Public Information Notice No. 08/87

Public Information Notice: IMF Concludes 2008 Article IV Consultation with The Federal Democratic Republic of Ethiopia

July 21, 2008

On July 14, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with The Federal Democratic Republic of Ethiopia .¹

Background

The Ethiopian economy has been growing rapidly in the last four years. Favorable weather conditions and pro-growth policies have helped sustain recovery from a sharp drought-related contraction in 2002/03 (fiscal year begins July 8). Growth has averaged 11 percent since 2003/04, far exceeding the minimum growth target of 7 percent in the Program for Accelerated and Sustainable Development (PASDEP) that is estimated to be consistent with keeping the Millennium Development Goals (MDGs) within reach. In recent years, however, it has become clear that demand is running ahead of the expansion in the capacity of the economy. Inflation was almost 40 percent on a 12-month basis in May 2008, and international reserves have fallen to 1.5 months of imports. Inflation is being driven largely by rapidly rising domestic food prices.

Domestic public sector borrowing has been at a high level in the last two years in part because of heavy public enterprise expenditure. Helped by some revenue measures and increased external financing and privatization revenues, domestic financing of the general government is being contained below the 2.5 percent of GDP budget target in 2007/08. But with significant borrowing by public enterprises, IMF staff estimate that the overall domestic public sector borrowing will remain at about 5 percent of GDP.

Broad money growth remains high. The National Bank of Ethiopia (NBE) raised minimum reserve requirements on commercial bank deposits and the minimum interest rates on time and saving deposits in July 2007 and April 2008. This has helped reduce banks' excess reserves. But broad money growth has stayed high due to credit expansion to public enterprises and the financing of the general government deficit.

The rise in world oil prices has significantly added to pressures on international reserves. Surging coffee prices have helped to limit the impact on the terms of trade, and private remittances have risen sharply. However, IMF staff estimate that a full-year impact of higher oil prices will raise Ethiopia's oil import bill by about $1 billion (over 3 percent of GDP) over its 2006/07 level. High oil prices were only partially passed through to consumers, with higher costs being absorbed by the Oil Stabilization Fund. The official exchange rate for the Birr against the U.S. dollar (the intervention currency) has continued to depreciate and reached Birr 9.6 per U.S. dollar at end-May 2008.

IMF staff project that real GDP growth will slow to 8.4 percent in 2007/08. Inflation is projected to be about 30 percent at the end of 2007/08 on a 12-month basis.

Executive Board Assessment

Executive Directors welcomed Ethiopia's stronger and more diversified economic growth of recent years, which has enabled the country to keep the Millennium Development Goals within reach. Directors cautioned, however, that the recent signs of growing macroeconomic imbalances manifested as higher inflation and a weakening of the balance of payments suggest that demand is running ahead of capacity expansion. They noted that some supply-side factors may also have driven up food prices and thereby contributed to inflationary pressures. At the same time, the surge in world oil prices is placing a large strain on the balance of payments.

Against this background, Directors welcomed the authorities' intention to address the macroeconomic imbalances and to absorb the world oil price shock in a manner that least affects the momentum for growth and poverty reduction. They commended the authorities' recent strengthening of policy coordination and their objective of slowing monetary growth and reducing public sector borrowing. Directors emphasized that the authorities' efforts should be supported by continued structural reforms to encourage private sector development and make the economy more resilient to shocks.

Directors stressed that forceful policy tightening will be needed in the period ahead to reduce inflation and ensure that inflation expectations do not become ingrained. The measures introduced to date to mop up excess reserves in the banking system will need to be complemented by strict limits on central bank advances to the government. Directors therefore welcomed the authorities' readiness to monitor developments closely and to tighten monetary policy further as needed.

Directors underscored that determined fiscal restraint, anchored in a significant reduction in public sector domestic borrowing, will be crucial to the authorities' adjustment efforts. They accordingly considered appropriate the authorities' intention to contain the government's domestic borrowing well below last year's level. Given the importance of public infrastructure investment, a tighter fiscal stance will require capital expenditure to be aimed at projects that enhance productivity and contribute most to economic growth. Restraint on domestic borrowing by public enterprises will be essential.

Directors stressed that continuing pass through of world oil prices to consumers will be needed to facilitate an adjustment to the oil price shock and to alleviate growing strains on the Oil Stabilization Fund. However, they acknowledged that determining the appropriate pace and timing of pass through will be challenging in the context of the current high inflation, the impact on specific sectors, and social and political feasibility.

Directors recognized the risk that the necessary policy tightening could slow growth and set back efforts to reduce poverty. They accordingly urged the authorities to carefully prioritize budget spending to protect the most vulnerable members of society. Directors also encouraged the authorities to seek additional foreign assistance to support their adjustment efforts and complement their plans to protect pro-poor spending and investment in capital projects. Grants or highly concessional financing should be sought to preserve external debt sustainability. In this context, Directors recommended that a comprehensive public debt strategy should be prepared, incorporating public enterprise debt and contingent liabilities.

In light of the fragility of the balance of payments, Directors welcomed the recent increase in exchange rate flexibility, and encouraged the authorities to foster a deeper and more competitive foreign exchange market. While noting staff's assessment that there is no clear evidence of exchange rate overvaluation, Directors nevertheless welcomed the authorities' intention to keep external competitiveness under review. Over time, sustained robust export growth will require the authorities to carry forward vigorously their structural reform agenda aimed at raising productivity and improving business conditions. Directors welcomed the authorities' intentions in this area.

Directors stressed that increasing competition in the banking sector is central to improving the environment for implementing monetary policy and encouraging private sector development. This could be facilitated by exploring partnerships with foreign financial institutions. More generally, Directors encouraged the authorities to step up banking reforms and to strengthen banking supervision.

Directors underscored the importance of reforms that ensure that the public sector contributes effectively to the development of the Ethiopian economy. They encouraged the authorities to complete their consideration of tax reforms and to implement measures rapidly to reverse the declining tax-to-GDP ratio. Measures to further strengthen public expenditure management, including through the introduction of performance budgeting, will be needed to improve the quality and efficiency of public spending.

Directors considered that the data provided to the Fund are adequate for surveillance purposes, but further steps should be taken to address shortcomings in several areas.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.