IMF Executive Board Concludes 2007 Article IV Consultation with The Federal Democratic Republic of EthiopiaPublic Information Notice (PIN) No. 07/68
June 15, 2007
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.
On June 1, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with The Federal Democratic Republic of Ethiopia.1
Ethiopia's favorable economic performance in recent years has significantly contributed to poverty reduction and progress toward the Millennium Development Goals (MDGs). The economy has enjoyed a strong and steady growth in the past three years after a significant drought-related contraction in 2002/03. This strong growth performance resulted in real per capita income increasing at 7 percent per annum-the fastest in Ethiopia's recent history. However, this has been accompanied by rising inflation, with consumer price accelerating to 19 percent in February 2007.
Net domestic borrowing for budget financing rose to 3.1 percent of GDP in 2005/06 from 0.2 percent of GDP in 2003/04, reflecting declining domestic revenue effort and significantly reduced budget support from donors (a shortfall of 2 percentage points of GDP from what was budgeted) in view of political governance concerns following the 2005 election. Thus, despite efforts to reduce government expenditures by cutting large-scale infrastructure projects and constraining recurrent outlays, the overall budget deficit (including grants) remained large at about 4½ percent of GDP in 2004/05-2005/06.
Broad money growth remained fast in 2005/06, driven by credit expansion to both the government and nongovernment sectors. The demand for bank credit rose sharply to finance large-scale investment projects by the public enterprises and the rapidly expanding private sector. Substantial negative real interest rates and commercial banks' excess reserves facilitated the rapid expansion of credit.
Furthermore, current account deficit (after official grants) widened to 10½ percent of GDP in 2005/06, reflecting rising domestic demand. Although exports grew steadily, imports—particularly for raw material and capital goods—rose even faster, while donor assistance was reduced significantly. As a result, the overall balance of payments moved from a significant surplus in 2003/04 to a cumulative deficit equivalent to 2 percent of GDP during 2004/05-2005/06. Gross official international reserves declined from the equivalent of 3.7 months of imports at end-2003/04 to 2.1 months of imports at end-2005/06. The official exchange rate for the birr, however, remained relatively stable against the U.S. dollar (the intervention currency) at around birr 8.7 per U.S. dollar in 2005/06.
Strong economic growth is expected to continue in 2006/07. Real GDP growth is projected to hold at about 9½ percent as productivity gains in agriculture continue and nonagriculture activities, especially manufacturing and construction, expand further. Inflation is projected to decline to about 15 percent at the end of 2006/07, in light of the completion of the pass-through of fuel price increases and full adoption by farmers of the new pattern for food supply. After a period of relative stability, the depreciation of the birr against the U.S. dollar is expected to continue, reflecting the recent external balance developments.
Executive Board Assessment
Executive Directors welcomed Ethiopia's recent strong and steady growth, which has also led to the fastest increase in real per capita incomes in recent years, and encouraging progress toward achieving the MDGs. At the same time, pressures on domestic prices and the balance of payments are emerging, the fiscal deficit remains large, and the economy continues to be vulnerable to weather-related shocks and shortfalls in donor support. Directors considered that, to further strengthen Ethiopia's growth prospects and to meet its poverty alleviation goals, structural reforms will need to be intensified in the period ahead. These should aim to eliminate infrastructural and administrative bottlenecks, and support the further development of the agricultural sector and the emergence of a robust and flexible private sector.
Directors welcomed the authorities' plans to adhere to a policy of fiscal restraint, as shown by the tightened 2006/07 budget and the intention to limit domestic borrowing. They supported the recent steps to enhance fiscal revenues, and encouraged the authorities to take further measures to restrain domestic demand, if required. Such measures could include stretching out expenditures on projects with a large import content and cutting low-priority outlays, while safeguarding poverty-reducing and growth-enhancing spending. Directors encouraged the authorities to strengthen debt management capacity and develop a comprehensive public debt strategy over the medium term. In this regard, Directors suggested that the authorities avail themselves of Fund technical assistance.
Directors called for a tightening of monetary policy to reduce inflation and prevent the entrenchment of inflationary expectations. To help mop up excess reserves in the banking system, and pending the introduction of more sophisticated indirect monetary instruments, the authorities could consider testing the efficacy of issuing longer-term bonds. A gradual move to positive real interest rates would also help to contain inflationary pressures.
Directors welcomed the recent increase in exchange rate flexibility, and recommended that it be continued. This should allow the exchange rate to better reflect balance of payments developments and lay the groundwork for the needed buildup in international reserves. Directors cautioned that continued appreciation of the real exchange rate could weaken external competitiveness over the medium term, and encouraged the authorities to adopt productivity-enhancing structural reforms.
Directors observed that a critical challenge for Ethiopia is to accelerate structural reforms to buttress and sustain growth while maintaining macroeconomic stability. Emerging supply constraints need to be addressed expeditiously, and absorptive capacity expanded. Further efforts are needed to improve the investment climate, strengthen the financial sector, and promote trade openness. Directors encouraged the authorities to consider undertaking financial sector reforms within the framework of a developmental Financial Sector Assessment Program (FSAP).
Directors considered that data provided to the Fund are adequate for surveillance purposes, but that data shortcomings continue to complicate the analysis of economic developments, in particular with regard to the real sector and fiscal and balance of payments statistics. They called for further remedial efforts, and they supported the authorities' request for technical assistance from the Fund in this area.