Key takeaways:
Ethiopia is entering the second phase of its economic reform program, supported by a $3.4 billion IMF credit facility, with the birr being floated as a major policy shift.
The birr’s immediate 80% depreciation risks further inflation and economic instability, with potential central bank interest rate hikes impacting investment.
Ethiopia will likely emphasize infrastructure development, particularly through Chinese investments, to combat high youth unemployment, though internal demand remains weak.
Regional instability, especially near Sudan, Kenya, and Somalia, threatens foreign investment and economic stability, despite Ethiopia's strategic foreign relations
Ethiopian economic reform
At the end of July 2024, the Ethiopian presidency released a policy statement on implementing the next major phase of its macroeconomic reform program. This comes on the heels of the government completing the first phase of its Homegrown Economic Reform Program (HGERF-1), which was heavily slanted toward financial sector reform and infrastructure development. The next phase of the reform comes amid high expectations for long-term growth in Ethiopia given that the economy has maintained a growth rate above 5% for the last two decades. As of August 2024, Ethiopia will embark on HGERF-2 with substantial support from various international institutions, notably the African Development Bank, the World Bank, and the International Monetary Fund (IMF). Most significant is the IMF approval of an Extended Credit Facility Arrangement of $3.4 billion for Ethiopia, which has allowed for the immediate disbursement of roughly $1 billion. A key requirement for this financing was that the Ethiopian government float its currency, a historic decision that the National Bank of Ethiopia instituted with immediate effect.
Immediate domestic risks
The announcement of the Ethiopian birr being floated led to an immediate depreciation as markets adjusted to supply and demand dynamics and the potential accumulated imbalances and distortion that a fixed rate may have masked. By the end of the first week of August, the currency had depreciated just over 80%. KSG anticipates that the currency will depreciate further as exporters will likely increase their demand for foreign currency to hedge against further depreciation.
Given that Ethiopia is highly reliant on the import of goods, the depreciation of the birr is highly likely to exacerbate inflation, which currently sits at just over 30%, despite the IMF having approved temporary subsidies for fuel and fertiliser as part of its financial package. Although the depreciation of the birr may make Ethiopian exports more attractive, much will depend on how the Ethiopian central bank manages interest rates in this environment. KSG expects that the central bank will likely resort to increasing interest rates, and this may ease inflation and reduce the pressure on foreign exchange reserves. The resulting increase in borrowing costs and decrease in business investment will have to be offset by prudent fiscal policy.
KSG expects that in this environment, the Ethiopian government will prioritise infrastructural development projects, which may also help as an immediate measure to offset high youth unemployment. However, much of this development will likely be driven by Ethiopia’s strong link to China’s Belt and Road initiative, which has already produced the Light Railway in Addis Ababa and the Ethiopia-Djibouti Railway, and has given landlocked Ethiopia much-needed access to port infrastructure. While infrastructure development is important, Chinese investment is unlikely to focus on developing internal demand for goods and services, which is ultimately necessary for the Ethiopian economy to become less dependent on the export of extracted resources.
International alignments and regional threats
Ethiopian foreign policy has remained largely unaligned and has not made major shifts in its approach to global powers. While it joined the BRICS group in January 2024 and continues to pursue developmental projects with China, Ethiopia retains a strong security relationship with the United States. The floating of the birr is likely to make the country an increasing centre for international economic competition, especially in its nascent financial sector.
However, regional stability remains a major deterrence for foreign investment. Most Ethiopian exports are currently directed toward the United States, Europe, the United Arab Emirates, and Saudi Arabia. Although a portion of its exports are directed toward Somalia, it may initially appear that regional instability does not directly affect Ethiopian trade dependencies. However, it is worth noting that Ethiopian gold mining is located on its northern, western and southern borders. Ethiopia’s coffee production is largely located in the centre and the east of the country. The implication is that Ethiopian extraction is vulnerable to rising instability in Sudan, in part due to internally displaced people in the southeast of Sudan crossing the border. On its southern border with Kenya, Ethiopia faces general insecurity from Al-Shabaab militants that look to recruit unemployed youths. The borders with Kenya and Somalia are also the regions where Ethiopia has the highest levels of youth unemployment and those most vulnerable to recruitment. Over and above these vulnerabilities, relations between Ethiopia and Eritrea are strained after a peace deal was struck with the Tigray People’s Liberation Front in November 2022. Tensions have also flared with Somalia after Ethiopia signed a Memorandum of Agreement with contested Somaliland for access to the Berbera port for commercial and military purposes.
Looking forward:
KSG expects that the depreciation of the birr will continue and that inflation in Ethiopia will not immediately subside. This will likely come with increased political risk as unemployment - especially youth unemployment - may be set to rise.
The immediate beneficiaries of Ethiopia’s economy opening up will likely be exporters, who can take advantage of the weakened birr. KSG anticipates that this will lead to an increase in the price of Ethiopian export products such as coffee beans, which make up almost 45% of its exports.
KSG expects that government funding will now largely focus on infrastructural development given its close integration with China’s Belt and Road Initiative. This will leave space for much-needed investment in Ethiopia’s nascent financial sector, especially institutions that can facilitate foreign exchange.
KSG does not expect that Ethiopian growth will soon translate into stronger regional growth as the Ethiopian economy is not well integrated regionally. Only Kenya, on Ethiopia’s southern border, is considered stable, yet the border area itself is insecure due to Al-Shabaab activity.
KSG assesses that although the Ethiopian economy shows promise after floating its currency, it now enters a period of vulnerability and uncertainty. Until the Ethiopian government has proven its fiscal and monetary prudence, and has brought inflation and unemployment to acceptable levels, the Ethiopian economy remains a relatively high-risk environment for investment.
By David Jacobs, Africa Analyst