction will be critical in determining the success of these reforms.
Drawing parallels with countries like Nigeria and Kenya, further depreciation of the Ethiopian birr can be anticipated as latent demand surfaces, with this adjustment process likely continuing until the end of the year. Initially, import prices might decrease due to reduced foreign currency costs, but this could be offset by increased taxation and speculative behavior among importers.
In addition, new taxes are being introduced, including excess stamps on beer and tobacco, fuel price increases, and real estate property taxes. Consequently, there is a projected rise in inflation and the cost of living. These new taxes aim to increase domestic revenue generation, a common condition of IMF facilities, but they will likely exacerbate the cost of living and inflation, especially given the timing around the Ethiopian New Year when household expenses naturally rise. The government must carefully balance these measures to avoid social unrest, as seen in Kenya with the Finance Bill 2024. The IMF has provisions to recalibrate, if necessary, but the next few months will be critical in assessing the public’s response and the overall economic impact.
Ethiopia can learn valuable lessons from Nigeria, which recently transitioned to a floating exchange rate system. Nigeria’s decision to float the naira was driven by the need to address currency stability and foreign exchange shortages. Nigeria aimed to eliminate arbitrage opportunities and promote transparency in the foreign exchange market by allowing the naira’s value to be determined by market forces. While this move has the potential to attract foreign investment and enhance export competitiveness, it has also led to increased exchange rate volatility and inflationary pressures.
For Ethiopia, adopting a floating exchange rate could similarly enhance the competitiveness of its exports and attract much-needed foreign capital. However, Nigeria’s experience highlights the risks of such a policy shift. Increased exchange rate volatility could create uncertainty for businesses and consumers, while inflationary pressures could undermine the purchasing power of Ethiopian citizens. Effective monetary policy tools and vigilant economic oversight will be essential in managing these risks and ensuring that the benefits of a floating exchange rate outweigh the challenges.
Nigeria’s journey also underscores the importance of managing external debt and maintaining financial stability. With the naira’s depreciation, Nigeria’s foreign debt obligations have increased, straining the government’s ability to service its debt. Ethiopia, with its own significant external debt, must carefully consider the implications of a floating exchange rate on its debt servicing capacity and develop strategies to mitigate potential risks.
In addition, Nigeria’s experience also reveals challenges such as exchange rate volatility, inflationary pressures, and the impact on external debt. The fluctuating naira has led to economic uncertainty, higher import costs, and increased debt servicing obligations. Ethiopia must carefully manage these risks with robust monetary policies, effective inflation control, and social safety nets to protect its most vulnerable citizens. Clear communication and public engagement are essential for successfully implementing such a policy, ensuring that the transition to a floating exchange rate supports long-term economic stability and development.
In conclusion, Ethiopia’s economic reforms, including the decision to close the currency and consider a floating exchange rate, are fraught with challenges but also hold the potential for significant long-term benefits. By studying Nigeria’s experience and implementing careful, well-coordinated policies, Ethiopia can navigate this economic crossroads and emerge stronger, with a more resilient and sustainable economy. The coming months will be critical in determining whether these reforms will succeed in laying the foundation for Ethiopia’s future growth and development.
Fahad Garba Aliyu is the Managing Partner at Ignite Capital Ltd and can be reached at fahad@ignitecapital.africa
