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  • Economic Analysis - Devaluing the Birr: Doing the Same Thing Over and Over Again and Expecting a Different Outcome 23 October 2017 | View comments

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    Addis Abeba — At the opening of Ethiopia's parliament on 9th October 2017, Ethiopia's President, Dr. Mulatu Teshome, stated that earning foreign exchange was has become a matter of life and death for Ethiopia. Apparently he was hinting that devaluation of the birr was about to take place. Sure enough, devaluation happened - a day later. The National Bank of Ethiopia (NBE) announced its decision to depreciate the value of the birr by 15% with immediate effect. This sequence of events clearly indicated that Ethiopia is in desperate need of hard currency. It sounds the authorities are panicking because the country's foreign exchange reserve has been rapidly depleting.

    Ethiopia's decision to devalue the birr brings to mind Albert Einstein's definition of insanity: doing the same thing over and over again and expecting a different outcome. I thought the EPRDF regime has done it more than enough number of times to know that the country would not achieve any economic gain by devaluing the currency. It was time the authorities do something else to address Ethiopia's economic malaise.

    In a two part piece, entitled "Is devaluation of birr the answer to Ethiopia's economic troubles?" and "Ethiopia's trade data and the effect of devaluation on import prices", I have previously covered the basics of devaluations, why it is necessary and how it works, specifically the political economy context of devaluations in Ethiopia. Hence, in this piece, I will limit my analysis to evaluation of the policy targets of the latest devaluation by relating it to achievements from the previous one. I will start by highlighting statements the authorities have put forward to justify depreciation of the birr.

    Rationale - official version

    Secrecy is a permanent feature of the authorities in Addis Abeba. Major decisions that most certainly will affect the livelihoods of tens of millions of Ethiopians get passed without any public debate, and the latest decision to devalue the birr is no exception. According to local media reports, the decision to devalue the birr was announced by Yohannes Ayalew, vice governor and chief economist at the NBE, "at a press conference where only the state media was invited to attend."

    Ironically, the National Bank of Ethiopia (NBE), the government body that announced this decision, did not even bother to put out any document for public record. I expected such a record to appear on NBE website, where I looked for further information on official version of the rationale for the decision to devalue the country's currency. Even the press statement or even a rehashed version of what was broadcast in the government media did not appear even as a "news items" listed on NBE's website.

    But, two separate policies were coupled into one policy package in the announcement of the devaluation. First, the birr was devalued by 15%, raising birr per USD to 26.91. This is supposed to stimulate exports, discourage imports and hence reduce trade deficit. Second, in order to ease inflationary pressure, the authorities have raised interest rate (by 2% to 7%).

    Let me separately examine the two elements in the policy package using Ethiopia's own experience and by addressing what happened to the two target policies after the previous devaluation in 2010, when the birr was devalued by 17%?

    Inflation

    It is useful to remind ourselves where the link between devaluation and inflation begins. Post devaluation inflation pressures begin to build up through two channels.

    First, devaluation makes the domestic currency cheaper in the foreign exchange market. Now that the birr is cheap, foreigners would buy Ethiopia's goods at a cheaper price than before, hence export competitiveness improves. The latter simply means the quantity of export goods foreigners demand will rise. If there is already a stock of exportable goods then more goods will be sold in the world market. The decrease in the stockpile of goods or the new orders will stimulate producers of exportable products, and hence they will engage in expanding their activities, which means more investment expenditure will take place. Payments for salaries or other supplies will mean new money will enter circulation and hence inflationary pressure builds up.

    Second, and more straightforward, is the price increase coming through imports. Devaluation makes imports expensive in domestic markets. Prices of new orders for imports or even those that were already imported and currently in stock will immediately translate to an increase in their prices, at the very least by the rate of devaluation. Inevitably, one way or the other, devaluation will trigger an upward inflationary pressure.

    Fig. one above presents Ethiopia's consumer price index Inflation, CPI (with 2010 = 100). The bar over 2010 is shaded in red to indicate that Ethiopia's birr was devalued in that year, by 17%.

    In two years preceding the devaluation, inflation was rising at much slower pace compared to the post devaluation year. The CPI rose only by 7% between 2008 to 2009 and then 8% between 2009 and 2010. The 2010 devaluation caused massive increase in inflation; it immediately rose by 33 points in 2011 and then by 32 points in 2012. This figures are taken from the World Development Indicators database, which is likely to be a highly conservative estimate. It was further reported in local press that the 2010 devaluation has resulted in about 40% increase in inflation.

    Normally devaluation is not coupled with an interest rate hike, but the authorities in Ethiopia seem to implicitly admit that the situation was not so normal in Ethiopia so they had to resort to an unusual measure. Apparently, they were worried that large increase in inflation may result from the latest round of devaluation, again, so they seem to preempt it by raising the interest rate. There are two strange things in this saga.

    First, a two per cent increase in interest rate is just a drop into an ocean, it cannot stop a powerful inflationary pressure, the kind of which the country had previously experienced. After all, the rates of devaluations are about the same, and inevitably inflation is likely to rise by about the same magnitude as before. Surely, the authorities are aware that this is the case, but they are just trying to find shortcuts by giving the impression that they have done something to stop inflation. For instance, the last devaluation was accompanied by some adjustments to salaries, e.g. for civil servants. This one is a quiet affair, no hint of possible salary adjustments. If civil servants ask for one, then the government would have a readily available answer - "look, we have increased interest rates and inflation won't happen", a dishonest way to address a legitimate public concern.

    Second, perhaps the authorities are unaware about contradictions or conflicts in the their policy package. As noted above, the potential effect of devaluation on export promotion can be realized if and only if economic activities on export productions expand. This requires investment but interest rate increase is likely to work against investment expansions in exports production. While currency depreciation tends to stimulate exports, interest rate increase as well as increases in prices of intermediate and capital goods imports become powerful disincentives against investment.

    In any event, even without creating additional hurdles in the way of export producing sectors, the benefits from devaluation would be realized only in the long run. Inevitably, devaluation would have contradictory effects in the short run. It would take time for investment decisions to be made and actual investments to take place. Given this situation, the authorities were expected to reduce interest rate to encourage economic activities, rather than doing the exact opposite.

    Exports

    It is appropriate to examine the likelihood that devaluation of the birr would lead to exports growth. Let's see the extent the previous devaluation has stimulated exports. Ultimately, whether or not devaluation has succeeded would depend on the effect on trade deficit, which is given as sum of earnings from exports minus expenditure on imports. Bear in mind that export growth by itself is not enough to indicate success with devaluation. Since devaluation will make imports more expensive, then increase from exports should more than compensate for the inevitable increase in expenditure on imports . In a nutshell, although devaluation is often discussed as a means of encouraging exports, the ultimate policy target is improvement of trade deficit.

    We are mainly interested in observing differences in the patterns of relationships between the three variables before and after 2010, the year of the previous devaluation, marked by the broken vertical line. Export revenues have increased from $2 billion in 2010 to $6 billion in 2014. Since the eruption of Oromo Protests, which eventually triggered the protest in Amhara regional state, export revenues have sharply declined and fell back to $2 billion in 2016, exactly where it was in the year of previous devaluation. Note that this figures are given in nominal terms, that is to say without taking the effect of inflation into account. The cumulative change in general price level (CPI) from 2010 to 2016 was 2.24; on average there has been more than two-fold increase in prices of goods and service in just six years (2010-2016). Therefore, in real terms Ethiopia's export revenues in 2016 was less than 50% of the amount earned in 2010.

    On the other hand, expenditure on imports have sharply increased from $9 billion in 2010 to $26 billion in 2015, nearly a three-fold increase. The sluggish growth in export earnings and rapid growth in expenditure on imports means Ethiopia's current trade surplus has deteriorated, rising from about $6 billion in 2010 to $17 billion in 2016, again nearly three-fold increase.

    Why doesn't Ethiopia's export respond to devaluation? The answer is clear and straightforward. It would be a gross understatement to say that the authorities do not do anything to stimulate export production. In fact, oddly enough, existing policies do actively discriminate against Ethiopia's mainstay of exports such as coffee, through regional and sectoral bias. The current export policy is to encourage a pocket of new export sectors, but their contribution to overall exports growth is a drop into an ocean.

    Why have expenditure on imports undergone such an explosive growth? Devaluation is an act of deliberately making imports expensive in the hope that high prices will discourage uses of imported products. However, Ethiopia's imports are mostly essential items, necessities, such as petrol, intermediate inputs for manufacturing, and fertilizer for agriculture, among others. Importantly, proliferation of large public infrastructural projects means the very government which tries to discourage imports is actively engaged in importing capital goods at massive scale. Therefore, devaluation would not cause reduction in quantities of goods Ethiopia imports, but it just makes imported items unnecessarily more expensive.

    The discrepancies between trade value and quantity would have far reaching implications. Welfare changes happen in response to changes in quantities of goods and services consumed, rather than their values. Exports are made cheaper, earnings from total exports do not grow that much, but most certainly the quantity of goods exports might have increased by significantly larger proportions than what exports in value terms would imply. There is some opportunity cost for scarce resources utilized to produce the additional goods unnecessarily made cheap and exported to earn about the same export revenue as before devaluation. On the other hand, households or businesses pay more for the same quantity of consumer or capital goods imported.

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