Public Information Notice No. 05/11

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with Ethiopia

January 31, 2005

On September 13, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Ethiopia and completed the final review under the Poverty Reduction Groth Facility (PRGF) Arrangement.¹

Background

The Ethiopian authorities have been implementing wide-ranging structural reforms and pursuing prudent macroeconomic polices. However, Ethiopia continues to face political uncertainties, which are mainly related to the unresolved dispute with Eritrea on boundary demarcation. The country ranks toward the bottom (170 out of 177 countries) in the 2004 Human Development Index ranking, an assessment combining life expectancy, adult literacy, primary school enrollment, and per capita income. The Poverty Reduction Strategy Paper (PRSP) indicates that the poverty headcount index was 44.2 percent in 1999/00 for the country as a whole, down from 45.5 percent in 1995/96.

Ethiopia's real GDP growth rebounded strongly by 11.6 percent during 2003/04, as agricultural production recovered fully from the drought-affected levels of 2001/02-2002/03. The average annual consumer price inflation rate has fallen from 15.1 percent in 2002/03 to about 9.6 percent in 2003/04. Although the exchange rate vis-à-vis the U.S. dollar has remained highly stable through 2003/04, the exchange rate has depreciated in nominal and real effective terms (by about 8 percent and 5 percent, respectively through end-March 2004). This policy has allowed the National Bank of Ethiopia (NBE) to build up its net foreign assets and establish a stronger reserve cushion for coping with future exogenous shocks.

Based on updated estimates, in 2003/04 the fiscal deficit (including grants) is likely to be about 4.8 percent of GDP. In nominal terms, revenue surpassed the program target because of strong indirect tax receipts stemming from buoyant import growth and improved customs administration, which more than offset lower-than-projected direct taxes that reflected weak corporate profits following the drought of 2001/02. Moreover, donors provided more external grants and less project loans, given the vulnerable debt situation. The external current account deficit (including grants) is estimated to narrow to 4 percent in 2003/04.

Progress has been made in implementing structural reforms that focused on public sector management, public expenditure policy, and the commencement of the implementation of restructuring plans for the Commercial Bank of Ethiopia (CBE) and the NBE. The first annual progress report of the poverty reduction strategy paper was discussed by the IMF and World Bank Boards in February 2004, and Ethiopia reached the completion point under the Heavily Indebted Poor Countries (HIPC) Initiative in April 2004.

Executive Board Assessment

Executive Directors welcomed the strong rebound of economic activity in 2003/04 despite the recent drought and the continued border conflict. Price stability has been maintained, the international reserve position has strengthened, and progress has been made with key structural reforms, notably in the fiscal and agricultural sectors. These achievements will help lay the foundation for sustaining higher growth over the medium term.

Directors observed, however, that Ethiopia remains highly vulnerable to external shocks, and poverty indicators continue to be among the highest in the world. Sustaining faster growth and making progress toward the Millennium Development Goals (MDGs), while maintaining debt sustainability, will require both stronger and broader structural reforms and stepped-up donor support. Directors underscored, in this regard, the importance of improving Ethiopia's capacity to absorb and use donor assistance more effectively, a peaceful resolution of the border dispute with Eritrea, and the continued reorientation of public resources to poverty-related expenditures.

Directors agreed that fiscal policy should continue to focus on strengthening expenditure management and enhancing revenues, while containing domestic financing and reducing the public debt burden. While welcoming the projected rise in social spending in the 2004/05 budget, they expressed concern about the increase in military expenditure and the higher level of domestic borrowing needed to finance the budget, which complicates efforts to reduce inflation and crowds out credit to the private sector. Directors therefore urged the authorities to consider additional fiscal measures, including cuts in non-priority outlays. They stressed that implementation of the Food Security Program should be supported by steps to strengthen the capacity of local governments to absorb the substantially higher federal transfers. The authorities should also seek additional donor grants to finance the program; this could be facilitated by timely external audits of the achieved outcomes.

Directors welcomed the progress that has been achieved in fiscal reforms. They emphasized that improving public expenditure management remains a critical priority, particularly in view of the need to strengthen the capacity of local governments following fiscal decentralization. At the same time, efforts should continue to consolidate and report the general government accounts in a timely manner to enhance fiscal transparency and accountability. Directors also urged the authorities to consolidate the gains made in improving tax and customs administration, and to review the VAT refund mechanism along with other audit and enforcement guidelines, aimed at creating a tax environment that is more conducive to private sector investment.

Directors encouraged the authorities to develop a comprehensive, prudent public debt management strategy, with clear rules for containing future domestic and external borrowing, and limiting borrowing to highly concessional loans and, preferably, grants to keep the public debt at sustainable levels. Consistent with any scenario involving a significant increase in external assistance, the authorities' medium-term fiscal framework needs to involve a rebalancing of expenditure to recurrent items, given large gaps in the required number of teachers and medical personnel. Directors welcomed the authorities' plan to develop their own fiscal scenarios for MDG purposes. They noted, however, that the "double aid" scenario, which appears ambitious, requires a much stronger policy effort on the part of the authorities to materialize. In any event, continued close consultation with the Fund and donors will be crucial, to identify the challenges early and mitigate any potential adverse effects on the broader macroeconomic framework arising from a substantial scaling-up of aid inflows.

Directors stressed that monetary and exchange rate policies need to focus on achieving the inflation and international reserve targets. To this end, and in the present environment of increased inflationary pressures, they urged the authorities to remain prudent and adopt more cautious targets for the expansion of money and credit to the government. They also suggested that market-based instruments be developed to enhance the central bank's liquidity management capacity. Directors welcomed the authorities' commitment to allow the exchange rate to be fully market-determined, with interventions being limited to smoothing fluctuations. In this context, the authorities were encouraged to safeguard external competitiveness through structural reforms that improve productivity and efficiency. Measures to further liberalize foreign trade, eliminate remaining exchange restrictions, and streamline customs procedures would support these objectives.

Directors urged the authorities to expedite the implementation of the structural reform agenda in support of rural and private sector development. Particular emphasis should continue to be placed on agricultural productivity, capacity building, and privatization. In the financial sector, Directors stressed that it will be important to fully implement the restructuring plans for the state-owned banks, particularly for the Commercial Bank of Ethiopia. They commended the authorities for the progress in implementing safeguards recommendations, strengthening bank supervision, and restructuring the National Bank of Ethiopia, and urged further consideration of measures to increase its operational autonomy. Directors also encouraged the authorities to accelerate financial reform aimed at increasing competition and financial intermediation, as well as strengthening the soundness of domestic banks. Consideration should be given to opening up more of the financial sector to the private sector, including by allowing foreign bank entry.

Directors welcomed the opportunity to review Ethiopia's performance under Fund supported programs since 1992. They broadly concurred with the conclusions of the ex post assessment of long-term Fund engagement with Ethiopia, and with the strategy for future Fund involvement. Directors welcomed in particular the authorities' strong ownership of programs, which had translated directly into action. They noted with concern, however, that Ethiopia's debt sustainability remain precarious even after three successive Fund-supported programs and the HIPC completion point, and that fiscal and external deficits remain large. Going forward, Directors emphasized the importance of realistic projections for real growth, government revenues, and foreign grants in developing macroeconomic programs; prudent debt management; more ambitious structural reforms; and programs that explicitly incorporate policies to help cope with exogenous shocks. They also highlighted the need to translate past lessons into better program design and future action, as well as to learn from the successful experiences of similar countries. In addition, improved cooperation and coordination with the World Bank and donors is critical to ensuring steady aid flows. Directors noted that the Fund continues to have an important role to play in providing technical assistance to strengthen capacity in the priority areas identified in the assessment.