been primarily supply-side determined. For this reason, the nominal exchange rate has been largely unresponsive to changes in macroeconomic fundamentals and external shocks. The birr is closely managed against the USD, which serves as the nominal anchor of Ethiopia’s exchange rate policy. It should be noted that managed exchange rate regimes could be sustained only if adjustments are made for significant changes in the exchange rates and inflation rates of the anchor currency country.

In the context of a pegged exchange rate, a stronger US dollar and higher domestic inflation led to rapid real appreciation of the birr. Since the US dollar appreciated sharply over 2014–2016 (Figure 6) and given that the country continued to experience higher positive inflation differentials relative to its major trading partners, the birr has been on an appreciation path against all currencies that are depreciating against the USD. The dollar has appreciated by about 22 percent between July 2014 and December 2016 against the currencies of the US’s trading partners. However, despite the considerable appreciation of the USD and bouts of relatively high domestic inflation, the nominal exchange rate adjusted only gradually. The gradual nominal depreciation meant insufficient adjustment to address excess demand for foreign exchange as well as to prevent further real appreciation and loss of international competitiveness.

As a result, Ethiopia’s real effective exchange rate has appreciated substantially. Figure 7 clearly indicates that the REER has undergone large and continuous appreciation from an overvalued starting point. It is important to note that a rise in the index signifies real appreciation, meaning that the birr became more expensive relative to the currencies of Ethiopia’s trading partners after correcting for relative price-level changes. The REER surged from 130 in July 2014 to 160 in June 2015. Therefore, while the birr steadily depreciated in nominal terms, it appreciated by about 23 percent in real effective terms at the end of June 2015 and by a cumulative 72 percent since the nominal devaluation in October 2010. This put substantial pressure on the authorities for a large-scale devaluation to rein in the rapidly increasing misalignment. The strong appreciation of the real effective exchange rate is a key factor underlying the country’s weak export performance, posing a potential risk to external competitiveness and stability. The REER was overvalued by 32.5 percent as of June 2015, which declined to about 12-18 percent in 2018 (IMF, 2015, 2018).<sup>3</sup> The observed signs of exchange rate overvaluation are confirmed by a number of quantitative assessments. Similarly, Nguyen (2014) finds, using the approach for measuring currency misalignment developed in Rodrik (2008), that Ethiopia’s real exchange rate was overvalued by 31 percent in the early 2010s. Figure 13 reveals that the country has maintained large and persistent currency overvaluation for most of the past decades. Overvaluation means that the birr is too expensive and the dollar is too cheap compared to the forces of demand and supply, which makes the country’s exports look expensive and undermines its competitiveness.

Compared to its peers, Ethiopia has steadily lost international competitiveness over the past year. Figure 8 shows the graphs of the real effective exchange rates of Ethiopia and those of its structural (Uganda, Tanzania, Mozambique, and Kenya) and aspirational peers (Ghana, Zambia, Bangladesh, Cambodia, and Vietnam),<sup>4</sup> and facilitates comparison of the evolution of international competitiveness. As compared to these countries, Ethiopia has continually lost external competitiveness over the last year because of the sharp real appreciation of the birr. Ethiopia’s REER moved in tandem with those of its peers until around mid-2014 when it sharply departed from them and has since been persistently appreciating. The steep divergence of the country’s effective exchange rate from those of its SSA peers is particularly noticeable.

> 3IMF (2015, 2018).

> 4Ethiopia’s _structural_ peers are countries that share similar characteristics: population size greater than 15 million people, real GDP per capita below $600, investment-to-GDP ratio exceeding 15 percent, real GDP growth higher than 5 percent per annum, non-resource-rich economy, and non-conflict countries. Its _aspirational_ peers are countries that set a good development precedent and that the country may emulate: population greater than 15 million people, GDP per capita between $600 and $2,000, real GDP growth higher than 5 percent, investment-to-GDP ratio more than 15 percent, credit rating below BB+, and natural resources export below 10 percent. These were identified by the World Bank’s SCD for Ethiopia using ‘Find Your Friends Tool’.

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