Financial disintermediation held back some growth. An expansion of credit to the private sector enables firms to invest in productive capacity, thereby laying the foundation for a sustainable growth path. However, Ethiopia is falling behind its peers in this area (Figure 4.3). Regression results suggest a small negative growth effect of financial repression policies whereby rationed credit is channeled through state-owned banks primarily towards public investment (see Figure 7.2). It is noteworthy that the negative quantitative effect was substantially smaller than what is generally perceived (-0.2 ppts in 2000-13). On the other hand, the growth penalty shows an increasing trend (rising to -0.3 ppts in the Early 2010s), suggesting that financial repression policies may become more costly if maintained. Indeed, this would be consistent with the experience of China.<sup>14</sup> Structural improvements were particularly important in the late 2000s supported by a positive external environment, but held back by macro imbalances. How did growth drivers change over time? While structural factors dominate in the Early 2000s (2.5 ppts) and Late 2000s (3.0 ppts), they become less pronounced in the Early 2010s (1.2 ppts). The diminishing effect in the last period, however, is affected by the choice of the infrastructure variable, as discussed in Section 4. The growth contribution of the external environment increased over the period, shifting from a negative (-0.6 ppts) to a positive contribution (1.0 ppts) between the Early 2000s to the Late 2000s and a weak positive effect in the Early 2010s (0.2 ppts). The deteriorating macro environment was a drag on growth only during the late 2000s (-0.6 ppts), but not in the other two periods. The substantial persistence effect observed in the late 2000s and early 2010s (about 3 ppts) echoes the growth drivers during the early and late 2000s, respectively. We interpret this as the lagged effect of the structural improvements implemented in earlier periods.<sup>15</sup> An improved external environment supported the growth acceleration. As argued in World Bank (2014a), a strong rise in exports helped support the economic boom. Since 2003 exports quadrupled in nominal terms, while volumes doubled, reflecting a substantial positive price effect (Figure 4.4). This is consistent with findings by Allaro (2012) that exports ‘Granger caused’ growth. The strong growth effect is somewhat surprising and may be an over-estimate given that merchandise exports account for only 7 percent of GDP – the lowest among populous developing countries (services exports account for an additional 7 percent of GDP).

The growth drag of macroeconomic imbalances sets Ethiopia apart from high performing regional peers, though the effect was modest. Growth was held back by high inflation and an overvalued exchange rate in the Late 2000s. The country experienced much larger inflationary impacts of the two commodity price shocks in 2008 and 2011 than other low-income and African countries (Figure 4.5). This is partly explained by expansionary policies in the form of high growth of the monetary base owing to credit expansions to state owned enterprises and direct central bank lending to the government. Following the 2010 devaluation, the monetary authorities also allowed the unsterilized accumulation of foreign exchange reserves arising from the ensuing rise in exports and this contributed to additional inflation (inducing a growth penalty of 0.3 ppts in the Late 2000s). Most other countries in Africa achieved better monetary control by shifting toward reliance on indirect instruments like open market operations to soak up liquidity. Monetary policy

> 14 See Huang and Wang (2011) for a review of the effects of financial repression policies on growth and for empirical evidence suggesting that such policies were conducive in the early (but not later) stages of growth in China. 15 The subsistence effect should not be conflated with the unexplained residual as per Equation (2).

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