# 3.3. Overvaluation

The NBE has also became less effective in preventing an overvaluation of the birr. While the NBE is mandated to maintain “a stable rate of exchange”,<sup>70</sup> this objective has been difficult to achieve in an environment of relatively high inflation. According to the NBE, Ethiopia’s annual inflation rate averaged 12.6 percent during the past five years (2012/13 ‐ 2017/18), while the average annual inflation in trading partners was only 4 percent. The rate of nominal depreciation was however too low to prevent a real effective exchange rate (REER) appreciation of some 7 percent during the period. This does not take into account the effects of productivity, terms‐of‐trade and other shocks that have impacted the equilibrium exchange rate of the birr. According to the IMF, based on data as of September 2018, the external position was assessed to be weaker than the level consistent with medium‐term fundamentals and desirable policies, and the exchange rate was estimated to be overvalued by around 12–18 percent.<sup>71</sup> Although the authorities devalued the birr by 15 percent in October 2017, the REER only depreciated by 1.5 percent by end‐September 2018. Thus, 90 percent of the benefits of the nominal devaluation were eroded by inflation differentials.

The birr overvaluation contributed to weaken Ethiopia’s external position. Instead of integrating into the world economy, Ethiopia appears to be retracting. The average share of exports and imports to GDP decreased from 20 percent of GDP in 2014/15 to 16 percent in 2017/18. During the period, the trade deficit averaged 17.8 percent of GDP and the current account deficit (excluding official transfers) 8.4 percent of GDP. Although the current account deficit has narrowed during the period, goods exports remained stagnant. In 2017/18, strong growth in air transportation and manufacturing exports (although the latter from a very low base), and continued restraint on public sector capital imports, helped offset stagnant commodity goods exports. Because of this small export base, the 2018 Debt Sustainability Analysis (DSA) shows that Ethiopia remains at high risk of debt distress.<sup>72</sup> Public and publicly‐guaranteed external debt breaches the thresholds for the present value of debt‐to‐exports and debt service‐to‐ exports in the baseline. Debt service payments are expected to increase in the coming years, as grace periods on non‐concessional debt acquired in the past expire.

# 3.4. Foreign exchange shortage

Foreign exchange reserves have reached critically low levels. By December 2018, the NBE’s net foreign assets were US$395 million, corresponding to less than US$4 per inhabitant. According to the IMF, Ethiopia’s foreign reserves are below both rule‐of‐thumb and model‐based optimal benchmarks.<sup>73</sup> The gross reserves‐to‐broad money ratio has trended down since early 2016 and has only rebounded in December 2018 to 14.1 percent thanks to large exceptional external disbursements.<sup>74</sup> Despite the depreciation of the birr against the U.S. dollar between August 2010 and November 2017, primarily through a series of controlled corrections, including a 20 percent devaluation in September 2010 and a 15 percent devaluation in October 2017, the growth in demand for forex has remained unabated. This was mainly because of insufficient parallel fiscal and monetary tightening. As of December 2018, the official

> 70 Proclamation No. 591/2008.

> 71 IMF (2018). Ethiopia: Staff Report for the 2018 Article IV Consultation. IMF, Washington D.C.

> 72 IMF (2018). Ethiopia: Staff Report for the 2018 Article IV Consultation. IMF, Washington D.C.

> 73 IMF (2018). Ethiopia: Staff Report for the 2018 Article IV Consultation. IMF, Washington D.C.

> 74 These included US$1 billion and US$800 million disbursements from the UAE and the World Bank, respectively.

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