Devaluation is less likely to be inflationary as imported consumer goods are being priced in a way that incorporates the higher cost importers incur in the parallel market (Rodrik, 2008b). As the economy is currently facing foreign currency rationing, the effective price of imports is that which includes the parallel market premium. Given the parallel market rate is significantly higher than the official one, the higher cost borne by importers who purchase foreign currency at the parallel rate will be reflected in the prices they charge. This will likely trigger those who already have access to foreign currency via official channels to follow suit and sell their products at similar prices. Thus, exchange rate devaluation may simply be tantamount to recognizing and validating the _status quo_ , without putting further upward pressure on inflation. Insofar as the economy maintains a rationed foreign exchange regime, it pays higher prices without enjoying the countervailing benefits of devaluation. Provided that devaluation increases the supply of foreign currency into the market, it is less likely to lead to significant price hikes.

# **6.2    Will a devaluation increase the cost of public investment?**

The imported capital inputs of government infrastructure investments would become more expensive as a result of devaluation. Policy makers are concerned that a weaker birr will be costly to the government as it increases the prices of capital goods needed for infrastructure and manufacturing. Hence, the case for devaluation should be assessed taking into account the increase in the local currency value of capital imports, which may slowdown the country’s import-dependent industrialization drive. Capital and consumer goods dominate imports, comprising roughly 42 and 27 percent of total goods imports respectively in 2014/15. Imported capital inputs for public investment purposes experienced a drastic increase in recent years and account for the lion’s share of the country’s total capital goods imports. A simple illustrative exercise indicates that a 10 percent nominal devaluation of the birr would increase the cost of government capital goods import by 6.12 billion birr, i.e. about 0.58 percent of GDP.

# **<mark>6.3    Will a devaluation increase the debt burden?</mark>**

<mark>A birr devaluation would also have balance sheet effects by raising the cost of debt servicing and public debt stock as denominated in local currency. Foreign currency-denominated public debt constituted about half of the gross public debt in 2014. External public debt stock as a percentage of GDP has been rising in recent years, which is mainly on account of the l</mark> arge debt financed imports of capital goods for public investmen <mark>t. But although public debt has been recently expanding at an unprecedented pace, it remains at a fairly acceptable level as a share of GDP. The 2013 Joint Bank-Fund Debt Sustainability Analysis indicated that Ethiopia’s risk of external debt stress was ‘low’. However, it increased to ‘moderate’ in 2014/15 due to unexpectedly high non-concessional borrowing and weak export performance, which seems to raise concerns over debt sustainability in the years ahead (IMF, 2015). If the NBE is to devalue the birr, the impact on external debt-service commitments and the overall debt stock should be assessed carefully in view of the country’s rapid debt-financed public investment expansion. A 10 percent devaluation would lead to an increase in the local currency value of annual debt service payments by roughly 1.3 billion birr (i.e. 0.13 percent of GDP) and public sector external debt stock by roughly 26 billion birr (i.e. 2.5 percent of GDP).</mark>

# **<mark>6.4    Would a devaluation engender investor uncertainty?</mark>**

There are claims that exchange rate devaluation will create an uncertain business climate, which might stifle investment and growth. However, given the significant misalignment of the Ethiopian birr, devaluation should be seen as offsetting previous exchange rate distortions. As touched upon previously, currency overvaluation is mostly associated with macroeconomic instability, rent seeking and corruption, and stop-and-go macroeconomic cycles, all of which are inimical to economic growth (Easterly, 2005; Rodrik, 2008a; Bhalla, 2008a). In addition, rather than inducing investor uncertainty, possible future devaluation could reflect the government’s unwavering commitment to fostering structural transformation (Subramanian, 2010). It is, however, important to bear in mind that uncertainty 17