Public Information Notice No. 05/18

Public Information Notice: IMF Executive Board Concludes Article IV Consultation with Eritrea

February 9, 2005

On September 3, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Eritrea.¹

Background

Eritrea remains one of the poorest countries in the world, with a per capita GDP of about $130 and a Human Development Index ranking of 156 out of 177 countries. More than half of the population lives on less than US$1 per day and about one third lives in extreme poverty (i.e., less than 2,000 calories per day). The authorities have produced an Interim Poverty Reduction Strategy Paper and a national food security strategy, which together set out plans aimed at increasing rural incomes and raising productivity.

The 1998-2000 border war with Ethiopia severely damaged the country's economic and social infrastructure and displaced over one-third of the population. Continued tensions over the border demarcation dispute with Ethiopia have resulted in Eritrea remaining in a heightened state of mobilization. The ongoing "no war/no peace" impasse could continue indefinitely, thereby delaying the demobilization program and a return to a peacetime economy. While committed over the long run to a return to market-based policies, the authorities have increasingly resorted to an administrative-controls approach to economic management.

The post-border war recovery has also been impaired by four consecutive years of recurrent drought. Domestic food production for 2004 is likely to cover only 17 percent of domestic demand, resulting in an estimated 1.7 million people (almost half the population) requiring humanitarian assistance. Malnutrition has increased in many parts of the country. There are encouraging signs, however, that the drought may be over.

Macroeconomic imbalances have grown in recent years and overall performance has been weak. In 2003, real GDP growth is estimated to have rebounded to around 3 percent. At the same time, average inflation rose to 23 percent, owing to food and non-food shortages and demand pressures associated with the large government deficit.

Substantial progress was made in reducing the overall fiscal deficit (including grants and special projects) to 17 percent of GDP in 2003, from 32 percent in the previous year. However, recurrent expenditure significantly exceeded budgeted spending, primarily because of overruns on defense spending and other discretionary expenditure was compressed. Monetary policy continued to be subservient to the government's financing requirements. While net credit to government declined, it still remained large (equivalent to 12 percent of GDP), and was entirely financed by the central bank.

The balance of payments situation deteriorated in 2003. Following a near collapse of exports during 1997-98 because of the emerging border conflict with Ethiopia, exports declined further owing to the break in trade relations with Sudan, while imports rose by 14 percent on account of food aid. Foreign reserves declined in 2003 to the equivalent of about 2 weeks of imports.

The commercial banks remain profitable owing to income from their foreign exchange activities, and they appear to be in compliance with prudential regulations. However, they continue to hold a high proportion of non-performing loans, largely on account of the effects of the border war, and their core lending activities do not generate enough income to cover operational costs.

Executive Board Assessment

Executive Directors regretted the high economic and social cost for Eritrea from the impasse in resolving the border dispute with Ethiopia. Poverty remains pervasive, defense spending large, and fiscal deficits and government debt are at unsustainable levels. A prolonged drought, acute capacity limitations, as well as serious weaknesses in economic management and governance have further worsened the country's conditions. While real GDP growth has accelerated in 2003, Directors expressed concern about the increase in inflation, the decline in international reserves to a critically low level, and the sharp contraction in Eritrea's exports.

Directors agreed that to improve Eritrea's economic and social outlook the authorities will need to make a sustained effort to sharply reduce government debt, lessen reliance on public sector intervention and administrative mechanisms in the conduct of the economy, and create—through wide-ranging structural reforms—an environment conducive to private-sector development. While recognizing the importance of a lasting resolution of the border conflict for a brighter outlook, Directors urged the authorities to act decisively on measures that would help improve the current situation while laying the foundations for sustained peacetime growth.

Directors welcomed the improvement in the fiscal balance and the better-than-expected revenue performance in 2003, as well as the development of a consolidated fiscal framework to guide budget execution in 2004. Nevertheless, the large fiscal deficits projected over the medium term are unsustainable. Directors stressed that moving ahead as rapidly as circumstances permit on the military demobilization program will be critical for bringing down the deficit to a sustainable level, while providing resources for spending on poverty reduction and social safety net programs and the implementation of key economic reforms. In the period immediately ahead, priority will need to be given to curtailing non-priority outlays, stepping up efforts to collect tax arrears, and further strengthening tax administration. To improve fiscal transparency and strengthen investor confidence and donor support, Directors urged the authorities to publish the budget on a regular basis.

Directors noted that Eritrea's debt situation would worsen significantly if current economic policies are maintained and that, even under more optimistic assumptions, sustainability might not be achieved. A few Directors observed that even after the application of traditional debt relief mechanisms, Eritrea would likely have debt levels above the HIPC Initiative thresholds. While the high levels of domestic and external debt are being sustained in the short run by administratively setting interest and exchange rates, it will be important to remove these controls gradually as the fiscal situation permits. Directors urged the authorities to develop a viable debt management strategy relying mainly on grant financing and anchored by a track record of good policies.

Directors expressed concern about the constraint that fiscal dominance imposes on the ability of the Bank of Eritrea to conduct monetary and exchange rate policy. The shift away from central bank financing of the fiscal deficit is welcome, but will need to be followed by a well-sequenced set of measures to improve the effectiveness of monetary policy in the context of a strengthened banking system. In addition to allowing interest rates and the official exchange rate to move gradually toward market clearing levels, Directors stressed the importance of developing appropriate instruments for a market-based conduct of monetary and exchange rate policy over the medium term.

Although Eritrea's commercial banks appear to be in compliance with prudential regulations, Directors urged the authorities to address the problem of nonperforming loans and pursue policies conducive to a profitable environment for bank lending activities. A first important step in this regard would be to regularly adjust the interest rate on treasury bills in line with the banks' cost of funds as fiscal circumstances permit.

Directors highlighted the adverse impact of the widespread use of administrative controls, the expanding role of the state into commercial activities, and the lack of a transparent regulatory environment, which undermine investor confidence and private sector development. They saw steps to address these issues as urgent structural priorities, and encouraged the authorities to return to their post-independence liberalization strategy as a basis for sustainable growth and poverty reduction.

To improve competitiveness and resource allocation, Directors urged the authorities to correct the distortions in the trade and exchange system and make it more transparent. They encouraged them to take the first steps to eliminate the multiple currency practices by unifying the current official dual exchange rate system at the more depreciated preferential rate, and to allow public and private foreign exchange bureaus to operate freely within an appropriate regulatory environment. In the short term, well-targeted and transparent subsidies might be used to limit the effect of exchange rate adjustments on prices of essential goods.

Directors welcomed the progress made by the authorities in finalizing Eritrea's interim Poverty Reduction Strategy Paper (I-PRSP) and completing its food security policy, and looked forward to the completion of a full PRSP. They encouraged the authorities to circulate these documents widely to Eritrea's development partners, and noted that Eritrea will need adequate assistance from the international community to support a sustained policy effort to address the daunting challenge of poverty reduction.

While welcoming the improvements made in Eritrea's money and banking statistics, Directors stressed the need for further progress in providing the Fund on a regular basis with fiscal and balance of payments data. Given Eritrea's capacity constraints, the country will continue to need technical assistance in a range of areas, and Directors urged the authorities to take full and effective advantage of the technical assistance being made available by Eritrea's development partners, including by the East AFRITAC. Directors looked forward to close cooperation between the staff and the authorities in the period ahead.