The unexamined life is not worth living," - Socrates; this wise expression becomes not only necessary but also existential for both individuals and states when problem trajectories show growth in magnitude and scope rather than narrowing. In such contexts, examination must be holistic, critical, and penetrating to understand interconnected issues and devise root cause solutions rather than addressing illusions and dynamic symptoms.
Through this lens, the challenges Ethiopia currently faces are complicated, deep-rooted, and multidimensional in nature, accumulating for decades. However, the advent of the "reform administration," championed by Prosperity Party (PP) head Prime Minister Abiy Ahmed (PhD) in 2018 with promises of democratic reforms, inclusivity, economic prosperity, and peace, sparked optimism and hope for a better future for most people.
Despite problems popping up and intensifying across security, socio-political, and economic life, the public continued to wait for 'the reform' to bear fruit. Now, nearly five years later, the learning curve may seem shallow for the PP-- as an integral part of the preexisting Ethiopian Peoples' Revolutionary Democratic Front (EPRDF), the party was in a better position and had capabilities to maneuver politics and drive the promised change.
- Advertisement -Unfortunately, the PP has not lived up to its promises. Hence, the room allowed for "benefit of the doubt" seems to be closing. Furthermore, given the severity of the situation, it is essential for citizens to examine it critically and share fact-based reflections.
This article aims to critically examine the behavioral drivers that compelled the Ethiopian government to relinquish its policy tools by undertaking an abrupt-forced reform program into a free-floating foreign exchange (FX) regime despite a soaring inflation, unemployment and high cost of living. Understanding a government's characteristics is essential to defining its nature and predicting its course of action and possible outcomes in the future. As long as those characteristics persist, the likelihood of changing the outcome trajectory remains low.
On the economic front, the fiscal spending behavior of the regime is one of the most important factors contributing to the crisis. Since coming to power, government expenditure on productive capital items has significantly declined.
According to the annual National Bank of Ethiopia (NBE) report, current expenditure under the PP's administration exceeded capital expenditure and grew in magnitude for the first time in a decade, excluding the 2016-2018 budget years during the 'state of emergency'.
If we examine expenditure increments for 2020-21 compared to the prior budget year, current expenditure grew 31 percent, while capital expenditure increased 15 percent. In 2021-22, current expenditure grew from 360 to 517 billion birr (42 percent), while capital expenditure increased from 235 to 262 billion birr (11.3 percent) compared to the previous budget year.
A report by the Ministry of Finance shows a substantial declining trend in poverty reduction expenditure from 84 percent in 2018-2019 to 53 percent in 2021-2022.
Apart from the numbers, flagship projects spearheaded by PM Abiy also underscore the government's priorities and intentions. Aside from questionable justifications for spending funds without parliamentary approval as if the funds were not granted in official capacity as head of government, it reveals the extent to which the administration is drawn to superficial projects like parks and a grand residential palace.
Instead of focusing on these non-essentials, the administration is considering cutting oil subsidies and scaling back public housing projects that could significantly benefit low- and middle-income households and the broader economy. Such fiscal policy orientation also hampers opportunities to curb forex shortages by investing in productive hard and soft assets that attract foreign direct investment (FDI) and create an enabling environment for the local private sector.
Another issue of concern is public debt. Inherently, a budget deficit or debt is not bad. However, in Ethiopia's case, the trajectory reflects a lack of fiscal discipline as the high volume and low quality of spending contributes to macroeconomic instability.
After Abiy's administration came to power, public debt significantly increased, rising 1.92 percent in 2019 and seven percent in 2020 from the previous year, until the devastating war in Tigray restricted access to foreign debt in 2021.
Though Ethiopia's debt-to-GDP ratio is around 50.1 percent, which is below the 77 percent critical point, it remains considerably high and growing. The debt service to export ratio of around 22 percent exceeds both the 15 percent International Monetary Fund (IMF) threshold for Ethiopia and the typical 20 percent rule of thumb threshold. Some empirical studies in Chad and Nigeria show a positive causal relationship between public debt and the exchange rate.
For instance, a 2018 study by Kouladoum found that a one percent variation in external debt leads to a 2.55 percent increase in the real exchange rate. This is due to the alarming rise in public debt, which signals risk to investors and triggers capital outflows and perpetual devaluation.
The regime's behavior in internal political affairs also forced it to relinquish policy instruments. There are examples showing deceitful, shortsighted and inept leadership.
Unconstitutional election postponement and causes of the deadly Tigray war; the government's role in Amhara-Tigray territorial disputes; and handling of Southern Ethiopia's self-administration inquiry demonstrate leadership flaws.
While debates exist around the regime's responsibility, no rational, informed person can deny the government's significant role and responsibility given its mandate and monopoly on violence. Just considering Tigray war's economic ramifications: Ethiopia lost USD 120 million in annual export earnings despite USD 1.03 billion in 2022 military expenditures.
Overall, the government has lacked transparency, accountability, responsiveness, and consistent, long-term decision-making. It repeatedly displayed unprincipled problem-solving, derogatory statements and actions undermining institutionalization for self-aggrandizement, making policies unpredictable for long-term investor commitments.
While a free-floating exchange rate regime may be appropriate for Ethiopia under the right conditions, it is not a panacea for the country's current shortage of foreign currency reserves. The most sustainable solution is to increase international demand for Ethiopian products and services.
Any fiscal or monetary policies should aim to expedite Ethiopia's economic transformation and make local industries more competitive globally. For a country like Ethiopia where the government plays a major role in development, effectively utilizing these policy tools is crucial.
By relinquishing these, the government risks losing its "commanding heights" needed to transform Ethiopia's agrarian economy into a higher-value manufacturing economy. This could prolong economic instability and high inflation.
Countries like South Korea formerly pegged their FX until reaching middle-income country status (USD 10,543 GDP per capita in 1996) and was forced to float freely by the IMF in 1997 as part of restructuring during the Asian financial crisis. Similarly, China formerly pegged its exchange rate during the early period of its development to enhance export competitiveness. This implies that such instruments are vital, particularly in the early days of economic growth.
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While interest rates (IR) can intervene indirectly when adjustment to the FX is needed, this has limitations. The purpose of interest rate manipulation is not limited to altering foreign exchange; it can produce multiple and different outcomes for other policies. For example, a government may want to reduce unemployment by lowering the cost of capital (IR), potentially leading to more investment and jobs.
However, the same move has the opposite and undesirable effect on FX value; since lower interest rates lead to lower relative gains on local currencies, capital outflows potentially reduce investment and increase unemployment. There are complex policy instruments that can address such problems, but indisputably it reduces the flexibility and effectiveness of policy measures.
As I illustrated in the preceding paragraphs, Abiy's administration's actions and responses to economic and political challenges display a lack of integrity and transparency, misguided policy priorities, shortsighted decisions, and undermining of institutions. As long as these characteristics persist, political solutions will be incoherent and at times contradictory.
The ongoing debt restructuring talks with the IMF, which amount to USD two billion, must be completed with transparency and accountability to ensure Ethiopia's long-term financial stability and sustainability. They should also seriously consider the impact on the public, especially low-income households, affected by inflation and suffering from a 20-25 percent annual devaluation.
Finally, those in power should conduct an overall evaluation of "homegrown reforms" that compromise strategic national interests for short-term gain and diminish prospects for rapid transformation.
(Alula Nera is an experienced economist.)
