Foreign Currency

Impacts Of Devaluation And Exchange Rate Shocks On Ethiopia’s Commercial Banks

Ethiopia finds itself at a critical juncture as it grapples with a complex economic landscape. A few months ago, the National Bank of Ethiopia (NBE) submitted a document to the Standing Committee of the House of Representatives, outlining its plan to devalue the purchasing power of the Birr by up to 95 percent compared to the parallel market. The bank refuted it made this claim. It then warned that any artificial price increases caused by speculation “unacceptable” and dismissed the reports published in the “Reporter Amharic” newspaper as misleading. However, the devaluation of the Birr has become a topic of discussion, partly due to the International Monetary Fund’s (IMF) emphasis on liberal exchange markets as a precondition for granting a loan to the Ethiopian government.

The Ethiopian economy has been grappling with a balance of payments crisis for several months, leading to a series of setbacks. These include the indefinite postponement of the first review of the IMF’s financial support program, which is crucial for fund disbursement, as well as the downgrade of the country’s sovereign rating by Moody’s from Caa3 to SD (Selective Default). Furthermore, there is a possibility that Ethiopian financial assets may be removed from certain international indices. Lastly, political tensions have resurfaced abruptly within the country and the region, exacerbating the challenges faced by Ethiopia.

The lack of flexibility in the Ethiopian Birr’s exchange rate has prompted the central bank to strive for foreign exchange reserves in accordance with the IMF’s prudent standards. Ethiopia heavily relies on imports, particularly fuel, fertilizer, and food, and its external debt stood at USD 27.8 billion as of September 2023, according to the Ethiopian Minister of Finance.

Given this context, the currency shortage has resulted in various forms of rationing, the emergence of a parallel exchange market, a deterioration in the net open position of the banking system, and, as a last resort, a gradual depreciation of the exchange rate.

Since mid-2018, the Birr has experienced an annual depreciation of more than 20 percent, while the exchange rate on the offshore market for a one-year period has now exceeded 110 birr for one US dollar, representing a gap of over 100 percent compared to the official exchange rate of 56 birr for one US dollar.

IMF conditions and challenges for Ethiopia’s economic reforms

The International Monetary Fund is placing significant conditions on its support for Ethiopia, primarily through structural adjustments. These conditions include the termination of government economic subsidies, with a focus on lifting fuel subsidies, as well as expanding the tax base through the implementation of property tax.

Additionally, the IMF calls for the liberalization and privatization of the economy by opening up sectors such as telecommunications, export, and import to foreign investors. Furthermore, the Fund emphasizes the need to weaken the purchasing power of the Birr and implement a flexible exchange rate system.

The IMF believes that currency depreciation can be used as a policy tool in developing countries to stimulate real economic activity by influencing export competitiveness through trade channels. It argues that the value of a currency should be determined by market forces, treating it like any other commodity. However, recent empirical evidence challenges the conventional theory, showing that currency depreciation does not always lead to economic expansion.

Regarding the IMF requirements, progress has been made in implementing subsidy cuts, liberalization, and privatization measures, aligning with its demands. However, the issue of devaluation and exchange rate flexibility is more challenging, particularly due to its potential impact on inflation—a persistent problem in the Ethiopian economy.

In February, consumer goods prices rose by 28 percent year-on-year, with core inflation reaching 35 percent. Such inflationary pressures can affect lending, liquidity, and profitability for banks, especially those with higher foreign currency liabilities than assets. These banks in a vulnerable open position may experience negative shocks, such as losses on exchange rates, impacting their net worth and potentially reducing lending in the event of currency depreciation. This, in turn, can negatively impact non-financial firms that rely on these banks for investment.

Therefore, the enhanced competitiveness of exporters resulting from currency depreciation (the trade channel) may be counteracted by a decrease in investment by non-financial firms due to the negative credit supply shock caused by currency depreciation (the borrowing-lending channel).

The private sector arm of the World Bank Group, the International Financial Corporation, estimated that Ethiopian banks annually accumulate outstanding letters of credit (LC) amounting to USD 200 to 300 million payable to foreign banks. These figures are expected to increase further due to the chronic foreign exchange shortage in the country. This highlights that most banks have significant foreign currency liabilities in their open positions.

In light of these circumstances, policymakers, particularly the central bank, must carefully consider both the foreign currency exposure of the banking system and its distribution across banks when evaluating the impact of exchange rate changes or depreciation on the real economy.

(Ameha Hailemairam holds a Master of Arts in Economics from Indira Ghandi University, with experience in the banking sector and as a financial analyst.)

Contributed by Ameha Hailemariam

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