Addis Abeba — It was widely acknowledged that Ethiopia's foreign exchange system was undergoing a period of significant transformation. In recent years, speculation regarding a substantial devaluation of the birr has been prevalent among observers, with some anticipating a potential shift in the exchange rate regime.
On 28 July, 2024, the National Bank of Ethiopia (NBE) issued a statement clarifying the matter definitively: Ethiopia is transitioning from a crawling peg exchange rate system to a market-based foreign currency regime.
Also known as a floating exchange rate, a market-based foreign currency system is one in which a nation's currency price is determined by the forex market based on supply and demand relative to other currencies. This differs from a crawling peg, where a fixed-rate currency is allowed to fluctuate within a predetermined band of rates.
Exchange rate regimes typically fall into one of the following categories: fixed or pegged, floating, crawling pegs, and managed floats exchange rate regimes. Ethiopia has adopted at least three of these exchange rate regimes over time.
Between 1976 and October 1992, the Ethiopian currency was pegged to the US dollar at a rate of 2.07 birr per US dollar.
This fixed official exchange rate remained unchanged for two decades. Consequently, the birr became overvalued relative to the US dollar and many other foreign currencies.
Following the devaluation in 1992, the exchange rate shifted from fixed to a managed floating regime. This change aimed to address the overvaluation by gradually depreciating the domestic currency each year.
This regime continued until last week, when the central bank announced that the nation was transitioning to a market-based exchange regime as part of a major revision of the country's forex system.
The foreign currency exchange regime reform was accompanied by about 40% depreciation in the value of the local currency, the birr, relative to major international currencies.
On Friday, the Commercial Bank of Ethiopia (CBE) announced that the exchange rate of the birr against the US dollar is now 83.94 birr per dollar, an increase from 57.48 birr per dollar as of the end of last week.
The implementation of the foreign currency exchange regime reform was also supplemented by a new directive authorizing non-banking entities, including independent foreign exchange bureaus, to engage in specific segments of the foreign exchange market. These segments encompass the purchase and sale of foreign currency banknotes and other designated operations.
Challenge or change for the better?
The NBE asserts that the recent reform introduces a competitive, market-based exchange rate determination mechanism, addressing a longstanding distortion within the Ethiopian economy.
A floating exchange system could ultimately inflict more damage than benefit." Kibur Ghenna, a seasoned economist
In its latest statement, the central bank indicated that the previously implemented crawling peg exchange rate system, while initially intended to stabilize the exchange rate and curtail inflation, has inadvertently led to the emergence of an uncontrolled parallel market exchange rate and elevated inflation.
The statement emphasized that "This system has facilitated large-scale illicit exports of Ethiopia's precious resources and diverted the country's foreign exchange earnings from the formal banking system and domestic economy."
It further elaborated that "Such practices have unduly benefited a select group of illegal operators and intermediaries at the expense of Ethiopia's productive sectors, which have endured chronic and severe foreign exchange shortages."
By transitioning to a market-based exchange rate determination, the NBE anticipates realizing a multitude of economic benefits.
According to the central bank, the reform will effectively capture and repatriate Ethiopia's full foreign earnings potential for the benefit of its citizens and productive sectors.
Moreover, the NBE emphasized that the FX reform will significantly bolster the country's burgeoning import-substitution industries, enabling them to expand operations and capture substantial market share.
Theoretically, studies suggest that a market-based foreign exchange regime, where exchange rates are determined by supply and demand forces within the foreign exchange market, offers several advantages for developing economies such as Ethiopia.
These benefits encompass flexibility, improved resource allocation, enhanced competitiveness, increased foreign investment, and a reduced need for foreign exchange reserves. However, some experts contend that it also presents significant disadvantages, particularly affecting economic stability and development in emerging economies.
While the theoretical underpinnings of transitioning from a crawling peg exchange rate system to a market-based foreign currency regime are sound, Henok Fasil (PhD), a macroeconomist and consultant at the World Bank office in Ethiopia, posits that the practical implementation in the Ethiopian context faces significant challenges that could potentially diminish its advantages.
He expresses doubt about the efficacy of such a regime given critical shortcomings such as weak institutional frameworks, inadequate oversight, a substantial trade deficit, low foreign exchange reserves, and exceedingly low public sector salaries.
"Developing economies are particularly susceptible to the drawbacks of a market-based foreign currency regime," he asserts. "This is particularly applicable to Ethiopia, given its underdeveloped financial markets and vulnerability to external shocks."
According to Henok, the inherent volatility of a market-based system can exacerbate economic instability, hindering the country's ability to manage inflation, stabilize the exchange rate, and achieve sustainable growth. "Furthermore, external shocks such as global economic recessions or fluctuations in commodity prices can have a more pronounced impact on Ethiopia's economy under a market-based system," he adds.
Kibur Ghenna, a seasoned economist, is among the experts who have expressed skepticism regarding the potential of macroeconomic reforms and the adoption of a floating exchange rate system to stabilize the Ethiopian economy.
In an interview with Addis Standard, Kibur contended that a floating exchange system could ultimately inflict more damage than benefit, with any potential advantages--such as expanded access to foreign currency, loans, market growth, and industrial support--manifesting only in the long term.
"However, these benefits can only be realized if crucial social and political preconditions are met," he asserted.
Kibur emphasized the necessity of augmenting production capabilities and reforming certain policies prior to the implementation of a market-based exchange rate. He drew a comparison to China's strategy in the 1970s, where the nation deliberately devalued its currency to enhance its competitive position in global markets, underpinned by a robust production capacity.
"In contrast," he explained, "Ethiopia grapples with challenges such as sluggish industrial growth and agricultural output insufficient to meet domestic demand."
He further warned, "The recent macroeconomic reform could further diminish purchasing power and intensify poverty unless Ethiopia substantially enhances its production capacity and addresses prevailing socioeconomic and security crises."
Some commentators posit that the recent reform does not originate from a deliberate governmental initiative to rectify a long-standing economic distortion.
Conversely, they contend that the reform is a consequence of a confluence of unfortunate circumstances, including persistent foreign currency shortages and a substantial discrepancy between the official and parallel foreign exchange markets.
Critics further assert that Ethiopia's adoption of a market-based foreign currency regime was compelled by pressure exerted by Bretton Woods institutions such as the IMF, which stipulated the change as a precondition for loan disbursement.
Henok is among the experts who concur with this perspective.
"Such external pressure can erode economic sovereignty, compelling the nation to prioritize short-term financial stability over long-term economic development," he observes. "Potential ramifications include heightened dependence on foreign aid, increased vulnerability to global economic fluctuations, and the possibility of social unrest stemming from immediate economic hardships imposed upon the populace."
Merid Tullu, a macroeconomist currently employed in the private sector, sees it is plausible that the Ethiopian government's decision to move towards a market-based regime was influenced by conditions set by these institutions, particularly in the context of loan agreements or economic support packages.
"For Ethiopia, this could include debt relief and the injection of capital into the economy. However, the success of these measures will depend on how well the government can manage the resulting economic dynamics and ensure that the benefits are broadly distributed across the economy," Merid contends.
The experience of some African countries that adopted a market-based foreign currency regime recently in order to receive bailout funds from the IMF has not been as favorable as anticipated.
In May 2023, Nigeria transitioned to a market-based exchange system in which the exchange rate is determined by market forces rather than by the central bank. The Nigerian government hoped this move would attract investors and stabilize the local currency.
However, the local currency, the naira, which had been pegged at an artificially high level against the dollar for years, has since fallen by 70%.
Egypt represents another African nation that has recently transitioned to a market-based foreign currency regime.
The Central Bank of Egypt implemented a market-driven exchange rate system in March 2024 with the objective of enhancing the country's external financial position, eliminating the parallel currency market, attracting foreign investment, and mitigating inflationary pressures.
Since the policy shift in March 2024, the Egyptian pound has depreciated significantly, losing more than 37% of its value against the US dollar. The exchange rate currently stands at 48.3 pounds per dollar.
A new era for the birr
Similar to the experiences of Nigeria and Egypt, the Ethiopian birr has depreciated significantly immediately following the nation's transition to a market-based foreign currency regime.
A day following the announcement of a significant overhaul of the foreign exchange regime, the state-owned financial behemoth, the Commercial Bank of Ethiopia (CBE), reported a precipitous 30% decline in the birr's value against the USD, with the exchange rate plummeting to 74.73 birr per dollar.
Prior to the adjustment, the currency had been trading at 57.48 birr per dollar. Continuing its rapid depreciation, the local currency had exchange rate as high as 90.6 birr per US dollar on 02 August, 2024.
This policy shift is aligned with the government's strategy to secure urgently needed foreign currency-denominated credit from Bretton Woods institutions.
Since 2020, Ethiopia has been actively pursuing financial assistance from external creditors. Following the Ethiopian government's most recent loan application, the Bretton Woods institutions indicated their willingness to provide financial support, contingent upon the fulfillment of "certain conditions."
Progress towards securing this financial assistance has been impeded by various factors, including the Tigray war. While the Pretoria Peace Agreement, concluded in November 2022, facilitated negotiations with the IMF, a concrete agreement has yet to be finalized.
However, a significant shift occurred this week with the Ethiopian government's announcement of the adoption of a floating exchange rate regime.
Central Bank Governor Mamo Mihretu disclosed in an online video that Ethiopia would receive $10.7 billion in external financing from the IMF, World Bank, and additional creditors as part of the reform package.
He further emphasized, "The IMF and World Bank are collectively providing exceptional and expedited funding support, which constitutes one of their largest allocations to the African continent."
His remark was followed by an announcement from the IMF, which revealed a loan of $3.4 billion to Ethiopia over four years as part of an economic reform program.
Additionally, the decision will facilitate the immediate disbursement of approximately $1 billion, as stated by the IMF.
Within less than 24 hours, the World Bank's Board of Executive Directors approved a $1 billion grant and a $500 million concessional credit from the International Development Association (IDA) to support the second phase of the Home Grown Economic Reforms, which the government began implementing in July 2023.
These funds are part of approximately $10.7 billion that Ethiopia anticipates receiving from creditors through loans, grants, and debt re-profiling.
In an interview with Addis Standard, an expert familiar with the matter discussed the significance of securing funds from external creditors to alleviate chronic foreign currency shortages and address the substantial disparity between the official and parallel foreign exchange markets.
According to him, a portion of the foreign currency obtained from the IMF and the World Bank is expected to be used to meet the Letter of Credit (LC) demands of importers who have been waiting for an extended period.
The expert noted, "once these demands are met, there will be diminished economic incentives for the existence of the black market."
The expert further asserts that, with the disappearance of the black market, all funds previously channeled through the parallel market, including remittances, will be redirected to official channels.
"This redirection will enable commercial banks to address the next round of importers' demands, thereby solving the foreign currency shortage and eliminating the black market entirely," he added.
However, Henok asserts that under a market-based regime, limited control over currency value can significantly hinder policymakers' ability to execute effective monetary policies.
He contends that efforts to manage inflation or stimulate economic growth through interest rate adjustments may be undermined by adverse currency fluctuations.
"For example, a substantial currency depreciation can induce imported inflation, complicating efforts to control overall price levels," Henok observes. "Conversely, unexpected currency appreciation can harm export competitiveness, impeding the attainment of balanced economic growth."
Kibur also emphasizes that the inherent volatility of a floating exchange system can engender market instability. "For instance, if an investor plans to secure a loan from a bank for a five-year project, fluctuations in the exchange rate could jeopardize their investment and lead to bankruptcy," he cautions.
While the reform may potentially improve access to foreign currency in the short term, the seasoned economist suggested that a minimum of two years is necessary for policy reforms to take effect and produce tangible results.
Widening currency gap, soaring inflation
A substantial disparity between the official and parallel foreign exchange markets has been a major macroeconomic challenge for Ethiopia.
In mid-March 2024, the official exchange rate stood at 56.55 birr per US dollar, while the Ethiopian birr plummeted to a record low of 116 against the US dollar on the parallel market.
The discrepancy between the official and parallel markets, which was approximately 74% in January 2021, also widened dramatically to 105% by March 2024.
However, experts interviewed by Addis Standard have expressed apprehension regarding the recent depreciation of the birr against the dollar, which was intended to reduce the discrepancy between the official and parallel markets.
They are concerned about a potential significant increase in the cost of living, particularly in light of the prevailing high inflation rates. Their assessment is grounded in previous instances of birr devaluation, which were followed by pronounced surges in the prices of food and other commodities, particularly imported goods.
Merid said the depreciation of birr leads to higher costs for imports, raising the overall price level. "This could cause immediate concern for businesses and consumers, particularly in a country where essential goods are heavily reliant on imports," he asserted.
"As most of Ethiopians rely on fixed income and people living below poverty line are significant in number, this depreciation of the birr and resulting inflation could place a substantial burden on the cost of living, leading to other socio-political crises," Merid stated.
He raises concerns that traders may also hoard FX and goods, creating artificial shortages and exacerbating inflationary pressures which will disrupt the supply of essential commodities, leading to a more pronounced economic burden on the population.
The Ethiopian birr has been subject to several devaluations in the past. Most notably, the birr was devalued by 16.7% against the US dollar in September 2010 and by 15% in November 2017.
These devaluations were implemented with the primary objective of stimulating exports. However, these adjustments resulted in an increase in prices, particularly for imported goods.
Between late 2018 and mid-2021, the NBE pursued a strategy of gradual depreciation of the birr. This involved monthly adjustments ranging from 1% to 6%.
Meanwhile, headline inflation has exhibited an average annual growth rate of 15% during the same period.
The recent depreciation of the birr has also garnered criticism from certain experts, as the country's inflation rate has inflicted substantial harm on consumers, significantly exceeding the 20% threshold since 2019 and culminating in an alarming 33.7% rate last year.
Although headline inflation moderated to 19.9% in June 2024, the costs of essential consumer goods remain elevated.
"Even without the new policy, our lives are already affected by staggering inflation, and this will only exacerbate the challenges," Dereje Tesfaye, an employee of the Addis Abeba city administration, told Addis Standard.
"I have three children who are enrolled in elementary schools. Meeting their basic needs such as food, clothing, books, and school supplies will become increasingly difficult," Dereje stated his fears.
Commentators posit that the recent depreciation of the local currency could serve as a primary catalyst for further price increases, both directly through escalated import costs and indirectly through heightened government import expenditures.
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Gradual birr depreciation rather than adopting a market-based exchange regime would have been more prudent for several reasons." Henok Fasil (PhD), a macroeconomist and consultant at the World Bank office in Ethiopia
Their predictions were realized this week as price increases and product hoarding became evident in the capital's major marketplaces. Reports indicate a price surge of up to 400 birr for edible oil.
Even though a detailed study is required to quantify the exact impact, Henok posits that the escalating costs of imported goods can elevate the overall cost of living, with a disproportionate effect on impoverished households.
"When essential commodities such as fuel and food become more expensive due to currency depreciation, these increased costs are frequently transferred to consumers," he notes.
According to Henok, impoverished households, which allocate a larger portion of their income to essential goods, will experience a more severe impact, leading to heightened economic hardship and an increase in poverty rates. "This inflationary pressure can exacerbate existing socioeconomic disparities and strain the social fabric."
Recently, the World Food Program (WFP) has voiced its apprehension regarding a potential large-scale devaluation of the Ethiopian birr or its transition to a floating exchange rate system.
The WFP noted that "this approach, if implemented as part of a strategy to address significant or persistent disparities between the official and parallel foreign exchange markets, could lead to a rise in the cost of imported production inputs such as fertilizers and fuel."
The UN agency posits that this consequence could negatively impact domestic food production and ultimately lead to an increase in food prices. "This scenario would disproportionately affect poorer households and threaten the food security situation for many Ethiopians," stated the WFP.
Government officials acknowledge the potential consequences of the situation.
To mitigate the anticipated inflationary pressures, the NBE has announced the government's intention to increase civil servant salaries within the constraints of available financial resources.
This measure is designed to be implemented without significantly exacerbating the budget deficit.
The statement by the NBE further indicates that the Productive Safety Net Program, which supports low-income rural and urban populations, is undergoing a substantial expansion to benefit approximately 10 million families.
Earlier this week, the Addis Abeba City Administration implemented measures against businesses engaging in unreasonable price hikes and product hoarding following the government's recent announcement of a shift to a floating exchange rate regime.
The city's trade bureau reported actions taken against seventy-one businesses accused of price increases and hoarding, citing macroeconomic adjustments as a justification.
Sewnet Ayele, Director of the bureau's Communication Directorate, stated that 77 businesses across all city districts have been closed.
However, some experts contend that the government should have pursued a strategy of gradual birr depreciation rather than adopting a market-based exchange regime, which could potentially expose the country to heightened inflationary pressure and external shocks.
Henok believes this approach would have been more prudent for several reasons.
"Firstly, gradual depreciation permits controlled adjustments, minimizing immediate economic disruptions and affording businesses and consumers sufficient time to adapt," he explains. "This approach can prevent abrupt inflation spikes that disproportionately affect lower-income households."
Secondly, according to Henok, a gradual depreciation strategy provides a buffer against external shocks.
"Sudden shifts to a market-based regime can result in abrupt currency fluctuations, exposing the economy to volatility driven by global market sentiments, geopolitical events, or macroeconomic data releases," he states. "This instability can undermine investor confidence and hinder policymakers' ability to implement effective monetary policies."
Additionally, Henok believes gradual depreciation can contribute to greater economic stability by enabling the central bank to intervene and manage the pace of depreciation.
"This can ensure that the currency adjustment process aligns with the country's broader economic objectives and development priorities," he concludes.
