written by: Samson Tsedeke
In a landmark policy shift, Ethiopia has announced the liberalisation of its foreign exchange market, a move that took effect on July 29, 2024. This decision allows the exchange rate of the birr to be determined by market forces for the first time in over half a century, marking a significant step towards economic modernization. This article explores the immediate, short-term, and long-term effects of this reform, along with its impact on various sectors of the economy and society.
Background
Prior to this reform, Ethiopia’s currency, the birr, was pegged or fixed by the government at a set exchange rate against major currencies like the US dollar. This fixed rate often did not reflect the true market value of the birr, leading to a significant gap between the official exchange rate and the black market rate. The new market-based foreign exchange regime aims to address these distortions and align the birr’s value with actual market conditions.
Exchange Rates Before and After Reform
| Currency | Before Reform (July 26, 2024) | After Reform (July 29, 2024) | Devaluation (%) |
| US Dollar (USD) | 57.4895 | 74.7364 | 29.98% |
| Pound Sterling (GBP) | 70.6759 | 91.8787 | 29.98% |
Immediate Effects
Currency Devaluation: The birr underwent a significant devaluation, with the cash buying rate for the US Dollar increasing from 57.4895 to 74.7364, marking a 29.98% devaluation. Similarly, the Pound Sterling’s rate increased from 70.6759 to 91.8787, also a 29.98% devaluation.
Inflationary Pressures: The immediate effect of devaluation is likely to be inflationary pressure. Imported goods and services will become more expensive, increasing the overall price level within the country. This is a critical factor that the government needs to manage to mitigate adverse effects on the population.
Exchange Rate Volatility: The shift to a market-based regime may initially cause exchange rate volatility as the market adjusts to the new system. This could lead to uncertainty in the short term.
Investor Confidence: The move signals a commitment to economic reforms and transparency, which can boost investor confidence. The immediate perception of a more open and predictable market may attract foreign direct investment.
Short-Term Effects
Increased Import Costs: Businesses relying on imported raw materials and finished goods will face higher costs, potentially squeezing profit margins. This could lead to cost-push inflation as businesses pass on higher costs to consumers.
Foreign Exchange Accessibility: The liberalisation of the foreign exchange market will improve access to foreign currency, reducing the reliance on the black market. This can streamline operations for businesses that depend on foreign exchange.
Supportive Financial Measures: The financial package from international partners will provide immediate support to stabilize the economy during the transition. This funding can help cushion the impacts of inflation and support critical sectors.
Policy Adjustments: The government may need to implement supportive monetary and fiscal policies to manage inflation and stabilize the economy. This includes tightening monetary policy and providing targeted subsidies or assistance to vulnerable populations.
Long-Term Effects
Economic Stability and Growth: Over the long term, a market-based exchange rate can lead to a more balanced and resilient economy. It aligns the currency with market conditions, reducing distortions and promoting sustainable growth.
Increased Exports: The devaluation makes Ethiopian exports cheaper and more competitive in the global market. This could boost the export sector, leading to increased foreign exchange earnings and improved trade balances.
Foreign Investment: The reforms are likely to attract sustained foreign direct investment due to increased transparency and predictability. Investors are more likely to commit capital to a market where currency values reflect true economic conditions.
Inflation Control: While inflation may rise initially, supportive policies and improved foreign exchange availability can help bring it under control over time. The government’s ability to manage inflation will be crucial for long-term economic stability.
Structural Reforms: The reform will likely be accompanied by other structural reforms aimed at improving the business environment, enhancing productivity, and fostering innovation. These changes can drive long-term economic transformation.
Affected Sectors
Import-Dependent Sectors: Sectors heavily reliant on imported goods and raw materials, such as manufacturing and retail, will face higher costs. These sectors will need to adjust to increased input prices.
Export-Oriented Sectors: Sectors such as agriculture, mining, and textiles that focus on exports will benefit from the devaluation. Their products will become more competitive globally, potentially boosting sales and revenues.
Financial Sector: Banks and financial institutions will need to adapt to the new market dynamics. The removal of surrender requirements and other regulatory changes will impact their operations and strategies.
Tourism and Services: The tourism sector may benefit from the devaluation as Ethiopia becomes a more affordable destination for foreign tourists. Similarly, service sectors catering to international clients may see increased demand.
Affected Parts of Society
Consumers: Consumers will face higher prices for imported goods and essentials, leading to an increase in the cost of living. Low-income households will be particularly vulnerable to these changes.
Businesses: Small and medium-sized enterprises (SMEs) that rely on imports will experience cost pressures. However, businesses in export-oriented sectors may see growth opportunities.
Farmers and Exporters: Farmers and exporters will benefit from the competitive pricing of their products in international markets. This can lead to higher incomes and expanded market opportunities.
Employees in Export Sectors: Workers in industries such as agriculture, textiles, and mining may see increased job security and potential wage growth due to higher demand for exports.
Urban and Rural Populations: Urban populations, particularly those in low-income brackets, will be most affected by rising costs. Rural populations involved in export agriculture may benefit from improved market access and higher prices for their products.
Strategic Implications
Economic Stability: While the initial period following devaluation might be turbulent, with proper management, the long-term effect could be economic stabilization. The market-based exchange rate should lead to a more balanced and resilient economy.
Policy Measures: To counteract the inflationary pressures, the government might need to implement supportive monetary and fiscal policies. These could include tightening monetary policy to control inflation, offering targeted subsidies or assistance to vulnerable populations, and ensuring efficient tax collection to bolster public finances.
Enhanced Competitiveness: The devaluation makes Ethiopian exports cheaper and more competitive in the global market. This could boost the country’s export sector, leading to increased foreign exchange earnings and improved trade balances.
Financial Support for FX Reform
To help mitigate the transitional costs and impacts of the FX reform, Ethiopia’s external partners have offered a financial package of $10.7 billion to support the reform—the largest ever coordinated commitment of support by international partners towards Ethiopia. This includes exceptional financing from the IMF, the World Bank, and creditors. Additionally, there is $2.8 billion in bilateral support in the form of central bank deposits and swap lines, as well as further financing from the World Bank, IFC, and other multilateral institutions, which will be announced in due course. Given the strength of the government’s reform package, the IMF and World Bank are both providing exceptional and front-loaded funding support, among their highest allocations in the African continent.
Key Elements of Ethiopia’s Foreign Exchange Reforms
The foreign exchange reforms involve significant new policy changes in the following areas:
- Shift to a Market-Based Exchange Regime: Banks are now allowed to buy and sell foreign currencies from/to their clients and among themselves at freely negotiated rates, with the NBE making only limited interventions to support the market in its early days and if justified by disorderly market conditions.
- End of Surrender Requirements to the NBE: Foreign exchange can now be retained by exporters and commercial banks, thereby substantially boosting FX supplies to the private sector.
- Removal of Import Restrictions: The previous prohibitions on 38 product categories are lifted, broadening the liberalization of the foreign exchange market for the imports of goods and services, while capital account outflows remain restricted as before.
- Improvement of Retention Rules: Exporters are now allowed to retain 50% of their foreign exchange proceeds, up from 40% previously.
- Removal of Rules Governing Banks’ Allocation of Foreign Exchange: Elimination of the waiting list system for different categories of imports.
- Introduction of Non-Bank Foreign Exchange Bureaus: These entities are now free to engage in the buying and selling of foreign currency cash notes at market rates.
- Removal of Restrictions on Franco Valuta Imports: To be implemented shortly through an upcoming regulation.
- Simplification of Rules Governing Foreign Currency Accounts: Especially those currently held by foreign institutions, FDI companies, and the Diaspora.
- Allowance for Residents to Open Foreign Currency Accounts: Based on remittance inflows, transfers from abroad, FX-based salary or rental income, and other specified cases, as well as the ability to use such foreign currency accounts for foreign service payments.
- Removal of Interest Rate Ceilings: That previously applied to private sector companies or banks when borrowing from abroad.
- Opening of Ethiopia’s Securities Market to Foreign Investors: Terms and conditions to be specified further in the near future.
- Granting of Special Foreign Exchange Privileges: To companies within Special Economic Zones, including the ability to retain 100% of their foreign exchange earnings.
- Relaxation of Rules on Foreign Currency Cash Notes: Travelers may carry when traveling into or out of Ethiopia.
Conclusion
The shift to a market-based foreign exchange regime marks a pivotal moment in Ethiopia’s economic policy. The substantial devaluation of the birr underscores the extent to which the currency was previously overvalued. While there are short-term challenges, particularly related to inflation, the move promises long-term benefits such as increased investor confidence, improved foreign exchange availability, and a more transparent economic environment. Effective management and supportive policies will be crucial to navigating the transition smoothly and maximizing the reform’s potential benefits.
The FX reforms introduced today represent a crucial step towards establishing a resilient and transparent foreign exchange market that aligns with Ethiopia’s long-term economic aspirations and enhances its global economic integration. The National Bank of Ethiopia remains committed to ensuring a smooth transition and will continue to provide guidance and support throughout the implementation process.