metadata: authors: 0: author: Haile,Fiseha
count: Ethiopia
docna: 0: docna: The Exchange Rate : Why It Matters for
            Structural Transformation and Growth in Ethiopia
docty: Policy Research Working Paper
subtopic: Common Carriers Industry,Food & Beverage Industry,Plastics & Rubber Industry,General Manufacturing,Construction Industry,Textiles, Apparel & Leather Industry,Pulp & Paper Industry,Business Cycles and Stabilization Policies,Inflation,Macroeconomic Management,Economic Growth,Economic Theory & Research,Industrial Economics,International Trade and Trade Rules
teratopic: Macroeconomics and Economic Growth,Industry,International Economics and Trade
abstracts: cdata!: Ethiopia has achieved sustained high
            growth for more than a decade. At the same time, the country
            has been facing several economic challenges, including
            falling exports, chronic foreign currency shortages, as well
            as a slow pace of structural transformation. In recent
            years, the already overvalued birr has appreciated sharply
            in real terms, partly driven by the appreciation of the
            dollar, thereby making Ethiopia’s competitiveness and
            industrialization drive more difficult. In response to these
            challenges, this paper looks at the question of why the real
            exchange rate is a useful policy instrument. The analysis
            suggests that Ethiopia needs a more flexible exchange rate
            policy. A competitive or undervalued exchange rate is
            important in bringing about productivity-enhancing
            structural change. There is robust evidence that a real
            devaluation stimulates exports in general and manufacturing
            exports in particular, improves the trade and current
            account balances, and spurs economic growth. Currency
            undervaluation is a second-best policy intervention that can
            help offset some of the key constraints to manufacturing
            growth prevalent in low-income countries and speed up
            structural transformation. However, exchange rate
            adjustments need to take into account the increase in the
            cost of capital imports and debt burden.
geo_reg_key: 517191
repnme: repnme: The Exchange Rate : Why It Matters for
            Structural Transformation and Growth in Ethiopia
display_title: The Exchange Rate : Why It Matters
            for Structural Transformation and Growth in Ethiopia
listing_relative_url: /research/2019/05/31113606/exchange-rate-matters-structural-transformation-growth-ethiopia
topicv3: Economic Growth m1326241 471,Manufacturing Sectors m1326521 1281,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698,Trade Balance m1327679 1136
publishtoextweb_dt: 2019-05-29T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Industry,International Economics and Trade
no_of_pages: 33
model_extractions: Policy Research Working Paper 8868

# The Exchange Rate

Why It Matters for Structural Transformation and Growth in Ethiopia _Fiseha Haile_ Macroeconomics, Trade and Investment Global Practice May 2019
Policy Research Working Paper 8868

# **Abstract**

Ethiopia has achieved sustained high growth for more than a decade. At the same time, the country has been facing several economic challenges, including falling exports, chronic foreign currency shortages, as well as a slow pace of structural transformation. In recent years, the already overvalued birr has appreciated sharply in real terms, partly driven by the appreciation of the dollar, thereby making Ethiopia’s competitiveness and industrialization drive more difficult. In response to these challenges, this paper looks at the question of why the real exchange rate is a useful policy instrument. The analysis suggests that Ethiopia needs a more flexible exchange rate policy. A competitive or undervalued exchange rate is important in bringing about productivity-enhancing structural change. There is robust evidence that a real devaluation stimulates exports in general and manufacturing exports in particular, improves the trade and current account balances, and spurs economic growth. Currency undervaluation is a second-best policy intervention that can help offset some of the key constraints to manufacturing growth prevalent in low-income countries and speed up structural transformation. However, exchange rate adjustments need to take into account the increase in the cost of capital imports and debt burden.

This paper is a product of the Macroeconomics, Trade and Investment Global Practice. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://www.worldbank.org/prwp. The author may be contacted at fgebregziabher@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **The Exchange Rate: Why It Matters for Structural Transformation and Growth in Ethiopia**<sup>*****</sup>

_Fiseha Haile_<sup>‡</sup> JEL: F3, L16, O24, O11, O55. Keywords: Exchange rate, foreign exchange, exports, structural change, growth, Ethiopia

> *Thanks are due to Michael Geiger (Sr. Country Economist, World Bank) for his very insightful comments and suggestions on an earlier draft as well as for his overall guidance in preparing this paper. Lars Christian Moller (Practice Manager, World Bank) offered very useful comments and guided the work in its early stages for a presentation, the storyline of which forms the basis of this paper. The author would also like to thank Ha Nguyen (Economist, World Bank) for sharing the data on real exchange rate undervaluation used for Nguyen (2014). Helpful comments were also received from Kevin Carey (Practice Manager, World Bank). Mesfin Girma Bezawagaw (Senior Economist, World Bank) provided assistance with data collection.

> ‡Fiseha Haile Gebregziabher, Economist, World Bank, E-mail: _<u>fgebregziabher@worldbank.org</u>_
# **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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consequences of devaluation? How can the country go about devaluing the currency and what other policy actions would need to be considered to maximize gains from it?

The remainder of the paper is organized as follows: Section 2 briefly discusses the major economic challenges encountered by Ethiopia in recent years. Section 3 examines the country’s current exchange rate policy and recent movements in the exchange rate. Section 4 discusses why the real exchange rate is a potent instrument of development policy. Section 5 presents and discusses the macroeconomic effects of devaluation in Ethiopia. Section 6 assesses the major policy trade-offs that currency devaluation entails. Finally, Section 7 concludes with implications for policy.

**Figure 1. Annual real GDP growth rate, % (1982-2018)**

<!-- Start of picture text --> 20<br>15<br>10<br>5<br>0<br>-5<br>-10<br>-15<br>Source: World Bank and Ministry of Finance.<br><!-- End of picture text --> <!-- Start of picture text --> Source: World Bank and Ministry of Finance.<br><!-- End of picture text -->

# **2. Major Challenges Facing the Ethiopian Economy**

Ethiopia has experienced sustained growth acceleration since 2004. Figure 1 shows the graph of annual real GDP growth rate for the period 1982-2018. Between 1980 and 2003, annual GDP growth averaged 3 percent. The pre-2004 growth trajectory was highly uneven, with growth hitting its highest level in times of good weather outturn and its lowest in dry (or turbulent) years. Unlike the erratic growth performance before 2004, the economy has staged a record-high growth of 10.3 percent per annum in 2004-2018, which is nothing short of impressive compared to the SSA regional average of 4.6 percent over the same period. The growth spell was, however, accompanied by inflationary pressures, with the inflation rate reaching an all-time high of around 40 percent year-on-year in 2011. Nonetheless, since 2013, inflation has been tamed to reasonable single-digit rates per year, except in 2018 when it crossed into double-digit territories.

However, the poor export performance in recent years has become a cause for concern. Exports have been on a downward slide since the early 2010s (Figure 2). Exports of goods and services as a percentage of GDP declined from its peak of 16.7 percent in 2011 to 8.9 percent in 2018. About 5 percent of Ethiopia’s total merchandise exports constitute manufacturing goods. Export as a share of national income is lower than the expected level of exports given Ethiopia’s GDP per capita, namely 24 percent (World Bank, 2014). It also bears noting that both goods and services exports have seen a decline. Exports steeply declined in recent years, which is very concerning taking into consideration the average annual export growth of about 20 percent registered over 2004–2014. Goods exports saw weak performance generally as a result of falling commodity prices, despite relatively solid volume growth.

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electricity, trade logistics, as well as a cumbersome regulatory framework. This suggests that the country could grow its exports and improve its competitive standing by creating a more conducive business environment. In addition, by virtue of its position as primary exporter, the country has long been exposed to the vagaries of international commodity prices. Thus, gearing efforts toward diversifying the export portfolio and improving the quality of existing products could prop up exports.

Contracting exports and burgeoning imports have given rise to significantly widened trade and current account imbalances, despite the improvement in more recent years. Trade and current account deficit in percent of GDP have been persistently increasing since the early 2010s, reaching 13 and 22 percent respectively in 2014, which represent historical lows during the past decade. The increasing current account imbalance since the late 2000s is mainly ascribed to the worsening trade deficit, which is in turn due to the country’s falling exports and general downward trend in commodity prices, as well as surging imports of capital inputs for public investment programs. However, the external current account deficit narrowed to 6.5 percent of GDP in 2018, reflecting fiscal consolidation and a tighter monetary policy stance. Most of the current account deterioration in 2010-14 was on account of Ethiopia’s large real exchange rate appreciation (Portugal and Zildovic, 2014).

In recent years, Ethiopia has been pursuing an industrialization strategy with a view to promoting light manufacturing. GTP I seeks to transform the predominantly agrarian economy into a modern and industrialized one. Industrial development remained to be the centerpiece of the upcoming GTP II. These plans have the overriding objective of fostering structural transformation via the development of light manufacturing and the country is now making concerted attempts toward this end. However, with 90 percent of the country’s real output coming from the services and agricultural sectors, the GTP is yet to deliver its promised acceleration of structural change.

Progress in the manufacturing sector has particularly fallen short of expectations. Figure 4 plots value added by sector for the period 1981-2018. The share of manufacturing in GDP fluctuated around 4–6 for decades. Over the last decade, the manufacturing sector has expanded at an average of roughly 10 percent, which is on a par with the real GDP growth rate and below the targeted 22 percent in GTP I. In addition, manufacturing accounts for just less than 5 percent of total employment and this percentage has barely changed since the 1990s. Moreover, the sector has the second lowest level of labor productivity and the lowest growth in productivity among all sectors (World Bank, 2015). It is worth noting that the significant growth in the industrial sector over the past few years was driven by a construction boom. The services sector superseded agriculture as the largest contributor to the national economy. However, despite the relatively large shifts in production away from agriculture, there has not been significant commensurate labor shifts to industry and services (Martins, 2015).

# **3. Current Exchange Rate Policy and Recent Trends**

Ethiopia’s _de facto_ exchange rate regime is classified by the authorities as _managed float_ while by the IMF as _crawl-like_ due to stability of the exchange rate and NBE’s intervention policy. According to the NBE, the exchange rate has no predetermined path and thus it is allowed to fluctuate from day to day, with the authorities occasionally intervening in the foreign exchange market through buying and selling currencies. However, the fairly stable movements in the exchange rate and the NBE’s interventionist stance has led the IMF to categorize the exchange rate regime as a _crawl-like_ arrangement. The annual pace of nominal depreciation of the birr against the USD has been gradual and quite stable at about 5 percent in recent years (Figure 5).

The nominal exchange rate is determined in an interbank foreign exchange market. The NBE supplies foreign exchange to the interbank market based on supply and demand estimates established at the beginning of a year. However, despite the role played by the interbank market, the exchange rate has 5
been primarily supply-side determined. For this reason, the nominal exchange rate has been largely unresponsive to changes in macroeconomic fundamentals and external shocks. The birr is closely managed against the USD, which serves as the nominal anchor of Ethiopia’s exchange rate policy. It should be noted that managed exchange rate regimes could be sustained only if adjustments are made for significant changes in the exchange rates and inflation rates of the anchor currency country.

In the context of a pegged exchange rate, a stronger US dollar and higher domestic inflation led to rapid real appreciation of the birr. Since the US dollar appreciated sharply over 2014–2016 (Figure 6) and given that the country continued to experience higher positive inflation differentials relative to its major trading partners, the birr has been on an appreciation path against all currencies that are depreciating against the USD. The dollar has appreciated by about 22 percent between July 2014 and December 2016 against the currencies of the US’s trading partners. However, despite the considerable appreciation of the USD and bouts of relatively high domestic inflation, the nominal exchange rate adjusted only gradually. The gradual nominal depreciation meant insufficient adjustment to address excess demand for foreign exchange as well as to prevent further real appreciation and loss of international competitiveness.

As a result, Ethiopia’s real effective exchange rate has appreciated substantially. Figure 7 clearly indicates that the REER has undergone large and continuous appreciation from an overvalued starting point. It is important to note that a rise in the index signifies real appreciation, meaning that the birr became more expensive relative to the currencies of Ethiopia’s trading partners after correcting for relative price-level changes. The REER surged from 130 in July 2014 to 160 in June 2015. Therefore, while the birr steadily depreciated in nominal terms, it appreciated by about 23 percent in real effective terms at the end of June 2015 and by a cumulative 72 percent since the nominal devaluation in October 2010. This put substantial pressure on the authorities for a large-scale devaluation to rein in the rapidly increasing misalignment. The strong appreciation of the real effective exchange rate is a key factor underlying the country’s weak export performance, posing a potential risk to external competitiveness and stability. The REER was overvalued by 32.5 percent as of June 2015, which declined to about 12-18 percent in 2018 (IMF, 2015, 2018).<sup>3</sup> The observed signs of exchange rate overvaluation are confirmed by a number of quantitative assessments. Similarly, Nguyen (2014) finds, using the approach for measuring currency misalignment developed in Rodrik (2008), that Ethiopia’s real exchange rate was overvalued by 31 percent in the early 2010s. Figure 13 reveals that the country has maintained large and persistent currency overvaluation for most of the past decades. Overvaluation means that the birr is too expensive and the dollar is too cheap compared to the forces of demand and supply, which makes the country’s exports look expensive and undermines its competitiveness.

Compared to its peers, Ethiopia has steadily lost international competitiveness over the past year. Figure 8 shows the graphs of the real effective exchange rates of Ethiopia and those of its structural (Uganda, Tanzania, Mozambique, and Kenya) and aspirational peers (Ghana, Zambia, Bangladesh, Cambodia, and Vietnam),<sup>4</sup> and facilitates comparison of the evolution of international competitiveness. As compared to these countries, Ethiopia has continually lost external competitiveness over the last year because of the sharp real appreciation of the birr. Ethiopia’s REER moved in tandem with those of its peers until around mid-2014 when it sharply departed from them and has since been persistently appreciating. The steep divergence of the country’s effective exchange rate from those of its SSA peers is particularly noticeable.

> 3IMF (2015, 2018).

> 4Ethiopia’s _structural_ peers are countries that share similar characteristics: population size greater than 15 million people, real GDP per capita below $600, investment-to-GDP ratio exceeding 15 percent, real GDP growth higher than 5 percent per annum, non-resource-rich economy, and non-conflict countries. Its _aspirational_ peers are countries that set a good development precedent and that the country may emulate: population greater than 15 million people, GDP per capita between $600 and $2,000, real GDP growth higher than 5 percent, investment-to-GDP ratio more than 15 percent, credit rating below BB+, and natural resources export below 10 percent. These were identified by the World Bank’s SCD for Ethiopia using ‘Find Your Friends Tool’.

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**Figure 5: Nominal exchange rate against the USD, annual and monthly**

<!-- Start of picture text --> 30<br>30<br>25 28<br>26<br>20 24<br>22<br>15<br>20<br>18<br>10<br>16<br>5 14<br>12<br>0<br>10<br>Source: Data from NBE.<br>2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2017/18 Jul. 13 Nov. 14 Mar. 14 Jul. 14 Nov. 14 Mar. 14 Jul. 15 Nov. 15 Mar. 15 Jul. 16 Nov. 16 Mar. 16 Jul. 17 Nov. 17 Mar. 17 Jul. 18 Nov. 18<br><!-- End of picture text -->

**Figure 6: U.S. Real Effective Exchange Rate (REER) index**

<!-- Start of picture text --> 125<br>120<br>115<br>110<br>105<br>100<br>95<br>Source: US Federal Reserve.<br>Jan. 12 Apr. 12 Jul. 12 Oct. 12 Jan. 13 Apr. 13 Jul. 13 Oct. 13 Jan. 14 Apr. 14 Jul. 14 Oct. 14 Jan. 15 Apr. 15 Jul. 15 Oct. 15 Jan. 16 Apr. 16 Jul. 16 Oct. 16 Jan. 17 Apr. 17 Jul. 17 Oct. 17 Jan. 18 Apr. 18 Jul. 18 Oct. 18 Jan. 18 Apr. 18<br><!-- End of picture text -->

**Figure 7: Ethiopia: Real Effective Exchange Rate (REER) Index**

<!-- Start of picture text --> 210<br>190<br>170<br>150<br>130<br>110<br>90<br>70<br>Source: Data from NBE.<br>2000M1 2000M7 2001M1 2001M7 2002M1 2002M7 2003M1 2003M7 2004M1 2004M7 2005M1 2005M7 2006M1 2006M7 2007M1 2007M7 2008M1 2008M7 2009M1 2009M7 2010M1 2010M7 2011M1 2011M7 2012M1 2012M7 2013M1 2013M7 2014M1 2014M7 2015M1 2015M7 2016M1 2016M7 2017M1 2017M7 2018M1<br><!-- End of picture text -->

**Figure 8: REER of Ethiopia and Selected Countries (2014-15) (Jan. 2014 = 100)**

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<!-- Start of picture text --> 130 Ethiopia Kenya 125 Bangladesh Cambodia<br>Tanzania Uganda Ethiopia Vietnam<br>Ghana Mozambique<br>120 120<br>Zambia<br>110 115<br>100 110<br>90 105<br>100<br>80<br>95<br>70<br>Source: Data from NBE.<br>Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15 Mar-15 May-15 Jan.-14 Feb.-14 Mar.-14 Apr.-14 May.-14 Jun.-14 Jul.-14 Aug.-14 Sep.-14 Oct.-14 Nov.-14 Dec.-14 Jan.-15 Feb.-15 Mar.-15 Apr.-15 Mar.-15<br><!-- End of picture text -->

**Figure 9. Official and Parallel Exchange Rates, and Parallel Market Premium**

<!-- Start of picture text --> 35 Panel A. Official and parallel exchange rates (2002/03-2017/18)<br>30<br>25<br>20<br>15<br>10<br>5<br>0<br>Source: Data from NBE.<br>2002/03_Q1 Q3 2003/04_Q1 Q3 2004/05_Q1 Q3 2005/06_Q1 Q3 2006/07_Q1 Q3 2007/08_Q1 Q3 2008/09_Q1 Q3 2009/10_Q1 Q3 2010/11_Q1 Q3 2011/12_Q1 Q3 2012/13_Q1 Q3 2013/14_Q1 Q3 2014/15_Q1 Q3 2015/16_Q1 Q3 2016/17_Q1 Q3 2017/18_Q1 Q3<br><!-- End of picture text --> <!-- Start of picture text --> 40 Panel B. Parallel Market Premium, % (2005/06-14/15)<br>35<br>30 Official exchange rate<br>Parallel exchange rate<br>25<br>20<br>15<br>10<br>5<br>0<br>Source: Data from NBE.<br>2002/03_Q1 Q3 2003/04_Q1 Q3 2004/05_Q1 Q3 2005/06_Q1 Q3 2006/07_Q1 Q3 2007/08_Q1 Q3 2008/09_Q1 Q3 2009/10_Q1 Q3 2010/11_Q1 Q3 2011/12_Q1 Q3 2012/13_Q1 Q3 2013/14_Q1 Q3 2014/15_Q1 Q3 2015/16_Q1 Q3 2016/17_Q1 Q3 2017/18_Q1 Q3 2018/19_Q1<br><!-- End of picture text --> 8
Another sign of the birr overvaluation is the flourishing parallel market. The growing prevalence of a parallel market provides additional attestation to Ethiopia’s misaligned real exchange rate. The spread between the parallel and official exchange rates (denoted the parallel market premium (PMP)) has widened significantly (Figure 9, Panel A). The birr buys fewer dollars in the parallel market and thus the effective price of the birr is the parallel market rate. This implies that the birr would have depreciated faster if more market-based movement of exchange rate were allowed. Figure 9 (Panel B) shows that the PMP has been steeply rising in recent years, though it has not yet reached the historic-high level in 2008/09. ‘Large’ PMP undermines productivity and growth (Fischer, 1993; Easterly and Levine, 1997) and, induces adverse efficiency and distributional effects (Dorosh _et al_ ., 2009). The PMP has been identified as one of the few robust policy determinants of economic growth (Easterly, 2005).

Given the NBE’s managed exchange rate regime and the particular policy of maintaining a relatively constant level of foreign exchange reserves, currency rationing has been the only market clearing mechanism. An overvalued birr means that there exists excess demand for dollars that cannot be satisfied at the official exchange rate; thus, quantity rationing (as opposed to the price mechanism) has been the only way for the market to clear. Import coverage of gross official reserves remained at a very low level of about 1.6 months in June 2018. The current level of foreign currency exchange reserves is below the medium-term target of 3 months of imports and the optimal reserve coverage of 5 to 6.8 months (IMF, 2018).

**Figure 10: Demand and Supply of Foreign Exchange (Rationed Market)**

<!-- Start of picture text --> Exchange<br>Rate Demand Supply<br>(Birr/$)<br>Unsatisfied<br>demand for<br>ER parallel<br>foreign<br>exchange<br>ER official<br>Demand met via Demand ‘met’ via Quantity<br>the official the parallel<br>channel market<br><!-- End of picture text --> <!-- Start of picture text --> Exchange<br>Rate<br>(Birr/$)<br><!-- End of picture text --> <!-- Start of picture text --> Demand met via<br>the official<br>channel<br><!-- End of picture text --> <!-- Start of picture text --> Demand ‘met’ via<br>the parallel<br>market<br><!-- End of picture text --> At the national level, currency rationing is effectively made based on the government’s priorities, which are in turn set centrally and effectuated via the NBE and Commercial Bank of Ethiopia. Rationing has been made based on criteria that accord utmost priority to public infrastructure investment, strategic private sector activities, and strategic imports (e.g. oil, medicines, and food items). The residual is then passed on to the private sector via the interbank market. Given that foreign currency reserves are held relatively constant at the NBE, the private sector bears the brunt of any chronic shortage of foreign exchange. Figure 10 shows a simple illustration of how the market clears in a rationed foreign exchange market. In a rationed regime, the demand for foreign exchange at the official exchange rate (ER<sup>official</sup> ) exceeds the total supply of foreign exchange. Only part of the demand for foreign currency is thus met via the official channel, which means that there is an excess demand that cannot be satisfied at the official rate. A parallel market for foreign exchange will tend to develop with an exchange rate ER<sup>parallel</sup> 9
such that the total demand at this rate equals the total supply. Accordingly, a portion of the demand unsatisfied through the official market is “met” via the parallel market while the rest remains unsatisfied.

<mark>Rationing has significant negative effects on economic growth and income distribution in Ethiopia (Dorosh</mark> _<mark>et al</mark>_ <mark>., 2009). Foreign currency rationing causes both substantially adverse efficiency and distributional consequences. Rationing depresses growth by reducing incentives for production of tradables and leads to more unequal income distribution by allowing the creation of rents that are largely appropriated by non-poor households (Dorosh</mark> _<mark>et al</mark>_ <mark>., 2009). In other words, rationing is highly distortionary and fosters illicit activities (Rodrik, 2008b). For instance, anecdotal evidence indicates that the scanty supply of foreign currency and the ensuing quantity rationing are promoting patronage in Ethiopia, with importers having personal connections getting access to foreign currency irrespective of the economic returns on the transactions in question. Foreign exchange control is thus likely to reduce economic efficiency as foreign currency is not directed to its most productive use. In addition, the unsatisfied demand for foreign exchange means that firms operate at less than full capacity and are forced to make future investment plans in such a way that the risk premium associated with the foreign exchange crunch is accounted for.</mark>

**4.** **<mark>The Exchange Rate as a Development Policy Tool</mark>**

# **<mark>4.1     The exchange rate matters for structural transformation</mark>**

Currency overvaluation hampers structural transformation. An overvalued real exchange rate hinders structural transformation through, among other channels, inducing a disproportionately detrimental impact on tradable industries in general and modern manufacturing activities in particular (Dollar and Kraay, 2003; Rajan and Subramanian, 2011; McMillan _et al_ ., 2014). For this reason, the large real appreciation and the concomitant overvaluation of the birr does not bode well for Ethiopia’s ongoing efforts toward promoting development of the manufacturing sector and fostering growth-inducing structural change. In other words, given that an undervaluation stimulates growth of the tradable sector, the overvalued exchange rate, combined with the very low levels of productivity and industrialization in Ethiopia, seems to indicate the existence of a substantial untapped potential for a more robust economic growth through structural transformation.

A competitive currency is critical for structural transformation. One of the key stylized facts and timetested recipes of economic development is that manufacturing-led structural change and the stimulation of new productive activities lie at the heart of broad, sustained economic growth. A significant portion of the gap in economic performance between successful and unsuccessful countries is due to the pace at which productivity-enhancing structural transformation takes place (McMillan _et al_ ., 2014; Timmer and Akkus, 2008). Historically speaking, more such structural change tends to take place in countries characterized by competitive or undervalued currencies (Rodrik, 2008a).<sup>5</sup> A competitive or undervalued real exchange rate may be the most effective policy instrument for igniting and accelerating industrialization-led structural transformation (Johnson _et al_ ., 2010).

# **<mark>4.2     The exchange rate as a tool for promoting manufacturing</mark>**

The real exchange rate, when managed carefully, can be a crucial policy instrument to stimulate manufacturing growth. The manufacturing sector has been associated with strong economic growth in developing countries and still remains at the heart of catch-up development (Jones and Olken, 2008; Gala, 2007; Rodrik, 2013, 2014). Countries with competitive or undervalued currencies tend to

> 5Nearly half of Africa’s overall economic growth since 2000 is accounted for by productivity-increasing structural transformation (McMillan _et al_ ., 2014).

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experience more rapid manufacturing growth. Real undervaluation stimulates new investments in the manufacturing sector by increasing price of tradables and undoing the adverse effects of market distortions that disproportionately affect this sector (Rodrik, 2008a, 2014). In developing countries, a sizable real depreciation facilitates the expansion of the manufacturing sector by encouraging firms to enter new export markets and new export sectors, and reducing the failure rates in them (Freund and Pierola, 2012; Eichengreen, 2008).

Currency undervaluation is a second-best policy intervention that can help mitigate the key culprits of manufacturing growth and stimulate a virtuous process of structural transformation. Undervaluation spurs the growth of tradable industries by more than offsetting the costs imposed by the plethora of market distortions (e.g. information and coordination externalities) and institutional weaknesses (e.g. institutional and contracting shortcomings), thereby working as a subsidy on them (Rodrik, 2008a). Tradables are more demanding of conducive institutional and market environments. In developing countries like Ethiopia, manufacturing activities are held back by binding business environment constraints. While addressing these bottlenecks is a cumbersome task and takes a reasonably long time, exchange rate depreciation expands tradable production by increasing the price of tradables and thus, in effect, serving as a substitute for industrial policy. For instance, a 20 percent depreciation would effectively mean a 20 percent subsidy on all tradable industries. The impact of undervaluation is most pronounced in those countries where institutions and markets are least well developed (Ibid.).

<mark>However, in an ideal world with properly functioning markets and a well-crafted global monetary system, countries would be well-advised to avoid subsidizing via undervaluation. From the international viewpoint, subsidizing exporting firms through a conscious policy of currency undervaluation may be globally suboptimal as it interferes with the natural workings of the market and distorts innovation and investment incentives. Undervaluation-induced subsidy disrupts the process of Schumpeterian (innovative or) creative destruction (UNCTAD, 2009).</mark><sup>6</sup> <mark>In principle, gains from deliberate currency manipulations for a certain country would have to be weighed against the associated losses to other countries, lest it may foster a destructive beggar-thy-neighbor behavior that leaves all countries worse off. Nonetheless, given the posited ideal world is non-existent and that the real world is rife with market and institutional imperfections (both at the national and international levels), an undervaluation strategy comes into play as an effective short-term mechanism of alleviating the hurdles to developing countries’ export-led growth ambitions.</mark>

# **<mark>4.3      A competitive exchange rate spurs growth and exports</mark>**

<mark>Countries targeting competitive or undervalued real exchange rates experience stronger and more sustainable economic growth. Developing countries that systematically keep their currencies undervalued are characterized by faster economic growth (Johnson</mark> _<mark>et al</mark>_ <mark>., 2010; Berg and Miao, 2010) and export surges (Freund and Pierola, 2012; Eichengreen and Gupta, 2013;</mark> Haddad and Pancaro, 2010). <mark>Growth accelerations tend to be preceded by large real exchange rate depreciations (Hausmann</mark> _<mark>et al</mark>_ <mark>., 2005) while their duration is strongly positively associated with the avoidance of real currency overvaluation (Berg</mark> _<mark>et al</mark>_ <mark>., 2012).</mark> <mark>In addition, significant real depreciation promotes exports. Real depreciation stimulates exports by making a country’s exports look cheaper and bolstering external competitiveness. This is particularly the case for exports of developing countries like Ethiopia, which are mainly primary commodities that compete more on price than on quality. In addition, a lower real exchange rate would encourage exports of primary commodities via increasing foreign demand for them and thus reducing leakage to domestic</mark>

> 6Creative destruction commonly refers to the process of industrial mutation through which new production units bring about the demise of outdated ones on the back of a continuous mechanism of product and process innovation.

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<mark>markets. A case in point is the recent local coffee price hike in Ethiopia, which exceeded foreign prices and resulted in partial reorientation of coffee sales from export markets to local ones.</mark>

# **<mark>4.4     East Asian economies pursued undervaluation in their heyday</mark>**

Historically, the fastest-growing Asian economies followed the well-trodden path of systematic currency undervaluation, with significant positive effects on growth and exports. The RER played an important role in promoting tradable industries and unleashing structural transformation <mark>during the heyday of East Asian countries</mark> (Dollar, 1992; Rodrik, 2008a; Bhalla, 2008a,b). Figure 13 (in Annex I) plots Nguyen’s (2014) real undervaluation index against the GDP per capita growth rate for four Asian (China, India, the Republic of Korea, Thailand) and two African (Uganda and Tanzania) countries for the period 1950-2011. The Asian countries have experienced a very strong comovement between growth and undervaluation.

Growth in China has been rapidly increasing in tandem with the increase in undervaluation (from an overvaluation of around 60 percent to an undervaluation of close to 50 percent) since the early 1970s, and both slowed down in the late 1990s. China’s spectacular growth is partly due to a deliberate policy of systematic undervaluation of the real exchange rate (Bhalla, 2008a). For India, the comovement between growth and undervaluation appears less pronounced; however, the story is by and large the same as that for China. For Korea and Taiwan, China, both growth and undervaluation have followed by and large a similar pattern, with growth tending to increase when undervaluation increases and vice versa. In general, East Asian countries have accomplished rapid growth on the back of unorthodox strategies including, but not limited to, intentional currency undervaluation.

The empirical regularities in the link between undervaluation and growth are not unique to Asian countries and are also observed in African economies. In line with the Asian experience, Uganda and Tanzania saw a reasonably strong comovement between undervaluation and growth. Uganda kept a somewhat undervalued currency since the late 1980s. Similarly, Tanzania’s real exchange rate was largely overvalued until the mid-1980s, after which undervaluation increased sharply. It is particularly notable that economic growth in both countries closely tracks the movements in the undervaluation index. Periods of growth slowdown were characterized by increasing overvaluation, and pickups in growth coincided with a rise in undervaluation. The IMF’s Article IV estimates for selected regional comparator countries (Uganda, Tanzania, Rwanda, and Kenya) indicate that, unlike Ethiopia’s increasingly overvalued currency, the REER of these countries were in (or close to) their respective equilibrium levels in recent years. Uganda’s effective exchange rate was only slightly overvalued in the year 2015 (by about 1.1 percent) and the estimated overvaluation for the period 2012-15 falls in the range 1-3.5 percent. Similarly, Tanzania’s currency was close to equilibrium in 2015 and there is no significant evidence of currency misalignment in the past few years. For Rwanda, the latest available estimate for 2014 points to an overvaluation of about 3 percent and the REER was broadly in line with fundamentals since 2009. Estimates for Kenya tell a similar story: the currency was about 10 percent overvalued in 2014 whereas there was no significant misalignment in the early 2010s.

<mark>Regression analyses in Rodrik (2008a) and Nguyen (2014) corroborate the graphical observations. Empirical analysis in Rodrik (2008a) suggests that a 10 percent real undervaluation is associated with an increase in GDP per capita growth of about 0.17 percentage points a year. The estimates imply that the growth impact of a similar undervaluation for Brazil, China, India, and Ethiopia at their current levels of income are 0.09, 0.12, 0.16, and 0.29 percentage points, respectively.</mark> Nguyen (2014) provides empirical evidence generally confirming the above-discussed findings. The results indicate that if a country keeps its RER undervalued by 10 percent, its real output growth becomes 0.88 percentage points higher.

<mark>For the Asian countries, perio</mark> ds of rapid export growth were also associated with large currency undervaluation (Nguyen, 2014) <mark>. Figure 12 (in Annex I) shows the graphs of export growth and Nguyen’s (2014) real undervaluation index for four Asian (China, India, Korea, and Thailand), four Latin American</mark> 12
<mark>(Argentina, Brazil, Mexico, and Peru), and two African (Uganda and Tanzania) countries covering the period 1950-2011. The Asian countries have seen large undervaluation during their respective catchingup periods. Since the early 1990s, China has had significant undervaluation, which coincided with a period of rapid export growth. Similarly, the 1960s and 1970s in Korea were periods of persistent undervaluation while at the same time the country saw its exports grew at unprecedented rates. Thailand has similarly experienced both large real undervaluation and fast export growth for most of the periods since the early 1970s.</mark> <mark>The anecdotal observations on the undervaluation-export growth nexus are borne out by econometric evidence. Overall, the empirical results in Nguyen (2014) support the proposition that an increase in undervaluation is significantly positively associated with higher export growth. Specifically, for every 10 percent undervaluation of a country’s RER its export growth increases by 0.59 percentage points a year. This main result holds true both for high-income and low-income countries (defined as those having real GDP per capita below the cut-off line of USD 6,000 in the year</mark> 2000).

# **<mark>4.5     Latin American economies adopted overvaluation with far less success</mark>**

<mark>Unlike their Asian counterparts, Latin American countries generally maintained overvalued currencies for most of the past decades, which were associated with poor growth and export performance.</mark> In the 1980s and 1990s, overvaluations were commonplace in many of the countries in Latin America, which often led to severe balance of payments crises and necessitated dramatic devaluations. Latin American countries generally exhibited disappointing economic growth as well as slower and more erratic export growth. Figure 13 unveils that Argentina’s currency was markedly overvalued prior to the year 2000, with RER misalignment exceeding 100 percent for most of the periods. During this period, the country saw meager levels of exports and GDP growth. Similarly, Brazil’s exchange rate has been increasingly overvalued (from somewhat undervalued starting point in the 1960s) since the early 1970s, which was accompanied by sharp growth slowdown and smaller export growth. In Latin America, Mexico represented a somewhat anomalous case in that the country substantially undervalued its currency until the late-1980s. Undervaluation moved in sync with growth for most of the years before the early 1990s, when the comovement turned negative. Peru typically experienced considerable overvaluation for most of the 1980s and 1990s, which was generally associated with poor economic performance.

# **5.     The Macroeconomic Effects of Devaluation in Ethiopia**

# **5.1     The impact of devaluation on exports and growth**

In Ethiopia, empirical analysis using the RER shows that a 10 percent lower exchange rate is associated with an increase in export and real GDP growth rates of 0.52 and 0.23 percentage points, respectively (Nguyen, 2014). These upper-bound estimates suggest that an exchange rate adjustment that at least partially corrects the currency misalignment would significantly increase export and income growth. This does not come as much of a surprise considering that the country’s exports are predominantly low value-added primary commodities which compete more on price than on quality. Moreover, the decline in imports due to real depreciation is less likely to have significant negative repercussion given that the import-content of agricultural exports, which are the mainstay of Ethiopia’s exports, is relatively small compared to the industrial sector. The results in Nguyen (2014) are generally consistent with Moller and Walker (2015), who find that an overvalued real exchange rate held back some economic growth in Ethiopia over the period 2000-13.

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# **5.2     The impact of devaluation on the trade balance**<sup>**7**</sup>

This section empirically addresses the question of whether a real exchange rate depreciation will improve the balance of trade in Ethiopia (Haile, 2015a). The analysis is based on annual data for Ethiopia covering the period 1980-2013 and employs multi-equation time-series approach. A real devaluation could improve the balance of trade via increasing exports and discouraging imports. Currency depreciation should positively impact on exports of the country because they are more competitively priced than identical products from other countries, all else being equal. There is, however, no clear-cut theoretical relationship between movements in the exchange rate and the trade balance. The reason for this is that exports may not strongly respond to exchange rate changes while the value of imports may not significantly decline as the country now pays higher price for a given quantity of imports. This is nonetheless an empirical issue and should be settled based on thorough empirical analysis.

There are some preconditions that should be fulfilled for the benefits of a real devaluation to materialize. In particular, the well-known Marshall-Lerner (ML) condition must hold for a devaluation of the birr to improve the trade balance position of the country. The ML condition states that an exchange rate devaluation (or depreciation) will have favorable impacts on the balance of trade only if the responses of export and import demand to the devaluation-induced price changes are sufficiently strong. Technically speaking, the sum of export and import demand elasticities should be greater than one in absolute value. A real depreciation would lead to an increase in the quantity of exports and a decline in the quantity of imports, and thus have a net positive impact on the trade balance. Specifically, a depreciation renders the cost of foreign goods higher relative to the cost of domestic goods, which instigates foreign consumers to buy more of the country’s exports and domestic consumers to buy fewer imported goods, thereby resulting in a positive quantity effect on the balance of trade. However, there is an offsetting cost effect stemming from a rise in the cost of imports. Therefore, the net impact depends on whether the quantity effect or the cost effect dominates. If the quantity effect outweighs the cost effect, the ML condition is satisfied.

**Table 1. Effects of RER Undervaluation on Export and Real Output Growth in Ethiopia**

|**Dependent**|**∆ln(real exports)**|**∆ln(real GDP)**|
|---|---|---|
|**Variable**|**(1)**|**(2)**|
|ln(Initial Real Exports)|–0.203**<br>(0.076)||
|ln(Initial Real GDP)||–0.104**<br>(0.044)|
|Undervaluation|**0.523****<br>(0.233)|**0.226*****<br>(0.064)|
|Constant|1.674***<br>(0.577)|0.807**<br>(0.307)|
|R-squared|0.151|0.340|

Note: Newey-West HAC Standard Errors in parenthesis. ***, **, * indicate statistical significance at the one, five, and ten percent, respectively. Source: Nguyen (2014).

In particular, the empirical analysis asks whether the ML condition holds for Ethiopia and whether a devaluation causes significant trade balance deterioration in the short-term. Note that even if devaluation is effective in improving the trade balance in the long-term, it may worsen it in the shortterm as trade in goods may tend to be inelastic while import prices increase in the immediate aftermath of a change in an exchange rate. Some previous studies find that it may take time to change

> 7See Annex III for more technical details on this section.

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consumption patterns and trade contracts (Bahmani-Oskooee and Ratha, 2004). However, although the balance of trade may deteriorate in the short-term, it will improve in the long-term as market participants adjust to the new prices. This is commonly referred to as the _J_ -curve effect. The _J_ -curve refers to the trajectory of the country’s trade balance following devaluation.

**Table 2. Effects of Devaluation on Exports and Imports in Ethiopia**

|**Dependent**<br>**Variable**|**ln(Real**<br>**exports)**<br>**(1)**|**ln(Real**<br>**imports)**<br>**(2)**|**ln(Manufacturing**<br>**exports)**<br>**(3)**|**ln(Agricultural**<br>**exports)**<br>**(3)**|
|---|---|---|---|---|
|ln(REER)|**–0.50*****|**0.59*****|**–1.06****|**–0.33***|
||(2.83)|(3.45)|(2.04)|(1.81)|
|ln(Domestic income)||0.55***<br>(3.16)|||
|ln(World income)|6.36***<br>(5.42)||4.59**<br>(2.28)|1.21**<br>(2.19)|

Note: _t_ -values in parenthesis. The empirical models allow for a linear trend to account for the trending nature of the variables and a broken linear trend in 1992 to capture the significant change in trend slopes (and thus the mean-shift in growth rates) due to the political and economic regime change. ***, **, * indicate statistical significance at the one, five, and ten percent, respectively. Source: Haile (2015a,b).

In Ethiopia, using the REER index, a 1 percent real devaluation increases exports by 0.5 percent and reduce imports by about 0.6 percent, thereby leading to an improvement in the trade balance of around 1.1 percent (Haile, 2015a). These results conform to economic theory as a policy of devaluation is expected to have both expenditure-switching (from foreign to domestic goods) and expenditurereducing (reduction in import demand) effects. The empirical estimates in Table 2 (columns 1 and 2), which represent causal effects, suggest that the sum (in absolute value) of export and import elasticities with respect to the real effective exchange rate is 1.1. Therefore, the ML condition is satisfied for Ethiopia, suggesting that a real devaluation of the birr will significantly improve the trade balance. This key finding holds up well against various sensitivity checks. Similar results are obtained using quarterly data for the sub-periods 1993-2013 and 2004-13. The short-run analysis provides robust evidence that Ethiopia’s trade balance does not exhibit the so-called _J_ -curve pattern following devaluation. In other words, the long-term improvement in Ethiopia’s external balance would be achieved without any significant shortterm deterioration in the trade balance (see Annex I).

Further analysis reveals that a 1 percent real devaluation increases Ethiopia’s manufacturing exports by 1.06 percent and agricultural exports by 0.33 percent (Haile, 2015b). The results in Table 2 (columns 3

**Figure 11. Contributions to Changes in the Current Account Balance (2010-13) (% GDP)**

<!-- Start of picture text -->
1.0%<br>0.5% Credit growth<br>0.0%<br>-0.5% FDI Lag NFA (share in GDP)<br>-1.0% Terms of trade Fiscal balance instrumented (share in GDP)<br>Relative openness (lag)<br>-1.5%<br>Real Aging speed<br>-2.0%<br>effective  Relative GDP growth<br>-2.5%<br>exchange Lag CA<br>-3.0% rate Inflation volatility (3 year average, lag)<br>-3.5% Relative income<br>-4.0%<br><!-- End of picture text -->

change compared to previous period (2010-2011) <!-- Start of picture text --> Source: Portugal and Zildovic (2014).<br><!-- End of picture text --> <mark>Source: Portugal and Zildovic (2014).</mark> 15
and 4) are based on quarterly data for Ethiopia from 2005 to 2013. As discussed above, a 1 percent devaluation increases total exports by 0.5 percent. Disaggregation of exports uncovers that an additional depreciation induces a larger increase in exports in the manufacturing sector than in the other sectors of the economy. This is to be expected as depreciation expands manufacturing exports via resource reallocation in the export sector and particularly through incentivizing firms to enter into new export products and new markets. Conversely, real appreciation has a more negative impact on manufacturing than agricultural exports. This is in line with the well-established empirical finding that an overvalued currency is particularly damaging to the manufacturing industry. Despite the fact that the manufacturing sector in Ethiopia remains relatively nascent and might be currently less important than the agriculture and services sectors, this was also the case for many historically fast-growing countries when they first kick-started development. Expansion of manufacturing activities served as an important engine of their growth take-off.

# **5.3    The impact of devaluation on the current account balance**

In Ethiopia, most of the external current account deficit could be arrested by allowing for a significant real exchange rate depreciation (Portugal and Zildovic, 2014). Figure 11 shows that REER appreciation accounts for most of the current account deterioration over the period 2010-13. This is not too surprising given the previous finding that an appreciation of the REER has a fairly large negative and positive impacts on exports and imports, respectively. As mentioned earlier, the country’s rapidly expanding current account deficit is principally attributed to a worsening trade deficit, which is in turn on account of weak export performance and soaring imports of capital goods for public investment programs. The significant contribution of changes in the effective exchange rate to movements in the current account balance indicates that devaluation would be an important step toward reversing the downward spiral in the current account balance.

# **6.    Major Policy Trade-offs of Nominal Devaluation**

# **6.1    Will a devaluation of the birr cause inflation?**

Nominal exchange rate depreciation did not cause inflation during 2004-13 in Ethiopia (Haile, 2015a) and thus future devaluation measures will not necessarily trigger higher inflation. Perhaps the foremost cause for concern for policy makers is that rapid exchange rate adjustment will be counter-productive by increasing domestic prices and possibly leading to an inflationary spiral. Nominal depreciation drives up import prices, which feeds into higher domestic production costs and, if left unchecked, might cause higher inflation rates. Nonetheless, imported goods account for a fairly small share of the consumer price index and thus the impact of nominal devaluation on inflation is likely to be less marked. The analysis finds that, over the past decade, inflation was mainly caused by strong economic growth, monetary expansion, and international oil and food price rises (Haile, 2015a).

Demand-driven inflation and supply shocks were the dominant forces behind the inflation surges since the mid-2000s. The empirical results indicate that excessive growth in aggregate demand gave rise to an inflationary gap and that the demand-pull inflation was at least partly monetary in origin, a phenomenon commonly referred to as “too much money chasing too few goods.” The finding that expansionary monetary policy partly explains the dramatic increase in inflation is unsurprising as rapid growth of base money characterized the post-2004 period. The average annual growth in the monetary base jumped from 6 percent in 1992-2003 to about 20 percent in 2014-13, during which inflation reached astronomical proportions. In addition, significant increases in global food and oil prices contributed to the higher inflation rates.

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Devaluation is less likely to be inflationary as imported consumer goods are being priced in a way that incorporates the higher cost importers incur in the parallel market (Rodrik, 2008b). As the economy is currently facing foreign currency rationing, the effective price of imports is that which includes the parallel market premium. Given the parallel market rate is significantly higher than the official one, the higher cost borne by importers who purchase foreign currency at the parallel rate will be reflected in the prices they charge. This will likely trigger those who already have access to foreign currency via official channels to follow suit and sell their products at similar prices. Thus, exchange rate devaluation may simply be tantamount to recognizing and validating the _status quo_ , without putting further upward pressure on inflation. Insofar as the economy maintains a rationed foreign exchange regime, it pays higher prices without enjoying the countervailing benefits of devaluation. Provided that devaluation increases the supply of foreign currency into the market, it is less likely to lead to significant price hikes.

# **6.2    Will a devaluation increase the cost of public investment?**

The imported capital inputs of government infrastructure investments would become more expensive as a result of devaluation. Policy makers are concerned that a weaker birr will be costly to the government as it increases the prices of capital goods needed for infrastructure and manufacturing. Hence, the case for devaluation should be assessed taking into account the increase in the local currency value of capital imports, which may slowdown the country’s import-dependent industrialization drive. Capital and consumer goods dominate imports, comprising roughly 42 and 27 percent of total goods imports respectively in 2014/15. Imported capital inputs for public investment purposes experienced a drastic increase in recent years and account for the lion’s share of the country’s total capital goods imports. A simple illustrative exercise indicates that a 10 percent nominal devaluation of the birr would increase the cost of government capital goods import by 6.12 billion birr, i.e. about 0.58 percent of GDP.

# **<mark>6.3    Will a devaluation increase the debt burden?</mark>**

<mark>A birr devaluation would also have balance sheet effects by raising the cost of debt servicing and public debt stock as denominated in local currency. Foreign currency-denominated public debt constituted about half of the gross public debt in 2014. External public debt stock as a percentage of GDP has been rising in recent years, which is mainly on account of the l</mark> arge debt financed imports of capital goods for public investmen <mark>t. But although public debt has been recently expanding at an unprecedented pace, it remains at a fairly acceptable level as a share of GDP. The 2013 Joint Bank-Fund Debt Sustainability Analysis indicated that Ethiopia’s risk of external debt stress was ‘low’. However, it increased to ‘moderate’ in 2014/15 due to unexpectedly high non-concessional borrowing and weak export performance, which seems to raise concerns over debt sustainability in the years ahead (IMF, 2015). If the NBE is to devalue the birr, the impact on external debt-service commitments and the overall debt stock should be assessed carefully in view of the country’s rapid debt-financed public investment expansion. A 10 percent devaluation would lead to an increase in the local currency value of annual debt service payments by roughly 1.3 billion birr (i.e. 0.13 percent of GDP) and public sector external debt stock by roughly 26 billion birr (i.e. 2.5 percent of GDP).</mark>

# **<mark>6.4    Would a devaluation engender investor uncertainty?</mark>**

There are claims that exchange rate devaluation will create an uncertain business climate, which might stifle investment and growth. However, given the significant misalignment of the Ethiopian birr, devaluation should be seen as offsetting previous exchange rate distortions. As touched upon previously, currency overvaluation is mostly associated with macroeconomic instability, rent seeking and corruption, and stop-and-go macroeconomic cycles, all of which are inimical to economic growth (Easterly, 2005; Rodrik, 2008a; Bhalla, 2008a). In addition, rather than inducing investor uncertainty, possible future devaluation could reflect the government’s unwavering commitment to fostering structural transformation (Subramanian, 2010). It is, however, important to bear in mind that uncertainty 17
over future nominal devaluations partly stems from the lack of central bank transparency and credibility surrounding the course of exchange rate policy.

The country could cushion the negative effects of policy uncertainty by pursuing a systematic approach to exchange rate policy (Stone _et al_ ., 2009). An institutional reorientation towards greater central bank credibility underpinned by improved policy coherence and consistency, transparency in exchange rate management, and more independent operations is crucial in tackling uncertainty for investors and ensuring macroeconomic stability (IMF, 2008; Stone _et al_ ., 2009). Accordingly, the course of future actions has to be consistent with any exchange rate changes that Ethiopia may undertake and there needs to be a more proactive communication about policy intentions and decisions. Provided that these policy and institutional frameworks are put in place, it is less likely that devaluation will give rise to significant uncertainty about the policy direction for the currency.

# **<mark>7.    Conclusions and Policy Implications</mark>**

<mark>A competitive real exchange rate would help provide an environment conducive to manufacturing-led structural transformation, sustained growth acceleration, and improved external balance. Ethiopia’s real exchange rate has witnessed rapid appreciation over the past year and the overvaluation of the birr currently stands at about 32 percent. The overvalued currency has manifested itself in, among others, the acute foreign exchange crunch, currency rationing, persistent trade and current account deficits, and slow pace of structural change. Empirical analysis using Ethiopian data provides fairly strong evidence to support the proposition that a real devaluation would be able to stimulate exports, improve the external balance, and bolster economic growth as well as promote industrialization-driven structural transformation.</mark> <mark>In other words, a birr devaluation will play an important role by fostering expenditure-switching effects and long-term development (i.e. the growth of efficient export-oriented and import-substituting industries). Nominal exchange rate devaluation will not necessarily cause inflation. However, devaluation would involve key macroeconomic trade-offs including the higher cost of imported capital equipment and increase in external debt stock and servicing when expressed in local currency.</mark> <mark>However, a nominal devaluation or faster depreciation must be accompanied by a tightening of the monetary policy stance to contain inflation. A competitive or undervalued real exchange rate could be achieved and sustained only if it is backed by an appropriate monetary and/or fiscal policy framework. Somewhat tighter monetary and fiscal policies may be required to maintain macroeconomic stability and ensure that the gains from devaluation are not neutralized by price surges. If necessary, a policy of devaluation should be complemented with other policy adjustments to circumvent major trade-offs. Furthermore, for a devaluation to be effective, foreign exchange controls might need to be phased out to allow market forces to come into play in determining the exchange rate.</mark> <mark>A more depreciated real exchange rate would be a major step forward, but it is not a panacea. Because exports are also constrained by binding capacity as well as business environment constraints, supply side factors must be tackled simultaneously. High cost of doing business is among the key obstacles hampering export development in Ethiopia (World Bank, 2014, 2015). Therefore, a one-off exchange rate adjustment is insufficient to redress the structural bottlenecks that hinder exports and a more comprehensive policy package would be needed to enhance the supply response to devaluation. This would include measures to address critical constraints in the still-challenging business environment (e.g. trade logistics, access to finance and land, infrastructure deficit, burdensome customs regulations, skills gap) (World Bank, 2015). Structural reforms targeted towards enhancing export growth and export diversification are particularly indispensable.</mark> 18
Concerning the possible ways out of the exchange rate conundrum, the real currency misalignment could be corrected through either discretionary devaluations or faster-than-usual nominal depreciations. One way of effecting a considerable correction of the rapidly increasing overvaluation is via discretionary devaluations. However, it is critical to strike the “appropriate” magnitude of a devaluation because overshooting will trigger inflationary effects while undershooting will be followed by further exchange rate adjustments down the road (Rodrik, 2008b). Put another way, the level of devaluation should not be ‘too large’ not to cause soaring inflation and ‘too small’ not to precipitate subsequent devaluations, but ‘large’ enough to significantly affect prices of tradables vis-à-vis nontradables and thus send <mark>clear signals about relative price changes throughout the economy.</mark> Since Ethiopia’s exchange rate misalignment is reinforced by the gradual and less-responsive birr depreciation, another potential route to achieve significant real depreciation may be to allow for fasterthan-ordinary nominal depreciations. The authorities may prefer to bring about the required adjustment through the combined effect of gradual nominal deprecation and inflation reduction. However, a gradualist stance is less likely to serve the purpose of redressing the large and growing real exchange rate misalignment while further reducing inflation is a difficult, if not impossible, task owing to bad weather spells this year. Regardless of which way the country opts to devalue, maintaining a low level of inflation is necessary for a desired level of real devaluation to materialize.

Ethiopia’s high vulnerability to volatile swings in the US dollar could be mitigated by resorting to a basket peg. A bilateral peg implies that fluctuations in the anchor currency are transmitted to the domestic economy. In other words, Ethiopia’s effective (trade-weighted) exchange rate will be driven by the fortunes of the dollar compared to its major trading partners. Th <mark>e vulnerability to externally-induced shocks is greater the lesser the trade weight attached to the anchor currency. Susceptibility to significant dollar fluctuations could be reduced by pegging rather to a basket, or a trade-weighted average, of other currencies. A basket peg would help ensure stable movements in the country’s effective exchange rate and minimize competitiveness concerns.</mark> <mark>The question of whether to peg to a single currency or a currency basket mainly depends on the country’s degree of trade diversification. If a country has diversified trade and no single dominant trading partner, a basket peg would be preferable, all other things being equal (</mark> Abed _et al_ ., 2003; <mark>Williamson 1982, 2005). For such a country, a single-currency peg widens the scope for large external imbalances and necessitates high reserve requirement (Argy, 1990; G</mark> udmundsson, 2005 <mark>). Although Ethiopia uses the dollar as exchange rate anchor, its exports to the US amount to only 5 percent of total exports. However, a basket peg might be harder to administer and could increase the challenge of foreign exchange reserve management (Frankel, 2003). Further, Ethiopia’s external debt is serviced mainly in US dollars, which may complicate the choice of anchor currency. These trade-offs need to be analyzed and considered carefully, which goes beyond the scope of this paper.</mark> <mark>Finally, from an international perspective, a policy of currency devaluation may entail beggar-thyneighbor effects. Conventional wisdom posits that competitive devaluations (also known as currency wars), with many countries manipulating their currencies to bolster competitiveness, are likely to neutralize one another and thus may not correspond to an optimal strategy. If Ethiopia and its major trading partners simultaneously pursue devaluation, they might undercut each other’s exports and indulge in a classic ‘competitive’ race-to-the-bottom, which leads to a situation where all countries reap no benefit. An international exchange rate coordination system could play a role in this regard, but this is beyond the scope of this paper. In the long run what mattes for exports to thrive is productivity and product quality. For this and other reasons, changes in the exchange rate would have to be undertaken in the wider context of external and internal developments. However, at its current level of development, Ethiopia’s currency adjustments are less likely to provoke strong reactions from its trading partners. For instance, Japan only in the late 1980s and early 1990s, and China in recent years faced scathing criticisms and threats from major trading partners for their soaring manufacturing exports driven by undervalued</mark> 19
<mark>currencies. So, Ethiopia would likely face such retaliatory measures from its trade partners only when it reaches a higher stage of development and claims a more prominent role in manufacturing worldwide.</mark>

# **<mark>References</mark>**

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22
# **Annex I: Undervaluation, Growth, and Exports**

**Figure 12. Undervaluation and Growth per capita, Ethiopia and Selected Countries**

<!-- Start of picture text --> 1 China 0.20 India<br>0.4 0.10<br>0.5 0.10 0.2 0.05<br>0<br>0.00<br>0 0.00 -0.2<br>-0.05<br>-0.4<br>-0.5 -0.10<br>-0.6 -0.10<br>-1 -0.20 -0.8 -0.15<br>Undervaluation (left scale) Growth per capita (right scale) Undervaluation (left scale) Growth per capita (right scale)<br>Republic of Korea Thailand<br>0.5 0.30<br>0.4 0.40<br>0.20<br>0.2 0.20<br>0<br>0.10<br>0 0.00<br>0.00<br>-0.5<br>-0.10 -0.2 -0.20<br>-1 -0.20<br>-0.4 -0.40<br>Undervaluation (left scale) Growth per capita (right scale) Undervaluation (left scale) Growth per capita (right scale)<br>Argentina Brazil<br>0.5 0.30 0.5 0.20<br>0.20<br>0 0<br>0.10<br>0.10<br>-0.5 -0.5<br>0.00<br>0.00<br>-1 -1<br>-0.10<br>-1.5 -0.20 -1.5 -0.10<br>Undervaluation (left scale) Growth per capita (right scale) Undervaluation (left scale) Growth per capita (right scale)<br>Mexico Peru<br>1 0.15 0.6 0.20<br>0.10 0.4<br>0.10<br>0.5 0.05 0.2<br>0.00<br>0.00 0<br>-0.10<br>0 -0.05 -0.2<br>-0.20<br>-0.10 -0.4<br>-0.5 -0.15 -0.6 -0.30<br>23<br>Undervaluation (left scale) Growth per capita (right scale) Undervaluation (left scale) Growth per capita (right scale)<br>1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011<br>1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011<br><!-- End of picture text --> Note: Undervaluation zone is above zero.
<!-- Start of picture text --> Ethiopia Tanzania<br>0 0.15 0 0.50<br>-0.2 0.10 -0.2<br>0.30<br>-0.4 0.05 -0.4<br>0.10<br>-0.6 0.00 -0.6<br>-0.10<br>-0.8 -0.05 -0.8<br>-0.30<br>-1 -0.10 -1<br>-1.2 -0.15 -1.2 -0.50<br>Undervaluation (left scale) Growth per capita (right scale) Undervaluation (left scale) Growth per capita (right scale)<br>1.0 Uganda 0.2<br>0.1<br>0.0<br>0<br>-1.0<br>-0.1<br>-2.0<br>-0.2<br>-3.0 -0.3<br>Undervaluation (left scale) Growth per capita (right scale)<br>1952 1955 1958 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 2006 2009 1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002<br><!-- End of picture text --> Note: Undervaluation zone is above zero. Source: Nguyen (2014) and Rodrik (2008).

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# **<mark>Figure 13. Undervaluation and Export Growth, Ethiopia and Selected Countries</mark>**

<!-- Start of picture text --> China India<br>0.6 0.4<br>0.4<br>0.2<br>0.2<br>0<br>0<br>-0.2<br>-0.2<br>-0.4<br>-0.4<br>-0.6<br>-0.6<br>-0.8 -0.8<br>1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011<br><!-- End of picture text --> <!-- Start of picture text --> Republic of 0.4 Thailand<br>0.8 Korea 0.3<br>0.6<br>0.2<br>0.4<br>0.2 0.1<br>0 0<br>-0.2<br>-0.1<br>-0.4<br>-0.6 -0.2<br>-0.8 -0.3<br>-1<br>-0.4<br>1 Argentina 0.6 Brazil<br>0.4<br>0.5<br>0.2<br>0<br>0<br>-0.2<br>-0.5 -0.4<br>-0.6<br>-1 -0.8<br>-1<br>-1.5 -1.2<br>1 0.6<br>Mexico Peru<br>0.8<br>0.4<br>0.6<br>0.2<br>0.4<br>0<br>0.2<br>-0.2<br>0<br>-0.4<br>-0.2<br>-0.4 -0.6<br>-0.6 -0.8<br>1953 1956 1959 1962 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011 1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 2011<br><!-- End of picture text --> Note: Undervaluation zone is above zero. Source: Nguyen (2014) and Rodrik (2008).

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<!-- Start of picture text --> Ethiopia 0.6 Tanzania<br>0.8<br>0.4<br>0.6<br>0.4 0.2<br>0.2 0<br>0 -0.2<br>-0.2<br>-0.4<br>-0.4<br>-0.6 -0.6<br>-0.8 -0.8<br>-1 -1<br>-1.2<br>-1.2<br>1.5 Uganda<br>1<br>0.5<br>0<br>-0.5<br>-1<br>-1.5<br>-2<br>-2.5<br>1951 1955 1959 1963 1967 1971 1975 1979 1983 1987 1991 1995 1999 2003 2007 2011<br>1961 1964 1967 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003<br>1951 1954 1957 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002<br><!-- End of picture text --> Note: Undervaluation zone is above zero. Source: Nguyen (2014) and Rodrik (2008).

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**Annex II: Text Box 1. Definitions of Terms and Acronyms**

**The real exchange rate (RER) is defined as the nominal exchange rate (NER) between two currencies corrected for relative price-level changes.** The NER for Ethiopia is the price of the birr in terms of another currency (i.e. the number of birr units per foreign currency unit). For instance, if it costs someone US$0.05 to buy one birr, from the birr holder’s perspective the NER is 20. However, the NER tells us nothing about the real purchasing power of the birr vis-à-vis other currencies. The RER is obtained by adjusting the NER between the birr and another currency for the effects of inflation. It is used to measure the international competitiveness of the country’s exports. The RER between two countries is given by the product of the NER and relative price levels in each country:

where _pi_ , _t_ and _pj_ ∗ , _t_ are domestic and foreign price levels at time _t_ respectively. An increase in RER is a depreciation.

**Economists are, however, more interested in the effective exchange rate.** As alluded to above, the bilateral NER and RER involve a currency pair. In contrast, the effective exchange rate is a summary measure of the rate at which a country’s currency is exchanged for a basket of other currencies, in either nominal or real terms. The nominal effective exchange rate (NEER) is a weighted average of the bilateral NERs between Ethiopia and each of its trading partners, with the weights being the respective trade shares of each partner. Adjusting the NEER for price differentials between the country and its trading partners yields the REER, which plays a central role as an overall yardstick of international competitiveness. Assuming that Ethiopia has _N_ trading partners and letting _tradei_ denote the bilateral trade with country _i_ , the REER can be computed as:

_trade1 tradeN REERt_ � _RER1,t trade_ �⋯� _RERN,t trade_ where _trade_ is the total value of international trade between Ethiopia and its trading partners, and RER is as defined above. The REER and NEER represent the same path only in the ideal situation that exchange rate changes have no impact on inflation rates. The REER index is defined in the opposite way to the standard RER; thus, an increase in the REER means real appreciation.

**This paper mainly employs the REER, although some references to the RER are made along the way.** The REER is used for most of the analysis in this paper for two interrelated reasons. First, compared to the RER, it is the relevant measure of exchange rate movements for a country that trades and undertakes investment transactions with several countries. Second, unlike the NEER, the REER takes into account the effects of inflation differentials and thus better captures the evolution of external competitiveness.

**The Ethiopian birr is referred to as overvalued (or undervalued) when the real effective exchange rate is above (or below) its ‘equilibrium’ level, i.e. the level consistent with fundamentals and macroeconomic stability.** The currency is said to be overvalued if its official price is lower than its open market value. For instance, an overvaluation of Ethiopia’s RER would indicate that the birr is too expensive and the dollar is too cheap in comparison with the exchange rate predicted by the forces of demand and supply. Overvaluation implies that exports are more expensive and less competitive compared to identical products from competitor <u>countries.</u>

# **Annex III: Additional Details on the Marshall-Lerner (ML) Condition in Ethiopia**<sup>**8**</sup>

## **Theoretical Framework**

The ML condition states that an exchange rate devaluation (or depreciation) will improve the balance of trade only if the sum of long-run import and export demand elasticities exceeds unity in absolute value. It is conventionally formulated using the following equations for long-run import and export demand respectively: where im� stands for imports of goods and services; ex� for exports of goods and services; y� for domestic income; y�� for world income; reer� for real effective exchange rate; and t is a linear trend term, capturing terms of trade effects and unaccounted-for impacts of policy or quality improvements. A decline in reer� (representing a depreciation) potentially lowers the volume of imports; thus, δ� is 8This section heavily draws upon Haile (2015a,b) and for further details the reader is referred to these papers.

27
expected to be negative. An increase in domestic income supposedly leads to an increase in the consumption of imported goods. Therefore, δ� is expected to be positive. A rise in world income and real currency depreciation would stimulate exports, suggesting a positive sign for θ� and θ� . The ML condition can be tested by estimating Eqs. (1) and (2), and then checking whether the sum in absolute value of the elasticities ( δ� and θ� ) is greater than 1.

However, even if a devaluation improves the trade balance in the long-run under the aforementioned condition, it may worsen it in the short-run as trade in goods tends to be inelastic while import prices increase in the immediate aftermath of a change in an exchange rate (Bahmani-Oskooee and Ratha, 2004). Although the balance of trade may deteriorate in the short-term, it will improve in the long-term as consumers adjust to the new prices. This is commonly referred to as the _J_ -curve effect. The _J_ -curve refers to the trend of a country’s trade balance following a real exchange rate devaluation.

# **Empirical Framework**

The empirical analysis employs the cointegrated vector autoregressive (CVAR) methodology. The baseline model is specified with two lags and a linear trend restricted to the long-run relations: where x� is a p�1 vector comprising the above-mentioned variables (where _p_ is the number of variables), i.e. �ex�, im�, reer�, y�, y��� ; β�x��� are r long-run (cointegration) relations; α is a p�r matrix of adjustment coefficients (denoting the speed of adjustment to equilibrium); Γ� is a p�p matrix capturing short-run effects; μ� is a vector of constant terms; ε� is a p�1 vector of error terms; and ∆ is the first difference operator. Given that all variables are in logs, their differences represent growth rates.

To ensure valid statistical inference, the analysis controls for three outliers (1985, 1992, 2009) using impulse dummies. The years 1985 and 2009 coincide with periods of severe famine and global recession respectively, while 1992 marks the advent of market-oriented reforms. Of the three outlying observations, the 1992 outlier was found to have significantly caused a mean shift in the growth rates. The sharp turn from a ‘state-led’ economy to a ‘market-oriented’ one appears to have placed some of the variables on a higher growth trajectory. An algorithm searching for breaks developed in Doornik _et al_ . (2013) was used to determine the existence, timing, and significance of breaks in mean growth rates. Accordingly, the above-mentioned event was modeled using a broken linear trend �t����� in the longrun relations, β<sup>�</sup> x� (to account for the change in trend slopes underlying the long-run equilibrium relationships) and a step dummy �D�92�� in the equations, ∆x� (to model the mean-shift in the growth rates of the macroeconomic variables). See Haile (2015a) for more details.

Note that the annual sample encompasses two starkly distinct political and economic regimes: the socialist Derg regime (1974-1991) and the incumbent EPRDF regime (post-1991). Therefore, to make sure that the estimated coefficients represent constant parameter regimes, the empirical model is reestimated using quarterly data for the period 1993-2013. The model for the quarterly data included a number of impulse dummies to account for extraordinary observations.

# **Results**

## **The long-run impact of a devaluation on the trade balance**

Table 3 reports the identified long-run structure of two long-run relations. The first long-run relation is between export, REER, and world income. Only export is equilibrium correcting to the relation, signifying its importance as an export relationship: The signs of the coefficients are in line with the theoretical expectation. The results suggest that REER and world income are significant determinants of long-run movements in exports. A devaluation or depreciation of the REER leads to an increase in the exports of goods and services. The coefficient estimate indicates that the effect of a 1 percent depreciation of the REER would be to increase exports 28
by 0.50 percent. The positive coefficient on y�� suggests that the higher the world income, the higher the exports.

The second long-run equilibrium relation describes a strong association between import, REER, and domestic income, and normalization is made on import: im� �0.59reer� �0.55y� �0.05t���� REER possesses a positive coefficient, which is to be expected as devaluation discourages imports. A 1 percent depreciation of the REER is associated with roughly 0.60 percent reduction in the imports of goods and services. A 1 percent increase in domestic income would increase imports by 0.55 percent. The adjustment coefficients show that only import equilibrium corrects to the long-run relation.

Altogether, the estimates show that the sum (in absolute value) of the export and import elasticities with respect to the real effective exchange rate exceeds unity. Therefore, the ML condition is met in the long run, suggesting that a real devaluation of the birr will considerably improve the balance of trade in Ethiopia. This finding is sufficiently robust against a wide array of sensitivity checks, such as using quarterly data for the subperiods 1992-2013 and 2004-13.

**Table 3. Identified Long-Run Structures**

||**Marshall**|**-Lerner co**<br>**Annua**<br>**(1980-**|**ndition**<br>**l data**<br>**2013)**|||**Expo **<br>**Qu**<br><br>**Manufac**|**rts By Se**<br>**arterly da**<br>**(2005-13)**<br>**turing**|**ctor**<br>**ta**<br>**Agric**|**ulture**|
|---|---|---|---|---|---|---|---|---|---|
|Var.|β<sup>�</sup>�|β<sup>�</sup>�|α��|α��|Var.|β<sup>�</sup>�|α��|β<sup>�</sup>�|α��|
|reer�|**0.50**<br>(2.83)|**-0.59**<br>(-3.45)|∗|∗|reer�|**1.06**<br>(2.04)|∗|**0.33**<br>(1.81)|∗|
|ex�|1.00|–|-1.11<br>(-4.27)||ex�<br>��|1.00|**-0.49**<br>(-2.36)|∗|∗|
|im�|–|1.00|0.52<br>(1.98)|-0.85<br>(-3.19)|ex�<br>����|–||1.00|**-2.04**<br>(11.10)|
|y�|–|-0.55<br>(-3.16)|∗|∗|y�<br>�|-4.59<br>(-2.28)|0.006<br>(2.31)|-1.21<br>(-2.19)|∗|
|y�<br>�|-6.36<br>(-5.42)|–|∗|∗|t|-0.06<br>(-5.80)|–|-0.03<br>(-9.97)||
|t����|-0.14<br>(-9.70)|-0.05<br>(-4.17)||||||||
|t|0.27<br>(6.11)|–||||||||

Note: _t_ -values in parentheses. The empirical models allow for a linear trend �t� to account for the trending nature of the variables and a broken linear trend in 1992 �t����� to capture the significant change in trend slopes (and thus the mean-shift �� ���� in growth rates) due to the political and economic regime change. ex� and ex� represent manufacturing and agricultural exports, respectively. *Denotes statistically insignificant error correction coefficients. Source: Haile (2015a,b).

# **The short-run impact of a devaluation on the trade balance**

Figure 14 plots the dynamic impulse response functions<sup>9</sup> for export and import as a result of a one standard error shock to the REER. The analysis finds that the contemporaneous impact of a one standard error positive shock to the REER (representing an appreciation) is a sharp decline in exports of about 0.04 percent and a surge in imports of approximately 0.07 percent. This implies a contemporaneous contraction in the trade balance of circa 0.11 percent. Conversely, a one standard error negative shock to REER, say via devaluation, would lead to a contemporaneous increase in the balance of trade of 0.11

> 9Impulse response analysis describes the knock-on effects on the system variables of a one standard error shock to a variable of interest, assuming that the system is not hit by other shocks thereafter.

29
<!-- Start of picture text --> 0.06<br>0.04<br>0.02<br><!-- End of picture text --> <!-- Start of picture text --> 0.00<br>-0.02<br>-0.04<br>o 5 10 15 20 25 30<br><!-- End of picture text --> rm = —1.06reer, + 4.59y! + 0.06t aor! — _0.33reer, + 1.21y” + 0.03t
statistically significant at the 10 percent level. Compared to manufacturing exports, the increase in agricultural goods export that an additional real depreciation yields is quite smaller.

31