Financial Liberalization and Debt Sustainability in Ethiopia

By: Keita Takemura (MPA/ID ’22)

As an intern with the Growth Lab, I was working with the National Bank of Ethiopia on macroeconomic issues. Ethiopia has achieved rapid economic growth from the early 2000s, alongside large capital account and fiscal deficits (when the deficit is broadly defined). In spite of this situation where depreciation would be necessary to clear excess demand for FX, the exchange rate has not been devalued in a manner consistent with the level of deficit monetization. The exchange rate control, together with restrictions on financial account transaction, have led to a persistent excess demand for FX in relation to supply.

This policy stance appears to have caused several serious problems. Since the controlled FX market cannot meet the demand for FX, the amount of FX has been scarce in Ethiopia, leading to a constraint on imports. Shortage of FX also has led to the emergence of black market for foreign exchange and a stubbornly high black market premium. The real exchange rate has been overvalued due to the insufficient depreciation, which has resulted in declining global competitiveness.

To attack these issues, Ethiopia may want to consider unification of its de facto dual FX regime by allowing larger depreciation, while loosening control on FX market. Opening the financial account, however, would raise several concerns. One of them is a possible increase in the debt service of the Ethiopian government. The interest rate on public debt in Ethiopia has been set low compared with the inflation rate, which has helped contain the increase in public debt service (a form of financial repression). After Ethiopia loosens FX control, however, it would be expected that the arbitrage between domestic and foreign markets should work, and the real interest rate on public debt would rise. This rise could be a serious issue in Ethiopia, where there is a concern toward debt sustainability.

Therefore, my internship theme was analyzing the effect of FX control loosening on debt service in Ethiopia. I conduct my research from two approaches; first, I explore the development of the real interest rate and the debt/GDP ratio after such liberalization in other countries. Second, I use Ethiopia’s data and develop a simulation of the debt/GDP ratio after FX liberalization in Ethiopia.

In cross-country analysis, I found that the real interest rate has increased in many developing countries, while the debt/GDP ratio has not necessarily increased. The key factors to contain the debt/GDP ratio are a positive primary balance, a real growth rate higher than the real interest rate, and a high inflation rate.

The simulation also confirms that the debt/GDP ratio would not increase in Ethiopia due to FX liberalization even with positive real interest rate, under the assumption of steady economic growth (5.0%) and inflation and depreciation rate in line with the level in the recent three years (15.3%). It is also true, however, that in the risk scenarios of (1) low growth rate and (2) high depreciation rate relative to the inflation rate, the ratio would destabilize. It should also be noted that high inflation can help contain the ratio under risk scenarios until the debt with fixed nominal interest rate is rolled over, though this containment would last only for five years.

Through the internship, I was able to brush up my analytical skill as an economist. Especially, my breakthrough was learning (1) how to conduct research on countries where there are little data available, (2) how to apply international macroeconomics to analysis in developing countries, and (3) how to communicate with policymakers.

There are little data available in Ethiopia. For example, GDP is available only on an annual basis, and there are very limited macroeconomic data around the labor market. Therefore, we should depend on descriptive analysis or simple regressions rather than more advanced methods. It does not, of course, mean that our research was easy. We have to have clear logic behind our statement and develop our arguments with simple and clear-cut descriptive graphs. This process helped me refine my critical thinking skills to provide coherent results.

International Macroeconomics
Before HKS, my research focus was on Japan, where the capital account is always positive and the foreign reserve is abundant. Therefore, even though I studied international economics in the first year at MPA/ID program, I did not fully understand whether the international macroeconomic models were useful to the practical research. However, when I analyzed capital control and exchange rate issues in Ethiopia, macroeconomic models such as the Mundell Fleming model, PPP, and UIP simplified these complex issues intertwined with many other variables and helped organize my thoughts.

Since COVID-19 forced this internship to be conducted remotely and counterparts at the NBE and the government broadly has been involved in a major reform push while also preparing for national elections these past months, I did not have many chances to engage in iterative discussions on this research with government officials. However, when I was discussing with supervisors at the Growth Lab, I was always asked, “does your interest really matter to what the NBE is facing?” or “does your suggestion really help the policy management of the NBE?” These comments helped me to start thinking about the needs of the policymakers while I was conducting research. These experiences should help my future career as a researcher working in the public policy area.

See also: Ethiopia