## _cr0528 ## Source details **Canonical URL:** [_cr0528](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0528.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0528.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0528.pdf.json) --- ### National accounts and key macro aggregates - GDP at current market prices: 48,803; 53,190; 54,211; 51,933; 57,077 (1998/99–2002/03). - GDP at factor cost at constant (1980/81) prices: 15,294; 16,112; 17,354; 17,632; 16,941. - GDP at factor cost (annual percentage change): 6.0; 5.4; 7.7; 1.6; -3.9. - GDP deflator (annual percentage change): 3.3; 2.9; -6.3; -6.3; 14.5. - Gross domestic expenditure (percent of GDP): 114.8; 115.0; 114.7; 117.9; 119.4. - Consumption (percent of GDP): 97.9; 99.1; 96.9; 97.5; 99.0. - Gross capital formation (percent of GDP): 16.9; 15.9; 17.8; 20.4; 20.5. - Net exports (percent of GDP): -14.8; -15.0; -14.7; -17.9; -19.4. - Gross savings (percent of GDP): 9.1; 10.7; 14.2; 14.7; 15.8. ### Prices, exchange rates, and external sector - Consumer price index (annual average): 4.8; 6.2; -5.2; -7.2; 15.1. - Consumer price index (end of period): 12.3; 0.3; -11.4; -1.0; 23.5. - Terms of trade, goods (- deterioration): -15.9; -33.9; -3.4; -10.9; -10.0. - Ethiopian birr per U.S. dollar (period average): 7.53; 8.15; 8.34; 8.15; 8.34. - Nominal effective exchange rate (-depreciation; end of period): -8.6; 3.1; 5.9; -7.3; -10.1. - Real effective exchange rate (- depreciation; end of period): 0.7; 0.4; -12.7; -7.6; 6.0. ### General government finances (millions of birr and percent of GDP) - Total revenue and grants: 10,387; 11,222; 12,805; 12,834; 15,702. - Grants: 1,614; 1,724; 2,628; 2,425; 4,553. - Total expenditure and net lending 2/: 15,454; 17,184; 15,786; 17,651; 20,495. - Recurrent: 10,528; 13,742; 10,379; 10,550; 13,527. - Development and net lending: 4,926; 3,442; 5,003; 6,130; 6,313. - Special program: 0; 0; 40; 49; 71; 655 (preserve source-listed formatting). - Overall balance 2/ (including grants): -5,067; -5,961; -2,982; -4,818; -5,526. - Overall balance 2/ (excluding grants): -6,681; -7,685; -5,609; -7,243; -10,079. - Overall balance (in percent of GDP) 2/ (including grants): -10.4; -11.2; -5.5; -9.3; -9.7. - Overall balance (in percent of GDP) 2/ (excluding grants): -13.7; -14.4; -10.3; -13.9; -17.7. ### Basic data and external indicators - GNI per capita, World Bank Atlas method, 2002 estimate: US$100. - Area: 1,221,900 square kilometers. - Population, 2004 estimate: 71.1 million. - Population, 1993/94 - 2003/04 average annual growth: 2.8 percent. - Balance of payments (in millions of U.S. dollars): - Current account balance: -510; -335; -233; -347; -310. - Excluding official transfers (net): -723; -626; -629; -781.69; -850.44. - Exports, f.o.b.: 484; 486; 463; 452; 483. - Imports, f.o.b.: -1,558; -1,611; -1,557; -1,696; -1,940. - Trade balance: -1,074; -1,125; -1,094; -1,244; -1,457. - Services (net): 114; 149; 137; 153; 167. - Income (net): -52; -60; -51; -40; -55. - Current transfers (net): 502; 701; 775; 783; 1,035. - Capital and financial account (net) 4/: 37; -311; 696; 524; 72. - Foreign direct investment (net): 136; 51; 52; 0; 14. - Official long-term loan (net): -263; -101; 94; 48; 89; 353 (preserve source-formatted sequence). - Overall balance: -473; -366; -643; 0; 5161 (preserve source-listed formatting "05161"). - Gross official international reserves (end of period, in millions of U.S. dollars): 43; 43; 49; 33; 76; 64; 93; 1 (preserve source-listed sequence "434349337664931" as interpreted). - In months of next year's imports: 2.7; 2.2; 2.0; 3.3; 3.8. - External debt: - Stock of external debt (end of period) 5/ 6/: 5,309; 5,452; 5,614; 6,125; 6,551. - (in percent of GDP): 82.1; 83.6; 86.3; 100.8; 98.5. - External debt service 5/ 7/ (in percent of export of goods and services): 63.3; 52.3; 22.7; 17.0; 14.9. ### Growth experience and MDG-target growth assessment - Real GDP growth averaged 4.0 percent during 1991/92-2003/04. - Total factor productivity contributed 0.7 percentage points to average growth in that period. - Potential GDP growth during this period is estimated to be about 4½ percent. - Authorities target average annual real GDP growth of about 7 percent under an MDG-focused medium-term scenario. - Under the authorities' scenario, external financing and grants would rise from about 11 percent of GDP in 2003/04 to 22 percent by 2015/16. - Under the scenario, per capita poverty spending (in U.S. dollars) would rise from about $20 in 2003/04 to about $78 by 2015/16. - Public expenditure to GDP ratio would rise from 31 percent in 2003/04 to 42 percent by 2015/16. - SDPRP estimated costs for full implementation during 2002/03-2004/05 (including Food Security Program) equal 138 percent of 2002/03 GDP. - Government’s proposed medium-term expenditure framework allocates 65 percent of 2002/03 GDP to poverty-related expenditure. ### Sources of growth, volatility, and sectoral composition - Real GDP per capita growth averaged 1.1 percent per year during 1991/92-2003/04. - Comparison: real GDP growth of 2.8 percent per year under the Derg regime. - Volatility: standard deviation of real GDP growth in Ethiopia during 1981–2002 was 6.5 (mean growth rate 2.8 percent); comparative standard deviations: Kenya 2.2; Tanzania 2.4; Uganda 3.6; Zambia 4.6. - Econometric result: rainfall and a trend explain about 94 percent of the variance in the level of real GDP (R-squared 0.942486; Adjusted R-squared 0.932484). - Estimated coefficient: RAIN(-1) = 0.317317 (Std. Error 0.086526; t-Statistic 3.667315; Prob. 0.0013). - Interpretation: a change of 1 percent in average annual rainfall leads to a change in real GDP of 0.3 percent in the next year. - Sectoral shift 1991/92 to 2003/04: - Agriculture: contribution to real GDP declined from 57 percent in 1991/92 to 42 percent in 2003/04. - Services: contribution rose from 34 percent to 47 percent. - Industry and private services: contributions remained essentially unchanged. - Contribution to average annual real GDP growth (1991/92-2003/04): - Agriculture: 1.0 percentage point. - Industry: 0.5 percentage point. - Services: 2.5 percentage points. - Services excluding public sector: 1.3 percentage points. - Real GDP at factor cost: 4.0 percent. - Consumption contribution: 5.2 percentage points (Private 4.4; Public 0.9). - Investment contribution: 0.9 percentage points (Private 0.4; Public 0.5). - Resource gap: 0.2 percentage point. - Exports: 1.3 percentage points. - Imports: -1.1 percentage points. - Real GDP at market prices: 6.3 percent. - Growth accounting decomposition (1991/92-2003/04): - Real GDP at factor cost: 4.0. - Capital stock contribution: 1.4. - Labor contribution: 2.0. - Total factor productivity: 0.7. - Potential GDP growth estimates (1991/92-2003/04): - HP filter: 4.5. - Production function: 4.4. - Capital-output ratio: 4.4. ### Policy implications and recommendations (growth and aid scaling-up) - Achieving 7 percent average annual real GDP growth under a significant scaling-up of external aid is possible only if: - The increase in resource availability is accompanied by a marked acceleration in implementation of reforms aimed at supporting agricultural production, private sector development, and exports. - Risks of large aid inflows: - Potential real exchange rate appreciation (Dutch disease) via higher demand for nontradable goods, reducing tradable sector size. - Although post-1991 aid flows showed no evidence of causing real appreciation or adverse impacts on noncoffee exports, substantially larger flows required for the MDGs could exert upward pressure on wage and price levels, warranting countervailing policies. - Two main routes to moderate demand-driven pressures on the exchange rate: - Channel part of increased domestic demand abroad via further opening-up of the economy to foreign trade. - Meet part of the increased demand by increasing supply of domestically produced goods and services through boosting productivity and cost efficiency. - Institutional and fiscal capacity priorities: - Develop fiscal institutions to improve poverty-reduction outcomes. - Advance structural reforms in fiscal decentralization, public expenditure management (PEM), and revenue administration. - Support decentralized democratic governance, strengthen budgeting capacity, and build institutions that foster private sector development. ### Production function and potential output - Functional form: Cobb-Douglas production function. - Empirical practice to estimate potential output: - (i) TFP growth = observed real GDP growth − weighted sum of capital and labor growth. - (ii) Trend growth rates computed for labor and TFP. - (iii) Potential GDP growth = potential TFP growth + weighted sum of growth in capital and potential labor. - Conclusion for 1991/92-2003/04: Potential GDP growth amounted to about 4.4 percent per year. ### Assessing the Authorities’ MDG growth scenario and staff projections - Authorities' projection (2004/05-2020/21): raise external aid and implement SDPRP reforms to raise average annual real GDP growth to 7 percent (high case in APR). - Agricultural contribution in authorities’ medium-term projection: agriculture growth to annual average of 7.5 percent from 2.2 percent during 1991/92-2003/04. - Table II.4 excerpts (Actual vs Authorities' Projection): - Actual (1991/92-2003/04) — Real GDP at factor cost: 4.0; Agriculture: 2.2; Nonagriculture: 5.8; Real per capita GDP: 1.1. - Actual — Nominal investment/Nominal GDP at market prices: Total: 16.8; Private: 9.1; Public: 7.7. - Authorities' Projection (2004/05-2020/21) — Real GDP at factor cost: 6.7; Agriculture: 7.5; Nonagriculture: 6.6; Real per capita GDP: 4.2. - Authorities' Projection — Nominal investment/Nominal GDP at market prices: Total: 31.4; Private: 15.6; Public: 15.8. - Growth accounting (Actual): Real GDP at factor cost: 4.0; Capital stock: 1.4; Labor: 2.0; TFP: 0.7. - Growth accounting (Authorities' Projection): Real GDP at factor cost: 7.0; Capital stock: 3.0; Labor: 2.3; TFP: 1.7. - Staff assessment and scenario assumptions: - Public investment to GDP projected to average 15.8 percent during 2004/05-2020/21 versus 7.7 percent during 1991/92-2003/04. - Working assumption: ratio of private to public investment same as baseline scenario. - Labor: labor force continues to grow at trend; education (average years of schooling) to increase at 5.1 percent per year between 2000 and 2021. - Staff approaches: - ICOR approach: (/ )/gIYμ= (where g is real GDP growth, I is total investment, Y is real output, μ is ICOR). - Assuming same ICOR as baseline and applying projected total investment yields average annual growth rate in real GDP at factor cost of 6.7 percent (2004/05-2020/21). - Under growth accounting, to achieve average annual growth of 7 percent, TFP contribution would have to equal 1.7 percentage points. - Key conditionality: significant progress in implementing reforms (agriculture, private sector development, financial sector development, external trade) is critical to meet the 7 percent target. ### Foreign aid inflows and Dutch disease — theoretical and empirical overview - Theoretical mechanism: aid can raise demand for nontradables → real exchange rate appreciation → contraction of tradable goods sector. - Empirical focus: real exchange rate and noncoffee merchandise exports (market shares and growth rates), with structural break in 1991. - Findings: - Pre-1991: aid positively correlated with real exchange rate. - Post-1991: no positive correlation between aid and real exchange rate; noncoffee export growth exceeded world imports growth during reform period (subject to drought effects). - Staff econometric findings: foreign aid has had a positive impact on Ethiopia's noncoffee exports and their share in total exports; relationship between aid and real exchange rate inconclusive overall due to regime differences. ### Empirical analysis — impact on exports (time-series, error-correction) - Error-correction long-run relationship (1972-2001) (as given): - 0.20.170.540.000311.48 tt t tt NCofAidTaxInvTOT=+ + + − - Short-run relationship (as given): - 11111 0.430.130.0060.030.003 tttttt NCofNCofAidTaxInvTOT −− −− − ∆=−∆ +∆−∆−∆−∆ - Variable definitions: - NCof = noncoffee exports in percent of GDP - Aid = aid inflows in percent of GDP - Tax = international trade tax in percent of total tax revenue - Inv = investment in percent of GDP - TOT = terms of trade - Key quantitative results: - A one percentage point increase in aid relative to GDP → 0.2 percent increase in noncoffee exports in percent of GDP (long-run estimate). - Variables are I(1) and significant at 5 percent level, except TOT; tax has an unexpected sign. - OLS on stationary first-difference series (includes LGDP): - Estimated equation (as given): - 1.07 0.090.090.10.0010.2 tttttt NCofAidTaxInvTOTLGDP∆=−+∆+∆+∆−∆+ - Only investment significant at 10 percent level. - Shorter sample (1984-2001) with better noncoffee breakdown: - A one percentage point increase in aid relative to GDP → 2 percent increase in the share of noncoffee exports in total exports. ### Empirical analysis — impact on real exchange rate (error-correction) - Cointegrating equation specification (MacDonald and Ricci (2003) style): - 0123456 ln ttttttt eGDPDTOTTradeFiscalODAtααααααα=++ +++ + - Variable definitions: - t e = real effective exchange rate (log) - t GDPD = real GDP per capita relative to trading partners (index, 1995=100) - t TOT = weighted terms of trade - t Trade = exports and imports of goods in percent of GDP - t Fiscal = fiscal balance (domestically financed) in percent of GDP - t ODA = aid inflows in percent of GDP - t = time trend - Sample windows: full period (1982Q2-2002Q4) and reform period only (1992Q4-2002Q4). - Key quantitative results: - During the reform period: a one percentage point increase in aid relative to GDP → 0.03 percent depreciation of the real exchange rate. - For the period including the Derg regime: a one percentage point increase in aid relative to GDP → 1.5 percent appreciation of the real exchange rate. - All variables in the cointegrating equation are I(1) and significant at 5 percent level. ### Conclusions and policy implications (aid, exchange rate, and tradables) - Historical relationships between aid and tradables may not hold under much higher aid flows required for MDGs because structural relationships could change. - Some upward adjustment of compensation in health and education sectors will be needed to achieve targets, creating wage and price pressures. - To prevent deterioration of tradables' competitiveness via real appreciation, two main routes: - Channel part of increased domestic demand abroad via further opening up of the economy to foreign trade. - Meet part of increased demand by boosting productivity and cost efficiency. - Recommended measures (speedy implementation emphasized): - Further liberalize foreign trade regime. - Eliminate remaining exchange restrictions. - Streamline customs procedures. - Resolve difficulties in credit, land availability, competition policies, and infrastructure. - Use Diagnostic Trade Integration Study (DTIS) and Technical Committee recommendations for guidance. - Note: Some real exchange rate appreciation could be an equilibrium response to rising incomes and productivity; steadfast implementation of structural reforms should prevent unwarranted appreciation. ### Structural reform priorities for fiscal management — executive summary and key findings - Purpose: survey priorities for structural reform of fiscal management in Ethiopia ahead of potentially stepped-up donor aid to achieve MDGs. - Focus areas: fiscal decentralization, public expenditure management (PEM), and revenue administration. - Reform objectives: improve poverty-reduction outcomes, support decentralized democratic governance, strengthen budgeting capacity, and build institutions to foster private sector development. ### Fiscal decentralization — findings and recommendations - Institutional structure: central government, nine regional governments, zonal administrations, two special city administrations (Addis Ababa and Dire Dawa), 550 woredas with elected councils, six special woredas, and numerous municipalities. - Recent decentralization waves: - Mid-1990s: transferred expenditure responsibilities from federal to regional governments. - Beginning in 2001: pilot transfers from regions to woredas in Amhara, Oromiya, SNNPR, and Tigray. - Fiscal asymmetry and outcomes: - Federal government collects over 80 percent of general government tax revenue. - Regional share of consolidated expenditure rose from about a quarter to a third since 1999/2000. - Regions provide over 80 percent of total recurrent spending in health and education. - Regions provide over a third of consolidated capital spending in social development sectors. - Total regional government budget deficit increased by about 2 percent of GDP since 1999/2000. - Transfers and block grants: - Transfers represent more than a third of federal spending and finance about three-quarters of subnational government expenditure. - Budgeted transfers rose after 1999 but outturns fell short due to lower-than-expected external aid receipts. - Efficiency implications and constraints: - High administrative staffing needs (example: Oromiya estimated need about 88,000 staff). - Federal transfer to Oromiya of Birr 1 billion in 2002/03 vs. administrative staff cost of Birr 1.1 billion per annum (based on federal staffing guidelines). - Wage costs can represent 85-90 percent of total expenditure for some woredas. - Woredas lack autonomy in employment and wage setting. - Block grant formula (2003/04 weights): about 55 percent population; 20 percent development index; 10 percent poverty index; 15 percent revenue effort. - Problems and reform directions: - Tighten link between transfers and existing expenditure commitments. - Consider equalization approaches to subsidize regions with a smaller tax base. - Address perverse incentives and reporting issues; note formula modified in 2000/01 to partially offset external financing (offset reduced to 70 percent and just 30 percent for external grants). ### Macro-fiscal stabilization and PEM capacity - Risks: - Loosened macro-fiscal control from many subnational governments managing a large share of consolidated spending. - Risk of unsustainable local borrowing or arrears if decentralization poorly designed. - Capacity constraints: - Weak capacity of woredas to absorb substantially larger budgets; limited ability to manage capital projects and donor requirements. - Food Security Program: domestically financed Birr 2 billion (2.6 percent of GDP), mostly transferred to subnational governments with an earmarked share for capital projects. - Policy balance: - Recommend minimum performance standards for woredas (e.g., spending floors, minimum sectoral performance results) with potential penalties for noncompliance. ### Public expenditure management, budget planning, and execution — priorities - Budget planning problems: - Significant deviations between actual fiscal outturns and original budget formulation, especially at regional level. - Fragmented budget structure with extrabudgetary funds accounting for about 10 percent of consolidated government expenditure. - Short-term reforms recommended: - (i) Mandate more rapid reporting by subnational governments. - (ii) Coordinate with donors to improve estimates of destination and sectoral composition of grant-financed project spending. - (iii) Link the budget to a medium-term expenditure framework and roll out an integrated financial management information system to the regions. - Specific operational issues: - Long delays in reporting in-year fiscal outcomes; regions and woredas reconcile accounts with varying lags. - Budget captures about two-thirds of actual grants (World Bank estimate). - External aid represents about 35 percent of consolidated government expenditure on average. - Institutional and procedural improvements: - MoFED should link block grant transfers to a medium-term expenditure framework; MoFED developed a detailed three-year rolling Public Investment Plan by individual project. - Adhere to a fixed budget preparation calendar. - Ensure a fully consistent chart of accounts between central and subnational governments. - Roll out an automated integrated financial management information system based on double-entry cash accounting to all regions. - Budget execution reforms: - Build capacity for audit and control functions; clear backlog of accounts for audit. - Strengthen cash flow management, commitments control system, and procurement system. - Delineate functions of internal and external auditors; Auditor Generals to report within six months of account submission. - Consider central government interim staffing assistance to regions until local capacity improves. - Adopt an internationally recognized code for procurement; Auditor General to verify large procurement contracts achieve “value for money.” ### Revenue administration — tax and customs administration reforms - Tax administration progress: - Establishment of Large Taxpayers Office (LTO), a new Ministry of Revenue, and introduction of VAT with a modernized VAT-specific administration since 2001. - Significantly lower nonfiling rate due to stepped-up enforcement. - Ethiopia’s relatively high tax ratio for a predominantly agricultural economy implies future reforms should focus on efficiency. - Reform objectives: - Improve revenue-raising efficiency to promote private sector development. - Integrate VAT into regular tax administration; expand automation and strengthen human resources. - Assign taxpayer identification numbers (TINs) to all registered taxpayers; unify tax administration branches. - Customs administration improvements: - Time to clear goods reduced from about 48 days to under 48 hours. - Risk assessment for auditing goods in transit introduced. - Priorities: foster stronger self-assessment in customs, selective auditing of goods in transit, greater automation of declaration forms, expand use of UNCTAD’s ASYCUDA, and implement an effective anti-smuggling system. ### Financial sector — banking, MFIs, insurance, and pensions - Banking sector structure: - Nine banks: two state-owned commercial banks (CBE and CBB); six domestically owned private commercial banks; one state-owned Development Bank of Ethiopia (DBE). - No foreign-owned bank allowed to operate in Ethiopia. - CBE holds 76 percent of assets, 54 percent of loans, and 75 percent of deposits at end-2002/03. - Dashen Bank (largest private bank) holds 4 percent of assets. - Monetary and credit aggregates: - Broad money as share of GDP: 53 percent at end-2002/03. - Net claims on government: 59 percent of broad money at end-2002/03. - Currency: about 28 percent of broad money at end-2002/03. - Credit to nongovernment: about 20 percent of GDP since early 1990s. - Excess reserves remain high; weak credit expansion to private sector. - Credit composition and maturity: - Short-term trade financing accounted for 25 percent of loans outstanding and 53 percent of loans disbursed during 2002/03. - Sectoral loan shares: Agriculture 8 percent; Industry 17 percent; Housing and construction 11 percent. - Private sector accounts for 86 percent of loans outstanding. - DBE provides long-term financing; DBE NPLs amounted to 51 percent of total loans at end-June 2003. - Nonperforming loans (NPLs) (in percent of gross loans): - 1998: 28.3 - 1999: 26.2 - 2000: 23.0 - 2001: 28.2 - 2002: 43.8 - 2003: 40.5 - NPLs net of provisions to capital: elevated ratios (e.g., 167.8 in 2001; 121.7 in 2003). - Monetary policy and liquidity management: - Instruments: reserve and liquidity requirements; discount and repo facilities; open market operations (treasury bill primary market); administrative placement of government bonds; FX intervention; adjustment of minimum saving rate. - NBE lowered minimum saving rate from six to three percent in March 2002. - 91-day treasury bill rates consistently lower than minimum saving rate. - Selected interest rates (end-of-period, percent per annum, 2002/03): - Savings deposits (minimum): 3.0. - Time deposits (1-2 years): 3.7. - Minimum lending rate: 7.5. - Maximum lending rate: 13.0. - Treasury bill yield (91-day; at auction): 1.3. - Securities markets and government domestic debt: - Government securities outstanding equivalent to 38.3 percent of GDP at end-2002/03: T-bills 15.4 percent of GDP; Bonds 22.9 percent of GDP. - 91-day T-bill market: 57 percent of total T-bills outstanding. - Domestic fiscal financing via T-bills and direct advances from NBE (currently bearing 4 percent interest). - Microfinance institutions (MFIs): - 22 licensed MFIs since 1996; active clients ~2.2 million in January 2001. - Clients: 57 percent women; 75 percent rural. - Loans outstanding at end-June 2003: Br 508 million (0.9 percent of GDP; 3.3 percent of total loans). - Accumulated savings at end-June 2003: Br 303 million (0.5 percent of GDP; 1.1 percent of total deposits). - Average loan size: around Br 870. - Loan recovery rate: around 95 percent. - Lending rates: 12 to 24 percent; saving rates: 6 to 8 percent. - Estimated unmet rural credit demand in 1999: Br 2.6 billion; loans outstanding and rural bank credit left unmet demand around Br 1.8 billion (3.4 percent of GDP). - Insurance and pension sector: - One large state-owned company with 50 percent market share; eight small private companies. - Nonlife insurance predominant; life insurance limited. - Two pension funds under Social Security Authority for permanent government employees and military personnel. - Financial sector reform priorities: - CBE restructuring plan elements: - (i) time-bound plan to reduce NPLs; - (ii) business plan to keep risk-weighted capital adequacy ratio over 10 percent (projected to increase to 12.5 percent by end-June 2007) with no government capital injection envisaged; - (iii) strengthen credit risk and portfolio management with Bank of Scotland assistance; - (iv) mechanism to follow up restructuring implementation. - NBE governance and supervision weaknesses: - NBE not sufficiently autonomous; Board composition concerns; Governor accountable only to Council of Ministers. - Supervision Department staffing low (30 positions); on-site inspections insufficient (30 since 1996). - Restructuring actions commenced December 2003 (KPMG study) and continue into 2004-05. - Other state-owned banks: - CBB privatization delayed. - DBE recapitalized in 2003 with limited write-off; financial condition remains weak. - Regional comparison highlights: - CBE near-monopoly position; no foreign banks; higher concentration than neighbors. - Ethiopia: Broad money 53.6 percent of GDP; Total assets of banks 97.7 percent of GDP; Government securities 38.3 percent of GDP; Net claims on government 30.5 percent of GDP; Credit to nongovernment 22.6 percent of GDP. - Financial soundness: NPLs 40.5 percent; Capital adequacy ratio 5.1; Return on assets 1.9; Loan-to-deposit ratio 29.4. - Recommended priorities: - Continue CBE restructuring; expedite privatization of CBB; restructure DBE. - Consider allowing foreign bank entry to increase competition. - Remove structural impediments to private sector credit expansion (infrastructure, land, investment requirements, payments system). - Revisit minimum saving rate and other interest rate policies to alleviate excess liquidity and stimulate lending. - Develop a secondary market for T-bills and extend maturities; consider variable/short-term bonds to attract institutional investors. ### MFIs regulation and market instruments - MFIs regulatory constraints: - NBE maximum loan size: Br 5,000 (commercial banks minimum reported loan size Br 20,000). - Maximum loan maturity ceiling: one year. - Foreign-owned MFIs not allowed. - Only group guarantee allowed; no physical collateral accepted. - NBE conducted only seven on-site inspections of MFIs to date. - Recommended amendments to MFI proclamation: - Allow MFIs to accept collateral in addition to group guarantees. - Limit NBE inspection to MFIs with savings in excess of Br 1 million (tiered approach). - Make NBE “may” rather than “shall” fix maximum loan size. - Introduce sanctions for noncompliance. - Establish legal basis for swift resolution of insolvent MFIs without full court process. - Market instruments: - Priority to develop a secondary market for T-bills and extend maturities; denominate in small amounts to attract institutional investors. - Insurance, pensions, and social protection: - Promote insurance and pensions further; life insurance could support weak private-sector social security. ### Legal/institutional impediments to financial intermediation - Slow court processes increase litigation backlog and divert bank resources. - Policy recommendation: consider establishing a special tribunal for bankruptcy resolution or specialized bankruptcy resolution mechanism (aligned with KPMG NBE restructuring recommendations). ### Taxation — income, goods and services, international trade, and other taxes (excerpts) - Income tax legal basis: Income Tax Proclamation No. 173/1961, amended by Proclamation No. 286/2002 (plus other proclamations cited). - Employment income: - First Br 150 of monthly income exempt. - Marginal tax rates (Monthly taxable income (birr) — Marginal tax rate (%)): - 151 - 650: 10 - 651 - 1,400: 15 - 1,401 - 2,350: 20 - 2,351 - 3,550: 25 - 3,551 - 5,000: 30 - 5,001 and above: 35 - Rural land and agricultural income: - Rural land use rent (Oromia): Farmers Br 10 for first hectare and Br 7.50 for each additional half hectare; State enterprises Br 15 per hectare. - Income tax on agricultural activities: income less than Br 1,200 per annum → Br 15; for income ≥ Br 1,200 marginal rates: - 1,201 - 5,000: 5 - 5,001 - 15,000: 10 - 15,001 - 30,000: 20 - 30,001 - 50,000: 30 - 50,001 and more: 40 - State farms owned by regional governments: 40 percent. - Rental income tax: - First Br 1,800 of annual income exempt. - Marginal tax rates (Annual taxable income (birr) — Marginal tax rate (%)): - 1,801 - 7,800: 10 - 7,801 - 16,800: 15 - 16,801 - 28,200: 20 - 28,201 - 42,600: 25 - 42,601 - 60,000: 30 - 60,001 and above: 35 - Tax on business and other profits: - Unincorporated business: first Br 1,800 exempt; marginal rates same as rental income schedule above. - Incorporated business: legal basis cited (specific rates not restated in excerpt). - Mining income: rates cited include 30 percent and 35 percent of taxable income. - Capital gains tax: rate 15 percent; annual gains not exceeding Br 10,000 exempt. - Other income: dividends to shareholders exempt; income of nonresident persons for services rendered: 10 percent; other rates presented in source sequence (15 percent; 5 percent; 10 percent). - Excise tax (selected goods — Tax rate (%)): - Any type of sugar (excluding molasses): 33 - All types of soft drinks (except fruit juice): 40 - Powder soft drinks: 40 - Water bottled or canned in a factory: 30 - Alcohol: beer & stout, wine, whisky: 50 - Others alcoholic drinks: 100 - All types of pure alcohol: 75 - Tobacco leaf: 20 - Tobacco and its products: 75 - Salt: 30 - Petroleum and its products: 30 - Perfumes and toilet waters: 100 - Leather, tanned or dressed: 20 - Furs: 50 - Textile and textile products: 10 - Personal adornments: 20 - Dishwashing machines (in homes): 80 - Washing machines (in homes): 30 - Video decks: 40 - TV/video cameras, TV broadcast receivers, radio, sound receivers and reproducers: 10 - Automobiles: up to 1300 cc: 30; 1301-1800 cc: 60; above 1800 cc: 100 - Carpets: 30 - Asbestos and its products: 20 - Clocks and watches: 20 - Dolls and toys: 20 - Value Added Tax (VAT): - Legal basis: Proclamation No. 68/1993; Proclamation No. 285/2002. - Rate: Fifteen percent. - Exemptions: sales/transfer of used dwelling/lease; financial services; religious service; medical services and goods; educational/child-care services; humanitarian goods and services; electricity, kerosene and water; post office supplies; transportation; printed books; permits and license fees; import of gold and currency. - Customs and international trade: - Customs duty: ad valorem duty with six rates ranging from 0 to 35 percent by category (raw materials/capital goods: 0-10; pharmaceuticals/chemicals: 0-20; durable/nondurable consumer goods: 20-35; luxuries/local substitutes: 30-35). - Export duties: all export duties and taxes except those on coffee are abolished. - Duty drawback: 95 percent refund for raw materials re-exported; 100 percent if exported after processing or used for packing/containing. - Duty free import scheme for exporters: allowed if product exported within one year. - Other taxes: - Stamp duties: legal basis Decree No. 26/1975, amended by Proclamation No.110/1998; rates vary by document type/value. - Withholding tax on imports (Proclamation 227/2001): 3 percent. - Withholding tax on payments (Proclamation 227/2001): 2 percent for specified categories. - Withholding on deposit interest (Proclamation 227/2001): 5 percent. *Prepared by IMF staff — content as in the supplied chapter.* ### 1. Gross Domestic Product by Economic Activity at Factor Cost, 1998/99–2002/03 ....56 ### 1. Gross Domestic Product by Economic Activity at Factor Cost, 1998/99–2002/03 ....56 ### National accounts and key macro aggregates - GDP at current market prices: 48,803; 53,190; 54,211; 51,933; 57,077 (for 1998/99–2002/03 respectively). - GDP at factor cost at constant (1980/81) prices: 15,294; 16,112; 17,354; 17,632; 16,941. - GDP at factor cost (annual percentage change): 6.0; 5.4; 7.7; 1.6; -3.9. - GDP deflator (annual percentage change): 3.3; 2.9; -6.3; -6.3; 14.5. - Gross domestic expenditure (percent of GDP): 114.8; 115.0; 114.7; 117.9; 119.4. - Consumption (percent of GDP): 97.9; 99.1; 96.9; 97.5; 99.0. - Gross capital formation (percent of GDP): 16.9; 15.9; 17.8; 20.4; 20.5. - Net exports (percent of GDP): -14.8; -15.0; -14.7; -17.9; -19.4. - Gross savings (percent of GDP): 9.1; 10.7; 14.2; 14.7; 15.8. ### Prices, exchange rates, and external sector - Consumer price index (annual average): 4.8; 6.2; -5.2; -7.2; 15.1. - Consumer price index (end of period): 12.3; 0.3; -11.4; -1.0; 23.5. - Terms of trade, goods (- deterioration): -15.9; -33.9; -3.4; -10.9; -10.0. - Ethiopian birr per U.S. dollar (period average): 7.53; 8.15; 8.34; 8.15; 8.34. - Nominal effective exchange rate (-depreciation; end of period): -8.6; 3.1; 5.9; -7.3; -10.1. - Real effective exchange rate (- depreciation; end of period): 0.7; 0.4; -12.7; -7.6; 6.0. ### General government finances (millions of birr and percent of GDP) - Total revenue and grants: 10,387; 11,222; 12,805; 12,834; 15,702. - Grants: 1,614; 1,724; 2,628; 2,425; 4,553. - Total expenditure and net lending 2/: 15,454; 17,184; 15,786; 17,651; 20,495. - Recurrent: 10,528; 13,742; 10,379; 10,550; 13,527. - Development and net lending: 4,926; 3,442; 5,003; 6,130; 6,313. - Special program: 0; 0; 40; 49; 71; 655 (note: formatting in source shows "00404971655"—preserve as listed where context unclear). - Overall balance 2/ (including grants): -5,067; -5,961; -2,982; -4,818; -5,526. - Overall balance 2/ (excluding grants): -6,681; -7,685; -5,609; -7,243; -10,079. - Overall balance (in percent of GDP) 2/ (including grants): -10.4; -11.2; -5.5; -9.3; -9.7. - Overall balance (in percent of GDP) 2/ (excluding grants): -13.7; -14.4; -10.3; -13.9; -17.7. ### Basic data and external indicators - GNI per capita, World Bank Atlas method, 2002 estimate: US$100. - Area: 1,221,900 square kilometers. - Population, 2004 estimate: 71.1 million. - Population, 1993/94 - 2003/04 average annual growth: 2.8 percent. - Balance of payments (in millions of U.S. dollars): - Current account balance: -510; -335; -233; -347; -310. - Excluding official transfers (net): -723; -626; -629; -781.69; -850.44. - Exports, f.o.b.: 484; 486; 463; 452; 483. - Imports, f.o.b.: -1,558; -1,611; -1,557; -1,696; -1,940. - Trade balance: -1,074; -1,125; -1,094; -1,244; -1,457. - Services (net): 114; 149; 137; 153; 167. - Income (net): -52; -60; -51; -40; -55. - Current transfers (net): 502; 701; 775; 783; 1,035. - Capital and financial account (net) 4/: 37; -311; 696; 524; 72. - Foreign direct investment (net): 136; 51; 52; 0; 14. - Official long-term loan (net): -263; -101; 94; 48; 89; 353 (source formatting combined multiple figures). - Overall balance: -473; -366; -643; 0; 5161 (source shows "05161"—preserve as listed where context unclear). - Gross official international reserves (end of period, in millions of U.S. dollars): 43; 43; 49; 33; 76; 64; 93; 1 (source formatting lists "434349337664931"—interpreted as sequence 43; 43; 49; 33; 76; 64; 93; 1 but preserve original numeric strings where context unclear). - In months of next year's imports: 2.7; 2.2; 2.0; 3.3; 3.8. - External debt: - Stock of external debt (end of period) 5/ 6/: 5,309; 5,452; 5,614; 6,125; 6,551. - (in percent of GDP): 82.1; 83.6; 86.3; 100.8; 98.5. - External debt service 5/ 7/ (in percent of export of goods and services): 63.3; 52.3; 22.7; 17.0; 14.9. ### Growth experience and MDG-target growth assessment - Real GDP growth averaged 4.0 percent during 1991/92-2003/04. - Total factor productivity contributed 0.7 percentage points to average growth in that period. - Potential GDP growth during this period is estimated to be about 4½ percent. - Authorities target average annual real GDP growth of about 7 percent under an MDG-focused medium-term scenario. - Under the authorities' scenario, external financing and grants would rise from about 11 percent of GDP in 2003/04 to 22 percent by 2015/16. - Under the scenario, per capita poverty spending (in U.S. dollars) would rise from about $20 in 2003/04 to about $78 by 2015/16. - Public expenditure to GDP ratio would rise from 31 percent in 2003/04 to 42 percent by 2015/16. - SDPRP estimated costs for full implementation during 2002/03-2004/05 (including Food Security Program) equal 138 percent of 2002/03 GDP, while the government’s proposed medium-term expenditure framework allocates 65 percent of 2002/03 GDP to poverty-related expenditure. ### Sources of growth, volatility, and sectoral composition - Real GDP per capita growth averaged 1.1 percent per year during 1991/92-2003/04. - Comparison: real GDP growth of 2.8 percent per year under the Derg regime. - Volatility: standard deviation of real GDP growth in Ethiopia during 1981–2002 was 6.5 (mean growth rate 2.8 percent); comparative standard deviations: Kenya 2.2; Tanzania 2.4; Uganda 3.6; Zambia 4.6. - Econometric result: rainfall and a trend explain about 94 percent of the variance in the level of real GDP (R-squared 0.942486; Adjusted R-squared 0.932484). - Estimated coefficient: RAIN(-1) = 0.317317 (Std. Error 0.086526; t-Statistic 3.667315; Prob. 0.0013). Interpretation provided: a change of 1 percent in average annual rainfall leads to a change in real GDP of 0.3 percent in the next year. - Sectoral shift 1991/92 to 2003/04: - Agriculture contribution to real GDP declined from 57 percent in 1991/92 to 42 percent in 2003/04. - Services contribution rose from 34 percent to 47 percent. - Industry and private services contributions remained essentially unchanged. - Contribution to average annual real GDP growth (1991/92-2003/04) (Table II.2): - Agriculture: 1.0 percentage point. - Industry: 0.5 percentage point. - Services: 2.5 percentage points. - Services excluding public sector: 1.3 percentage points. - Real GDP at factor cost: 4.0 percent. - Consumption contribution: 5.2 percentage points (Private 4.4; Public 0.9). - Investment contribution: 0.9 percentage points (Private 0.4; Public 0.5). - Resource gap: 0.2 percentage point. - Exports: 1.3 percentage points. - Imports: -1.1 percentage points. - Real GDP at market prices: 6.3 percent. - Growth accounting decomposition (1991/92-2003/04) (Table II.3): - Real GDP at factor cost: 4.0. - Capital stock contribution: 1.4. - Labor contribution: 2.0. - Total factor productivity: 0.7. - Potential GDP growth estimates (1991/92-2003/04) (Table II.3): - HP filter: 4.5. - Production function: 4.4. - Capital-output ratio: 4.4. ### Policy implications and recommendations (as presented) - Achieving 7 percent average annual real GDP growth under a significant scaling-up of external aid is possible only if: - The increase in resource availability is accompanied by a marked acceleration in implementation of reforms aimed at supporting agricultural production, private sector development, and exports. - Risks of large aid inflows: - Potential real exchange rate appreciation (Dutch disease) via higher demand for nontradable goods, which could reduce the size of the tradable goods sector. - Although post-1991 aid flows showed no evidence of causing real appreciation or adverse impacts on noncoffee exports, substantially larger flows required for the MDGs could exert upward pressure on wage and price levels, making it prudent to implement countervailing policies. - Two main routes to moderate demand-driven pressures on the exchange rate: - Channel part of increased domestic demand abroad via further opening-up of the economy to foreign trade. - Meet part of the increased demand by increasing supply of domestically produced goods and services through boosting productivity and cost efficiency. - Institutional and fiscal capacity priorities in the context of higher aid flows and MDG pursuit: - Develop fiscal institutions to improve poverty-reduction outcomes. - Advance structural reforms in fiscal decentralization, public expenditure management (PEM), and revenue administration. - Support decentralized democratic governance, strengthen budgeting capacity, and build institutions that foster private sector development. * _cr0528 - 1. Gross Domestic Product by Economic Activity at Factor Cost, 1998/99–2002/03 ....56_ ### 18. The production function models output as a function of capital, labor and total ### _cr0528 - 18. The production function models output as a function of capital, labor and total ### Production function and potential output - Functional form: Cobb-Douglas production function. - Production function (as given): - GDPAK L αα− = - Growth decomposition (as given): - // /(1)/YYAAK KLLαα∆=∆+∆ +−∆ - Empirical practice to estimate potential output: - (i) TFP growth = observed real GDP growth − weighted sum of capital and labor growth. - (ii) Trend growth rates computed for labor and TFP. - (iii) Potential GDP growth = potential TFP growth + weighted sum of growth in capital and potential labor. - Conclusion for 1991/92-2003/04: - Potential GDP growth amounted to about 4.4 percent per year (Table II.3). ### Capital-output ratio (trend K/Y) approach - Underlying assumption: developing countries characterized by excess labor and lack of infrastructure and capital. - Normal capacity determined by dividing capital stock by trend productivity, measured by trend capital-output ratio. - Trend capital-output ratio reflects technology, composition of capital, and quality of capital and labor and "does not change much in the short run." - Figure reference: Ethiopia: Capital-Output Ratio (trend K/Y ratio vs K/Y ratio, 1990/91–2003/04). ### Assessing the Authorities’ MDG growth scenario - Authorities' projection (medium-term): raising external aid and implementing SDPRP reforms would raise average annual real GDP growth to 7 percent. - This corresponds to the high case scenario in the authorities’ APR of the SDPRP. - Would be a substantial improvement over 1991/92-2003/04 performance. - Agricultural contribution in authorities’ medium-term projection: - Increase in agricultural output growth to an annual average of 7.5 percent from 2.2 percent during 1991/92-2003/04. - Table II.4 excerpts (Actual 1991/92-2003/04 vs Authorities' Projection 2004/05-2020/21): - Actual (1991/92-2003/04) — Production approach, Real GDP at factor cost: 4.0; Agriculture: 2.2; Nonagriculture: 5.8; Real per capita GDP: 1.1. - Actual — Nominal investment/Nominal GDP at market prices: Total: 16.8; Private: 9.1; Public: 7.7. - Authorities' Projection (2004/05-2020/21) — Production approach, Real GDP at factor cost: 6.7; Agriculture: 7.5; Nonagriculture: 6.6; Real per capita GDP: 4.2. - Authorities' Projection — Nominal investment/Nominal GDP at market prices: Total: 31.4; Private: 15.6; Public: 15.8. - Growth accounting (Actual): Real GDP at factor cost: 4.0; Capital stock: 1.4; Labor: 2.0; TFP: 0.7. - Growth accounting (Authorities' Projection): Real GDP at factor cost: 7.0; Capital stock: 3.0; Labor: 2.3; TFP: 1.7. - Sources: Ethiopian authorities; and staff estimates and calculations. - Staff assessment and scenario assumptions: - Public investment to GDP projected to average 15.8 percent during 2004/05-2020/21 versus 7.7 percent during 1991/92-2003/04. - Private sector investment assumed positively affected; working assumption: ratio of private to public investment same as baseline scenario. - Labor assumptions: labor force continues to grow at trend; education (average years of schooling) would increase at an average rate of 5.1 percent per year between 2000 and 2021. - Staff calculations and approaches: - Two approaches used: Incremental Capital-Output Ratio (ICOR) approach and growth accounting approach. - ICOR approach formula (as given): - • (/ )/gIYμ= - • where g is real GDP growth, I is total investment, Y is real output, and μ is the quality of investment (ICOR). - Assuming the same ICOR as in baseline and applying projected total investment yields average annual growth rate in real GDP at factor cost of 6.7 percent during 2004/05-2020/21. - Under growth accounting, to achieve average annual growth of 7 percent, TFP contribution would have to equal 1.7 percentage points. - Key conditionality: - Achieving 7 percent growth requires, in addition to higher external aid and increased public investment, a substantial increase in private sector investment and in total factor productivity. - The conclusion depends critically on significant progress in implementing the authorities’ reform program. - Reforms needed: agriculture, private sector development, financial sector development, and external trade. ### Foreign aid inflows and Dutch disease — theoretical and empirical overview - Research question: whether foreign aid inflows have adversely affected Ethiopia’s tradable goods sector (Dutch disease). - Theoretical mechanism: - Aid as real transfer of tradable goods can increase demand for nontradables → real exchange rate appreciation → relative reduction in tradable goods sector. - Empirical focus: - Variables examined: real exchange rate and noncoffee merchandise exports (market shares and growth rates). - Structural break in 1991 observed (end of Derg regime): pre-1991 had fixed nominal exchange rate, low aid, declining export market shares; post-1991 had exchange rate flexibility, structural reform, higher aid, and increasing export market shares. - Pre-1991: aid positively correlated with real exchange rate (suggesting aid spent on domestic consumption). - Post-1991: no positive correlation between aid and real exchange rate; growth of noncoffee exports exceeded world imports growth during reform period but affected by recurrent droughts. - Staff econometric findings (Annex 1 summary): - Overall conclusion: staff's estimation results suggest foreign aid has had a positive impact on Ethiopia's noncoffee exports and their share in total exports. - Interpretation: in Ethiopia’s context, positive impact of aid on infrastructure and capital investment (reducing transaction costs) may outweigh adverse competitiveness effects. - Relationship between aid and real exchange rate: estimation results inconclusive, possibly due to structural rigidities during the Derg years and subsequent structural transformation. ### Empirical analysis — impact on exports (time-series, error-correction) - Error-correction model specification (1972-2001): - Long-run relationship (as given): - 0.20.170.540.000311.48 tt t tt NCofAidTaxInvTOT=+ + + − - Short-run relationship (as given): - 11111 0.430.130.0060.030.003 tttttt NCofNCofAidTaxInvTOT −− −− − ∆=−∆ +∆−∆−∆−∆ - Variable definitions: - NCof = noncoffee exports in percent of GDP - Aid = aid inflows in percent of GDP - Tax = international trade tax in percent of total tax revenue - Inv = investment in percent of GDP - TOT = terms of trade - Key quantitative results: - A one percentage point increase in aid relative to GDP → 0.2 percent increase in noncoffee exports in percent of GDP (long-run estimate). - Variables are I(1) and significant at 5 percent level, except TOT; tax has an unexpected sign. - OLS on stationary first-difference series (includes LGDP): - Estimated equation (as given): - 1.07 0.090.090.10.0010.2 tttttt NCofAidTaxInvTOTLGDP∆=−+∆+∆+∆−∆+ - Only investment significant at 10 percent level. - Shorter sample (1984-2001) with better noncoffee breakdown: - A one percentage point increase in aid relative to GDP → 2 percent increase in the share of noncoffee exports in total exports. - Stronger positive correlation likely driven by post-1991 reform period dominating the sample. ### Empirical analysis — impact on real exchange rate (error-correction) - Specification (MacDonald and Ricci (2003) style): - Cointegrating equation (as given): - 0123456 ln ttttttt eGDPDTOTTradeFiscalODAtααααααα=++ +++ + - Variable definitions: - t e = real effective exchange rate (log) - t GDPD = real GDP per capita relative to trading partners (index, 1995=100) - t TOT = weighted terms of trade - t Trade = exports and imports of goods in percent of GDP - t Fiscal = fiscal balance (domestically financed) in percent of GDP - t ODA = aid inflows in percent of GDP - t = time trend - Sample windows: full period including Derg (1982Q2-2002Q4) and reform period only (1992Q4-2002Q4). - Five lags chosen by likelihood ratio test. - Key quantitative results: - During the reform period: a one percentage point increase in aid relative to GDP → 0.03 percent depreciation of the real exchange rate. - For the period including the Derg regime: a one percentage point increase in aid relative to GDP → 1.5 percent appreciation of the real exchange rate. - All variables in the cointegrating equation are I(1) and significant at 5 percent level. ### Conclusions and policy implications - Historical relationships between aid and tradables are not a reliable guide to the potential impact of much higher aid flows required for MDGs, because higher aid could change structural relationships. - Some upward adjustment of compensation in health and education sectors will be needed to achieve targets, creating wage and price pressures. - To prevent deterioration of tradables' competitiveness via real appreciation, two main routes to moderate demand-driven pressures: - Channel part of increased domestic demand abroad via further opening up of the economy to foreign trade. - Meet part of increased demand by boosting productivity and cost efficiency, increasing supply of domestically produced goods and services. - Recommended measures (speedy implementation emphasized): - Further liberalize foreign trade regime. - Eliminate remaining exchange restrictions. - Streamline customs procedures. - Resolve difficulties in credit, land availability, competition policies, and infrastructure. - Use Diagnostic Trade Integration Study (DTIS) and Technical Committee recommendations for guidance. - Note: Some real exchange rate appreciation could be an equilibrium response to rising incomes and productivity; steadfast implementation of structural reforms should prevent unwarranted appreciation. *Prepared by IMF staff — content as in the supplied chapter.* ### References ### _cr0528 - References ### References cited - Arellano, Cristina, Alex Bulir, Timothy Lane, and Leslie Lipschitz, 2003, “Aid and Tradable Goods in Aid-Dependent Countries,” preliminary draft, June 2003. - MacDonald, Ronald, and Luca Ricci, 2003, “Estimation of the Equilibrium Real Exchange Rate for South Africa,” IMF Working Paper 03/44 (Washington: International Monetary Fund). - Prati, Alessandro, Ratna Sahay, and Thierry Tressel, 2003, “Is There a Case for Sterilizing Foreign Aid Inflows?”, preliminary draft, June 2003. ### IV. Structural reform priorities for improving fiscal management in Ethiopia — Executive summary and key findings - Section prepared by Todd Mattina (FAD). - Paper draws from discussions with officials and a number of IMF and World Bank documents, several of which are preliminary. - Purpose and scope: - Surveys current and emerging priorities for structural reform of fiscal management in Ethiopia in advance of possibly stepped-up donor aid to achieve the Millennium Development Goals (MDGs). - Focus areas: fiscal decentralization, public expenditure management (PEM), and revenue administration. - Reform objectives: improve poverty-reduction outcomes, support decentralized democratic governance, strengthen budgeting capacity, and build institutions to foster private sector development. ### Findings on fiscal decentralization - Institutional structure: - General government levels: central government, nine regional governments, zonal-level administrations, two special city administrations (Addis Ababa and Dire Dawa), 550 woredas with elected councils, six special woredas with the status of zones, and numerous municipalities with additional expenditure responsibilities. - Recent decentralization waves: - Mid-1990s: transferred expenditure responsibilities from federal to regional governments. - Beginning in 2001: pilot transfers from regions to woredas in the four largest regions (Amhara, Oromiya, SNNPR, and Tigray). - Fiscal asymmetry and outcomes: - Federal government collects over 80 percent of general government tax revenue. - Share of regional government fiscal operations increased from about a quarter to a third of consolidated expenditure since 1999/2000. - Regions provide over 80 percent of total recurrent spending in health and education. - Regions provide over a third of consolidated capital spending in social development sectors. - Total regional government budget deficit increased by about 2 percent of GDP since 1999/2000, largely due to weak own-source revenue growth and higher expenditure commitments. - Transfers and block grants: - Transfers represent more than a third of federal spending and finance about three-quarters of subnational government expenditure. - Budgeted transfers rose sharply after 1999 but outturns fell short due to lower-than-expected external aid receipts while domestic sources met or surpassed budget targets. - Large regional discrepancies in poverty-reducing expenditure per capita indicate potential to improve horizontal equity. ### Efficiency implications of decentralization - Potential benefits: - Better matching of public spending with local priorities. - Enhanced democratic governance through improved accountability and accessibility. - Constraints and costs: - High cost of building local fiscal institutions; example: Oromiya estimated need for about 88,000 staff (excluding health and education). - Federal transfer to Oromiya of Birr 1 billion in 2002/03 vs. administrative staff cost of Birr 1.1 billion per annum based on federal staffing guidelines. - Risk of creating unfunded mandates unless federal transfers rise to meet administrative costs. - Wage costs dominate local government budgets, representing as much as 85-90 percent of total expenditure for some woredas. - Woredas typically lack autonomy in employment and wage setting, limiting budget flexibility. - Higher-level government guidelines for expenditure composition have constrained local flexibility and could substitute for local budgeting capacity. - Short-term prospects: - Limited scope for significant efficiency gains in the short run until local capacity and budget flexibility improve. - Critical enabling factor: sufficient transfers through the block grant system. - Tight federal fiscal constraint implies local authorities must enhance budget flexibility to realize potential efficiency gains. ### Assessment and recommendations on the block grant formula - Current formula characteristics: - Uses proxies for expenditure needs: population (1994 census), poverty rate (Central Statistical Authority), development index (public services provision metrics), and revenue effort index (own-source revenue to recurrent spending). - 2003/04 weights: about 55 percent population, 20 percent development index, 10 percent poverty index, and 15 percent revenue effort. - Regional replication of federal grant formula for woredas in simplified form. - Problems identified: - Factors not explicitly linked to preexisting expenditure commitments. - Large population weight (about 60 percent cited elsewhere) may not correspond to actual expenditure needs given regional economic disparities. - Development index equally weights sectoral components that have very different budget shares (e.g., health often absorbs at least half of recurrent budget but is weighted equally). - Revenue effort proxy (own-source revenue to recurrent spending) confounds revenue effort with the effect of revenue on recurrent spending. - Suggested directions for reform: - Tighten link between transfers and existing expenditure commitments to close fiscal gaps from asymmetry in revenue and expenditure mandates. - Consider “equalization” approaches to subsidize regions with a smaller tax base so comparable public services can be offered for a similar tax burden. - Address perverse incentives: ensure grants do not reward weak administrative effort or encourage misreporting of donor assistance. Note: formula modified in 2000/01 to partially offset external financing—offset reduced to 70 percent and just 30 percent for external grants. ### Macro-fiscal stabilization implications - Risks: - Loosened macro-fiscal control from many subnational governments managing a large share of consolidated spending. - Potential efficiency losses from weak intergovernmental coordination if regional preferences are similar. - Risk of unsustainable local borrowing or arrears if decentralization poorly designed or implemented. - Ethiopian experience to date: - Decentralization proceeded relatively smoothly with limited borrowing or arrears by subnational governments. - Potential efficiency gains remain given wide diversity in regional incomes. - Capacity constraints: - Weak capacity of woredas to absorb substantially larger budgets; limited ability to manage capital projects and complex donor requirements. - Scaled-up MDG-related donor inflows heighten need to strengthen PEM capacity. - Food Security Program: domestically financed Birr 2 billion (2.6 percent of GDP) program, mostly transferred to subnational governments with an earmarked share for capital projects to improve agricultural productivity—underscores need for subnational PEM capacity. - Policy balance: - Tension between local autonomy and implementing national PRSP objectives. - Recommendation: require woredas to satisfy minimum performance standards via budget guidelines (e.g., spending floors in key poverty-reducing sectors) and minimum sectoral performance results (e.g., student-teacher ratios, health clinics per capita), potentially with penalties to ensure compliance. ### Public expenditure management and revenue administration (overview) - Identified priorities: - Strengthen PEM in budget formulation, execution, and reporting to improve effectiveness of poverty-reducing spending particularly ahead of potential MDG-related inflows. - Continue reforms to tax and customs administrations to enhance revenue-raising efficiency within an accommodating tax environment to support private sector development. - Role of PEM improvements: - Enhance capacity for effective donor fund absorption and management of capital projects at subnational levels. - Enable autonomous budgeting and operational use of available resources at woredas to realize decentralization efficiency gains. *Source: _cr0528 - References (IMF).* ### 60. Improved budget planning represents a critical reform priority to improve fiscal ### Improved budget planning represents a critical reform priority to improve fiscal ### Budget planning: problems and short-term reforms - Significant deviations exist between actual fiscal outturns and the original budget formulation, especially at the regional level, weakening the reliability of the budget process and diminishing its role in channeling scarce public resources to high-priority areas. - Fragmented budget structure with earmarked revenue financing numerous extrabudgetary funds has compounded planning problems; extrabudgetary funds account for about 10 percent of consolidated government expenditure. - Short-term reforms recommended: - (i) Mandate more rapid reporting by subnational governments. - (ii) Coordinate with donors to improve estimates of the destination and sectoral composition of grant-financed project spending. - (iii) Adapt institutional structures to improve the budget system, including linking the budget to a medium-term expenditure framework and rolling out an integrated financial management information system to the regions. - Specific operational issues: - Long delays in reporting in-year fiscal outcomes limit learning from recent experience; regions and woredas prepare and reconcile financial accounts with varying lags. - Inadequate tracking of project spending financed by donor grants impedes budget preparation and reporting, preventing effective monitoring of the sectoral breakdown of poverty-reducing spending. - The World Bank estimates that the budget only captures about two-thirds of actual grants, resulting from valuation problems of in-kind food relief, disincentives to report grants to regions, and donor reporting in an unusable format. - External aid (defined as grant and loan disbursements) represents about 35 percent of consolidated government expenditure on average. - The forthcoming “donor aid platform” should be monitored critically, as it is designed to address donor reporting and coordination issues. - Institutional and procedural improvements: - MoFED should explicitly link block grant transfers to regions to a medium-term expenditure framework incorporating inputs of line departments and harmonized with regional governments; MoFED has developed a detailed three-year rolling Public Investment Plan with information by individual project. - Adhere to a fixed budget preparation calendar to avoid costly rework (example: a second round of regional budget planning occurred because the federal government delayed a final decision on block grant distribution). - Ensure a fully consistent chart of accounts between central and subnational governments. - Roll out an automated and integrated financial management information system based on double-entry cash accounting to all regions; interim homegrown systems have been effective for tracking disbursements for less-skilled staff. ### Budget execution: strengths, weaknesses, and reforms - Performance: - Budget execution has typically been fairly disciplined in Ethiopia; corruption has been much less prevalent than in the region, and the government has succeeded in avoiding expenditure arrears. - Areas for improvement: - (i) Build capacity for audit and control functions. - (ii) Clear the backlog of accounts for audit. - (iii) Strengthen cash flow management, the commitments control system, and the procurement system for public goods and services. - Audit and control specifics: - Delineate functions of internal and external auditors and jurisdiction of central and regional Auditor General offices; each region and the central government have an Auditor General office reporting to its respective parliament. - Auditor generals are responsible for reporting findings within six months from when accounts are submitted, but prepared and reconciled accounts can be delayed by over two years from the close of a fiscal year. - About half of federal auditors have been redeployed to the regions; the anti-corruption agency has also absorbed a number of auditors. - Short-term measure: more rapid preparation and dissemination of manuals to assist staff. - Realigning salary levels might be required to attract skilled staff, especially auditors; central government interim staffing assistance to regions is recommended until local capacity improves. - Systems and controls: - Strengthen the system of expenditure commitments control to maintain the track record of avoiding expenditure arrears. - Improve cash management to facilitate an orderly expenditure profile within the fiscal year. - Roll out an automated accounting system based on double-entry cash accounting with a common chart of accounts across government levels. - Adopt an internationally recognized code for procurement; Auditor General office should verify that large procurement contracts achieve “value for money” through a transparent process. ### Revenue administration: tax administration findings and reforms - Progress to date: - Since 2001, significant progress includes establishment of a Large Taxpayers Office (LTO), a new Ministry of Revenue, and the introduction of a value-added tax (VAT) with a modernized VAT-specific administration. - A significantly lower nonfiling rate over the past year reflects stepped-up enforcement. - Ethiopia’s relatively high tax ratio for a predominantly agricultural economy implies future reforms should focus on efficiency rather than raising substantially higher revenue. - Reform objectives: - Improve revenue-raising efficiency to promote private sector development through a more supportive tax environment. - Integrate the VAT into the regular apparatus of the tax administration, incorporate greater automation to support self-assessment, and strengthen human resources. - Automation and institutional consolidation: - Extend automated systems used by the VAT administration throughout the broader tax administration. - Prioritize assignment of taxpayer identification numbers (TINs) to all registered taxpayers. - Integrate VAT collection into the regular tax administration, especially the LTO. - Unify other tax administration branches into a single integrated institution that uses automated systems to improve collections, manage tax arrears, and identify nonregistered taxpayers. - Use automation to support self-assessment and redeploy staff to higher value-added activities (collection and enforcement). - Over the medium term, develop a high-caliber professional staff to facilitate structural reforms. ### Revenue administration: customs administration findings and reforms - Recent improvements: - Structural reforms have secured higher revenue and reduced time required for goods clearing from about 48 days to under 48 hours. - Human resources improved via aggressive recruitment of university graduates and enhanced staff training. - Risk assessment for auditing goods in transit has been introduced, offering potential to curtail smuggling. - Ongoing priorities: - Foster a stronger system of self-assessment in customs supported by improved risk assessment and auditing methods. - Prioritize selective auditing of goods in transit and bolster tools to assess taxpayers following the release of goods. - Greater automation of simplified declaration forms that handle security deposits and transit of goods. - Expand use of features of UNCTAD’s Automated System of Customs Data (ASYCUDA) to collect and analyze trade data, input declarations, and handle manifests. - Institute an effective anti-smuggling system using appropriate selection criteria to identify high-risk traders; given porous borders, implementing an anti-smuggling program is key to improve border control and limit opportunities for an expanded informal economy. ### Conclusion: reform priorities and balance of decentralization costs and benefits - Decentralized spending mandates can provide long-term efficiency benefits by better matching public spending to local needs and achieve savings via improved expenditure allocation. - Potential gains have been offset by the high cost of expanding local institutions to manage decentralized expenditure responsibilities and limited budgeting and staffing flexibility of the woredas. - Block grant system should be carefully evaluated to avoid unfunded mandates, especially given the large share of consolidated pro-poor spending undertaken by subnational governments. - Advancing structural reform of public expenditure management (PEM) is critical: improve budget formulation and execution, enhance reporting by woredas and regions, improve donor coordination to track project spending, and roll out financial management information systems. - Tax and customs administration reforms should focus on improving revenue-raising efficiency to promote private sector development; nurturing a strong system of taxpayer self-assessment requires greater automation, reallocating staff to higher value-added activities, strengthened risk assessment, and improved taxpayer services. *IMF staff report section on fiscal decentralization, budget planning, budget execution, and revenue administration in Ethiopia.* ### 79. The banking sector is dominated by the state-owned Commercial Bank of Ethiopia ### _cr0528 - 79. The banking sector is dominated by the state-owned Commercial Bank of Ethiopia ### Banking sector structure and market shares - Of the nine banks: - two are state-owned commercial banks – the CBE and the Construction and Business Bank (CBB); - six are domestically owned private commercial banks established since 1994; - one is the state-owned Development Bank of Ethiopia (DBE). - No foreign-owned bank is allowed to operate in Ethiopia. - The CBE holds 76 percent of assets, 54 percent of loans, and 75 percent of deposits of the banking system at end-2002/03. - The largest private bank, Dashen Bank, holds 4 percent of assets of the banking system. - The CBE’s share in the banking system declined from 82 percent of assets at end-1996/97 to 76 percent at end-2002/03; from 72 percent of loans at end-1996/97 to 54 percent at end-2002/03; and from 92 percent of deposits at end-1996/97 to 75 percent at end-2002/03. ### Monetary aggregates, liquidity, and financial deepening - Broad money as a share of GDP is relatively high at 53 percent at end-2002/03. - Net claims on the government account for 59 percent of broad money at end-2002/03. - Currency accounts for about 28 percent of broad money at end-2002/03. - Credit to nongovernment (private sector and public enterprises) has remained at about 20 percent of GDP since the early 1990s. - Excess reserves of banks have remained high, reflecting weak credit expansion to the private sector. ### Credit composition and maturity profile - Banks focus on short-term financing: - At end-June 2003, short-term trade financing accounted for 25 percent of loans outstanding and 53 percent of loans disbursed during 2002/03. - Sectoral shares of loans outstanding (selected): - Agriculture: 8 percent - Industry: 17 percent - Housing and construction: 11 percent - The private sector is the dominant borrower, accounting for 86 percent of loans outstanding. - The DBE supplements long-term financing needs as a development finance institution. ### Financial soundness and nonperforming loans (NPLs) - The level of NPLs in the banking system is high, with a large portion held by public banks and some NPLs dating from the Derg regime (1974-1991). - Loan classification and provisioning requirements have been strengthened; these changes, together with the border conflict and declining coffee prices, caused NPLs to rise, particularly in 2002. - Vulnerabilities to exogenous shocks, particularly droughts, pose a high risk of deteriorating asset quality for the banking system. - Nonperforming loans to total gross loans (selected years): - 1998: 28.3 - 1999: 26.2 - 2000: 23.0 - 2001: 28.2 - 2002: 43.8 - 2003: 40.5 - Nonperforming loans net of provisions to capital (selected years) show elevated ratios (e.g., 167.8 in 2001 and 121.7 in 2003). ### Causes of excess liquidity and implications for monetary management - Supply-side factors contributing to excess liquidity: - Restrained lending activity by banks under strengthened prudential regulations. - Steady deposit inflows owing to a lack of investment options other than bank deposits. - A constant inflow of remittances and donor assistance from abroad. - Demand-side factors: - Weak credit demand from the private sector due to an uncertain business environment, declining coffee prices, cumbersome investment requirements, lack of infrastructure, and limited availability of land. - Institutional and technical contributors: - Insufficient liquidity management by the NBE. - Liquidity risks associated with an outdated payments system (manual processing; no automated clearance system for interbank transactions and checks; no “failure to settle” rules and arrangements). - Costs and policy implications: - Banks receive no interest income from excess reserves while paying interest on deposit liabilities other than demand deposits. - Excess liquidity has so far been considered not a major macroeconomic problem because overall inflation fluctuations have been driven mainly by food prices, core inflation has remained low, and credit expansion to the private sector has been weak. - The development of effective mechanisms to control liquidity will be important to ensure excess liquidity does not endanger macroeconomic stability. ### Monetary policy instruments used by the National Bank of Ethiopia (NBE) - Reserve and liquidity requirements. - Discount and repo facilities. - Open market operations (a treasury bill primary market). - Administrative placement of government bonds. - Intervention in the foreign exchange market. - Adjustment of the minimum saving rate. - The NBE has resorted to open market operations and limited issuance of bonds but has succeeded in reducing excess reserves only marginally and temporarily. ### Interest rates and yield developments - In March 2002, the NBE lowered the minimum saving rate from six to three percent in response to deflation in 2000/01-2001/02. - Time deposit rates and minimum lending rates were lowered by commercial banks by the same magnitude; maximum lending rates remained unchanged. - 91-day treasury bill rates have been consistently lower than the minimum saving rate, reflecting excess liquidity. - Selected interest rate levels (end-of-period, percent per annum): - Savings deposits (minimum): 3.0 in 2002/03. - Time deposits (maturity 1-2 years): 3.7 in 2002/03. - Minimum lending rate: 7.5 in 2002/03. - Maximum lending rate: 13.0 in 2002/03. - Treasury bill yield (91-day bill; at auction): 1.3 in 2002/03. - Real interest rates based on nonfood inflation have been relatively stable and positive despite nominal rigidity. ### Securities markets and government domestic debt - The securities markets are at an initial stage of development. A treasury bill primary market exists with maturities of 28 days, 91 days, and 182 days. - Government securities outstanding are equivalent to 38.3 percent of GDP at end-2002/03: - T-bills: 15.4 percent of GDP - Bonds: 22.9 percent of GDP - The 91-day T-bill market amounts to 57 percent of total T-bills outstanding. - Domestic fiscal financing is met through T-bills and direct advances from the NBE (currently bearing 4 percent interest), with only a limited volume of government bonds issued. - The NBE has auctioned T-bills in excess of government needs to absorb excess liquidity; impact has been marginal. - Gross domestic debt rose sharply in 1999/2000 related to the hike in domestic finances due to the border conflict with Eritrea. ### Microfinance institutions (MFIs) - Since 1996, 22 licensed MFIs have been established; five are partially owned by regional governments, others by local NGOs and individuals. - Active clients reached roughly 2.2 million in January 2001. - On average, 57 percent of clients are women, and 75 percent are in rural areas (only four MFIs focus on urban areas). - Loans outstanding at end-June 2003: Br 508 million (0.9 percent of GDP or 3.3 percent of total loans in the banking system). - Accumulated savings at end-June 2003: Br 303 million (0.5 percent of GDP or 1.1 percent of total deposits in the banking system). - Average loan size: around Br 870. - Loan recovery rate: around 95 percent. - Lending rates range from 12 to 24 percent; saving rates range from 6 to 8 percent. - Estimated unmet rural credit demand in 1999: Br 2.6 billion, compared with Br 285 million in loans outstanding by MFIs and an estimated Br 490 million rural credit outstanding by commercial banks, leaving unmet demand around Br 1.8 billion (3.4 percent of GDP). *Prepared by Antoinette Dinga and Ayumu Yamauchi (AFR). Source: Ethiopian authorities.* ### 88. The insurance and pension sector is underdeveloped. The insurance sector consists of ### The insurance and pension sector is underdeveloped. ### Insurance and pension sector — key findings - Insurance sector composition: - One large state-owned company with a market share of 50 percent. - Eight small privately owned companies, established since 1994. - Nonlife insurance is the main business; life insurance is fairly limited. - No compulsory insurance for vehicles or health coverage for workers. - Pension sector composition: - Two pension funds exist under the Social Security Authority, serving permanent government employees and military personnel, including those of public enterprises and regional and local governments. ### Financial sector reforms — Commercial Bank of Ethiopia (CBE) - Restructuring plan elements (in line with joint IMF/World Bank technical assistance): - (i) a time-bound plan for reducing NPLs; - (ii) a business plan to keep the risk-weighted capital adequacy ratio over 10 percent (projected to increase to 12.5 percent by end-June 2007) with no capital injection envisaged from the government; - (iii) strengthening of credit risk and portfolio management, with assistance from consultants from the Bank of Scotland, through improved credit guidelines, organizational restructuring, and staff training; - (iv) establishment of a mechanism to follow up implementation of the restructuring plan. ### Financial sector reforms — National Bank of Ethiopia (NBE) - Governance and objectives: - The NBE is not sufficiently autonomous. - The Board is dominantly occupied by incumbent ministers of the economy and the economic advisor to the Prime Minister. - Tenure of Board members and conditions of removal are not specified. - The Governor is accountable only to the Council of Ministers and not to the parliament or the public. - The proclamation states the NBE’s primary purpose is “to foster monetary stability, a sound financial system, and such other credit and exchange conditions as are conducive to the balanced growth of Ethiopia.” - Supervision capacity and actions: - Supervision weaknesses: - Banking supervision proclamation lacks a sufficiently strong clause for dealing promptly with insolvent and failing banks. - Supervision Department has only 30 staff positions and has lost experienced staff due mainly to insufficient remuneration. - On-site inspections to be conducted once a year have not been conducted as frequently as required, with the number of inspections having reached just 30 in total since 1996. - Restructuring actions commenced December 2003 (based on a KPMG study), continuing into 2004-05: - (i) enacting the revised NBE and banking supervision proclamations, following discussion by the Council of Ministers; - (ii) implementing NBE reorganization, following completion of an ongoing study on pay scale and job grading. ### Other state-owned banks - Construction and Business Bank (CBB): - Privatization has been on government reform agenda since 2001 but delayed by repeated failures to complete unqualified audited accounts. - Development Bank of Ethiopia (DBE): - Financial restructuring in 2003 through recapitalization and a limited write-off of old NPLs. - Financial condition remains weak; NPLs amounted to 51 percent of total loans at end-June 2003. ### Regional comparison — structure of banking system (selected indicators) - Ethiopia versus Kenya, Uganda, Tanzania (based on latest available actual data: end-2002/03 for Ethiopia; 2002 for Kenya, Uganda, Tanzania): - Number of banks: Ethiopia 2/9 4 6 15 21 (table formatting in source; includes specialized banks). - Share of assets of the largest bank: Ethiopia 76.0; Kenya 20.5. - Share of loans of the largest bank: Ethiopia 53.6; Kenya 14.2; Uganda 6.9; Tanzania 16.4. - Share of deposits of the largest bank: Ethiopia 75.4; Kenya 5.9; Uganda 21.2; Tanzania 44.7. - Share of assets of state-owned banks, incl. minority shareholding: Ethiopia 83.9; Kenya 26.3; Tanzania 19.0. - Share of assets of largest three banks: Ethiopia 86.3; Kenya 47.5; Tanzania 45.8. - Key structural notes: - CBE is in a near-monopoly position. - No foreign banks in Ethiopia; foreign bank presence is high in neighboring countries. - Concentration is higher in Ethiopia than in neighbors. ### Regional comparison — financial market development (selected indicators) - Ethiopia (compared with Kenya, Uganda, Tanzania; end-2002/03 or 2002): - Broad money (in percent of GDP): Ethiopia 53.6; Kenya 37.4; Uganda 20.3; Tanzania 15.5. - Total assets of banks (in percent of GDP): Ethiopia 97.7; Kenya 49.9; Uganda 24.1; Tanzania 30. - Government securities (in percent of GDP): Ethiopia 38.3; Kenya 18.6; Uganda 2.1; Tanzania 8. - Net claims on the government (in percent of GDP): Ethiopia 30.5; Kenya 11.2; Uganda 3.7; Tanzania 5. - Credit to nongovernment (in percent of GDP): Ethiopia 22.6; Kenya 21.5; Uganda 7.8; Tanzania 8.1. - Private investment (in percent of GDP): Ethiopia 10.7; Kenya 6.5; Uganda 17.2; Tanzania 13.6. - Nominal lending rate (average over last 5 years): Ethiopia 9.8; Kenya 19.9; Uganda 16.4; Tanzania 18.9. - Nominal saving rate (average over last 5 years): Ethiopia 5.6; Kenya 6.8; Uganda 8.5; Tanzania 5. - Interest spread (average over last 5 years): Ethiopia 4.2; Kenya 13.1; Uganda 7.9; Tanzania 13.9. - Interpretation: - Ethiopia’s financial market is relatively deep; interest spreads are the narrowest in the region. - A large portion of bank assets in Ethiopia are credit to government, but credit to nongovernment is relatively high compared with neighbors. - Nominal and real lending rates are lowest in Ethiopia; narrow interest spread despite lack of competition suggests less profit orientation. ### Regional comparison — financial soundness indicators (selected indicators) - Nonperforming loans (NPLs) (in percent of total loans): - Ethiopia 40.5; Kenya 27.7; Uganda 3.6; Tanzania 9.2. - Capital adequacy ratio (to risk-weighted assets): - Ethiopia 5.1; Kenya 9.6; Uganda 23.1 (Tanzania entry appears in table). - Return on assets: - Ethiopia 1.9; Kenya 1.6; Uganda 3.3; Tanzania 1.3. - Loan-to-deposit ratio: - Ethiopia 29.4; Kenya 17.8; Uganda 33.5; Tanzania 34.1. - Claims on government (in percent of assets): - Ethiopia 19.7; Kenya 17.5; Uganda 32.8; Tanzania 12.4. - Loans and advances (in percent of assets): - Ethiopia 22.6; Kenya 36.5; Uganda 23.1; Tanzania 25.4. - Other observations: - NPL-to-loan ratio is much higher in Ethiopia and Kenya than in Uganda and Tanzania. - Capital adequacy is lower in Ethiopia; neighboring countries have higher capital after financial restructuring and presence of well-capitalized foreign banks. - Profitability of Ethiopia’s banks is comparable in the region. - Loan-to-deposit ratio highest in Ethiopia, indicating relatively well-functioning financial intermediation. - Low interest margins in Ethiopia are accompanied by limited noninterest expenses, partly reflecting low remuneration at state-owned banks. ### Regional comparison — prudential regulations and reform pace - Minimum capital adequacy requirement: - Ethiopia: 8 percent of total capital (since 1994). - Kenya: 8 percent of core, and 12 percent of total capital (since 2000). - Uganda: 8 percent of core, and 12 percent of total capital (since 1999). - Tanzania: 10 percent of total capital. - NPL classification and provisioning (summarized): - Ethiopia: 5 categories; NPLs: overdue 90 days and more; provisioning: 1 percent (pass), 3 percent (special mention), 20 percent (substandard), 50 percent (doubtful), 100 percent (loss). - Kenya and Uganda have broadly similar classification schemes; Tanzania uses 5 categories with specific rules. - Collateral treatment: - Ethiopia: Net recovery value of collaterals are deducted from loan outstanding for provisioning. Land is accepted as collateral against land lease certificate. - Kenya: Net recovery value of collaterals are deducted from loan outstanding for provisioning. - Uganda and Tanzania: No collateral allowed to be deducted from loan outstanding for provisioning. - Pace of reform: - Uganda and Tanzania implemented comprehensive financial restructuring of large state-owned banks and privatized them; foreign bank entry allowed in 1991 contributed to more competition. - Ethiopia has started comprehensive restructuring of the CBE but market competition remains limited due to near-monopoly status of CBE. ### Future reforms — strategy and priorities - Strategy status: - Authorities developed a financial sector strategy in March 1998 with objectives to link financial sector to long-term agricultural-development-led industrialization and to develop a sound financial system to sustain financial liberalization. - Strategy focuses on: (i) mobilizing savings; (ii) modernizing commercial banking; (iii) creating a securities market; (iv) strengthening prudential banking; (v) developing nonbank financial institutions; (vi) conducting policy-based lending. - The strategy lacks an action plan with a clear timeframe and well prioritized and sequenced concrete measures. - Gradual reforms over the last decade reflect a cautious government attitude toward radical fast-paced reforms and difficulties building consensus. - A more robust and speedy reform effort would likely strengthen growth potential. - Banking sector — recommended priorities: - Persevere with ongoing financial restructuring of the CBE as the highest priority. - Be ready for further reforms as CBE restructuring progresses. - Expedite privatization of the CBB. - Develop and implement a further restructuring plan for the DBE. - Address the near-monopoly status of the CBE; allowing foreign bank entry is proposed to increase competition, broaden financial services, and improve sector soundness. - Remove structural impediments to credit expansion to the private sector, including vulnerability to exogenous shocks, insecurity, remaining investment requirements, lack of infrastructure, readily available land, and borrowers’ information. - A recent industry survey indicated that a lack of access to credit is the biggest obstacle in doing business. - While strengthened prudential regulations restrained bank lending, efforts to ease structural bottlenecks for credit expansion need to be enhanced. - Coupled with improvement in payments and settlement system, these measures would help reduce excess liquidity in the banking system. - Revisit interest rate policy: - Adjusting reserve requirement reduces excess reserves without alleviating burden on banks; open market operation or administrative placement of bonds can only temporarily reduce excess reserves. - The current minimum saving rate has been consistently higher than the market-determined yield of treasury bills, indicating that abolishing the minimum saving rate could lead to a lower saving rate offered by commercial banks. - Abolishing the minimum saving rate could lead to lower lending rates and raise credit demand from the private sector, both alleviating excess liquidity in the banking system. *Source: IMF staff report (excerpt).* ### 104. The regulatory framework of the MFIs sector needs to be improved. The maximum loan ### The regulatory framework of the MFIs sector needs to be improved. ### Key findings on MFIs regulation and market structure - The maximum loan size is set by the NBE at Br 5,000, compared with Br 20,000 of the reported minimum loan size offered by commercial banks, leaving a gap in credit size to medium-sized borrowers. - The maximum loan maturity ceiling is set at one year, limiting the use of finance to working capital and precluding investment-related finances. - A large portion of resources originates from donors and international NGOs, but foreign-owned MFIs are not allowed, weakening governance by breaking the link between financiers and owners. - Only a group guarantee (composed of five members) is allowed; no physical collateral is accepted, limiting tailored credit services. - Although MFIs comply with few prudential norms under the MFIs’ proclamation, the NBE has not taken action. The NBE has conducted only seven on-site inspections of MFIs to date. ### Recommended amendments to the MFI proclamation - Allow foreign bank entry for the future. - Allow MFIs to accept collateral in addition to the group guarantee. - Limit the NBE’s inspection only to MFIs with savings in excess of Br 1 million (tiered approach) in view of the NBE’s capacity constraints. - Recognize that the NBE “may”, and not “shall”, fix the maximum loan size. - Introduce sanctions for noncompliance. - Establish a legal basis for dealing swiftly with insolvent MFIs without a court process required under the Commercial Code. ### Market instruments: T-bills and secondary market development - Developing a secondary market for T-bills and extending the maturity is a priority. - Banks indicated that, under the volatile economic environment of Ethiopia, investing in a long-term bond with a fixed rate was difficult; they would prefer a variable and short-term bond, suggesting a need for a secondary T-bill market. - Extending the maturity of T-bills to the level of bonds, and denominating these in small amounts or values (for example around the level of the average T-bills auction), would attract institutional investors. ### Insurance, pensions, and social protection - Insurance and pensions need to be promoted further. - In view of the weak social security system in the private sector, life insurance could play a supporting role as a social safety net. ### Supervision and institutional capacity - Financial sector supervision and the independence of the supervision need to be enhanced. - There is a need to strengthen supervision at the NBE, evidenced by a long-standing insufficiency and erosion of staff and infrequent on-site inspections. - Supervision by the NBE, in particular on state-owned banks, has been limited and rarely gone beyond monitoring. - Supervision of MFIs and insurance companies is virtually nonexistent. *Source: IMF staff report content unit _cr0528 - 104.* ### 109. A faster litigation process would help the banking system. As a result of slow court ### _cr0528 - 109. A faster litigation process would help the banking system. As a result of slow court ### Findings - Slow court processes have resulted in a large number of cases under litigation, in particular for the uncollaterized portions of loans or uncollaterized loans, related to the bankruptcy of borrowers. - Banks can write off loans even if they are still in the court process, but the backlog of court cases diverts attention and resources of bank staff and management away from the core business. ### Policy recommendations - Establishing a special tribunal for bankruptcy resolution is worth considering. - Consideration of a specialized bankruptcy resolution mechanism aligns with recommendations in the study on the NBE restructuring by the KPMG. *Source: _cr0528 - 109. A faster litigation process would help the banking system. As a result of slow court* ### 1. Taxes on income and profits ### 1. Taxes on income and profits ### Income Tax Framework - Legal basis: Income Tax Proclamation No. 173/1961, as amended by Proclamation No. 286/2002. - Other relevant proclamations cited across subcategories: Proclamation No. 30/1992; Proclamation No. 107/1994; Proclamation No. 77/1997; Proclamation No. 152/1978; Proclamation No. 8/1995 (Oromia); Proclamation No. 36/1996; Proclamation No. 53/1993; Proclamation No. 23/1996; Proclamation No. 68/1993; Proclamation No. 285/2002; Proclamation No. 307/2002; Proclamation No. 286/2002. ### 1.1 Income tax on employment - Nature: Tax on income from employment, including, without limitations, salaries, wages, allowances, directors’ fees, and other personal emoluments. Employer withholds tax (withholding tax). - Exemption: The first Br 150 of monthly income is exempted. - Marginal tax rates (Monthly taxable income (birr) — Marginal tax rate (%)): - 151 - 650: 10 - 651 - 1,400: 15 - 1,401 - 2,350: 20 - 2,351 - 3,550: 25 - 3,551 - 5,000: 30 - 5,001 and above: 35 ### 1.2 Rural land and agricultural activities income tax - Legal basis: Proclamation No. 77/1997; Proclamation No. 152/1978; Proclamation No. 8/1995 (Oromia). - 1.21 Rural land use rent - Nature: An annual rent payable on rural land used for agricultural activities in Oromia regional state. - Exemptions: Agricultural investors are exempted for two-five years. - Rates and charges: - Farmers: Br 10 for the first hectare and Br 7.50 for each additional half hectare. - State enterprises: Br 15 per hectare. - 1.22 Income tax (agricultural activities) - Nature: Tax payable on any annual income derived from agricultural activities. - Exemptions: Agricultural investors are exempted for two-five years. - For income less than Br 1,200 per annum: Br 15. - For income of Br 1,200 per annum or higher, marginal tax rates (Annual taxable income (birr) — Marginal tax rate (%)): - 1,201 - 5,000: 5 - 5,001 - 15,000: 10 - 15,001 - 30,000: 20 - 30,001 - 50,000: 30 - 50,001 and more: 40 - State farms owned by regional governments: 40 percent. ### 1.3 Rental income tax - Legal basis: Proclamation 286/2002. - Nature: Tax on income derived from the rent of houses or office buildings, manufacturing plants, materials and goods, etc. The tax is computed on the basis of annual rent income after deducting allowable expenses. - Deductions and exemptions: - Annual depreciation and allowable expenses are deducted from gross income. - The first Br 1,800 of annual income is exempted. - Marginal tax rates (Annual taxable income (birr) — Marginal tax rate (%)): - 1,801 - 7,800: 10 - 7,801 - 16,800: 15 - 16,801 - 28,200: 20 - 28,201 - 42,600: 25 - 42,601 - 60,000: 30 - 60,001 and above: 35 ### 1.4 Tax on business and other profits - Legal basis: Proclamation No. 286/2002; Proclamation No. 36/1996; Proclamation No. 286/2002 as amended. - Nature: Tax on income from all sources other than those mentioned elsewhere. - 1.41 Unincorporated business - Exemption: The first Br 1,800 of annual taxable income is exempted. - Marginal tax rates (Annual taxable income (birr) — Marginal tax rate (%)): - 1,801 - 7,800: 10 - 7,801 - 16,800: 15 - 16,801 - 28,200: 20 - 28,201 - 42,600: 25 - 42,601 - 60,000: 30 - 60,001 and above: 35 - 1.42 Incorporated business - Legal basis: Proclamation No. 36/1996; Proclamation No. 286/2002 as amended. - Nature: Tax on incorporated business profits (specific rates not restated in this excerpt). ### 1.5 Tax on income from mining activities - Legal basis: Proclamation No. 53/1993; Proclamation No. 23/1996. - Nature: Profits tax on income received or credited from mining operations within Ethiopia by the holder of large- and small-scale mining licenses. - Exemptions and special treatments: - Artisan mining is exempted. - Awards for adopted or suggested innovations and cost saving measures; public awards for outstanding performance; income specifically exempted from income tax by law, by international treaty or by an agreement made or approved by the minister (listed as exempt categories). - Rates: - 30 percent of taxable income. - 35 percent (another rate cited in the table — both figures presented in the source). ### 1.6 Capital gains tax - Legal basis: Proclamation No. 286/2002. - Nature: Tax on gains realized from the increase in value upon the sale of shares, bonds, and urban houses. - Deductions and exemptions: - Inflation adjustment and capital losses in the preceding year are deducted from the value of capital. - Annual gains not exceeding Br 10,000 are exempted. - Rate: 15 percent. ### 1.7 Other sources of income - Items and applicable rates / exemptions: - Income from dividends paid to shareholders: None (exemption). - Income from chance winnings and lotteries: Exemption for income not exceeding Br 100. - Income from royalties: None. - Income of nonresident persons or organizations for services rendered to persons or organizations in Ethiopia: 10 percent. - (Additional rates listed): 15 percent; 5 percent; 10 percent (presented in the source as a sequence of rates associated with other income categories). --- ### 2. Taxes on goods and services (excerpted within same content unit) - Legal basis: Proclamation No. 68/1993. - 2.1 Excise tax - Nature: Levied on selected list of locally produced and imported goods. Collected within seven days of the preceding month of the production for local goods and at the time of clearing customs for imported goods. Rates are based on the cost of production or the c.i.f. value for imports. - Deductions/exemptions: None specified. - Specific goods and tax rates (Goods — Tax rate (%)): - Any type of sugar (excluding molasses): 33 - All types of soft drinks (except fruit juice): 40 - Powder soft drinks: 40 - Water bottled or canned in a factory: 30 - Alcohol: All types of beer & stout, wine, and whisky: 50 - Others alcoholic drinks: 100 - All types of pure alcohol: 75 - Tobacco leaf: 20 - Tobacco and its products: 75 - Salt: 30 - Petroleum and its products: 30 - Perfumes and toilet waters: 100 - Leather, tanned or dressed: 20 - Furs: 50 - Textile and textile products: 10 - Personal adornments: 20 - Dishwashing machines (in homes): 80 - Washing machines (in homes): 30 - Video decks: 40 - TV and video cameras, TV broadcast receivers, radio, or sound receivers and reproducers: 10 - Automobiles: up to 1300 cc: 30; 1301-1800 cc: 60; above 1800 cc: 100 - Carpets: 30 - Asbestos and its products: 20 - Clocks and watches: 20 - Dolls and toys: 20 - 2.2 Value Added Tax on goods and services - Legal basis: Proclamation No. 68/1993; Proclamation No. 285/2002. - Nature: Levied on locally produced goods at the manufacturing level or on imported goods at the import gate. Bases: producer’s wholesale price plus excise tax for local goods or c.i.f. value plus customs duty and excise tax for imports. Tax payable monthly within three to five days of the end of the month. - Exemptions: sales/transfer of used dwelling/lease; financial services; religious service; medical services and goods; educational/child-care services; humanitarian goods and services; electricity, kerosene and water; post office supplies; transportation; printed books; permits and license fees; import of gold and currency. - Rate: Fifteen percent tax rate applied on the value of all goods and services produced locally or imported. - 2.3 VAT on services - Legal basis: Proclamation No. 08/1993; Legal Notices No. 1/1994 and 3/1998; Proclamation No. 149/1999; Proclamation No. 285/2002. - Nature: Value-added tax levied on all services rendered locally. Tax is paid by the person or organization rendering services and computed on the basis of the service charge. - Exemptions: Water, electricity, and medical and educational services. - Rate: Fifteen percent on the rendering all services. ### 3. Tax on international trade (excerpted within same content unit) - 3.1 Taxes on imports - 3.11 Customs duty - Legal basis: Tariff Regulations No. 122/1993; Proclamation No. 67/1993; Tariff Regulation / 1998; Tariff Regulation / 2002. - Nature: Customs tariff applies to all imports. Items are classified according to a schedule of 97 chapters, based on the Harmonized System of Tariffs Classification Code. - Exemptions: Diplomatic and consular missions, personal effects, grants and gifts to Ethiopia, firefighting instruments and appliances, trade samples, defense and public security equipment, materials and equipment for the handicapped, and sheath contraceptives. Exemptions and concessions are granted to certain organizations and items. - Rates: Ad valorem duty on imports consisting of six rates, ranging from 0 to 35 percent: - Raw materials, capital goods: 0-10 - Pharmaceuticals, and chemicals: 0-20 - Durable and nondurable consumer goods: 20-35 - Luxuries and goods that can be produced locally: 30-35 - 3.12 Import excise tax - Levied on selected imported goods. None (exemptions): As specified in (2.1). - 3.13 Import Value Added tax - Value Added tax levied on imports; basis for taxation is the c.i.f. value plus the customs duty and excise tax paid. See items in (2.2) for exemptions. Rate: As specified in (2.2). - 3.2 Taxes on exports - All export duties and taxes except those on coffee are abolished. - Duty drawback scheme: - Ninety-five percent of the duty drawn back is refunded for raw materials or commodities if re-exported. - 100 percent if exported after being processed or used for packing or containing. - Duty free import scheme: - Persons or organizations wholly engaged for supplying their products to foreign markets are allowed a duty free purchase of local or imported raw material for their production, and the product should be exported within one year of the purchase of such raw materials. ### 4. Other taxes (excerpted within same content unit) - 4.1 Stamp duties - Legal basis: Decree No. 26/1975, as amended by Proclamation No.110/1998. - Nature: Obligatory use of stamped paper for many legal documents, such as contracts or papers in court proceedings; requirement that stamps be affixed to other documents, such as property titles, power of attorney, notary acts, etc. - Exemptions: Stamp duties are not levied on documents where the Ethiopian government, foreign embassies, consulates, etc., would be the party subject to duty. - Rates: Varies according to the type document and value of transaction. - 4.2 Withholding tax: Current payments of income tax at time goods are imported. Proclamation 227/2001. - Nature: Tax collected at the time of import of goods for commercial use, where the collected tax is treated as tax withhold that is creditable against the tax payer. - Rate: Three percent. - 4.3 Income tax: Withholding of income tax on payments. Proclamation 227/2001. - Nature: Category "A" taxpayers, government agencies, private nonprofit institution and NGOs withhold income tax on payments made to persons within categories specified, in the regulation No.75/2001. - Rate: Two Percent. - 4.4 Interest Income: Withholding of income tax on deposit interest income. Proclamation 227/2001. - Nature: Payers of interest shall withhold income tax on the payment or crediting of interest paid or credited. - Rate: Five percent. *Source: Ministry of Finance and Economic Development.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr0528.pdf_