Economic Jigsaw: Ethiopia Floats the Birr

The choice of exchange rate system (regime) can be a crucial one for emerging and developing countries. Ethiopia's central bank has made a bold move by floating the birr, the national currency, causing its value to plummet by 30% against the US dollar. This dramatic shift marks a significant step in Ethiopia's journey toward economic stabilisation and reform, aiming to attract International Monetary Fund (IMF) support and address long-standing issues like high and volatile inflation and persistent foreign currency shortages.

This article from the Economist (Feb 2024) provides some background context on Ethiopia

The Floating Birr: A Double-Edged Sword?

The decision to float the birr, transitioning to a market-based exchange rate, signifies Ethiopia's commitment to overhaul its economy. Previously, the currency was tightly controlled, leading to distortions such as a thriving black market for US dollars. By allowing the birr's value to be determined by market forces, the Ethiopian government hopes over time to curb inflation, enhance transparency, and attract foreign investment.

However, this move comes with its challenges. The sudden depreciation of the birr increases the cost of imports, which could further fuel inflation—a significant concern given Ethiopia's existing high inflation rates. On the flip side, a weaker birr makes Ethiopian exports relatively cheaper and potentially more price competitive internationally, offering a silver lining for the country's trade balance.

IMF and World Bank to the Rescue?

Securing support from the IMF and the World Bank is a crucial aspect of Ethiopia's economic strategy. The promise of $10.7 billion in external financing is expected to provide much-needed liquidity and help stabilize the economy. This aid comes with expectations: Ethiopia must implement structural reforms, including fiscal discipline and better governance.

The international community's response, particularly from major economic players like the United States, has been cautiously optimistic. The U.S. acknowledged the difficult but necessary nature of this shift to a market-based exchange rate, highlighting the importance of addressing "macroeconomic distortions."

Economic Reforms: A Balancing Act

In addition to floating the currency, Ethiopia has introduced other economic reforms, such as adopting an interest rate-based monetary policy. These measures are crucial for creating a more predictable and stable economic environment, which is essential for attracting investment and fostering economic growth. The reforms also align with the conditions set by international creditors for debt restructuring and financial support.

However, these changes come at a social cost. The immediate impact of the birr's devaluation on the cost of living can lead to public discontent, especially among lower-income households. The government must carefully manage this transition to avoid exacerbating social tensions. Rising inflation is nearly always regressive for poorer families least able to cope with increases in prices for basics.

Discussion Questions:

1. What are the potential short-term and long-term impacts of floating the birr on Ethiopia's economy?
2. What role do international institutions like the IMF and World Bank play in shaping the economic policies of developing countries?
3. How might Ethiopia's new exchange rate policy affect its trade balance and foreign investment inflows?
4. What lessons can other African countries learn from Ethiopia's approach to economic reform and debt restructuring?

Glossary of Key Economic Terms:

• Black Market: An illegal market where goods or currencies are bought and sold without government regulation.
• Currency Float: A system where the value of a currency is determined by the foreign exchange market rather than being fixed by the government.
• Debt Restructuring: A process where a country renegotiates the terms of its debt to achieve some advantage, often to avoid default.
• Devaluation: A reduction in the value of a country's currency with respect to foreign currencies.
• Exchange Rate: The value of one currency for the purpose of conversion to another.
• Foreign Exchange Market (FX Market): A global marketplace for exchanging national currencies against one another.
• IMF (International Monetary Fund): An international organization that aims to promote global monetary cooperation and financial stability.
• Inflation: The rate at which the general level of prices for goods and services is rising, eroding purchasing power.
• Monetary Policy: The process by which a central bank manages the supply of money in an economy, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
• Structural Reforms: Measures implemented to improve the economic framework and institutions of a country, often involving significant changes in policies and regulations.