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What's Behind the Soaring Inflation in Ethiopia?
By Tsegamlak Solomon | Sun Sep 05 2021
Co-authored by Yoseph Getachew and Tsegamlak Solomon
Inflation in Ethiopia hit a near-decade high of 26.4% (32% in food and 19% in non-food) in July 2021. Following that problematic high and the widening difference in the foreign exchange market between the official exchange rate and the parallel market (also known as the black market), the Ethiopian government has taken several strong regulatory measures aimed at curbing illegal foreign exchange trading and reducing the local currency supply circulating in the economy. At its high, the difference between the official and parallel market rates reached almost 50%, before eventually narrowing to today’s rate difference of approximately 25%, following the policy measures taken by the government. The major measures that have been taken by the Ethiopian government chronologically include:
- August 7 - Following an increase in the difference between the official FOREX market rate and the parallel market rate, which ranged from 28% to 48%, it has been reported by the government that the Tigray People's Liberation Front (TPLF), which is currently fighting with the Federal Government, is using illicit financial networks to finance its activities and that is resulting in a sharp price rise. As a result, the government has taken police action against the alleged black market.
- August 11 - Through a text message circulated to all commercial banks, the central bank of the country ordered all commercial banks to suspend all collateral-based loans for an indefinite period. The suspension included the dispersion of already approved loans. As reported, the decision was made to curtail economic sabotage. The government believes that supporters of the TPLF are using their assets to take out loans from commercial banks and use that money to fund their illicit foreign exchange market. Drying up that source of funds has helped narrow the gap between the official and parallel exchange rates.
- August 25 - The central bank suspended all commercial banks from providing loan guarantee services effective August 25.
- August 30 - The central bank adopted a restrictive monetary policy in order to restrict the liquidity of banks and reduce the amount of money in circulation, including:
- The reserve requirement for commercial banks was doubled from the original 5% to 10% in hopes of sucking up money circulating in the economy. When there is more money circulating in the market, the demand for goods and services increases as consumers have more money to spend. Sucking some of that money out of the economy will help reduce price escalation. The new reserve requirement went into effect as of September 1st.
- The interest rate at which commercial banks can borrow directly from the central bank in order to sort their short-term liquidity problem has been increased from 13% to 16%.
- The central bank also increased the amount of foreign currency commercial banks must remit. All commercial banks are mandated to transfer 50% of their foreign exchange holdings to the central bank, up from 30%. The central bank also terminated the surrender requirement of foreign currency generated by commercial banks from foreign direct investment and diaspora foreign currency deposit accounts and also bumped the retention of forex by foreign exchange generators from 31.5% to 40%. This is intended to better benefit foreign currency generating customers, and in effect, increase the foreign currency remittance by these customers. This is expected to encourage these customers to import essential food items using their retained foreign currency earnings.
- The central bank also introduced a new mandatory rule that demands commercial banks invest at least 1% of their annual loan disbursement and that insurance companies allocate 15% of their net annual income to purchase bonds from the Development Bank of Ethiopia (DBE), which is the state policy bank. The government uses DBE to finance some of the mega government projects, MSMEs and some priority sectors.
- August 30 - NBE lifted the freeze on loans for bank credits provided against vehicles. The central bank reiterated that the freeze on all other loan disbursements will continue until further notice.
- September 3 - The Federal Government has designated edible oil, sugar, wheat and rice as tax-exempt consumer goods. In addition, the value-added tax levied on food products like eggs and pasta was also lifted. VAT applied on these goods was 15%.
- September 4 - The central bank eased a loan freeze on importers and manufacturers of edible oil. Edible oil manufacturers are allowed to take on any form of loan from banks. However, importers are only allowed to borrow when their letter of credit is approved to make the payment.
The Ethiopian central bank took these short and long-term policy changes in the hopes of controlling inflation, reducing the gap between the official and parallel rates and controlling illicit activities. Some of the policy changes such as banning all collateral-based loans will likely have a deep adverse impact on the economy as many businesses are reliant upon funding from the banking sector but the bans are thought to be short-term measures and are expected to be lifted soon.
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