has the 3<sup>rd</sup> highest public investment rate in the world, but the 6<sup>th</sup> lowest private investment rate. As illustrated in Figure 7.5, public investment has been rising since the end of the 1990s, while private investment has been declining (as a share of GDP). As a result, the estimated marginal returns to public investment have been falling, while marginal returns to private investment have been rising (Figure 7.6). In fact, the expected marginal return to private investment in Ethiopia is estimated to be three times higher than for public investment (22.5 vs. 7.5 percent), according to Eden and Kraay (2014ab). They find that the public capital stock is 12-20 percent ‘too high’ relative to the private capital stock compared to the economically efficient distribution of these two types of capital. The opportunity cost of using credit and foreign exchange to finance public projects has thus risen unmistakably in recent years.

The level of public investment is also too high relative to the level of recurrent spending. For public capital stocks to be well preserved, sufficient budget needs to be allocated to operations and maintenance (O&M). Analysis conducted in the context of the ongoing World Bank Public Expenditure Review reveals that there is currently an imbalance between the two. Accordingly, it would be prudent to target budgetary investment at no more than 8 percent of GDP compared to its current level of 10 percent of GDP. In addition, recurrent expenditure would need to increase from 9 to 10 percent of GDP to ensure sufficient O&M budget. This, in turn, would ensure a more sustainable balance between capital and recurrent spending.

The marginal cost of financing public investment is also rising. To finance public investment, Ethiopia has relied on a number of ‘creative’ strategies, including low recurrent spending, financial repression, and central bank financing. External financing is another important source and is currently the residual source of finance. Multilateral financing from institutions such as the World Bank is currently provided interest free (with front end fees of 0.75 percent). However, such concessional financing is inherently limited. In recent years, therefore, the government has been resorting to non-concessional financing at increasingly harder terms. The average interest rate on such financing increased from 2.7 percent in 2013 to 3.4 percent in 2014. Moreover, a maiden Euro Bond was issued in December 2014 at a coupon rate of 6.625 percent. Given the optimality condition that the return to public investment has to exceed the interest rate for a project to go ahead, it is clear that there has been a narrowing of this gap in Ethiopia in recent years thus raising the risk that some investment projects would not yield a positive net economic return.

A final consideration relates to the rising risk of external and public debt distress. Between 2011 and 2013, Ethiopia’s risk of debt distress was rated low in consecutive Joint Bank-Fund Debt Sustainability Analyses. Although this was also the case in 2014, the assessment noted that the risk level is ‘on the cusp to transition to moderate’. This was partly a result of substantial external non-concessional borrowing commitments totaling close to US$8 billion in 2013-14 as well as declining export performance. The latter is reflected by a rising NPV of external debt to exports indicator. The public debt to GDP ratio in 2014 was 44.7 percent compared to 32.7 percent in 2012. Ethiopia’s sovereign debt rating is high risk (B/B1/B: S&P, Moody’s, Fitch). Debt service indicators (debt service to exports and debt service to revenue) have risen substantially since 2009 and are gradually approaching levels seen in the early 2000s before Ethiopia received debt relief.

These warning signs merit continued monitoring to inform future adjustments of strategy. As the examples of China and the Republic of Korea aptly demonstrate, growth strategies need to 29