# 4.7. Correcting the overvaluation of the birr

Engineering a gradual real depreciation of the birr to eliminate the overvaluation. To restore Ethiopia’s external equilibrium, the authorities need to reverse the policy for real appreciation of the birr that has taken place in recent years. Although the birr has depreciated against the U.S. dollar by 6 percent per year on average in the last 5 years in nominal terms, the depreciation has been insufficient to compensate for the inflation differential between Ethiopia and its trading partners. In addition, Ethiopia has been subject to several terms of trade, productivity and other domestic and external shocks that have had an impact on its equilibrium exchange rate—that is, on the real exchange rate that would preserve its external balance.<sup>106</sup> While productivity gains may have played in favor of a more appreciated exchange rate equilibrium,<sup>107</sup> negative terms of trade shocks, such as the sharp decrease in international coffee prices, have played in the other direction. Overall, as noted above, the current overvaluation of the birr is estimated in the 15‐20 percent range. Going forward, the authorities need to gradually restore their stock of foreign exchange and stop selling foreign exchange beyond a floor set in the NBE’s annual financial program (see below). The exchange rate should then gradually be brought into line with its market clearing level so as to eliminate the administrative allocation of foreign exchange and the parallel exchange market.

Maintaining capital controls to further support the competitiveness of the economy through undervaluation. As noted earlier, the liberalization of the capital account and full convertibility of the national currency constitute the last stage of financial liberalization. These are generally second‐ generation reforms that are currently premature in Ethiopia. Instead, like many successful developing countries that have adopted export‐led strategies in recent decades, especially in Southeast Asia, the (temporary) maintenance of capital controls makes it possible for monetary variables to impact real variables—notably the real exchange rate—and provides a competitive edge in external markets. Because capital controls prevent the domestic private sector from offsetting the public accumulation of foreign assets by borrowing abroad, the accumulation of foreign assets induces “forced savings” in the domestic economy and thereby a real undervaluation of the national currency.<sup>108</sup> In financially repressed financial systems, capital controls are not only necessary to avoid the “overborrowing” syndrome (when the external borrowing of domestic firms builds up too rapidly) but also to limit the risk of inflation (when the domestic money counterpart of foreign inflows grows too fast).<sup>109</sup> Part of China’s extraordinary success as a global export powerhouse has been its capacity to constrain domestic consumption and to ceteris paribus maintain a real undervaluation of the renminbi for several years in the mid‐2000s (see Box 9). In maintaining capital controls and prioritizing the build‐up of official reserves in its annual financial

> 106 For instance, during 2017/18, global prices of most Ethiopia’s major export items dropped, namely those of coffee (10.1 percent), pulses (13.7 percent), and spices (32.4 percent). Meanwhile, fuel import prices increased by 28 percent.

> 107 Tica, J. and Druzic, I. (2006). The Harrod–Balassa–Samuelson Effect: A Survey of Empirical Evidence, EFZG Working Paper Series 0607.

> 108 Jeanne, Olivier (2012). Capital Account Policies and the real Exchange rate. Working Paper #12‐14, Peterson Institute for International Economics. Washington D.C.

109 As noted in McKinnon (1993), because the governments of repressed economies may consider themselves to be short of foreign exchange on a month‐to‐month basis, they often behave myopically: they encourage, rather than discourage, inflows of private capital—even though such inflows are artificially stimulated by domestic borrowers trying to evade the domestic inflation tax (p. 104).

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