Tuesday, September 7, 2010
Will Africa prosper?
What economic prospect will the 21st century bring to Africa? Renowned scholars take their time to reflect on it. Click here to read.
Thursday, September 2, 2010
Birr's devaluation: the rationale, consequences and precautionary measures.
The recent devaluation by the National Bank of Ethiopia (NBE) has attracted a significant public attention. Many Ethiopians are anxious about the devaluation’s impact.
After having been hammered hard by a galloping inflation since 2005, many rightly worry about impact of the current devaluation on their purchasing power. On the other hand, those who send money to home (from abroad) and those in export sector, though may still worry about the potential for inflation, take the devaluation as a good news to get more Birr for each dollar they send home. In this short article, I will try to share my thoughts on what led to the current devaluation, its potential impact on people’s life and what measures could be taken to mitigate the potential adverse effects. I believe that the devaluation is a right policy measure. It addresses the serious problem that the country’s export sector, upon which the country’s potential for growth heavily relies on, faced due to the recent inflation. Though there are reasonable concerns about people’s life due to the potential effect of the devaluation on inflation, particularly consumers of imported goods, keeping the exchange rate low is not an appropriate policy to address it. First of all, except for certain commodities, the devaluation is unlikely to have a proportional effect on prices. Secondly, other policy options can be used to mitigate the inflationary impact of devaluation. Those options include monetary policies, fiscal policies, temporary subsidies for selected items (such as petroleum) and possibly salary adjustments.
The devaluation is a necessary outcome of the inflation that we saw over the past years. The fundamental determinant of exchange rates is the currencies’ values at home (how much goods and services one can buy with a unit of currency in the domestic market). Due to the inflation in Ethiopia over the past years, Birr’s value has significantly fallen within Ethiopia. Compared to the prices in 2001, Birr’s domestic value (the purchasing power of Birr in Ethiopia) has fallen by nearly a third. This is in contrast to the relatively stable prices in the big world economies. Figure A shows the Ethiopian and the US consumer price indexes (a weighted average of consumer goods in the two countries) from 2001 to 2010 (month of March). Compared to the price levels in 2001, the 2010 US price level has only increased by 23.5%, whereas in Ethiopia, it has increase by nearly 200% (prices tripled).
In the face of such high inflation, keeping a constant exchange rate will undermine the country’s economic growth. Exporters who face expensive prices at home but relatively stable prices abroad will find their profits squeezed. Keeping the exchange rate artificially low is like taxing the exporters. If the exchange rate was to be kept constant to its level in 2001, an exporter today (compared to an exporter in 2001) could have faced an equivalent of 65% SALES tax. This will adversely affect the country’s export both in the short and long run. In the short run, exportable items end up in domestic markets. In the long run, producers of export items (such as coffee farmers) may shift to non-exportable items, and those who intend to start establishing export companies will change their mind. With the export sector facing so much disincentive, the country’s growth would suffer a lot. So Birr’s devaluation is a reasonable policy to deal with the disincentive to exporters created by the inflation. And Birr has been devalued repeatedly in recent times. The question is whether devaluation is of enough magnitude. The graph below (Figure B) shows the exchange rates during 2001 to 2010 (for the month of March). The exchange rate increased to about 13.4 Birr/USD in 2010 from 8.4 Birr/USD in 2001. During March 2001 to March 2010, Birr had depreciated by about 60%. If the prices in the US and Ethiopia are good indicators of where the exchange rate should be, the exchange rate that leaves Ethiopian exporters with same level of earning for each product they export would be around 18.63 Birr/USD (=Exchage rate in 2001*(Price Level Eth in 2010)/(Price Level US 2010)). So the depreciation so far (excluding the most recent one) is far below what is needed to compensate the export sector. The new exchange rate (which is about 16.35), though not yet enough to fully compensate the exporters created by the inflation, is a huge incentive to the sector and close enough to what the price differences indicate.
Equally concerning issue about devaluation is its impact on inflation. Many Ethiopian consumers who haven’t seen equivalent amount of wage adjustments to face the turbulent inflation in recent years have lost so much of their purchasing power. A threat for a new wave of inflation due to devaluation will for sure be a source of major concern. Though that is a reasonable concern, keeping the exchange rate artificially low is not a proper solution. First of all, consumers haven’t got all the benefits from low exchange rate. A significant portion of the benefit actually went to the importers (who are already the better-off ones) rather than the average consumer. The artificially low exchange rate created foreign exchange shortage (by discouraging exporters and encouraging importers). And to address the shortage, banks have repeatedly used forex rationing. The rationing generated significant rent to importers. An importer whose turn is to get the forex is likely to have a monopoly power in the product market (since other importers cannot import the product). So even though the importer gets the forex at a cheap rate, he/she will sell the product at a much higher price. Instead of benefiting the consumers, the low exchange rate ends up generating higher profit for the importer (at the expense of the exporter whose profit is squeezed and consumers who pay high prices). Increasing the exchange rate, while providing access to every importer who is willing to buy at the ongoing exchange rate, can eradicate such rent for the importers without creating a proportionate increase in prices.
Though this argument applies to many of goods imported by private importers, there are important exceptions. One important exception is petroleum. Petroleum prices are administered by the government. Recently, subsidies on petroleum prices have been largely lifted. If the same policy is to be followed in the wake of the devaluation, the petroleum prices will observe a huge increase (almost proportional to the devaluation). One policy option could be subsiding the petroleum prices for a certain amount of period (with the aim of lifting them over time). This option applies also to other import items whose prices are administered by the government. Accommodating monetary (managing the money supply) and fiscal options (reducing government demand for imported goods) could also be combined with the subsidy for import items whose prices are adminstered by the government. If the inflation gets worse despite all these measures, adjusting salaries should be kept in the list of potential policy measures.
The contractionary monetary and fiscal policies to tackle the inflation could have a potential to slow growth. Providing subsidies and adjusting civil servants salaries to compensate for the inflation may, at least for a year or two, create pressure on the government’s budget. But those challenges are worth facing than maintaining a distortionary exchange rate that stifles the country’s export, creates inefficient rent for importers, and undermines the country’s growth.
After having been hammered hard by a galloping inflation since 2005, many rightly worry about impact of the current devaluation on their purchasing power. On the other hand, those who send money to home (from abroad) and those in export sector, though may still worry about the potential for inflation, take the devaluation as a good news to get more Birr for each dollar they send home. In this short article, I will try to share my thoughts on what led to the current devaluation, its potential impact on people’s life and what measures could be taken to mitigate the potential adverse effects. I believe that the devaluation is a right policy measure. It addresses the serious problem that the country’s export sector, upon which the country’s potential for growth heavily relies on, faced due to the recent inflation. Though there are reasonable concerns about people’s life due to the potential effect of the devaluation on inflation, particularly consumers of imported goods, keeping the exchange rate low is not an appropriate policy to address it. First of all, except for certain commodities, the devaluation is unlikely to have a proportional effect on prices. Secondly, other policy options can be used to mitigate the inflationary impact of devaluation. Those options include monetary policies, fiscal policies, temporary subsidies for selected items (such as petroleum) and possibly salary adjustments.
The devaluation is a necessary outcome of the inflation that we saw over the past years. The fundamental determinant of exchange rates is the currencies’ values at home (how much goods and services one can buy with a unit of currency in the domestic market). Due to the inflation in Ethiopia over the past years, Birr’s value has significantly fallen within Ethiopia. Compared to the prices in 2001, Birr’s domestic value (the purchasing power of Birr in Ethiopia) has fallen by nearly a third. This is in contrast to the relatively stable prices in the big world economies. Figure A shows the Ethiopian and the US consumer price indexes (a weighted average of consumer goods in the two countries) from 2001 to 2010 (month of March). Compared to the price levels in 2001, the 2010 US price level has only increased by 23.5%, whereas in Ethiopia, it has increase by nearly 200% (prices tripled).
In the face of such high inflation, keeping a constant exchange rate will undermine the country’s economic growth. Exporters who face expensive prices at home but relatively stable prices abroad will find their profits squeezed. Keeping the exchange rate artificially low is like taxing the exporters. If the exchange rate was to be kept constant to its level in 2001, an exporter today (compared to an exporter in 2001) could have faced an equivalent of 65% SALES tax. This will adversely affect the country’s export both in the short and long run. In the short run, exportable items end up in domestic markets. In the long run, producers of export items (such as coffee farmers) may shift to non-exportable items, and those who intend to start establishing export companies will change their mind. With the export sector facing so much disincentive, the country’s growth would suffer a lot. So Birr’s devaluation is a reasonable policy to deal with the disincentive to exporters created by the inflation. And Birr has been devalued repeatedly in recent times. The question is whether devaluation is of enough magnitude. The graph below (Figure B) shows the exchange rates during 2001 to 2010 (for the month of March). The exchange rate increased to about 13.4 Birr/USD in 2010 from 8.4 Birr/USD in 2001. During March 2001 to March 2010, Birr had depreciated by about 60%. If the prices in the US and Ethiopia are good indicators of where the exchange rate should be, the exchange rate that leaves Ethiopian exporters with same level of earning for each product they export would be around 18.63 Birr/USD (=Exchage rate in 2001*(Price Level Eth in 2010)/(Price Level US 2010)). So the depreciation so far (excluding the most recent one) is far below what is needed to compensate the export sector. The new exchange rate (which is about 16.35), though not yet enough to fully compensate the exporters created by the inflation, is a huge incentive to the sector and close enough to what the price differences indicate.
Equally concerning issue about devaluation is its impact on inflation. Many Ethiopian consumers who haven’t seen equivalent amount of wage adjustments to face the turbulent inflation in recent years have lost so much of their purchasing power. A threat for a new wave of inflation due to devaluation will for sure be a source of major concern. Though that is a reasonable concern, keeping the exchange rate artificially low is not a proper solution. First of all, consumers haven’t got all the benefits from low exchange rate. A significant portion of the benefit actually went to the importers (who are already the better-off ones) rather than the average consumer. The artificially low exchange rate created foreign exchange shortage (by discouraging exporters and encouraging importers). And to address the shortage, banks have repeatedly used forex rationing. The rationing generated significant rent to importers. An importer whose turn is to get the forex is likely to have a monopoly power in the product market (since other importers cannot import the product). So even though the importer gets the forex at a cheap rate, he/she will sell the product at a much higher price. Instead of benefiting the consumers, the low exchange rate ends up generating higher profit for the importer (at the expense of the exporter whose profit is squeezed and consumers who pay high prices). Increasing the exchange rate, while providing access to every importer who is willing to buy at the ongoing exchange rate, can eradicate such rent for the importers without creating a proportionate increase in prices.
Though this argument applies to many of goods imported by private importers, there are important exceptions. One important exception is petroleum. Petroleum prices are administered by the government. Recently, subsidies on petroleum prices have been largely lifted. If the same policy is to be followed in the wake of the devaluation, the petroleum prices will observe a huge increase (almost proportional to the devaluation). One policy option could be subsiding the petroleum prices for a certain amount of period (with the aim of lifting them over time). This option applies also to other import items whose prices are administered by the government. Accommodating monetary (managing the money supply) and fiscal options (reducing government demand for imported goods) could also be combined with the subsidy for import items whose prices are adminstered by the government. If the inflation gets worse despite all these measures, adjusting salaries should be kept in the list of potential policy measures.
The contractionary monetary and fiscal policies to tackle the inflation could have a potential to slow growth. Providing subsidies and adjusting civil servants salaries to compensate for the inflation may, at least for a year or two, create pressure on the government’s budget. But those challenges are worth facing than maintaining a distortionary exchange rate that stifles the country’s export, creates inefficient rent for importers, and undermines the country’s growth.
Sunday, June 14, 2009
Impact of the financial crisis on Africa
Shimeles Mekonnen, from Carnegie, provides an insightful analysis of how the financial crisis affects Africa. Click here to read his article.
Wednesday, January 21, 2009
Dealing wisely with the incumbment
Whether a ruler (the incumbent) gives up power peacefully depends on what awaits him after he retires (among other factors). If the ruler is insecure about potential reprisals when he loses power (say due to prosecution for what he has done as a ruler), he will be reluctant to transfer power peacefully. He will fight and cling to power fearing such threats. And political economists suggest that offering a secure retirement to rulers who give up power peacefully may solve the problem. The Ghanaians seem to get it right!
Click here to read the BBC report on how they dealt with the outgoing president.
Click here to read the BBC report on how they dealt with the outgoing president.
Saturday, January 17, 2009
The flower sector as 'a self-discovery'
After his recent visit to Ethiopia, Dani Rodrik (from Harvard) reflects on the flower sector as a self-discovery.
Click here to read the article!
Click here to read the article!
Thursday, January 15, 2009
More innovative approach for capital flow
It is a well-known fact in the economics descipline that the engines of economic growth are technological progress and capital accumulation. High-tech activities usually need skilled labor and use of large physical capital (machineries). It is not feasible to observe economic prosperity in a society with large number of machineries but with no know-how about the machines. The same is true for a society with many skills but doesn't have the resource to buy equipments. So any country's growth policy should put a clear strategy as to how to get its population more skilled and how to get the needed physical capital.
For a poor country like Ethiopia, foreign capital flows are one source. Besides foreign aid (needed to finance public investment), the government has put a lot of focus to attract foreign investors who can come with their capital and invest in Ethiopia. Such investments are called foreign direct investment (FDI).
The other route to access foreign capital is through financial markets. In this route, domestic private investors can access credit from international sources. For example, a domestic bank at home can borrow from a U.S. bank and lend the money to home investors (at a higher rate). Since foreign banks lend hard currencies (like US dollar, Euro,etc), this route also opens more access to foreign exchange. The problem with this route arises if the foreign lenders want to withdraw their asset, leading to a sudden loss of foreign exchange reserve and potential currency crises. And it is mainly due to this fear that the government forbids foreign banks to work in Ethiopia. Though the ban helps to avoid such sudden capital flight, it also comes at a cost: a potentially important door to access capital is closed. In stead of just shutting the door to outside lenders, the National Bank needs a more innovative approach that allows access to the international capital market while at the same minimizing the risk of capital flight.
For a poor country like Ethiopia, foreign capital flows are one source. Besides foreign aid (needed to finance public investment), the government has put a lot of focus to attract foreign investors who can come with their capital and invest in Ethiopia. Such investments are called foreign direct investment (FDI).
The other route to access foreign capital is through financial markets. In this route, domestic private investors can access credit from international sources. For example, a domestic bank at home can borrow from a U.S. bank and lend the money to home investors (at a higher rate). Since foreign banks lend hard currencies (like US dollar, Euro,etc), this route also opens more access to foreign exchange. The problem with this route arises if the foreign lenders want to withdraw their asset, leading to a sudden loss of foreign exchange reserve and potential currency crises. And it is mainly due to this fear that the government forbids foreign banks to work in Ethiopia. Though the ban helps to avoid such sudden capital flight, it also comes at a cost: a potentially important door to access capital is closed. In stead of just shutting the door to outside lenders, the National Bank needs a more innovative approach that allows access to the international capital market while at the same minimizing the risk of capital flight.
Wednesday, January 14, 2009
Could the inflation be responsible for the current forex shortage?
In the past two years, the Ethiopian central bank has been reported to face foreign exchange shortage. And the foreign exchange shortage is mainly driven by increased demand for import despite a significant increase in export. And the government's focus so far seems to focus on increasing the country's access to foreign exchange by increasing exports and foreign capital inflow (aid, loans, remittances, etc). A number factors may lie behind the increased demand for foreign exchange. Until recently, oil import alone used to take away whatever is earned from exports (due to high oil prices in the international market). There may also be pressure on import demand due to high inflation at home and a relatively stable exchange rate. The domestic inflation increases import demand by increasing the real price of domestic goods compared to imported goods. The mechanism is as follows. Suppose the price of goods in China is unchanged. And assume the exchange rate in Addis Ababa is also unchanged. What this implies is that, for an importer in Addis, the price of importing goods from China is unchanged. On the other hand, if home made goods are getting expensive at home (due to high domestic inflation), consumers in Addis tend to buy more of imported foreign goods and less of home-made goods. For example, if the price of orange juice produced by Mama keeps on increasing while the one imported from Dubai remains the same, then consumers will shift from using Mama juice to the relatively cheaper juice imported from Dubai. According to the Economist, the price of home goods increased roughly by at least 33% compared to imported goods during 2004-2008. Such a shift in consumer demand will then increase import demand putting more pressure on the central bank's foreign exchange reserve.
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