1 Ethiopia: Impacts of the Birr Devaluation on Inflation¹ November 8, 2017 On October 10, 2017, the National Bank continued unabated. The REER overvaluation of of Ethiopia (NBE) devalued the Birr by the Birr was estimated at 30 percent in FY15 and 15 percent as pressures on the foreign 20 percent in FY17.4 The premium in the parallel exchange intensified.² According to the foreign exchange market reached 20 percent on Government, the devaluation was undertaken the eve of the October devaluation. to encourage exports and overcome the foreign exchange shortage.³ Exports, which with The appreciation of the REER has been remittances constitute Ethiopia’s main source of a drag on competitiveness and on the foreign exchange, have seriously underperformed restoration of external balances for several in recent years (as compared to the Government’s years. Recent empirical analyses conducted by objective in its Development Plan). Foreign reserve the World Bank, the IMF and others all conclude decreased from around USD4 billion or 2.5 that the Ethiopian economy has been suffering months of imports at end-2015 to USD3.2 billion from an overvalued exchange rate. These or 2 months of imports in June 2017. analyses also generally underlined that a more competitive real exchange rate would provide a The forex pressure stemmed from an more conducive environment to manufacturing- overvalued real effective exchange rate. led structural transformation, sustained growth After a brief decline following the 17 percent acceleration, and improved external balance.5 devaluation of the Birr in 2010, the real effective Specifically, it was estimated that a 10 percent exchange rate (REER) started appreciating again depreciation of the REER would reduce the current in 2011. Since 2014, and notwithstanding the account deficit by about 2 percentage points of depreciations of the official exchange rate against GDP (through a 5 percent increase in exports and the US dollar by 6 percent in 2015/16 and 5.8 a 6 percent decrease in imports) and increase real percent in 2016/17, the pace of appreciation GDP growth by more than 2 percentage points in ¹ This note was prepared by Zerihun Getachew Kelbore (Research Analyst MFM) and Nora Dihel (Senior Economist, MFM) with inputs from Tom Bundervoet (Senior Economist, POV) and reviewed by Jean-Pierre Chauffour (Lead Economist, MFM) and Mathew Verghis (Practice Manager, MFM). ² Ethiopia’s exchange rate arrangement is classified as a crawl-like arrangement by the IMF. The authorities describe it as a managed float with no predetermined path for the exchange rate. In practice, the Birr is pegged to the US dollar. 3 National Bank of Ethiopia, 2017. Newsletter (Amharic Version), Vol. 5, No. 25, October 2017, Addis Ababa, Ethiopia; and https://addisfortune.net/articles/ethiopia-devalues-currency-raises-interest-rates/ 4 International Monetary Fund 2015, “Ethiopia: 2015 Article IV Consultation”, Washington D.C.; International Monetary Fund 2017, `Ethiopia: 2017 Article IV Consultation’, Washington D.C. (Draft) 5 See for instance World Bank 2016, Ethiopia`s Great Run: The Growth Acceleration and How to Pace It. 2 a year. However, in the short term, the devaluation with the world economy by pursuing export-led will have the immediate adverse effect of raising development strategies. Such strategies were the external debt and debt service payments in typically underpinned, at least in the initial phase local currency. of economic catching-up, by competitive REERs. The exchange rate instrument was strategically Successful exporters have usually avoided used to maintain external balances and fuel overvaluation of their currency. Developing economic growth and job creation, including countries that managed to transition from low- through episodes of successful exchange rate income to middle-income, such as several devaluations (see Box 1). countries in East Asia, have generally engaged Box 1: Examples of relatively successful use of the exchange rate instrument • South Korea undertook successive Brazilian experience suggests that the devaluations in the 1970s, as part of its resurgence in growth was a result of the export-led strategy to boost growth and devaluation combined with structural shared prosperity. The devaluations were and institutional reforms including fiscal generally supported by restrictive monetary adjustment, structural reforms of the and fiscal policies to keep inflation in check. financial sector and the adoption of Furthermore, the success of devaluation credible inflation-targeting.8 in boosting exports was tied to the strong external demand and continued high • Egypt depreciated the Egyptian pound by investment in the export sector.6 about 200 percent between November 2016 and May 2017 and adopted a • Brazil devalued the Real by 64 percent in floating exchange regime. The devaluation 1999 without causing a major surge in coupled with the introduction of a VAT, and inflation, thanks to a massive tightening partial removal of energy and petroleum of monetary and fiscal policies.7 Economic subsidies fueled inflation. Inflation peaked growth, underpinned by the agriculture at 30 percent, but the devaluation achieved and services sectors, turned positive the desired depreciation of the REER. The in 1999 and further expanded by 4.4 central bank increased interest rates by percent in 2000. FDI increased by 37 400 basis points and tighten liquidity in percent between 1998 and 2000. Industry the banking sector. The gap between the then became the lead growth sector in parallel and the official exchange rate 2000, reflecting a lagged response to eventually closed and official foreign the changing policy environment. The exchange reserves began to grow again. 6 World Bank 2016 Devaluing the Exchange Rate in Ethiopia: Why, When and How. June 2016, Addis Ababa 7 Annual inflation increased from 1.7 percent in 1998 to 8.9 percent in 1999 followed by a decline to 6 percent in 2000. 8 Aman, E. and W. Baer (2002), Anchors Away: The Costs and Benefits of Brazil`s Devaluation, Working Paper No. 02- 01222, University of Illinois, Urbana Champaign. http://www.business.uiuc.edu/Working_Papers/papers/02-0122.pdf 3 The long term positive effects of Ethiopia’s of food inflation, that lasted until March 2013 (see devaluation will depend on how much Figure 1). The inflation rate picked up to 41 percent the nominal devaluation translates into in August 2011. However, within this period, not a real depreciation of the Birr. The larger only Ethiopia did not tighten monetary conditions, the exchange rate pass through to the CPI the but it had to deal with the 2011 international lower will be the beneficial real effects of the commodity price hikes (e.g., coffee) and suffered devaluation. The pass-through in turn depends from a severe drought that affected 4.5 million on the elasticity of demand for imports and people. These developments contributed - beyond import substituting domestic goods.9 That is, if the effects of the devaluation - to inflation and the elasticity of demand is low, the pass-through thus to a welfare loss for many poor Ethiopians. would be higher. The IMF recently estimated an exchange rate pass-through of around 30 percent Since October 10, 2017, inflation seems to for the general CPI and 10 percent for the food have remained under control, although CPI.10 With a 15 percent devaluation, it is thus some prices have picked up. Annual inflation expected that, ceteris paribus, the general CPI as measured by the Consumer Price index (CPI) would increase by an additional 4.3 percentage increased by 12.2 percent in October 2017 as points and the food CPI by an additional 1.6 compared to October 2016.12 The monthly CPI percent over a 12 months’ period. To limit the increased by 0.2 percent between September 2017 pass-through on inflation, the authorities could and October 2017.13 An informal assessment adjust their macroeconomic policies by tightening of the evolution of market prices14 over the last fiscal and/or monetary policies (see below). The couple of weeks shows that, as expected, the price World Bank estimates also show that larger prices of imported goods not subject to price controls changes will be observed in the non-food items have swiftly adjusted and increased by 15 percent than food items.11 (compared to their September level).15 By contrast, prices of locally produced goods and imported The precedent of the 2010 Birr devaluation goods subject to price controls (e.g., petroleum should help guide policymakers. Because products and wheat) have remained fairly stable. of exceptional circumstances and the lack of appropriate accompanying macroeconomic Grain prices, which are quite socially policies, the devaluation of the Birr in September sensitive, have broadly been stable so 2010 led to an episode of high inflation, especially far and may have actually benefited from 9 The change in the exchange rate is transmitted to domestic prices both directly through higher import prices and indirectly through the higher demand for domestic goods (import-substitution). 10 IMF 2017 Article IV Consultation Presentation in Addis Ababa, September 2017. 11 World Bank 2016 Devaluing the Exchange Rate in Ethiopia: Why, When and How. June 2016, Addis Ababa 12 Annual food inflation has increased by 16.1 percent in October 2017. Cereal prices such as teff, maize and wheat showed a slight decline as compared to last month. Price declines were also observed for meat, milk, cheese and eggs, butter and onions. By contrast, prices for fruits, sugar, selected vegetables, and coffee increased in October 2017. Annual non-food inflation increased by 7.8 percent mainly due to increases in the prices of chat, clothing and footwear, housing and energy (especially charcoal), household goods and furnishings, health care, and food and drinks (Central Statistical Agency of Ethiopia, October 6, 2017). 13 Monthly food and non-food inflation increased by 0.2 percent and 0.3 percent, respectively (Central Statistical Agency of Ethiopia, October 6, 2017). 14 Randomly visited the local markets, supermarkets and assessed the price developments. 15 Note that theses price increases for non-food items are higher than those reported by the Central Statistical Agency of Ethiopia in October 2017. 4 a favorable seasonal effect (see Figure 3). decrease consumption of the poor by 1.4 percent.18 Indeed, the average seasonal pattern of grain Given their higher dependence on imported prices shows that there is a 7 percent difference items, urban households are expected to be more between the peak and slack season prices in the affected than rural ones. In most scenarios, the course of the year (see Figure 4). Interestingly poverty rate is expected to slightly increase (by while wholesale prices decreased, retail prices about one percentage point) immediately after registered increases for certain cereals such as the devaluation. Poverty would decrease again teff.16 On average, grain prices start decreasing when the devaluation triggers a supply response in October until February. The timing of the and exports increase. devaluation may therefore have been opportune to attenuate the inflationary pressures on grains Supportive monetary and fiscal policy in the and related basic commodities. In the same coming months can maximize the positive vein, although the Ethiopian economy is not effects of the devaluation and minimize well integrated into global markets, the benign negative effects on the poor. To be successful, international commodity prices outlook should the devaluation needs to be accompanied by tight help ease some of the inflationary pressure.17 monetary and fiscal policy. This has been the case so far. The NBE appropriately tightened its Instances of inflation bouts (in certain monetary policy in the immediate aftermath of the regions and/or certain products) may also devaluation by raising the floor on time and savings reflect adverse local market conditions that deposits from 5 to 7 percent and by reducing are unrelated to the devaluation. Temporary the 2017/18 target growth of base money.19 shortage of goods and services in local markets Given the lagged effect of monetary policy, the may drive up prices independent of the country’s NBE would need to be particularly vigilant as the exchange rate policy. Such shortages could reflect relaxation of monetary policy in the first part of the lack of access to market, the monopolistic the year – that is before the October devaluation nature or lack of contestability of certain markets, – may have created inflationary pressures that or disruption in the supply chains. For example, would need to be reduced in the coming months. prior to the devaluation, the shortage of sugar in Fiscal policy could usefully help the NBE with the the country has increased sugar prices by around burden sharing. The more the fiscal deficit could 175 percent (from 18.15 Birr/kg in April to 50 be contained and the domestic financing of the Birr/kg in October 2017). deficit limited, the more liquidity will be available for the private sector to grow the economy and The adverse effect of the devaluation on create jobs without jeopardizing the inflation the poor should be limited in scope and target. Additional structural and institutional time. These adverse effects come mainly from reforms would also need to complement these rising prices of imports. According to World monetary and fiscal policy measures. Bank estimates, a 10 percent devaluation would 16 Wholesale price reductions of about 10 percent did not translate into lower retail prices; in fact, retailers increased the teff price by between 10 to 15 percent depending on the location of the market. 17 In 2018, crude oil prices are forecasted to increase only moderately to reach USD56 per barrel (compared to USD53 per barrel in 2017) and agricultural prices are projected to stabilize (World Bank Commodity Markets Outlook, October 2017). 18 World Bank 2016 Devaluing the Exchange Rate in Ethiopia: Why, When and How. June 2016, Addis Ababa 19 The NBE`s operational target for monetary policy (growth of base money) was reduced from 22 percent to 16 percent to contain the pass-through from the exchange rate into domestic prices. 5 Figure 1: Year-on-Year Inflation (CPI), Figure 2: Inflation (CPI) and RER (growth), 2008-2016 2008-2016 Inflation and rate of change in REER 90 60 80 50 70 40 60 30 50 20 Percent 40 10 30 0 20 -10 10 -20 0 -30 -10 2008m1 2009m1 2010m1 2011m1 2012m1 2013m1 2014m1 2015m1 2016m1 2008m1 2009m1 2010m1 2011m1 2012m1 2013m1 2014m1 2015m1 2016m1 Month Month Inflation Food Non-food Inflation REEX_g Source: World Bank Staff calculation based on data from CSA Source: World Bank Staff calculation based on data from CSA and IMF Figure 3: Grain prices in Addis Ababa, Figure 4: Average seasonal impact on food June-October, 2017 prices, 1997-2016 2,500 105 2,000 1,500 100 1,000 500 0 95 Jun Jul Aug Sep Oct Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Teff White Teff Red Teff Mixed Maize Wheat Source: Ethiopian Grain Trade Enterprise (EGTE) Source: World Bank Staff calculation based on data from CSA and IMF