In a landmark financial policy shift, the Ethiopian government has introduced a new foreign exchange trading system, allowing market forces to determine the exchange rate. This decision marks a significant departure from past practices and is the most substantial economic policy change in the country’s recent history, spanning over five decades.
Key Changes in Foreign Exchange Policy
The new system, effective from Monday, July 22, 2016 (Ethiopian calendar), permits banks across the country to negotiate foreign currency transactions directly with their customers. Previously, the National Bank of Ethiopia set daily foreign exchange rates, which banks had to follow. Now, the National Bank will compile the daily rates from all banks to establish an Indicative Daily Exchange Rate (IDER), serving as a reference rather than a mandated rate.
Under the new policy, banks can retain a portion of their foreign currency holdings, providing more liquidity to the private sector. Exporters are also allowed to keep up to half of their foreign exchange earnings, a significant shift from the previous requirement to deposit 50% of their weekly foreign exchange reserves with the National Bank. Additionally, non-bank entities are now permitted to participate in foreign exchange transactions, a first in recent history. Individuals can also open foreign currency accounts, either through remittances or other sources.
Rationale Behind the Reform
The National Bank of Ethiopia justified this reform by highlighting issues with the previous system, which fostered a parallel market where the dollar traded at twice the official exchange rate. This parallel market contributed to a persistent shortage of foreign exchange, hampering the private sector and benefiting a few illicit operators.
The change is seen as a necessary step to attract foreign investment, which has been stymied by ongoing internal conflicts. Ethiopia’s recent failure to pay $33 million in interest on a $1 billion bond underscores the urgency of economic stabilization. The country is currently negotiating a new $10.7 billion loan agreement with the International Monetary Fund and the World Bank, highlighting the critical need for macroeconomic adjustments, including currency devaluation.
Potential Challenges and Concerns
The announcement of the new system has led to a significant depreciation of the Ethiopian Birr, losing a third of its value against the dollar. Historically, such devaluations have led to increased prices for imported goods, raising concerns about inflation among Ethiopians. The National Bank acknowledged the challenges of this transition, describing the devaluation as “extremely important” while recognizing the potential economic discomfort.
To mitigate the impact on government employees, who are particularly vulnerable to inflationary pressures, the government has promised salary adjustments. However, there are no specific details on how this will be achieved without worsening the budget deficit.
While the new foreign exchange policy aims to position Ethiopia as an attractive destination for foreign investment, the ongoing conflicts in regions like Oromia and Amhara pose significant challenges. Investors are seeking stronger security guarantees from the government to ensure a stable investment environment.
Conclusion
Ethiopia’s move to a market-based foreign exchange system is a bold step towards economic reform. While it promises to enhance transparency and attract foreign investment, the potential for inflation and economic instability remains a concern. The success of this policy will depend on the government’s ability to manage the transition and address the underlying issues affecting the country’s economic and political stability.