## _cr14304

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---

### Main findings on Ethiopia’s development strategy and outcomes
- Ethiopia pursued a public sector-led development strategy focused on high public investment, concentrating government expenditures on human capital and social sectors and a dominant role for public enterprises in critical infrastructure investments.
- The authorities adopted a 5–year Growth and Transformation Plan (GTP) in November 2010 aiming at average annual GDP growth of over 11 percent and achieving the MDGs. Main pillars: raising agricultural output and productivity, promoting industrialization, and investing heavily in infrastructure.
- Economic performance: growth averaged in double-digits since 2004, with growth initially led by agriculture and later broader with a rising contribution from services.
- Ongoing macroeconomic challenges: negative short-term real interest rates, an overvalued exchange rate, and low reserve cover in months of imports coexist with single-digit inflation.
- Model-based assessment of the GTP investment program:
  - Positive long-run growth effects from the investment program.
  - Transition challenges and macroeconomic trade-offs that depend on financing strategy.
  - Heavy reliance on domestic bank borrowing may require substantial fiscal and macroeconomic adjustments and could entail a sharp increase in inflation.
  - External commercial borrowing may ease short-run adjustments but can lead to significant increases in debt-to-GDP ratios.

### Comparative analysis with selected Asian peers (China, South Korea, Thailand, Vietnam)
- Comparator study periods: China 1982–91; South Korea 1968–77; Thailand 1970–79; Vietnam 2000–09; Ethiopia 2004–13.
- Structural transformation differences:
  - In successful Asian transitions, manufacturing share of GDP typically rose from about 20 percent in low-income phase to about 40 percent in middle-income phase.
  - Ethiopia shows only a partial shift from agriculture toward services; manufacturing share remains relatively stable and low.
- Industrialization targets versus performance:
  - GTP envisaged increasing the industrial sector share from 13 to 19 percent of GDP in 2010/11–2014/15, implying an average annual industrial sector growth rate of 20 percent.
  - Actual industrial sector performance is falling considerably short of GTP objectives.
- Domestic financing and savings:
  - Ethiopia’s gross domestic saving and domestic credit to the private sector are markedly lower than the Asian comparators.
  - Ethiopia’s gross capital formation as a share of GDP in 2012 is comparable only to China in 1990 and Vietnam in 2008, though higher than Thailand in 1978 and South Korea in 1976.
- Trade performance:
  - Ethiopia’s exports have not been as dynamic as comparators and declined as a share of GDP in recent years.
  - Ethiopia’s imports are sizeable, with overall higher share in GDP compared to Asian comparators except Vietnam.

### Export competitiveness and logistics constraints
- Key constraints:
  - Export competitiveness is hampered by an overvalued exchange rate and lagging export productivity.
  - Trade costs and logistics are major contributors to weak export performance.
- World Bank Logistics Performance Index (LPI) 2012 scores:
  - Ethiopia overall LPI score: 2.24; Customs 2.03; Infrastructure 2.22; International Shipments 2.35; Logistics Competence 2.16; Tracking & Tracing 2.10; Timeliness 2.54.
  - China overall LPI score: 3.52; Customs 3.25; Infrastructure 3.61; International Shipments 3.46; Logistics Competence 3.47; Tracking & Tracing 3.52; Timeliness 3.80.
  - Thailand overall LPI score: 3.18; Customs 2.96; Infrastructure 3.08; International Shipments 3.21; Logistics Competence 2.98; Tracking & Tracing 3.18; Timeliness 3.63.
  - Korea, Rep. overall LPI score: 3.70; Customs 3.42; Infrastructure 3.74; International Shipments 3.67; Logistics Competence 3.65; Tracking & Tracing 3.68; Timeliness 4.02.
  - Vietnam overall LPI score: 3.0; Customs 2.65; Infrastructure 2.68; International Shipments 3.14; Logistics Competence 2.68; Tracking & Tracing 3.16; Timeliness 3.64.
- Cost examples (World Bank Doing Business 2012):
  - Cost to import a container to Ethiopia: US$2,660 (export US$1,760).
  - Comparable costs: China US$545; Vietnam US$670.
- Implication: poor logistics raise costs for local industries, impede exports, and increase import costs for consumers; being landlocked and dependent on Djibouti (700 km from Addis Ababa) exacerbates inland transport cost importance.

### Recent policy actions on logistics and observed limits
- Government initiatives:
  - Establishment of Ethiopian Shipping and Logistics Enterprise (ELSE) via merger of three major state-owned enterprises to centralize transit and transport until delivery.
  - Late 2012 amendment allowed other private transit operators to operate in parallel with ELSE; deep sea transport for imports remains exclusive to ELSE.
  - Focus on transport infrastructure (roads and railways) requiring significant investments and financing.
- Observed outcomes:
  - Improvements in logistics did not materialize as intended; anecdotal evidence points to increased time for clearing imports and worsening congestion at Djibouti port and Mojo dry port.
  - Reforms favoring public entities without adequate private sector involvement struggled to deliver efficiency gains.

### Policy implications emphasized in the note
- Financing strategy matters: trade-offs exist between domestic bank borrowing (inflationary and adjustment costs) and external commercial borrowing (higher debt ratios).
- Given binding external financing constraints and limited short-run domestic saving potential, mobilizing domestic savings would require offering attractive interest rates to savers, but this may have macroeconomic consequences.
- To sustain robust growth and realize industrialization ambitions, leveraging the transformation power of the private sector—especially entrepreneurs—is essential to overcome constraints inhibiting innovation, competitiveness, and job creation.

### GTP context and financing gap
- GTP aims to reach middle income status by 2025 and requires large public sector borrowing and domestic resource mobilization to finance high levels of investment.
- Current domestic savings are insufficient to finance the high investment (particularly public), creating a large resource gap.
- Risk that planned investment levels would not materialize and may outstrip the economy’s absorptive capacity.
- GTP financing plan envisages borrowing levels that average 15 percent of GDP annually, of which some two-thirds is to be borrowed externally.

### Financing structure and observed pressures (2010/11–2012/13)
- Plan characterized by substantial upfront “off-budget” financing, with a significant part undertaken by public enterprises.
- Directed domestic credit for priority projects is squeezing credit and foreign exchange availability for the rest of the economy.
- Removing the disincentive to save from negative real interest rates may alleviate some domestic financing needs, but poses a risk of reversion to substantial monetary financing or excessive non-concessional borrowing.

### Financing requirement (percent of GDP)
- General government: 2010/11 = 2.7; 2011/12 = 1.7; 2012/13 = 1.9; 2013/14 = 1.9; 2014/15 = 3.3.
- Net external financing: 2010/11 = 1.0; 2011/12 = 0.8; 2012/13 = 0.8; 2013/14 = 0.8; 2014/15 = 0.6.
- Net domestic financing: 2010/11 = 1.6; 2011/12 = 0.9; 2012/13 = 1.1; 2013/14 = 1.2; 2014/15 = 2.7.
- Privatization: 2010/11 = 0.1; 2011/12 = 0.0; 2012/13 = 0.0; 2013/14 = 0.0; 2014/15 = 0.0.
- Off-budget: 2010/11 = 18.2; 2011/12 = 27.5; 2012/13 = 22.3; 2013/14 = 14.4; 2014/15 = 8.3.
- Of which: own resources: 2010/11 = 6.1; 2011/12 = 9.2; 2012/13 = 7.4; 2013/14 = 4.8; 2014/15 = 2.8.
- Domestic currency (off-budget): 2010/11 = 8.0; 2011/12 = 13.3; 2012/13 = 10.7; 2013/14 = 6.8; 2014/15 = 3.9.
- Foreign currency (off-budget): 2010/11 = 10.2; 2011/12 = 14.2; 2012/13 = 11.6; 2013/14 = 7.6; 2014/15 = 4.4.
- Note: Calculated using nominal GDP assumed in the GTP.

### Model used for sustainability assessment and Base Case calibration
- Model: variant of the open-economy Debt, Investment and Growth (DIG) model (Buffie et al., 2012).
- Investment program specifics:
  - Energy investments increase very rapidly in the short run; infrastructure investment increases more gradually.
  - Long-run capital stock changes: energy sector increases by 250 percent; infrastructure stock doubles.
  - Total supply of energy increases four-fold (300 percent) at the 10-year horizon due to energy investment and efficiency gains from the Renaissance Dam.
  - By year 10, electricity exports account for 38 percent of total energy sales.
  - Public investment limited to energy and physical infrastructure in the model.
- Base Case calibration and assumptions:
  - Nominal base money growth is held at 16 percent (trend growth plus 8 percent).
  - New concessional loans equal 2.2 percent of GDP in year one and then decrease steadily to 1 percent of GDP in year ten; repayments start after an 8-year grace period.
  - Paths for all variables reflect deviations from the trend growth rate (5 percent per capita).
  - Civil servants required to sacrifice one-month’s pay to buy Renaissance Dam bonds is modeled as time-varying transfer payments.
  - Purchases of Diaspora bonds by Ethiopians living abroad are part of non-concessional borrowing.
  - General calibration values:
    - Initial return on infrastructure investment = 20 percent.
    - Initial return on energy investment with existing technology = 30 percent.
    - Shadow price of energy sold to firms is 3.76 times higher than the current tariff (US$.03kWh).
    - Financial return at EEPCO = 8 percent.
    - Export price = US$.075kWh (2.5 times the domestic tariff).
    - Renaissance Dam reduces average per unit operating plus maintenance costs by 30 percent.
    - 50 percent of bank credit is allocated to the public sector.
    - No cost increases from absorptive capacity constraints are assumed in the Base Case.

### Illustrative financing scenarios and key simulation results
- Two Base Case scenarios to cover the financing gap:
  1. Transfer adjustment (cutting other government non-capital expenditures) supplemented with domestic bank borrowing.
  2. Transfer adjustment supplemented with external commercial borrowing.
- Domestic bank borrowing (Base Case) — long run (by year thirty):
  - Real GDP increases by 40 percent relative to its original level (steady state).
  - Private consumption and investment are crowded in; private demand expands by about 20 percent relative to steady state.
- Domestic bank borrowing — transition challenges:
  - Transfers have to decrease by more than 5 percent of GDP within two years to stabilize debt.
  - Public sector already borrows 50 percent of bank credit; bank deposits are approximately 20 percent of GDP, implying banks can borrow at most another 9–10 percent of GDP by seizing all bank credit.
  - By year three the share of public sector bank credit rises from 50 percent to approximately 68 percent.
  - Domestic bank borrowing induces significant crowding out of private consumption and investment in the short run and a sharp increase in inflation (model uses the 2-year moving average of inflation as a guide).
- External commercial borrowing — short- to medium-term:
  - Eases fiscal and macroeconomic adjustment and avoids large cuts in transfer payments.
  - Much smaller increase in inflation in the short run; the 2-year moving average of inflation stays below 9 percent in the first year.
  - No temporary crowding out of private investment is observed; both public and private investment can increase continuously.
- External commercial borrowing — debt dynamics and risks:
  - Total debt to GDP increases from 24 percent to 48 percent of GDP in 5 years under external commercial borrowing.
  - Rapid external debt growth is temporary: after year ten external debt decreases rapidly as the investment program yields economic and financial returns (especially from energy).
  - Substantial inefficiencies or lower rates of return could reduce growth pay-off and fiscal gains, potentially making debt unsustainable.

### Fiscal supporting measures (mitigation strategies) and effects
- Fiscal measures analyzed:
  - Doubling energy prices charged to firms.
  - Increasing tax revenues by about 1 percent of GDP.
- Effects:
  - These measures can induce large reductions in the growth of external debt.
  - With these measures, the ratio of non-concessional debt to GDP starts decreasing after year six and total debt stays below 40 percent of GDP.
  - Inflation remains stable.
  - Short- to medium-term private consumption and investment are moderately affected, but medium- to long-run positive effects are comparable to the case without these measures.

### Risk scenarios: low returns and absorptive capacity constraints
- If return on infrastructure falls to 10 percent and absorptive capacity constraints increase infrastructure project costs:
  - External debt may reach 50 percent of GDP for several years.
  - Ratio of non-concessional debt to GDP does not drop below 20 percent until year 15.
  - Ratio for total external debt does not fall below 40 percent until year 14.
  - Moving-average inflation jumps to 10.6 percent in year one and to 10.8 percent in year two.
- Conclusion: poorly run or inefficient investment programs can jeopardize debt sustainability even with supporting fiscal measures.

### Key policy implications and recommendations
- Consider financing options for the GTP investment program and their macroeconomic impacts carefully.
- Trade-offs:
  - Domestic bank borrowing yields long-run gains but requires substantial fiscal adjustment, induces private sector crowding out, and can sharply increase inflation in the short run.
  - External commercial borrowing eases short-run adjustments and limits crowding out but raises non-concessional and total external debt-to-GDP ratios, creating debt sustainability concerns.
- To maximize growth benefits while preserving macroeconomic stability and debt sustainability:
  - Combine supporting fiscal measures (e.g., energy price adjustments for firms, modest tax increases) with well-run and efficient investment programs.
  - In the context of GTP II, consider reorienting the development strategy more toward the private sector to support investment and alleviate burden on the public sector.

### Summary: entrepreneurship, structural transformation, and the way forward
- State-led strategy has generated good results in growth and social indicators, but structural transformation toward manufacturing and export-oriented activities has not matched successful Asian cases.
- Hampering factors: environment inhibiting entrepreneurship; inadequate leveraging of the private sector; weak business climate; weak incentives for domestic savings characterized by negative real interest rates, limited financial instruments, and an underdeveloped financial system.
- Entrepreneurship is critical to connect capital and labor and to drive productivity and output; capital and labor investment alone are insufficient for high and sustained growth.
- Global Competitiveness Index (GCI) 2013–14:
  - Ethiopia: Rank 127 out of 148, Score 3.50.
  - Ethiopia sub-indexes (2013–14): Overall Index Rank 127 Score 3.5; Basic Requirements Rank 123 Score 3.67; Efficiency Enhancers Rank 126 Score 3.27; Innovation and Sophistication factors Rank 127 Score 2.98.
  - Stage of development: Ethiopia Stage 1.Factor Driven.
- Global Entrepreneurship and Development Index (GEDI) 2014:
  - Ethiopia: Rank 111 (out of 121), Score 19.8.

### Recommended reforms to leverage entrepreneurship and private sector
- Reorient industrial and development policy to provide greater scope for the private sector, especially entrepreneurship.
- Strengthen the entrepreneur-state nexus: government should partner with entrepreneurs to design and implement policies addressing entrepreneurship-inhibiting market failures.
- Use nuanced industrial policy to complement and strengthen the domestic entrepreneurial base, drawing on Asian experiences:
  - Facilitate entry of foreign entrepreneurship and provide financial support to allow entrepreneurs to take on more risk in imitating and adopting foreign technology.
  - Allow entrepreneurs to influence the evolution of institutional frameworks (“institutional entrepreneurship”).
- Broaden business opportunities by opening up specific sectors while allowing government control in strategic areas:
  - Sectors suggested for opening to private and foreign investment: telecommunications; transport and trade logistics; sugar industry; manufacturing.
  - Banking sector: open to local private sector and foreign investors to attract investment and improve efficiency and service delivery.
- Develop a proper legal and institutional framework for public-private partnerships (PPPs):
  - Put in place a transparent institutional framework, appropriate legal framework, credible regulations, and a dedicated and specialized PPP unit.
- Improve incentives for savings, including higher and more stable real interest rates, to eliminate bottlenecks and facilitate financing of entrepreneurial activities.

- Expected impacts:
  - Better leveraging of the private sector and entrepreneurship would facilitate structural change, shifting resources—especially labor—from agriculture to industry.
  - Promoting entrepreneurship can catalyze transition from the factor-driven stage to the efficiency-driven and innovation-driven stages, supporting Ethiopia’s aim to reach middle income levels by 2025.
  - Improvements in competitiveness are expected from removing bottlenecks, improving financial intermediation, and broadening private sector participation.

_Italic: International Monetary Fund. CONCLUSION (from _cr14304), September 5, 2014._

### CONCLUSION ___________________________________________________________________________ 25

### CONCLUSION

### Main findings on Ethiopia’s development strategy and outcomes
- Ethiopia pursued a public sector-led development strategy focused on high public investment, concentrating government expenditures on human capital and social sectors and a dominant role for public enterprises in critical infrastructure investments.
- The authorities adopted a 5–year Growth and Transformation Plan (GTP) in November 2010 aiming at average annual GDP growth of over 11 percent and achieving the MDGs. Main pillars: raising agricultural output and productivity, promoting industrialization, and investing heavily in infrastructure.
- Economic performance has been strong: growth averaged in double-digits since 2004, with growth initially led by agriculture and later broader with a rising contribution from services.
- Despite strong growth, macroeconomic challenges persist: negative short-term real interest rates, an overvalued exchange rate, and low reserve cover in months of imports coexist with single-digit inflation.
- A model-based analysis of the GTP investment program indicates:
  - Positive long-run growth effects from the investment program.
  - Transition challenges and macroeconomic trade-offs that depend on financing strategy.
  - Heavy reliance on domestic bank borrowing may require substantial fiscal and macroeconomic adjustments and could entail a sharp increase in inflation.
  - External commercial borrowing may ease short-run adjustments but can lead to significant increases in debt-to-GDP ratios.

### Comparative analysis with selected Asian peers (China, South Korea, Thailand, Vietnam)
- Comparator study periods: China 1982–91; South Korea 1968–77; Thailand 1970–79; Vietnam 2000–09; Ethiopia 2004–13.
- Structural transformation differences:
  - In successful Asian transitions, manufacturing share of GDP typically rose from about 20 percent in low-income phase to about 40 percent in middle-income phase.
  - Ethiopia shows only a partial shift from agriculture toward services; manufacturing share remains relatively stable and low.
- Industrialization targets versus performance:
  - GTP envisaged increasing the industrial sector share from 13 to 19 percent of GDP in 2010/11–2014/15, implying an average annual industrial sector growth rate of 20 percent.
  - Actual industrial sector performance is falling considerably short of GTP objectives.
- Domestic financing and savings:
  - Ethiopia’s gross domestic saving and domestic credit to the private sector are markedly lower than the Asian comparators.
  - Ethiopia’s gross capital formation as a share of GDP in 2012 is comparable only to China in 1990 and Vietnam in 2008, though higher than Thailand in 1978 and South Korea in 1976.
- Trade performance:
  - Ethiopia’s exports have not been as dynamic as comparators and declined as a share of GDP in recent years.
  - Ethiopia’s imports are sizeable, with overall higher share in GDP compared to Asian comparators except Vietnam.

### Export competitiveness and logistics constraints
- Key constraints:
  - Export competitiveness is hampered by an overvalued exchange rate and lagging export productivity.
  - Trade costs and logistics are major contributors to weak export performance.
- World Bank Logistics Performance Index (LPI) 2012 scores (Ethiopia versus comparators):
  - Ethiopia overall LPI score: 2.24; Customs 2.03; Infrastructure 2.22; International Shipments 2.35; Logistics Competence 2.16; Tracking & Tracing 2.10; Timeliness 2.54.
  - China overall LPI score: 3.52; Customs 3.25; Infrastructure 3.61; International Shipments 3.46; Logistics Competence 3.47; Tracking & Tracing 3.52; Timeliness 3.80.
  - Thailand overall LPI score: 3.18; Customs 2.96; Infrastructure 3.08; International Shipments 3.21; Logistics Competence 2.98; Tracking & Tracing 3.18; Timeliness 3.63.
  - Korea, Rep. overall LPI score: 3.70; Customs 3.42; Infrastructure 3.74; International Shipments 3.67; Logistics Competence 3.65; Tracking & Tracing 3.68; Timeliness 4.02.
  - Vietnam overall LPI score: 3.0; Customs 2.65; Infrastructure 2.68; International Shipments 3.14; Logistics Competence 2.68; Tracking & Tracing 3.16; Timeliness 3.64.
- Cost examples from World Bank Doing Business 2012:
  - Cost to import a container to Ethiopia: US$2,660 (export US$1,760).
  - Comparable costs: China US$545; Vietnam US$670.
- Implication: poor logistics raise costs for local industries, impede exports, and increase import costs for consumers; being landlocked and dependent on Djibouti (700 km from Addis Ababa) exacerbates inland transport cost importance.

### Recent policy actions on logistics and identified limits
- Government initiatives:
  - Establishment of Ethiopian Shipping and Logistics Enterprise (ELSE) via merger of three major state-owned enterprises to centralize transit and transport until delivery.
  - Late 2012 amendment allowed other private transit operators to operate in parallel with ELSE; deep sea transport for imports remains exclusive to ELSE.
  - Focus on transport infrastructure (roads and railways) requiring significant investments and financing.
- Observed outcomes:
  - Improvements in logistics did not materialize as intended; anecdotal evidence points to increased time for clearing imports and worsening congestion at Djibouti port and Mojo dry port.
  - Reforms favoring public entities without adequate private sector involvement struggled to deliver efficiency gains.

### Policy implications emphasized in the note
- Financing strategy matters: trade-offs exist between domestic bank borrowing (inflationary and adjustment costs) and external commercial borrowing (higher debt ratios).
- Given binding external financing constraints and limited short-run domestic saving potential, mobilizing domestic savings would require offering attractive interest rates to savers, but this may have macroeconomic consequences.
- To sustain robust growth and realize industrialization ambitions, leveraging the transformation power of the private sector—especially entrepreneurs—is essential to overcome constraints inhibiting innovation, competitiveness, and job creation.

_Italic: International Monetary Fund. CONCLUSION (from _cr14304), September 5, 2014._

### 18.      The high economic growth envisaged in the GTP is in line with the country’s objective

### _cr14304 - 18.      The high economic growth envisaged in the GTP is in line with the country’s objective

### Context and financing gap
- The GTP aims to reach middle income status by 2025 and requires large public sector borrowing and domestic resource mobilization to finance high levels of investment.
- Current domestic savings are insufficient to finance the high investment (particularly public), creating a large resource gap.
- There is risk that planned investment levels would not materialize and may outstrip the economy’s absorptive capacity.
- The GTP financing plan envisages borrowing levels that average 15 percent of GDP annually, of which some two-thirds is to be borrowed externally.

### Financing structure and observed pressures
- The plan is characterized by substantial upfront “off-budget” financing, with a significant part undertaken by public enterprises.
- Developments in the first three years (2010/11–2012/13) suggest directed domestic credit for priority projects is squeezing credit and foreign exchange availability for the rest of the economy.
- Removing the disincentive to save from negative real interest rates may alleviate some domestic financing needs, but poses a risk of reversion to substantial monetary financing or excessive non-concessional borrowing.

### Financing requirement (Table 2; percent of GDP)
- General government: 2010/11 = 2.7; 2011/12 = 1.7; 2012/13 = 1.9; 2013/14 = 1.9; 2014/15 = 3.3.
- Net external financing: 2010/11 = 1.0; 2011/12 = 0.8; 2012/13 = 0.8; 2013/14 = 0.8; 2014/15 = 0.6.
- Net domestic financing: 2010/11 = 1.6; 2011/12 = 0.9; 2012/13 = 1.1; 2013/14 = 1.2; 2014/15 = 2.7.
- Privatization: 2010/11 = 0.1; 2011/12 = 0.0; 2012/13 = 0.0; 2013/14 = 0.0; 2014/15 = 0.0.
- Off-budget: 2010/11 = 18.2; 2011/12 = 27.5; 2012/13 = 22.3; 2013/14 = 14.4; 2014/15 = 8.3.
- Of which: own resources: 2010/11 = 6.1; 2011/12 = 9.2; 2012/13 = 7.4; 2013/14 = 4.8; 2014/15 = 2.8.
- Domestic currency (off-budget): 2010/11 = 8.0; 2011/12 = 13.3; 2012/13 = 10.7; 2013/14 = 6.8; 2014/15 = 3.9.
- Foreign currency (off-budget): 2010/11 = 10.2; 2011/12 = 14.2; 2012/13 = 11.6; 2013/14 = 7.6; 2014/15 = 4.4.
- Note: Calculated using nominal GDP assumed in the GTP.

### Sustainability assessment: model and investment program
- The sustainability of the investment program is assessed using a variant of the open-economy Debt, Investment and Growth (DIG) model (Buffie et al., 2012).
- Investment program specifics in the model:
  - Energy investments increase very rapidly in the short run; infrastructure investment increases more gradually.
  - Long-run capital stock changes: energy sector increases by 250 percent; infrastructure stock doubles.
  - Total supply of energy increases four-fold (300 percent) at the 10-year horizon due to energy investment and efficiency gains from the Renaissance Dam.
  - By year 10, electricity exports account for 38 percent of total energy sales.
  - Public investment is limited to energy and physical infrastructure in the model (does not include large public enterprise investments in non-infrastructure goods).

### Model calibration and assumptions (Base Case)
- Nominal base money growth is held at 16 percent (trend growth plus 8 percent).
- New concessional loans equal 2.2 percent of GDP in year one and then decrease steadily to 1 percent of GDP in year ten; repayments start after an 8-year grace period.
- Paths for all variables reflect deviations from the trend growth rate (5 percent per capita).
- Requirement that civil servants sacrifice one-month’s pay to buy Renaissance Dam bonds is analytically equivalent to time-varying transfer payments.
- Purchases of Diaspora bonds by Ethiopians living abroad are part of non-concessional borrowing.
- General model calibration values:
  - Initial return on infrastructure investment = 20 percent.
  - Initial return on energy investment with existing technology = 30 percent.
  - Shadow price of energy sold to firms is 3.76 times higher than the current tariff (US$.03kWh).
  - Financial return at EEPCO = 8 percent.
  - Export price = US$.075kWh (2.5 times the domestic tariff).
  - Renaissance Dam reduces average per unit operating plus maintenance costs by 30 percent (model calibrated to capture this).
  - 50 percent of bank credit is allocated to the public sector.
  - No cost increases from absorptive capacity constraints (investment surge increases construction costs in the short run).

### Illustrative financing scenarios
- Two base case scenarios to cover the financing gap:
  1. Transfer adjustment (cutting other government non-capital expenditures) supplemented with domestic bank borrowing.
  2. Transfer adjustment supplemented with external commercial borrowing.
- Additional common assumptions listed above apply to all simulations.

### Domestic bank borrowing: key simulation results and transition challenges
- Long run (by year thirty):
  - Real GDP increases by 40 percent relative to its original level (steady state).
  - Private consumption and investment are crowded in; private demand expands by about 20 percent relative to steady state.
- Transition (short- to medium-term) challenges:
  - Transfers have to decrease by more than 5 percent of GDP within two years to stabilize debt.
  - Public sector already borrows 50 percent of bank credit; bank deposits are approximately 20 percent of GDP, implying banks can borrow at most another 9–10 percent of GDP by seizing all bank credit.
  - By year three the share of public sector bank credit rises from 50 percent to approximately 68 percent.
  - Domestic bank borrowing induces significant crowding out of private consumption and investment in the short run and a sharp increase in inflation (the model notes limitations in tracking short-run price dynamics; the 2-year moving average of inflation is used as a guide).

### External commercial borrowing: key simulation results and trade-offs
- Short- to medium-term:
  - External commercial borrowing eases fiscal and macroeconomic adjustment and avoids large cuts in transfer payments.
  - Much smaller increase in inflation in the short run; the 2-year moving average of inflation stays below 9 percent in the first year.
  - No temporary crowding out of private investment is observed; both public and private investment can increase continuously.
- Debt dynamics and risks:
  - Total debt to GDP increases from 24 percent to 48 percent of GDP in 5 years under external commercial borrowing, posing risks to debt sustainability.
  - Rapid external debt growth is temporary: after year ten external debt decreases rapidly as the investment program yields economic and financial returns (especially from energy).
  - Substantial inefficiencies or lower rates of return could reduce growth pay-off and fiscal gains, potentially making debt unsustainable.

### Fiscal supporting measures (mitigation strategies) and effects
- Fiscal supporting measures analyzed:
  - Doubling energy prices charged to firms.
  - Increasing tax revenues by about 1 percent of GDP.
- Effects:
  - Such measures can induce large reductions in the growth of external debt.
  - With these measures, the ratio of non-concessional debt to GDP starts decreasing after year six and total debt stays below 40 percent of GDP.
  - Inflation remains stable.
  - Short- to medium-term private consumption and investment are moderately affected, but medium- to long-run positive effects are comparable to the case without these measures.

### Risk scenarios: low returns and absorptive capacity constraints
- If return on infrastructure falls to 10 percent and absorptive capacity constraints increase infrastructure project costs:
  - External debt may reach 50 percent of GDP for several years.
  - Ratio of non-concessional debt to GDP does not drop below 20 percent until year 15.
  - Ratio for total external debt does not fall below 40 percent until year 14.
  - Moving-average inflation jumps to 10.6 percent in year one and to 10.8 percent in year two.
- Conclusion: poorly run or inefficient investment programs can jeopardize debt sustainability even with supporting fiscal measures.

### Key policy implications and recommendations
- Careful consideration is needed of:
  - Financing options for the GTP investment program and their macroeconomic impacts.
  - The impact of public financing choices on the private sector (crowding out risks).
- Trade-offs:
  - Domestic bank borrowing yields long-run gains but requires substantial fiscal adjustment, induces private sector crowding out, and can sharply increase inflation in the short run.
  - External commercial borrowing eases short-run adjustments and limits crowding out but raises non-concessional and total external debt-to-GDP ratios, creating debt sustainability concerns.
- To maximize growth benefits while preserving macroeconomic stability and debt sustainability:
  - Combine supporting fiscal measures (e.g., energy price adjustments for firms, modest tax increases) with well-run and efficient investment programs.
  - In the context of GTP II, consider reorienting the development strategy more toward the private sector to support investment and alleviate burden on the public sector.

*Source: _cr14304 - 18.      The high economic growth envisaged in the GTP is in line with the country’s objective*

### 30.      To sum up, the analysis above indicates that while Ethiopia’s state led development

### To sum up, the analysis above indicates that while Ethiopia’s state led development strategy has so far generated good results

### Summary of findings
- Ethiopia’s state-led development strategy has generated good results in terms of economic growth and improving social indicators, but the structural transformation towards manufacturing and export oriented activities has not materialized as in the successful Asian countries.
- Factors hampering progress include: an environment hampering entrepreneurship; inadequate leveraging of the private sector; weak business climate; and weak incentives for domestic savings—characterized by negative real rates of interest, limited financial instruments, and an underdeveloped financial system.
- Capital and labor investment alone are insufficient for high and sustained growth; entrepreneurship is needed to connect capital and labor and to drive productivity and output.
- Entrepreneurship played a key role in Asian success stories; for example, Samsung, Hyundai, and LG account for more than 30 percent of South Korea’s GDP.

### Entrepreneurship, structural transformation, and development stage
- Entrepreneurship is critical for reallocation of resources from agriculture to modern sectors, especially manufacturing (Gries and Naudé, 2010).
- The relationship between entrepreneurship and economic development exhibits an S-shape across three stages: factor-driven; efficiency-driven; and innovation-driven (Acs and Szerb, 2009; Acs and Naudé, 2013; Porter, Sachs, and McArthur, 2002).
- Ethiopia appears to be in the factor-driven stage.
- Global Competitiveness Index (GCI) observations:
  - GCI ranges from 1 to 7 (7 being most desirable).
  - Ethiopia ranks 127 out of 148 with a GCI score of 3.50 in 2013–14.
  - Comparator GCI entries (2013–14):
    - China: Rank 29, Score 4.84
    - Thailand: Rank 37, Score 4.54
    - Korea, Rep.: Rank 25, Score 5.01
    - Vietnam: Rank 70, Score 4.18
  - Sub-index (2013–14) for Ethiopia:
    - Overall Index: Rank 127, Score 3.5
    - Basic Requirements: Rank 123, Score 3.67
    - Efficiency Enhancers: Rank 126, Score 3.27
    - Innovation and Sophistication factors: Rank 127, Score 2.98
  - Stage of development (GCI classification):
    - China: Stage 2.Efficiency Driven
    - Thailand: Stage 2.Efficiency Driven
    - Korea, Rep.: Stage 3.Innovation Driven
    - Vietnam: Stage 1.Factor Driven
    - Ethiopia: Stage 1.Factor Driven
- Global Entrepreneurship and Development Index (GEDI) 2014:
  - Ethiopia: Rank 111 (out of 121), Score 19.8
  - China: Rank 47, Score 41.6
  - Thailand: Rank 65, Score 35.5
  - Korea: Rank 33, Score 46.7
  - Vietnam: n.a., n.a.

### Policy recommendations and the way forward
- Reorient industrial and development policy to provide greater scope for the private sector, especially entrepreneurship.
- Strengthen the entrepreneur-state nexus: government should partner with entrepreneurs to design and implement policies addressing entrepreneurship-inhibiting market failures.
- Use nuanced industrial policy to complement and strengthen the domestic entrepreneurial base, drawing on Asian experiences:
  - Facilitate entry of foreign entrepreneurship and provide financial support to allow entrepreneurs to take on more risk in imitating and adopting foreign technology (Nelson and Pack, 1999).
  - Allow entrepreneurs to influence the evolution of institutional frameworks (“institutional entrepreneurship”) as in China (Siebert, 2007).
- Broaden business opportunities by opening up specific sectors while allowing government control in strategic areas:
  - Sectors suggested for opening to private and foreign investment: telecommunications; transport and trade logistics; sugar industry; manufacturing.
  - Banking sector: open not only to local private sector but also to foreign investors to attract investment and improve efficiency and service delivery.
- Develop a proper legal and institutional framework for public-private partnerships (PPPs):
  - Put in place a transparent institutional framework, appropriate legal framework, credible regulations, and a dedicated and specialized PPP unit.
  - PPPs can engage private investors while allowing government oversight and influence in strategic ventures.
- Improve incentives for savings, including higher and more stable real interest rates, to eliminate bottlenecks and facilitate financing of entrepreneurial activities.

### Expected impacts of recommended reforms
- Better leveraging of the private sector and entrepreneurship would facilitate structural change, shifting resources—especially labor—from agriculture to industry.
- Promoting entrepreneurship can catalyze transition from the factor-driven stage to the efficiency-driven stage, and ultimately toward the innovation-driven stage, thereby supporting Ethiopia’s aim to reach middle income levels by 2025.
- Improvements in competitiveness are expected from removing bottlenecks, improving financial intermediation, and broadening private sector participation.

*Source: Excerpt from IMF staff report on The Federal Democratic Republic of Ethiopia (page section provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14304.pdf_