post The Price of Success

October 12th, 2008

Filed under: Economy — Lissan Magazine @ 21:54

Ethiopia is growing fast, but inflation is biting
From the Economist Intelligence Unit ViewsWire

Double-digit growth has its downsides, in the form of inflation of 40%-plus and foreign currency reserves that cover no more than six weeks of imports.

Since 2004 the Ethiopian economy has enjoyed double-digit growth rates, but this success has come at the cost of rapid inflation and a steep fall in foreign currency reserves. Surging coffee prices have played a major role in spurring accelerated growth, while inflation is being largely driven by the steep rise in world food and oil prices.

One adverse consequence has been the 33% appreciation of the real exchange rate, which threatens the country’s export drive (although it does have the beneficial effect of slowing inflation). This real exchange rate appreciation has taken place despite a 30% fall in the nominal exchange rate, meaning that the Birr has not fallen anywhere near rapidly enough to accommodate the widening gap between inflation in Ethiopia and its main trading partners.

According to the IMF’s latest report on the economy, growth will slow over the next five years, reflecting the combination of high inflation (which will have to be tackled by tightening fiscal and monetary policy), the infrastructural deficit (which will constrain production) and declining competitiveness, caused by real exchange rate appreciation. The Fund says that “front-loaded” fiscal and monetary tightening could bring inflation back to single-digit levels within two years, but because inflationary expectations have taken hold, slowing inflation could take longer, forcing the government into even tougher contractionary policies that threaten to curb GDP expansion.
Conflicting goals

Because the public sector plays such a dominant role in the Ethiopian economy, bringing down inflation will involve reduced borrowing and investment by the state at just the time when the government has embarked upon an ambitious infrastructural investment programme. Five new hydropower plants and a wind-power facility are being built; between them these will expand the country’s installed generation capacity from the current 660 megawatts to some 3,600 mw by 2012. Ethiopian Airlines is planning the purchase of ten new Dreamliner aircraft to be delivered over the next four years, and these costly schemes will have to be funded by a combination of domestic and offshore borrowing. To reduce inflation to single digits, however, the government will have to cut its public-sector borrowing by some 2.5% of GDP, and increased infrastructural investment—funded from borrowing—is simply incompatible with a tighter fiscal and monetary stance. This means that there is a very good chance that inflation will remain high and consequently that the real exchange rate will continue to appreciate, thereby undermining exports and increasing import demand.

Inflation reached a historic high of 40% in May. Ethiopian inflation has in the past been driven by drought, but not on this occasion, since the country has enjoyed four successive years of bumper harvests. Rather, inflation is being driven by fuel prices, currency devaluation, the spillover from the construction boom and (during 2008 in particular), rapidly rising food prices.

Money supply is also playing a role: having accelerated since 2005, money-supply growth has pushed above 40% early this year. There is an additional, technical problem, in the form of rising velocity of circulation. In other words, people are withdrawing cash from the banks and from savings and spending it, partly because they expect prices to continue to escalate (inflationary expectations), but also because real interest rates are negative so that money in the bank loses its value.
Exports threatened by inflation

Competitiveness is a worry too, because while the exchange rate has devalued by some 22% since 2004, reflecting much higher inflation in Ethiopia than the global average, the real exchange rate is strengthening, rising by one-quarter in the past four years. One consequence is that Ethiopia’s current-account deficit is now very large, at around 20% of GDP.

Exports continue to boom, despite the loss of competitiveness. Since 2004 Ethiopia’s share of the global coffee market has increased by 50%, albeit from a low base (ie, from 0.6% to 0.9%). Export shares for its other main products—flowers and oilseeds—have also increased, with horticulture’s global market share rising by 0.5%.

Aside from exchange rates, three factors are critical to Ethiopian competitiveness: wage levels, the state of infrastructure and the ease of doing business. In terms of wages Ethiopia is reckoned to be the most cost-effective country on the continent, with a manual worker earning US$60 a month as against US$190 in China. Indian investors have moved into the flower sector because land costs are much lower than in their home market, wages are one-third of Indian levels, freight costs are lower and there are no import taxes. In 2007 Ethiopian flower exports increased by 133%, while exports of oilseeds, leather goods and live animals rose by 20-30%.

In terms of the World Bank’s Doing Business indicators, Ethiopia is near the top of the African league table, behind only Botswana, Kenya and South Africa. Despite this and despite the country’s impressive export performance, it seems clear that competitiveness is under threat from high inflation and an appreciating real exchange rate.

In part this reflects economic fundamentals—very rapid import growth caused by strong output expansion. As growth slows in the next few years import growth will decline, but this may well be insufficient to counter overvaluation of the exchange rate. It is therefore likely that the Birr will continue to depreciate over the next two to three years.


1 Comment »

  1. They must be joking. The bir has fallen by more than 50%. It was 1 to 8 in 2008 no it is 1 to 14

    Comment by Tazabi — 29. June 2010 @ 21:40

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