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How a staggered exchange rate can solve Ethiopia’s foreign reserve woes

How a staggered exchange rate can solve Ethiopia’s foreign reserve woes

Jun 2020

Desperate times call for desperate measures

It is hard to believe that the Ethiopian economy, the fastest growing in Africa is crunched for foreign currency. The nation’s private sector is being squeezed by an extreme forex shortage. Businesses do not have the foreign currency required to conduct or expand operations. This problem is further compounded by the Ethiopia’s dependency on imports; Ethiopia imports more in goods and services, while exporting a faction of the import in USD. The National Bank of Ethiopia, which controls the value of the Ethiopian Birr, is hesitant to devalue the Birr (fearing inflation) but does not have the foreign exchange reserves to sustain Ethiopia’s importing need. The lack of liquidity between foreign currency and the Birr has resulted in many Ethiopians to use private and insecure means of currency transfer, usually at a higher rate, while keeping their own foreign capital abroad. Such actions, in turn, steer more capital away from the Ethiopian banking system and inflate the Birr even further, exacerbating the foreign reserve problem.

In short, almost all foreign investment is used to balance the budget deficit, fueled by the lack of exports and foreign currency to pay for the overwhelming import needs; basically, Ethiopia is using the investment inflows to simply fund its imports. The result is a private sector that is functioning severely under capacity, lacking the foreign funds and domestic investment required to function more efficiently.

Treating the symptoms instead of preventing the disease

The government’s proposed solution lies in prosecuting Ethiopians who privately exchange currencies. However, this by itself will not resolve the dual deficits, but rather just an effect of the phenomena. The economy will still suffer from a lack of liquidity and may even slow by making foreign exchange even more difficult, costly, and risky. In its effort to maintain fiscal autonomy, the Ethiopian government could potentially crash its market and increase its foreign deficit, eventually requiring international capital injection and ironically, subsequent globalization.

The true culprit of this issue lies in the disparity between Ethiopia’s economic policy and actual economy. The Ethiopian government wants to remain financially autonomous from the world and fears the prospect of inflation and foreign intrusion. At the same time, Ethiopia remains a part of the modern global economy, left to the whims of free market forces.

Ethiopians are hardworking, and the Ethiopian diaspora has spread around the world, finding relative success and wealth wherever it goes. It is inevitable that Ethiopian businesses will need to follow suit to find the goods and services they need to conduct or expand their operations. This is precisely what they cannot do, as they do not have the foreign capital necessary to purchase these imports and cannot freely trade their Birr. The simplest and most forward-looking solution is to allow the Ethiopian Birr to float. Rather than fixing the Birrs value, allow the free market to decide its worth and bet on the potential of the Ethiopian people. In the short term, there may be inflation—but as Ethiopian businesses start to finally operate at even 50 percent of their capacity, the demand for the Birr will only rise. It is impossible for the Ethiopian economy to rise to global prominence while barricading itself from the global economy. The best solution is to simply join the global economy and trust the people of Ethiopia.

That said, it is understandable why the Ethiopian government does not want to risk its cautiously optimistic economic outlook to the wrath of inflation and “crowding out” that can occur.

A more comprehensive solution

Rather than solely decreasing the liquidity and value of the Birr further, Ethiopia should consider an additional solution that tackles the foreign deficit directly by encouraging its largest sources of foreign capital inflow: the Ethiopian diaspora world-wide.

The Ethiopian diaspora sent USD 4.6 billion worth of remittances in 2016 alone, more than twice the value of Ethiopian exports over the same period. This is in spite of incredibly high costs, lack of service in rural areas, high transaction costs, and policies that discourage diaspora involvement.

Rather than discourage such valuable inflows, the Ethiopian government should facilitate these inflows by making formal remittance procedures easier for Ethiopian diaspora around the world. The policy can also be structured in a way to minimize the current deficits while still maintaining a degree of Ethiopian financial autonomy. An intuitive example is to stagger the Birr exchange rate by priority.

For example, if the Ethiopian government was to determine that the field of medicine was a priority, and that businesses in that field needed more foreign currency to operate at a higher capacity, then a staggered exchange rate could be employed where 25 percent of all remittances were exchanged for Birr at a rate below market value.

Priority Industry Exchange Rate Effective Cash Flow of a $100 remittance
1 Medicine 27 birr/USD 675 birr for USD 25
2 Manufacturing 30 birr/USD 750 birr for USD 25
All else @ market value 35 birr/USD 1,700 birr for USD 50
Total 3125 birr for USD 100

This method is extremely advantageous for a number of reasons:

  1. It encourages a legal and secure transfer of currency and simultaneously discourages private currency transactions.
  2. It will surely result in a huge increase in official remittances, and thus foreign capital, flowing into Ethiopia. By facilitating easier transfers of funds, the total capital remitted will increase.
  3. It stimulates sectors of the economy without sacrificing government control. This method will not only increase the gross amount of foreign capital available to Ethiopian businesses but will also allow the government to focus on industries that require short-term foreign investment to function more efficiently and at a higher capacity.
  4. It is incredibly quick and easy to implement and does not require major legal or financial reform.

 

Before Ethiopia can reach its full potential, it must reconfigure its financial policies by engaging one of its most abundant resources: its diaspora. As the world economy races towards modernization and globalization, Ethiopia will need to call upon diaspora-friendly and free market policies to ensure it does not fall behind.

Ed.’s Note: Samuel Alemu, Esq is a partner at the ILBSG, LLP. He is a graduate of Harvard Law School, University of Wisconsin-Madison Law School, and Addis Ababa University. Samuel has been admitted to the bar associations of New York State, United States Tax Court, and the United States Court of International Trade. The writer gives credit to Praveen C. Medikundam, Esq., Zewdu Alem Derseh, Esq and Akshat Jain for their invaluable comments. The writer can be reached at salemu@gmail.com.

Contributed by Samuel Alemu

Note: released first on Reporter English

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