# 4. Pathways out of financial repression in Ethiopia

While Ethiopia can learn from (the many) international experiences with exit pathways, it would need to develop its own vision of the transition from financial repression based on its own circumstances. Transitioning from the current Ethiopian financial repression paradigm to one where market forces play a greater role in the allocation of domestic and external liquidities necessarily involves measures to gradually consolidate public finance, overhaul public financial institutions, issue marketable government securities, introduce indirect instruments of monetary control, improve the coordination of fiscal and monetary policies, and correct the overvaluation of the birr.

## 4.1. International experiences with exit pathways

As noted earlier (see section 1.4), options to exit financial repression are essentially along four dimensions: timing, sequencing, scope and pace. Timing refers to the circumstances or initial conditions best suited to undertake a process of financial liberalization. Countries could strategically decide to orderly graduate and shift away from financial repression as soon as the costs (for instance in terms of real interest rates, distortions, inflation, forex shortage, etc.) appear to outweigh the benefits. Conversely, countries could delay graduation until a major crisis causes an adjustment in a less orderly fashion. The Republic of Korea’s experience of the mid‐1960s provides an example of having the timing right, which seems particularly relevant for Ethiopia (see Box 3).

### **Box 3.  The Republic of Korea’s Liberalization Experience of the Mid‐1960s**<sup>**84**</sup>

Back in the mid‐1960s, the Republic of Korea’s economy shared many characteristics with today’s Ethiopian economy, which makes the Korean liberalization experience instructive.

Prior to 1964, Korea had both severely repressed foreign trade and a repressed financial system with ongoing price inflation. Like Ethiopia today, the ratio of goods exports to GDP was very low (less than 3 percent). Almost all foreign exchange earnings originated from official sources (i.e., U.S. military contributions or funds from USAID). These earnings also provided much of the financial saving in the economy because households’ financial saving was small. Net inflows of private foreign capital in the financial system were also negligible because foreign bankers considered the repressed Korean economy to be too risky and unprofitable.

In 1964, with the support of USAID, trade and exchange reforms, including some liberalization of imports and a unification of the currency associated with a large exchange‐rate devaluation, were implemented, followed by a major financial reform. The domestic capital market, which had been totally moribund, was suddenly brought back to life when interest rates were sharply increased and brought into positive territory in real terms. This was accompanied by a major fiscal reform: no change was made in the tax law, but a different director was put in charge of the tax collection mechanism. Tax revenue doubled in the course of the year. These reforms were appropriately timed. They laid the foundation for Korea’s success in subsequent years.

> 84 This box draws on McKinnon (1993).

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