On January 12, 2018, the Executive Board of the International Monetary Fund concluded the Article IV consultation with the Federal Democratic Republic of Ethiopia.

Ethiopia has recorded annual average GDP growth of about ten percent in the last decade, driven by public investments in agriculture and infrastructure. The poverty rate has fallen from 44 percent in 2000 to 23.5 percent in 2015/16. In 2016/17 GDP growth is estimated at 9 percent, as agriculture rebounded from severe drought conditions in 2015/16. Industrial activity expanded, with continued investments in infrastructure and manufacturing. The current account deficit declined in 2016/17 to 8.2 percent of GDP from 9.1 percent the previous year, reflecting lower drought-related imports and lower public sector capital goods imports. However, export revenues were largely unchanged despite significant volume growth, as global agricultural commodity prices remained low. Foreign direct investment (FDI) growth, was 27.6 percent due to investments in the new industrial parks and privatization inflows. International reserves at end-2016/17 stood at US$3.2 billion (1.8 months of prospective imports cover).

In October 2017, the National Bank of Ethiopia (NBE) devalued the birr by 15 percent relative to the U.S. dollar, thereby reducing overvaluation and enhancing competitiveness. Simultaneously, the NBE increased interest rates and adopted a restrictive stance to minimize adverse effects on inflation – which was 13.6 percent in November 2017. Since October 2016, the Ministry of Finance and Economic Cooperation (MOFEC) implemented further cuts in external borrowing by the government and public enterprises (SOEs), and reduced outstanding non-concessional commercial debt. The general government deficit outturn in 2016/17 was 3.4 percent of GDP (including privatization) and the 2017/18 budget speech announced additional consolidation policies, with the budget deficit projected at 2.5 percent of GDP.

Growth is expected to stay high in 2017/18, at 8.5 percent, supported by continued recovery from droughts and export expansion as new manufacturing facilities and infrastructure come online – offsetting the potentially dampening impact of restrictive macroeconomic policies. Over the medium term, growth is expected to remain around 8 percent, supported by sustained expansion in exports and investment. The authorities’ policies envisaged under the second Growth and Transformation Plan (GTP II) are expected to underpin domestic private sector development and FDI. The GTP II also envisages allocating significant resources to poverty alleviation and the social safety net, while efforts to strengthen financial inclusion are underway.

Staff Report

Outlook and Risks

Output growth is expected to remain high at 8.5 percent in 2017/18, and only slowly decelerate over the medium term. In the short term, ongoing recovery from droughts and the expected pick-up in exports are expected to offset the impact of the restrictive macroeconomic policy stance announced by the authorities. Medium-term real GDP growth is expected to converge to 8 percent, supported by strong private investment, continuing investment in infrastructure, and improving productivity – as FDI and export-oriented industries expand. In the immediate term, inflation is likely to remain above the 8 percent target due to price momentum from earlier months and the pass-through from devaluation. Nevertheless, the announced restrictive monetary and fiscal policy stances should bring inflation back to target in 2018/19.

Export growth is expected to pick up as key supporting projects come online, but the current account deficit will only gradually decline. Exports of goods and services are envisaged to pick up substantially in the medium term, reflecting the completion of key infrastructure (electricity generation and transmission, railway to Djibouti and other logistics, industrial parks) and pay-offs from domestic investment and greenfield FDI. Nevertheless, this pickup is unlikely to reach its full extent immediately: time may be needed for testing, installation and training of newly-hired industrial workers before production facilities can operate at full capacity. Import growth will remain moderate in 2017/18, premised on continued public sector restraint, as announced in the recent budget speech. However, imports will gradually accelerate over the medium term since expanding manufacturing activities will entail substantial importation of inputs until alternative local sourcing, where feasible, develops. Thus, the current account deficit is projected to remain wide and decline only gradually.

Medium-term policies will remain framed by the GTP II strategic objectives. The GTP II allocates a major role to the public sector for public goods provision and anti-poverty and developmental programs. However, the strategy emphasizes private sector development and FDI, particularly in export-oriented manufacturing, through wide-ranging structural reforms and infrastructure improvements.

The external debt and debt service burden pose the main identifiable risk to macroeconomic stability (Annex I and Debt Sustainability Analysis, DSA). In particular, liabilities acquired in past years coupled with export supply delays have resulted in a deterioration of DSA indicators, warranting a reclassification to high risk of debt distress. Under the baseline, both the net present value (NPV) of public and publicly guaranteed external debt and debt service ratios relative to exports breach the standard cross-country thresholds calling for reclassification to high risk of debt distress. Current debt service is becoming significant: Ethiopia faces about US$1.5 billion in external public debt service payments coming due during 2017/18 and significant obligations over the medium term. Given thin reserves (Annex II) and uncertainty in the timing and profile of the export pick-up, adverse shocks could pose debt servicing risks. This in turn, could force an undesirably abrupt import compression and undermine confidence, potentially compromising, at least temporarily, Ethiopia’s successful growth trajectory. In addition, further delays in the export take-off could also put growth projections at risk. The authorities have adopted appropriate decisive policy initiatives to forestall the emergence of debt stress episodes. These include restrictive public sector external borrowing policies, devaluation of the birr, a tight policy stance to increase domestic savings and contain demand spillovers through the balance of payments, and fast-track adoption of initiatives to mobilize private sector resources for infrastructure and public goods provision. Ethiopia remains vulnerable to climate-related risks, including droughts. The authorities have strengthened their safety net and humanitarian response mechanisms, which have been commended by donors, and are developing plans for preventive mitigation with assistance from the WB.

Policy Discussions

There was agreement that after more than a decade of sustained public sector-led growth, the lead needs to be transferred now to the private sector – as envisaged in the authorities’ GTP II strategy. Should the public sector continue undertaking on its own a broad array of public projects, even if highly productive in the long term, it would risk aggravating external imbalances in the short term. These imbalances in turn would undermine the very objective of the public projects: the development of a vibrant private sector and dynamic markets able to lead the economy into its next growth phase. Thus, the timing and sequence of public investment and other public sector activities needs to be reprofiled to a pace commensurate with actual export revenue increases, and with progress in mobilizing domestic savings.

In 2016/17, the authorities appropriately curbed accumulation of external debt, but the protracted export supply response to past investment requires additional actions. Thus, the more restrictive macroeconomic policy stance adopted by the authorities, including after the birr devaluation, is appropriate. Staff also supports the reforms in tax administration and financial management of SOEs – which will enhance domestic resources and their effective use. The envisaged private sector development reforms, such as the roll-out of a financial market and improvements in the business climate should be accelerated. Use of PPPs (with adequate safeguards), private concessions, and privatizations, as envisaged by the authorities, will preserve public resources while helping private sector development.

Fiscal Policy

Box 2. Domestic Revenue Mobilization in Ethiopia

Ethiopia has a low tax ratio compared to other low-income countries. Administrative bottlenecks and weak tax compliance have been the main obstacles to revenue administration. Given the current low collection rate, achieving the target of 17.2 percent of GDP by 2019/20 will be challenging. Some countries in the region have successfully implemented reform programs aimed at improving tax compliance and strengthening effectiveness and efficiency in revenue administration (e.g. Mozambique, Congo Republic, Cabo Verde and Liberia). Reforms have focused on strengthening core operational processes, improving organizational structures, better use of data and information technology, and enhanced human resource management.

The authorities are pursuing an ambitious revenue administration reform agenda. The income tax and tax administration laws approved in 2016 aimed at improving tax collection, broadening the tax base and setting up a more efficient tax system overall. The authorities designed the strategy in collaboration with development partners and established a Tax Policy Directorate under the MOFEC. Also, the Ethiopian Revenue and Customs Authority is implementing strategic measures in human resources, data management, large-taxpayers’ compliance, tax auditing, arrears, automation, and public outreach.

Supporting the Emerging Private Sector

Efforts to spur industrialization are showing positive results. The strategic orientation of industrialization policy – a focus on labor intensive light manufacturing such as in leather, apparel, textiles, agro-processing and electricity – capitalizes on Ethiopia’s competitive advantages. This is buttressed by the promotion of industrial parks, which circumvent business climate impediments through simplified procedures, tax advantages, and easy access to financial services. Wider reforms aim at addressing other bottlenecks, most notably power supply and transport links. In this regard, the imminent start of operations of key projects such as the railway to Djibouti and transmission lines from Gibe III are welcome developments. Staff encouraged the authorities to expedite the process of World Trade Organization (WTO) accession to enhance export prospects.

Other reforms to the business climate are necessary to elicit increased investment. Businesses consider foreign exchange shortages and onerous tax administration and licensing requirements the main impediments to investment. The package of measures around the October 2017 birr devaluation discussed above will help in this regard. The authorities’ commitment to improving key business environment rankings (e.g., WB’s Doing Business, World Economic Forum’s Competitiveness Index) is a positive step. The Financial Inclusion Strategy has the potential to ease the cost of doing business and support domestic investment. The authorities have intensified anticorruption initiatives, which resulted in a number of high-profile arrests and legal prosecutions. Progress in strengthening the anti-corruption regime will also contribute to improve the investment environment.

New PPP legislation, with the appropriate fiscal safeguards, can help private sector development and fund public infrastructure. The Council of Ministers recently endorsed PPP legislation, soon to be approved by parliament. The creation of a PPP Directorate within MOFEC tasked with the centralized management and oversight of PPPs is welcome. Staff encouraged the authorities to work with development partners on the implementation of a PPP framework that strikes the appropriate balance between eliciting private participation and minimizing fiscal risks.

Ethiopia is leveraging participation in the G20’s Compact with Africa to make progress on reforms and attract FDI. The authorities have integrated their strategic goals, as outlined in the GTP II, with policy commitments aimed at maintaining macroeconomic stability, strengthening domestic revenue mobilization, upgrading public investment management, and improving the business climate.

Annex II. External Sector Assessment

Based on data as at June 2017, the external position was assessed to be moderately weaker than the level consistent with medium-term fundamentals and desirable policies. The exchange rate was found to be overvalued by about 20 percent, while international reserves were found to be below modelbased optimal benchmarks. To address external imbalances and strengthen competitiveness, the authorities devalued the currency and tightened monetary policy in October 2017. The magnitude of these changes likely largely addressed the estimated currency overvaluation. However, the final impact will depend on the pass-through of exchange rate changes into domestic prices. The tight monetary stance should help preserve a significant part of the competitiveness gains, support net exports and strengthen foreign reserves.

Until the devaluation of the exchange rate in October 2017, the National Bank of Ethiopia’s framework on managing its exchange rate had remained unchanged since the 2016 Article IV Consultation. The official exchange rate against the U.S. dollar depreciated by 5.8 percent in 2016/17, similar to the 6 percent depreciation observed in 2015/16. Data on the parallel market rate also showed a widening of the margin. On a trade-weighted basis, the birr depreciated by a smaller magnitude, 2.8 percent in 2016/17, reflecting the strengthening of the U.S. dollar against other currencies which partly offset the depreciation in the bilateral rate. As a result of this and Ethiopia’s relatively high inflation rate relative to its trade partners, the real effective exchange rate appreciated by 3.3 percent over the same period.

Since the staff mission took place, the NBE has taken significant actions to address external imbalances. The birr was devalued by 15 percent against the U.S. dollar in October 2017. Also, to contain inflationary pressures, the NBE has tightened monetary policy. The floor on deposit rates was raised from 5 to 7 percent, while the NBE’s reserve money target was lowered from 22 percent to 16 percent. Staff expects that while some pass through from the exchange rate to domestic prices will occur, the tightening of policies will help preserve a significant part of the gains in competitiveness and thus reduce the overvaluation going forward.

Before taking the devaluation into account, the real exchange rate was higher than warranted by productivity levels. Some of the observed real appreciation could arise in equilibrium as a result of Ethiopia’s strong per capita GDP growth (an indicator of productivity growth) due to the Balassa-Samuelson-Penn effect. However, even when taking this effect into account, the real exchange rate in 2016 was elevated in a cross-country context. Staff used a variant of the approach in Rodrik (2009), and fitted a log-linear model of real exchange rates against per capita GDP (both measured relative to the annual sample average, and with time dummies) in a large sample of countries for 2000-2016. Fuel and commodity exporters as well as small and micro-states were excluded from the sample. Comparing the actual real exchange rate with the level estimated by the fitted curve, the birr was found to be overvalued by 20.8 percent in 2016. This is smaller than the 36 percent estimated using Rodrik’s original methodology (which provided a poorer statistical fit) for 2015 in the last staff report.

The current account model of the Fund’s EBA-lite methodology pointed to a similar magnitude of overvaluation of around 22 percent in 2016/17 – thus, also before the recent devaluation. The current account deficit for 2016/17 was 8.2 percent of GDP, whereas the fitted current account deficit – consistent with Ethiopia’s economic and demographic fundamentals – is 5.1 percent, a gap of 3.1 percentage points. Decomposing this gap into a policy gap (the contribution of policies to the divergence), and the norm (the residual, including cyclical factors), we find that policies had reduced the gap by 1.3 percentage points due to a private credit-to-GDP ratio below the long-run level, though this is partly offset by the lower-than-adequate level of international reserves. The other policy variables – the fiscal deficit and degree of capital and financial account openness – were near their assumed long-run values and therefore broadly neutral on the gap. Once imports arising from public sector-driven investment were excluded, the remaining gap amounted to 0.7 percentage point. Applying the updated export and import elasticities in the current account EBA-lite template, we derived an overvaluation of 21.9 percent for 2016/17, lower than the 33.2 percent in the last staff report.

The October 2017 devaluation likely reduced the estimated overvaluation substantially. The immediate impact of the devaluation was a commensurate depreciation of the real exchange rate of around 13 percent (measured as USD per birr), which brought the estimated overvaluation to around 7 percent. However, the full final impact will depend on the magnitude of the pass-through effects of the devaluation on domestic inflation. Steadfast implementation of the strong monetary policy response announced by the NBE would help contain inflation after an initial increase and ensure that the gains to competitiveness are largely preserved. Subsequently, the NBE should also stand ready to adopt a more flexible exchange rate determination to ensure that inflation differentials vis-à-vis major trade partners and fluctuations of the USD against trading partners’ currencies (which are unrelated to Ethiopia’s economic conditions) do not erode the regained competitiveness.

Foreign reserves have declined in 2016/17. The National Bank of Ethiopia received an inflow of US$1 billion from an official bilateral creditor at the end of 2015, which was mainly used to finance imports, primarily foodstuffs, to alleviate the adverse impact of drought. As at March 2017, the level of reserves stood at US$3.2 billion, sufficient to finance 1.8 months of prospective imports of goods and services, down from 2.1 months in June 2016. According to the NBE’s own measure, reserves amounted to 2.5 months at the end of June 2017.

Balance of payments developments could put pressure on international reserves. Data for the H1 2016/17 showed a narrowing of the external current account deficit on account of a decline in imports of goods and non-factor services that more than offset lower private transfers. Current projections suggest the deficit will remain large at 8.2 percent of GDP in 2016/17. Given the central bank’s policy of smooth and predictable depreciation at about 6 percent annually, pressures on international reserves may emerge. Shortages of foreign exchange have persisted. The unofficial (parallel) exchange rate, previously published by the NBE, is no longer being disclosed publicly. However, based on the NBE’s latest surveys, the average parallel market exchange rate for June 2017 was 18.2 percent more depreciated than the average official exchange rate.

Evaluated using data for June 2017, Ethiopia’s foreign reserves are below model-based optimal benchmarks. While the reserves-to-broad money ratio shows reasonable coverage around 10-20 percent, other indicators are raise concerns. A formal reserve adequacy assessment based on a cost-benefit analysis for a credit-constrained low income country gives a range of estimates for adequate reserve levels, depending on the assumptions on the costs of maintaining reserves. The model evaluates shocks in external demand, terms of trade, foreign direct investment and aid flows, based on an updated panel regression. The model also assesses reserve adequacy based on the exchange rate regime, with a fixed rate regime calling for higher reserves. Ethiopia maintains a crawllike arrangement,6 with the authorities aiming for a smooth depreciation of the birr against the U.S. dollar. Therefore, the model’s assessment for a country with a fixed exchange rate suggests that the optimal reserve coverage should lie between 5.8 and 8.9 months of prospective imports for plausible costs of reserves (proxied here by the range of yields observed on Ethiopia’s sovereign 10-year Eurobond between July 2015 to June 2017). In the floating rate case, adequate reserves are assessed as between 2.1 to 2.8 months. The model results underscore the need for further reserve accumulation.

Debt Sustainability Analysis

Stagnant exports in 2016/17, due to a weak external environment and delays in completing key export-oriented projects, and the maturing of non-concessional borrowing contracted in the last 5 years has resulted in a deterioration of the 2017 Debt Sustainability Analysis (DSA) indicators relative to 2016. As in the 2016 DSA, the net present value of external debt-to-exports (PVDE) breaches the threshold in the baseline. In addition, there is now a breach of the debt service-to-exports (DSE) indicator. That said, there is no breach of the debt service-to-exports-plus-remittances indicator. In 2016/17 there was also a decline in external reserves, and widespread foreign exchange shortages. As a result, the risk of external debt distress is now assessed as “high”.

After the 2016 DSA discussions, and as exports underperformed, the authorities took decisive remedial actions consistent with staff advice. They curtailed import-intensive public projects to reduce external public borrowing and keep non-concessional borrowing (NCB) within the 2016 DSA envelope. They introduced strict control mechanisms on NCB by government and state-owned enterprises which resulted in the stabilization of the PV of external debt. The 2017/18 budget speech reaffirmed this restrictive fiscal stance. These policies were crucial in narrowing the external current account deficit by one percentage point of GDP to 8.2 percent in 2016/17 despite weak exports. In October 2017, following the 2017 Article IV Consultation and DSA discussions, the authorities devalued the birr by 15 percent and adopted a restrictive monetary stance to further reduce external imbalances and gain competitiveness.

With steadfast implementation of the announced policies, and the expected export take-off, risks are projected to diminish. However, policy slippages or further delays in export supply would keep risks elevated for an extended period. On the upside, faster-than-projected ramp up of exports – driven by recently completed projects – would strengthen debt sustainability. The projected baseline path of total public sector debt (external plus domestic) does not result in additional risks beyond those discussed for the external debt.

Background and recent developments

Growth in 2016/17 is estimated to have been strong, at 9 percent, sustained by a recovery in agriculture and expansion in industry. The re-emergence of drought in the pastoral regions in the south and east did not halt the recovery: their GDP contribution is small, government interventions were effective, and substantial past investments have enhanced the productivity and resilience of agriculture. Exports of goods and services rose by 2.9 percent in 2016/17, underperforming expectations, as merchandise exports were nearly flat during the year. On the other hand, imports fell by 4.8 percent in 2016/17 due to lower imports of food and capital goods imported by the public sector. Thus, the current account deficit narrowed significantly to 8.2 percent of GDP (from 9.1 percent in 2015/16).

The main sources of external financing in 2016/17 were foreign direct investment (FDI), and public sector borrowing, mainly in the form of project loans, largely concessional. Net FDI increased significantly from US$4.2 billion in 2015/16 to US$4.9 billion in 2016/17, driven by the newly-opened industrial parks. In addition, a stake in the National Tobacco Company, the state-owned tobacco monopoly, was sold to foreign investors during the year. New public external loans signed in 2016/17 (including loans not guaranteed by the government) amounted to US$2.8 billion. About half of the new commitments were concessional loans from multilateral development agencies and institutions. Of the remainder, close to half were at below-market rates with a roughly 30 percent grant element from EXIM Bank of China. Some of these loans were used together with IDA resources for the financing of the water and sanitation infrastructure as well as for the rehabilitation of the power infrastructure. New loan commitments from private creditors on commercial creditors were small, amounting to US$97.3 million, and used for power rehabilitation projects in the power and transmission sector.

Outlook and key assumptions

The revised macroeconomic assumptions incorporate the lower-than-expected export performance in 2016/17. The main fiscal assumptions assume a sustained fiscal consolidation effort, based on announced policies and the government’s record of prudent budget implementation. However, export performance in the immediate term were revised downward to reflect the more gradual improvement in exports in light of recent data. The export performance projections incorporate the positive impact from the new industrial parks, especially the Hawassa Industrial Park where activities have started; the new railway line to Djibouti which has already been completed and is pending the finalization of operational and safety test runs; and hydropower facilities and electricity transmission lines gradually coming online in 2017 and over subsequent years. The projections also build in gains in competitiveness due to the devaluation of the birr in October 2017. However, this medium-term outlook faces downside risks emanating from potential further delays in export-supporting infrastructure, slower-than-expected progress in implementing structural reforms to elicit investment, and shocks to the external market environment faced by Ethiopia’s exports. Upside risks include a faster-than-projected recovery in exports – driven by faster ramp up of production in industrial parks or early completion of the power transmission lines to facilitate electricity exports to Kenya.

The DSA assumes the amount of NCB disbursed over the medium term will decline significantly between 2017/18 and 2021/22. Actual NCB disbursed in 2016/17 (including disbursements to EAL) was around US$1.3 billion, consistent with what was assumed in the 2016 DSA. Going forward, the DSA assumes the level of non-concessional financing, mainly from official bilateral lenders at below-market rates, will decline substantially and amount to between US$300-650 million annually until 2021/22. The DSA also incorporates US$1.8 billion in concessional lending from donors in 2017/18, the bulk of which (US$1.3 billion) is from IDA. Going forward, concessional lending will remain stable at US$1.5-1.8 billion annually until 2021/22 on the back of new IDA commitments before declining gradually as Ethiopia gets closer to graduating to middle-income status and relying more on IBRD and other sources of financing. As a result, new disbursements of medium- and long-term external borrowing is assumed to remain largely concessional, with an average interest rate of 1.3 percent, maturity of 30.3 years and grace period of 5.7 years. In considering the stress tests, the DSA assumes that the marginal debt required to cover any financing gaps that may occur under the stress scenario would be evenly split between domestic and external borrowing, maintaining the current split for debt outstanding.

Ethiopia’s capacity to carry debt is assessed as “medium”. The 3-year average of the Country Policy and Institutional Assessment Ratings (CPIA) scores for 2014-16, which is used to classify countries based on their debt-carrying capacity, stood at 3.48, within the 3.25-3.75 range for medium capacity countries. The score for 2016 was 3.47.