Sustaining Growth: A Way Forward

By Ken Ohashi
World Bank’s Country Director for Ethiopia and Sudan

Setting aside the food crisis for a moment, Ethiopia’s two main economic challenges today are rampant inflation and rising trade deficits. They are interrelated. They reflect an economy that is trying to grow faster than the supply side could keep up. When domestic demand grows faster than domestic supply, an underlying inflationary tendency is created, and imports rise sharply to alleviate domestic shortages. Of course, the external shocks of high oil and other commodity prices and the failure of Belg rains earlier this year have exacerbated the problem.

Is this a credible scenario? Should the donors step up aid efforts to help fill the temporary financing gap? I believe this strategy has certain coherence. But, the recent experience has also revealed an important weakness. Private investment, while very strong in select sectors, has not responded to the increasing opportunities on the scale needed to keep the supply side of the economy growing fast enough. Various analyses indicate that investors still find the ‘business climate’ in Ethiopia not good enough for a major investment rush that could have avoided this supply problem. One should also not forget that after a 17-year Derg regime, Ethiopia’s private sector started from a very weak base in the early 1990s.

This does not mean the basic strategy is wrong. I think it can still be viable, and I hope it will prove successful. I believe, however, some mid-course corrections may be necessary. To give a more considered answer, we will have to examine carefully the possible export and import trajectories, underlying investment projections, etc. But, I have some tentative suggestions.

First, I do not think Ethiopia can count on increased aid and remittances alone to offset the rising trade deficits for the next several years. The gap is simply too large. An important part of the solution is likely to be found in increasing foreign direct investment (FDI), while moderating investment by the public sector. Both types of investments require imports, but FDI brings its own foreign financing. This switch will allow Ethiopia to maintain high levels of investment without causing foreign exchange problems. Of course, this assumes some public investment projects can be delayed without harming growth, or can even be replaced by private investment. Ethiopia may find such substitution opportunities in electricity generation, transportation, etc. If state-owned enterprises are involved in conventional manufacturing activities, they would offer obvious opportunities for FDI substitution.

Second, there is still much Ethiopia can do to encourage private sector investment broadly and increase the supply response to the growth in demand. Studies have identified several areas of action, including access to finance, access to land, etc. Measures that encourage FDI are usually also good for domestic investors (unless they are preferential measures). Since Ethiopia faces a shortage of foreign exchange, focusing on areas that can attract FDI may be timely. One idea I found interesting is the possibility of opening the domestic civil aviation sector to foreign/domestic joint ventures, and lifting the limit on the size of aircraft private companies can operate. This can bring not only foreign investment but also increase Ethiopia’s attractiveness to foreign tourists. Furthermore, it would increase the passenger traffic for Ethiopian Airlines from its international routes, a major foreign exchange earner for the country. Although I do not know all the complexities of this industry, this seems like an attractive proposition. I imagine there are many other such ideas. If foreign investors are required to enter Ethiopia through joint ventures, then it would also help promote domestic businesses.

Third, agricultural productivity remains too low. This is true despite the significant growth in output and some impressive success stories (e.g., roses). I had indicated in part one that an important foundation has been laid to accelerate productivity growth. There is now a need for a comprehensive program to make it happen on a large scale. Although there is an important role for public investments, e.g., in rural infrastructure and research and development, this needs to be complemented by a policy environment that leads to significantly higher levels of investments by entrepreneurial farmers and the agribusiness sector alike. One way to achieve this is through active promotion of public-private partnerships. For example, a strong cooperation between public agricultural research on the one side and private seed companies and farmers on the other can facilitate market access and availability of high-yielding varieties to farmers.

Fourth, it is essential to tackle inflation. High inflation tends to stifle savings and investment in productive assets, favoring holding of inflation-resistant assets (such as buildings, undeveloped land, or even teff). This does not help growth. Inflation in Ethiopia already points to some of these problems. East Asian countries that sustained rapid growth for many years all kept inflation in check and encouraged domestic savings and investment. I cannot think of any easy solution for Ethiopia’s inflation, for it seems to be now driven significantly by expectations. GoE has already done much to contain growth of money supply. Whether this, combined with good harvest this fall, will be enough to revere the inflationary expectations is yet to be seen. All I can suggest is GoE needs to remain vigilant and perhaps be prepared to take tougher actions as needed (possibly including further slowing of public investments).

These challenges are daunting. It is important, however, to remember that these policy problems arose from too much growth, not lack thereof. Many governments would gladly exchange their headaches of slow growth for GoE’s headaches. Although increased donor assistance is unlikely to be big enough to solve the problem of foreign exchange, I do believe that when combined with policy measures to increase supply responsiveness of the economy, additional aid could be very helpful in facilitating a smoother transition to a more sustainable growth path. Without such help, the acute foreign exchange shortage could force Ethiopian economy to slow down abruptly. That would be a huge setback for poverty reduction and a costly way to adjust to macro imbalances.

In part one of this piece, I had indicated that the potential growth rate of Ethiopia may have risen to around 7.5-8% in recent years. Ethiopia should not be satisfied with maintaining that trend line. With strong policy measures to increase supply responsiveness and manage inflation, I believe that rate has the potential to head toward 10%. Poverty reduction in Ethiopia needs that kind of growth. That would make Ethiopia’s growth strategy truly bold, and well worthy of strong donor support.