Devaluation, Trade Balance & Livelihood Sustainability in Ethiopia

 Devaluation, Trade Balance & Livelihood Sustainability in Ethiopia

Costantinos, Aug 2014

        Governance is a conscious management of regimes with the aim of enhancing the effectiveness of political authority. It can be thought of as the applied realm of politics, in which political actors seek mechanisms to convert political partiality into managing society and the economy. Economic governance involves improvements in the technical competence and efficiency under a more accountable, transparent and predictable public policy domain. The missing links in economic governance and participation in the global arena point to the dismal policy performance of states that can be attributed to poor economic governance policies and fragility of states. The importance of the missing link in such a convergence of the economic, social, and political schema reflects an emerging consensus on the mutually reinforcing role of these arenas that emphasize the political context of development. 

            The economic & developmental agenda focuses on rehabilitating the role of the State in its core regulatory functions and link sustainable development to political liberalization. Such paradigmatic bonds notwithstanding, the definition of good governance is mired in the dilemma of an Africa that is growing rapidly, but the gloomy pace of translating such growth into sustainable livelihoods can be attributed to state dominance of the commanding heights.

      On 25 Sept. 2010, the Ethiopian Management Professionals Association held a Symposium on Management Priorities of the newly re-elected Ethiopian Government - Ethiopia: Public Management Priorities 2010 – 2015 at the AAU CBE campus. At that time, Ciuriak &  Previlleit (2010) on whose submission this article is based, asserted that as the government faces the usual panoply of challenges endemic in developing countries. Against a background of too few instruments and too few resources, it had to grapple with the perennial problem of managing development: sequencing of policy reforms, all subject to the political constraints of containing the disruptive impacts of policy reforms to acceptable levels. Given the very narrow margins for manoeuvre imposed by fiscal and external deficits, subsistence levels of household income for much of the population and a complex ethnic/regional weave in its social fabric; this is a particularly important problem for Ethiopia. Getting the priorities right was the central agenda of the Symposium.

This write up is inspired by the talk of massive devaluation recommended by the World Bank recently. The surprise 22% devaluation of the Birr on Aug 31, 2010, designed to boost export performance, represents an important recognition by the government that its policy setting had been a factor in inhibiting Ethiopia’s external performance. However, by itself, this move fell short of addressing the problem, which reflected numerous complex factors.  In the first instance, given the role that the exchange rate peg had played in promoting domestic price stability, the series of devaluations leave open the question whether the strategy will maintain macroeconomic stability while it seeks to boost export performance.   Moreover, it is not out of question that the devaluation alone might prove to be disappointing in terms of its impact on trade performance. In the very short term due to a “J-curve” response whereby the trade balance initially deteriorates as import costs are driven up while the export response is slow to take effect.

       This article argues that Ethiopia’s trade performance has been held back by a combination of factors that are amenable to policy treatment: very high trade costs, onerous red tape and a confusing macroeconomic framework and policy mix that seem with reach only elude, seems tractable only to resist realization. Similarly, it argues that targeted infrastructure and regional cooperation developments, in conjunction with a trade-friendly macroeconomic policy and domestic administrative reforms would, if properly sequenced, enable Ethiopia to use its abundant factor of production: natural resources and cheap labor. 

      The concerns that stand out in the latter are, first, the Marshall-Lerner condition states that the trade balance will correct if the sum of the import and export demand elasticities is greater than one. In the context of a developing country which is importing goods for which there are no domestic substitutes, and is exporting commodities for which demand tends to be price inelastic, the sum of the trade elasticities may indeed be less than unity. In a developing country with a highly skewed income distribution, imports are likely to fall into two broad categories: basic necessities and/or production inputs which would naturally have low price elasticities and luxury goods, for whom the devaluation would constitute a relatively minor deterrent.  For both reasons, overall import demand may be quite price inelastic.

           As Prof. Hassan (2014) asserts, “to see the paradoxical and non-market driven nature of the Ethiopian situation, one can look into, for example, the long-time co-existence of high inflation rates and low interest rates. There is a difference between nominal and real exchange rates. The nominal exchange rate is the price of birr in terms of a foreign currency. This is indicated by the birr-U.S. dollar exchange rate, which was $1 = 19.7720 birr as of July 30. 2014. Just before 31 August 2010, the birr/dollar exchange rate was 13.6284. On 1 Sept. 2010, the birr was quoted by the NBE at a weighted average of 16.3514 birr against the U.S. dollar. Given the current rate of 19.7720, the reader can easily observe that the birr was continuously and quietly devalued by about 21% since Sept. 2010. At the same time, annual inflation rates in Ethiopia from 2005 to 2013, respectively, were 9.95%, 12.20%, 17.25%, 43.80%, 10.57%, 8.12%, 33.00%, 23.33% and 8.07%. The reader can observe from this that the exchange rate has not been coping with the country’s inflation rates”.

      Further, market structure may work to dampen the impact of the devaluation. Commodities produced by developing countries are often sold into commodity markets dominated by a few major international buyers whose market power enables them to appropriate the rents; because of this market structure, it is quite possible for the devaluation to boost the profits of multinational buyers with little of the benefit trickling down to the Ethiopian producers. By the same token, this would limit the supply response and thus the extent of correction in the external balance. At the same time, given high margins in Ethiopia’s distribution system, import price changes due to the devaluation may not be fully passed on by importing wholesalers to final buyers (e.g., if importers seek to maintain volumes on those import items that are price elastic), which would also work to reduce the overall correction in the trade balance. Finally, it is important to take into account the impact of the devaluation on the cost of some of the commodities that are part of the value chain for domestic production and exports. 
           Ethiopia’s main imports are petroleum products, fertilizer, edible oil, wheat, clothing and machinery and industrial goods for the massive infrastructure development taking place. None is a luxury good that can be curtailed by a devalued Birr. On the flip side, one can ask what rationale can revolutionize the monetary value of raw coffee and sesame in a devalued Birr. National economic management is complex. Powerful manifestation of this dictum is the fact that getting this process to work undoubtedly reflects the fact that economic development does not evolve out of a wish list. It is systemic in that it involves the generation of a complex ecology of different types of firms interacting with a host of trade partners and building infrastructure and institutions that in the end, the economy’s output transforms the jobs and knowledge base of its workers.

         Accordingly, a more comprehensive policy response of adjusting the monetary policy mix, expanding Ethiopia’s industrial supply capacity and reducing trade costs, policy commitment to enhance the role of the global private sector and confidence building in its citizenry, sustained over the long-term, is required to redress a situation generated by decades of policy settings inimical to good export performance.