# **1. Introduction**

Although Ethiopia has achieved rapid economic growth since 2004, addressing the major challenges facing the economy is critical to maintaining the growth momentum. Exports witnessed relatively weak performance since the early 2010s. Exports plunged from 16.7 percent of GDP in 2011 to 8.9 percent in 2018. This, combined with the surge in imports, resulted in considerable deterioration in the trade and current account balances. The lackluster export performance is generally reflected in, among others, the acute shortage of foreign exchange, currency rationing, and flourishing parallel market. Real currency appreciation accounts for a significant part of the widening external imbalance, particularly before the devaluation in October 2017. The birr appreciated rapidly over the past few years and it remains overvalued by 12-18 percent in real effective terms depending on the period of analysis (IMF, 2018). The sharp appreciation of the United States dollar (USD) during 2015–2016 has caused additional real overvaluation of the birr, which has been reinforced by the gradual nominal depreciation of the birr.

Slow pace of structural transformation<sup>2</sup> poses another challenge to the Ethiopian economy. The country’s first Growth and Transformation Plan (GTP I) (2010-2015) was mainly targeted towards jumpstarting structural change by promoting light manufacturing. Manufacturing-led industrialization also features prominently in the GTP II, which covers 2015-2020. Structural change has, however, progressed slower than planned and the results of the industrialization strategy are yet to come to fruition. Manufacturing’s share in GDP has stagnated at a low level of 4-6 percent for almost three decades. However, there are good reasons to think that the country is at a critical juncture marking the reversal of past trends and ushering in a new era where manufacturing makes increasingly significant contribution to the economy. The government has formulated well-articulated goals geared towards making the country a manufacturing hub by 2025 and has put in place the appropriate legal, regulatory, and institutional frameworks. In addition, substantial investments are being channeled into developing industrial parks and relevant infrastructure. The sharp increase in FDI flow to the country is another reason to be optimistic about the future of Ethiopia’s nascent manufacturing sector.

The real exchange rate, when managed carefully, can be a useful policy instrument to support the goals of structural change and export promotion. Several studies provide compelling evidence that a competitive or an undervalued real exchange rate (henceforth RER) plays a pivotal role in unleashing structural transformation, which in turn enhances overall productivity and fosters growth (Rodrik, 2008a; Johnson _et al_ ., 2010; Bhalla, 2008a). Analysis based on Ethiopian data finds that a competitive RER will yield beneficial effects by boosting exports, improving external balance, and strengthening economic growth. Specifically, a 10 percent depreciation of the real effective exchange rate increases exports by 5 percent and reduces imports by 6 percent, thereby improving the trade balance by roughly 11 percent. Similarly, a 10 percent lower RER increases real GDP growth by about 0.23 percentage points. In addition, a depreciation has a stronger impact on manufacturing exports: a 10 percent real devaluation increases manufacturing goods export by about 10 percent.

Against this backdrop, the present paper attempts to address the following main questions: What are the major macroeconomic challenges facing Ethiopia? Is devaluation of the birr a step in the right direction to boost exports and improve the country’s external balance? Why and how is the real exchange rate an important policy tool to bring about structural transformation and reinvigorate economic growth? What are the key macroeconomic trade-offs related to exchange rate devaluation? What complementary measures could policy makers introduce to come to grips with any negative

> 2Structural transformation is conventionally defined as the reallocation of labor from low-productivity sectors to more dynamic (higherproductivity) economic activities. In the context of most developing countries, this would generally mean moving labor from subsistence agriculture to modern commercial farming, manufacturing, and relatively advanced services. However, the term is also used to describe changes in the sectoral composition of output. Nevertheless, given that production shifts tend to accompany labor shifts, the process of structural change is purportedly set in motion only once labor reallocation toward high-productivity sectors is ignited (Martins, 2014).

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