Ethiopia: The Economics of Deposit Insurance and the Rate of Exchange in Ethiopia

Deposit insurance and all!

The National Bank of Ethiopia is to set up a deposit insurance fund to protect bank deposits against potential bank failure to honour depositors' right to freely access their deposited cash ("Fortune," July 26, 2020). Bank failures could occur for a number of reasons including the following major ones:

Severe business downturns which disrupt loan repayments with interest;

Declines in non -interest incomes of banks like service charges and exchange commissions as a result of serious economic recession;

Decreases in wages and salaries as a result of rising unemployment, which causes bank cash deposits to decline;

Loss of interest income and loan repayment cash flow from bad bank debts;

Non-repayment of loans and credits granted on government orders (so - called "directed credit").

On the other hand, increased cash withdrawals from banks may be caused due to:

Loss of income and revenue from business downturns, which would necessitate resort to bank savings and hence cash withdrawals;

Rising inflation which requires a larger amount of money for the same basket of goods and services;

Business and economic uncertainty causing increased cash holdings on hand.

Recently, particularly following the advent of Covid -19, Ethiopia's banking system (both the state and private banking sector) has faced an increasingly serious liquidity shortage and the National Bank of Ethiopia (NBE) has had to come to its rescue with an infusion of liquidity to the tune of about 58 billion Birr.

Deposit insurance becomes important particularly when a bank goes bankrupt and faces liquidation or receivership. Then, bank depositors would want to know how much of their deposit money would they be able to recover, depending on the insurance coverage. The proposed deposit insurance fund is expected to provide 100 percent coverage for deposits up to 100,000 Birr. The initial capital of the fund (about 200 million Birr) is to be covered by the government, and banks and other financial institutions are to pay a premium of 0.3 percent of their average deposits ("Fortune," July 26,2020).

In the past, state -owned banks, particularly the Commercial Bank of Ethiopia, was considered to be "too big to fail." Not anymore. Already, the former Construction and Business Bank has gone bankrupt; the Development Bank of Ethiopia, with a bad debt ratio as high as 40 percent, is as good as having gone under. The elephant in the room, the CBE, is repeatedly reported to have kept its accounts hidden from both independent internal and external auditors. The allegation, though, is that it may already have buckled under the heavy weight of what the IMF calls "directed credit" to mostly unviable and unproductive government development agencies running into hundreds of billions of Birr (which some estimate at over 500 bln. Birr)! That is more than half of the total deposits (917 bln. Birr) in the entire banking system (both government- owned and private) in Ethiopia! The main reason for this turn of events is that the officials in the government banking sector (mainly the CBE and the NBE) obsequiously allowed the now defunct TPLF/EPRDF government to re- christen the CBE a "policy bank" and let it lend long -term loans on short -term deposits (a gross mismatch for a deposit -taking bank)! It is now these same people who are advising the Abiy government to establish a deposit insurance fund without ever having been held accountable for the egregious damage they have done to the Ethiopian banking system! They had better first figure out how to write-off the CBE's mountain of non -payable loans and credits it extended to corruption -ridden government development agencies! I know they do not listen to sound advice because I gave them a study on how to set up a viable deposit insurance corporation some thirty years ago when CBE's problem was not a shortage of liquidity but rather an abundance of excess reserves!

The Birr exchange rate

The Governor of the National Bank of Ethiopia (NBE), Dr. Yenager Dessie, has announced that the transition to a market -determined Birr exchange rate would be completed within three years as part of the economic reform program to be implemented in the context of the recently unveiled Ten -Year Perspective Development Plan (" Reporter," Amharic, July 26,2020). Why is the Birr exchange rate said to be not market -determined? It is because there are two Birr exchange rates. One is the official exchange rate which is at present about 35 Birr per USD; and the other is what is taken as a proxy for a market -determined rate, which is the black market birr exchange rate, currently going at about 45 birr per USD. Both rates have registered massive increases in Brr terms from 2.07 birr per USD under the Derg regime to what they are now. The cross - rates vis - -vis other hard currencies such as the euro and the yen are calculated on the basis this Birr /USD rate.

The determinants of the Birr exchange rate are interwined and may appear difficult to separate, but perhaps one of the best ways to understand them in the aggregate would be to compare the supply of birr and the supply of foreign exchange as proxied by the main reserve currency, the USD. The supply of birr can be increased simply by printing it, but Ethiopia cannot print the USD for obvious reasons. So, there is at least one built-in reason for the Birr to depreciate against the USD over time. By contrast, Ethiopia must earn or otherwise obtain the USD through merchandise exports, Ethiopian Airlines transport service to foreigners, tourism, inward remittances, foreign grants and loans, foreign direct investment, etc.

On the demand side of foreign exchange, the main items are merchandise imports, external debt -service payments and profit repatriation on foreign direct investment. The demand for imports is raised almost exponentially through domestic birr currency printing to finance ever growing fiscal deficits, and domestic monetary expansion via money creation on the basis of fractional reserves through domestic bank loans and credits, which in Ethiopia are mostly unproductive, particularly in the government sector. Another major source of foreign exchange hemorrhage is capital flight in hard currency engaged in by corrupt individuals and institutions, including government officials and business persons. It has been estimated that something like 30bn USD has left the country in this way over the last thirty years.

Hence, on the one hand there is an excessive supply of birr through excessive fiscal and monetary expansion and on the other hand the supply of foreign exchange is limited, thus leading to a situation of too many birr notes chasing too few US dollars with the obvious result of birr depreciation and devaluation. What the official birr exchange rate, which is clearly overvalued, is causing to happen is a suppression of the emergence of a birr exchange rate determined by the market forces of demand for and supply of foreign exchange in terms of birr, which, unfortunately, the illegal black market rate attempts to simulate. In summary, the main sources of excessive birr supply expansion are a/ fiscal expansion through currency printing and b/ monetary expansion through fractional reserve - based bank money creation. On the other hand, the main causes of excessive demand for foreign exchange, which contribute to birr depreciation and devaluation, are contraband trade, capital flight, currency speculation and dollar hoarding in the absence of legitimate tariff and non -tariff import restriction, etc.

What to do?

Economic deformities and malfunctions are a reflection of lack of democracy, the rule of law and accountability. In a society where such is the case, political repression and corruption give rise to capital flight, contraband trade, speculation, excessive currency printing and monetary expansion and therefore to excessive currency depreciation and devaluation. So, in essence, the key to establishing a properly functioning economy lies in setting up a democratic political system. As things stand now, the probability of succeeding in doing so under identity-based politics, where the identity groups vary widely in population size, is extremely low, as democracy is essentially a matter of numerical majority.

Be that as it may, there are quite a few things the current Governor of the National Bank of Ethiopia (NBE) can do professionally (regardless of what the so-called Macro Team and the government may want him to do) in order to gradually merge the official and black -market birr exchange rates, and thus move towards an essentially market - determined rate. Consider the following main measures:

Re-introduce statuary limits on the annual amount of lending the NBE may effect to the government through direct advances, treasury bills and bonds;

Allow no more annual domestic monetary expansion than is consistent with an inflation rate of 2-3 percent per annum ;

Convert the existing black market into a set of currency shops operating under a clear legal and regulatory framework ;

Reduce the current spread between the official and black market Birr exchange rates (now about 10 Birr) to no more than one birr over a given period of time;

Try to recover the estimated 30 bln USD of illegal capital flight effected by former and current TPLF/EPRDF/PP officials and business persons. This would definitely greatly enhance the foreign exchange reserves of Ethiopia and help stabilize the birr/ USD exchange rate ;

In collaboration with the relevant institutions, make sure that new and expansion business enterprises pass the net foreign exchange gain criterion before advancing domestic bank loans and credit to them;

Finally, the ideas of deposit insurance and transitioning the birr exchange rate towards market determination are both great, but the economics behind them is pretty messy and complicated.

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