Ethiopia central bank announces 15% devaluation of Birr: The cost of devaluing the Birr may outweigh its benefit October 12, 2017

Africa News: Ethiopia central bank announces 15% devaluation of Birr

Economic Analysis: The cost of devaluing the Ethiopia’s Birr may outweigh its benefit

By Dr Mohammed Abbajebel Tahiro

The link between currency devaluation and domestic inflation

Ethiopia has been devaluing the Birr, in part because of pressures from the International Monetary Fund (IMF). Cheaper domestic currency, Vis a Vis major international currencies, makes exports more attractive to foreigners if a decent segment of the economy is based on manufacturing or, if the manufacturing sector is expanding and looking for international markets. Devaluing domestic currency makes exports more attractive to foreigners, which in turn spurs economic growth. The flip side of that is, cheaper domestic currency makes imports more expensive. Ethiopia imports medicine, fuel, food, and almost all productive capital, vehicles, and many more consumer goods. Cheaper currency means it takes more Birr to buy one foreign currency. Ethiopian importers will naturally raise their prices (inflation) to cover additional costs incurred because of a weaker Birr. The cost of devaluing the Ethiopian Birr may outweigh its benefit as the Ethiopian economy is still largely agricultural. The demand for agricultural products and minerals on the world market is largely stable and Ethiopia does not need to cheapen its currency to sell more to foreigners. The reason Africa can’t get a foothold in manufacturing is Chinese dumping of cheaply manufactured goods, not inability to access world markets for Africa’s manufactured goods. African infant manufacturing industry simply can’t compete with predatory practices of foreign manufacturers.
Ethiopia could simply let the exchange rate float. A floating exchange rate means the price of the Birr vis a vis major international currencies is determined by the relative supply and demand of the currencies. Consider the U.S. Dollar and the Birr are just goods like any other; say salt, just as in a free market the price of salt is determined by the supply and demand of salt, the exchange rate (price of Birr in Dollar) will be determined by the relative supply and demand of the two currencies. The United States follows floating exchange rate. In Ethiopia, the exchange rate is fixed by the National Bank. Fixed exchange rate always creates arbitrage opportunities as it seldom reflects the will of the international currency markets. The latest devaluation of the Birr ( 1USD = 27.07 Birr) will undoubtedly create more domestic price inflation as Ethiopian importers will raise prices on their imported goods. With the increase in the wage rate trailing far behind increase in prices, workers are getting a wage cut in real terms. Rising general level of prices means rising input prices. When input prices rise, manufacturers cut back on output, which means even more unemployment.
Inflation, two fundamental factors
When the Ethiopian parliament opened on Monday, President Mulatu Teshome made bold claims about the state of the Ethiopian economy. I will address the merits/demerits of that claim at a later date. Today, I will talk a little bit about the fundamental causes of domestic currency devaluation (inflation). There are two fundamental causes of currency depreciation:
1. The productive capacity of an economy.
2. The size of the money supply.
When an employee creates more value through increased productivity, his/her salary should increase proportionately. If the money supply in a country is fixed while productivity is increasing, each unit of currency will store greater value. On the other hand, if the increase in the money supply is proportionate to the increase in productivity, the amount of purchasing power (value) stored in each unit of currency remains unchanged. But, if you have a runaway money supply, that is, if the money supply grows faster than the growth in productivity, the value stored in each unit of currency decreases, and we call that inflation. When there’s more money in the economy than the productive capacity of the economy, the general level of prices increases and we call that demand-pull inflation. When prices of productive inputs rise, producers increase prices on finished products in order to recoup higher payments for input and, that can also lead to inflation; inflation created through an increase in input prices is called cost-push inflation. This source of inflation is less likely in Ethiopia as the manufacturing sector contributes less than 40% of the Ethiopian GDP.
The American Federal Reserve Bank’s counterpart in Ethiopia is the National Bank of Ethiopia. The National Bank is supposed to oversee the monetary policy of the country, including managing the money supply. The National Bank is supposed to be independent of undue political influence from the executive branch of the government. In Ethiopia today, appointments to key positions in the National Bank are based more on loyalty to the regime than professional aptitude. With that in mind, it’s easy to see how monetary policy could be mismanaged.

Ethiopia’s Attempt to Ease Dollar Shortage with Devaluation

By Barii Ayano

This is just to offer basic explanation of the issue without technical jargons. Exchange rate is the price of one country’s currency in terms of another country’s currency. For instance, the price of Birr in terms of U.S. dollar or vice versa. Exchange rates affect large flows of international trade (imports and exports). Foreign exchange facilitates flows of international investment, including foreign direct investments (FDI. Countries follow various exchange rate regimes: fixed exchange rate, pegged exchange rate, floating exchange rate, and managed floating exchange rate. The exchange rate regime of Ethiopia is characterized as managed floating exchange rate regime, which partly depends on supply and demand but with some government intervention in the exchange rate market, to concurrently adjust both exchange rates and foreign exchange reserves, monitored by the World Bank and the International Monetary Fund.

What is Devaluation?

Devaluation is mainly government intervention in the exchange rate market of the country to determine the price of Birr in terms of dollar-some kind of government price setting. Simplified, devaluation makes Birr cheaper relative to the dollar, and hence you will need more Birr to get a dollar, compared to the current rate of exchange. In short, you need more Birr to buy a unit of dollar, and the people who can afford to buy dollar declines.

The recent announcement states that Ethiopia devalued its currency (Birr) by 15% per cent, which means you will need 15% more Birr to buy a dollar since Birr has become cheaper by 15%.

Why Do Countries Devalue their Currencies?

There are several reasons behind the need to devalue currencies. Some do it to promote exports and restrain imports. The simplified assumption is this. If the local currency becomes cheaper due to devaluation, foreigners can buy the local export products more cheaply and hence exports will increase. On the other hand, cheaper local currency can serve as an import restraint since foreign products become more expensive in local currency and importers need more Birr to buy foreign products, and hence increase the cost of living.

When it comes to the developing economies like Ethiopia, with limited export promotion power, the devaluation policy measure is mainly related to exchange rate stability due to imbalance between supply and demand of hard currencies. As repeatedly explained by the government officials, including the PM & the President, there is severe shortage of hard currencies in Ethiopia caused by limited hard currency earning power of Ethiopia’s exports whereas imports have grown folds more than exports. Ethiopia gets dollar from exports and needs dollar for the imports. The gap between the dollar earning and dollar spending capacity leads to part of the current account deficit called trade deficit (export values greater than import values). The gap has been expanding every year-even more so in recent years.

If you buy something (imports) you have to pay for it via exports, foreign aid in hard currency, remittances, etc. The growing gap between exports and imports is not sustainable. It’s important to note that foreign exchange rate crisis is one of the major sources of economic crises that ravaged the economies of a number of countries. Google exchange rate crisis to read more about it.

Therefore, the devaluation of Birr, which has been urged by the World Bank for years, is the policy measure undertaken by the regime to relieve a crippling dollar shortage and meager foreign exchange reserve of Ethiopia. The World Bank, EU, IMF, etc. cover the foreign exchange gap of Ethiopia so that the economy does not collapse due to the shortage of foreign exchange. Without international support and the Diasporas remittance, Ethiopia can easily become hard currency illiquid country that cannot pay for its imports or pay for its debts in hard currency.

Although the shortage of hard currency is a common phenomenon of poor countries with limited exports, the widening gap between Ethiopia’s earning and spending in hard currency is evidently not sustainable. It can kill economic growth. At worst, it can lead to economic crisis due to currency (exchange rate) crisis since there is vivid evidence of liquidity gap in hard currency in Ethiopia owing to its weak foreign exchange earning capacity. Illicit outflow of hard currency is another key problem aggravating the pain.

Simply put, devaluation is not a success story as some want us to believe. It’s a desperate policy measure undertaken to ease the pain of severe shortage of hard currency and its adverse impacts.

I will highlight the effects of devaluation on consumers, business, foreign exchange shortage, etc. in my next note.

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A brief analysis of Birr devaluation