In December 2023, the National Bank of Ethiopia (NBE) released a three-year Strategic Plan, for the period 2023-26. The Strategic Plan contains five strategic objectives, action plans, key performance indicators, and time frame for implementation of each task. If the strategic plan is implemented, it will completely transform monetary policy and financial sector regulation and supervision, marking a significant progress in our recent central banking history.
Although a number of issues are incorporated in the Strategic Plan, I want to shed some light on the issues pertaining to monetary policy. One of the strategic objectives included in the Strategic Plan is ensuring price and external stability, on which the NBE has miserably failed for nearly two decades. The failure of the NBE on its primary task has emanated from the use of outdated monetary policy regime, lack of institutional independence and the existence of fiscal dominance.
The NBE's primary responsibility is ensuring price stability. In the current monetary policy framework, price stability is assumed to be achieved through targeting the growth of monetary aggregates, which is in turn is assumed to be influenced by siring the growth of reserve money along a predetermined path.
The ability of the NBE to influence the growth of monetary aggregates through adjustment of the reserve money has been called into question. Firstly, the NBE has less control over reserve money in the presence of fiscal dominance and other autonomous factors. Secondly, the relationship between reserve money and monetary aggregates has been unstable due to fast monetization of the economy and unpredictable lending behaviour of commercial banks.
Furthermore, this framework is based on the assumption that that there is a stable and predictable relationship between nominal quantity of money and nominal aggregate income. Experience has shown that this assumption is, however, untenable in the face increased monetization of the economy and for other reasons.
- Advertisement -The failure of monetary targeting regime has led many countries to move to a price-based (interest-based) framework. The NBE's plan of introducing a price-based framework is commendable, but caveats should be added to its practicality in the current Ethiopian banking sector context. The price-based framework assumes that the NBE can influence the level of private sector borrowing through the interest rate, set around policy rate, it charges when availing credit to the banking system in times of liquidity needs.
The application of a price-based framework depends on a banking sector functioning on market principles, the ability of the NBE to forecast and manage liquidity, and the existence of analytical capability in setting the policy rate, whose accuracy depends on the quality of the GDP forecast, trend GDP, and inflation projection etc. data.
Generally, the Ethiopian banking sector does not operate within the confines of market forces. The government and the NBE have widely intervened in the banking sector through credit allocation and interest rates determinations, causing significant market distortions. The interventions include the NBE lending to the government, directed credit schemes such as compulsory sale of five-year treasury bond, cheaper credits to state-owned enterprises (SOEs), regulatory-sanctioned interest rate determinations, preferential treatment to the CBE, and excessive market power of the CBE in influencing lending rates.
Over the past decade and half the state-owned enterprises (SOEs) and other government organs have accumulated substantial amount of loans from the Commercial Bank of Ethiopia (CBE) at interest rates, much lower than what would be in a competitive market, The CBE, in turn, has received preferential treatments, and cheaper deposits and credits.
Although the much contested 27-rule was lifted few years ago, a compulsory purchase of five-year treasury bond was introduced in November 2022. This regulatory-sanctioned directed credit scheme has a serious distortionary effect on credit allocation and interest rates setting behavior of banks.
Both the lending and deposit rates are also distorted. The real saving rates have remained negative for a decade and a half, and the real lending rates have been negative for majority of this time. The NBE sets the minimum savings and time deposit rate. The economic rationale on which this rate is determined is not clear. Similarly, the lending rates of the banking industry is hugely influenced by the pricing conduct of the CBE. Due to its sheer size, the CBE is a price maker whereas the rest of the banks are price takers. The SBE sets lending rates much lower than what would otherwise be in a competitive market as it is a policy bank. This interest setting practices force the private commercial banks lending rates hoovering around the CBE rates.
For a price-based monetary policy framework to work, the widely existing market distortions in the banking industry should be removed. This means removing any form of directed credit schemes and compulsory purchase of five-year treasury bond, ensuring that SOEs pay market rates of interest, and refraining from setting the minimum savings and time deposit rate, and letting the CBE to operate according to market principles. This seems in impractical in the near future.
The major failure of the NBE has sprang from its lack of institutional independence. The NBE is accountable to the Prime Minster, and its Governor and board of directors are appointed by the government. This problem is compounded by fiscal dominance. Although the proclamations preceding Proclamation No. 591/2008 made the NBE accountable to the government, they placed several restrictions on government borrowing from the NBE. Proclamation No. 592/2008 removed any restriction on government borrowing from the NBE, enabling unbridled government borrowing from the NBE. When this combined with expansion of bank credits, the result has been an explosive inflationary episode, never seen in our history.
The Strategic Plan mentions revising the NBE proclamation without providing any details. The revision should seriously consider creating a truly independent central bank, governed and run by competitively hired experts, and removing any form of fiscal dominance through heavy restrictions on the government borrowing from the NBE as many countries have done in the world.
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The Strategic Plan aims at establishing a Monetary Policy Committee responsible for setting interest rates. In the existing monetary policy framework, there is a Monetary Policy Committee on paper, but monetary policy issues are decided by the Macro Committee, chaired by the Prime Minster. Hence, the implementation of the Strategic Plan should be able to insulate the Monetary Policy Committee from fiscal authorities' interferences.
Modern monetary policy relies on effective communication with the banking community, the media and the general public. Previous experience has shown that the NBE has a severe communication deficiency. This suggests that a lot of work awaits the NBE ahead.
Equally important is the relationship between monetary policy and banking regulations as there are times when these two central banking functions conflict. Monetary policy often uses countercyclical tools to tame inflation while leaving the stability of the financial sector in jeopardy. This suggest that the two central banking functions should be synchronised.
Abdulmenan Mohammed (PhD) is a seasoned financial analyst. Based in London, United Kingdom, he closely follows updates in Ethiopia's financial system, and provided cut-edge commentaries for over a decade. Abdulmenan is presently working as an Account Manager at London Portobello Ltd.
By Abdulmenan Mohammed
