Many, perhaps most, readers are aware that it is exactly two years since Ethiopia started off on a journey toward a market-determined exchange, with the birr losing all its dollar value shortly thereafter. A principal objective of taking the new policy direction was to achieve price competitiveness, especially in nontraditional exports, thereby correcting Ethiopia’s external balance and improving its international payments position. Interestingly, the current account deficit declined markedly from 2.9% of GDP in fiscal year 2023/24 to 1.3% in 2024/25, before rising (tentatively) to 2.5% of GDP in 2025/26. It is projected to stabilize at around 2% of output by 2027/28 – the end of our IMF-backed adjustment program.
The question at issue is: Has there been enough evidence so far to regard a flexible exchange rate as the magic wand to be waved over Ethiopia’s external balance problems?
Grasping the nation’s external balance problems is a natural starting point. Per IMF data, our current account (economically the crucial component of Ethiopia’s official settlements balance) had on average a somewhat worrisome deficit of 5.3% of GDP over 2001-2025, peaking in 2006 at 10.4%. The trade deficit – the shortfall of exports from imports of goods and services – averaged 15.6% of GDP. Export receipts paid for, on average, just 23.8% of imports annually. Ethiopia’s export base has been low and narrow, with goods exports averaging just 5.3% of output in that same quarter of a century. In brief, we have run persistent current account (trade) deficits. And these trade deficits count as a deduction against our economy, which is epitomized by mass unemployment. Further, there have been recurrent balance-of-payments (BOP) deficits, whose financing has required sales of domestic firms to foreigners, drawing down foreign exchange reserves, donor budget support, and incurring foreign debts. And official international reserves averaged the equivalent of just 1.8 months of prospective imports during the 25-year period. Last, although the data are unavailable, Ethiopia is surely a net debtor country with negative net foreign wealth (roughly the cumulative sum of current account deficits). Altogether Ethiopia could do with an improved current account.
The next step is to identify the reason Ethiopia runs current account deficits. And at its core, it comes down to the fact that the country has not been spending within its means. That is, it’s because our economy uses more goods and services than it produces, or because it invests more than it saves. To substantiate this, Ethiopia has been investing 27.3% of GDP on average during 2001-2025, while saving only 12.8%. The implied resource gap roughly matches our trade deficit as a share of GDP. And inasmuch as our exchange rate affects relative prices of exports and imports, it is the one that helps translate resource gaps into trade gaps.
That being the case, the IMF essentially believes that if Ethiopia can get its exchange rate right, it can correct its external imbalances. For it already declared that an overvalued Ethiopian birr had been “the source of deep, long-standing macroeconomic distortions and protracted BOP vulnerabilities.” It also called for the abandonment of managed floating exchange rates in favor of freely floating ones. But as it happens, the IMF’s belief is a bit overenthusiastic.
For a start, while the birr’s overvaluation has been adjudged “eliminated” since the currency fell off a cliff a year ago, let’s not mistake this as an indication that the birr is now completely flexible; it is not. For the National Bank of Ethiopia still intervenes in Forex to temper exchange rate changes; specifically, it’s selling U.S. dollars for birr through auctions open to commercial banks. Doesn’t this capture the essence of a flexibly managed exchange rate regime? Or shall we call the current system a “dirty float”? And despite the IMF’s wish for quick price discovery, the exchange rate is yet to be “market-clearing” in the exact sense of the term.
Which is not to call for a clean float. Insofar as the intention is to make the real exchange rate competitive enough to promote a rapid growth in non-primary/manufactures exports, why would anyone demand freely floating exchange rates, which are infamous for their undependability? Floating rates jump around a great deal owing to market forces, being exposed to destabilizing speculation (unless buttressed by capital controls). On the other hand, the private sector needs to have confidence in the real exchange rate’s competitiveness for years to come in order to undertake the necessary plant and equipment investments for expanding export industries or capacity. Doesn’t this inevitably lead us to root for an intermediate exchange rate regime (like managed floating!)? The authorities should realize that if they really mean to have a market-driven exchange rate while allowing private capital mobility and retaining monetary policy autonomy, they must necessarily be willing to give up currency stability and, with it, confidence.
And there’s more. Combined with capital inflows, a floating exchange rate would enable deterioration in our current account. Ethiopia, we know, takes pains to attract more foreign direct investment (FDI), and the government prides itself on succeeding in doing this. Indeed. FDI can contribute required capital, skills, and know-how. But guess what – it is also normally accompanied by higher trade deficits. How so? Such an investment inflow, apart from resulting in more imported parts and materials, strengthens a local currency in Forex, hurting exports, promoting imports, and thereby increasing net imports.
Matters, indeed, become even more complicated outside Forex. Devaluation of the birr by no means necessarily, or even presumptively, lowers the relative price of Ethiopian goods. First, it depends on domestic inflation, which is erratic. Largely as a result, for example, even though nominal effective exchange rate was devalued on average by 4.5% during 2006-2020, real effective exchange rate still appreciated by 5%, failing to improve our presumed cost/price competitiveness. But second, Ethiopia has little or no influence over its terms of trade, anyway. The U.S. dollar prices of coffee and gold are fixed, determined on world markets; so currency overvaluation has not actually made our main exports look expensive compared with their counterparts sold abroad. In either case, our exchange rate gets lost in translation, so to speak.
No doubt, devaluation does result in higher birr prices for both exported and imported goods, creating an incentive for exporters, a disincentive for importers. But volumes do not adjust automatically. In fact, our export/import volumes can be deemed insufficiently responsive to the birr price changes. The export supply response is weak mainly due to well-known capacity constraints. The demand for imports (like capital equipment, fuel, medicine and fertilizers) is predominantly structural, and hence is not materially squeezable without hurting growth and living standards. That is, import prices are unlikely to go high enough to cause a serious fall in demand for economic essentials, for which domestic substitutes are not readily available. Under such conditions, birr’s depreciation is more likely to worsen the trade account than to improve it.
But haven’t Ethiopia’s export volumes increased in the wake of the huge devaluation? Yes, they have – but with major caveats. First, our export story principally features a handful of primary commodities that are volatile in nature, not manufactures. Also, the export quantities of both coffee and gold partly reflect a drawdown in hoarded inventory. And some amount of gold has moved from illicit to official channels due to price premiums paid by the NBE – a dominant buyer. Some amount of coffee, too, has shifted from domestic to export markets, not least due to preexisting efforts by the government to increase both the quantity and quality of coffee produced. The point is that it would be a stretch to claim an explicit link, as the standard theory would have it, between devaluation and export volumes herein.
To be fair, the current Ethiopian government has demonstrated a belief that the BOP constraint can be overcome not only by export growth but also by import substitution. For it argues that it has “saved” billions of U.S. dollars in just under two years by substituting for particular imports. Yet the aggregate value of goods imports increased in each of the past two fiscal years. Suppose, instead, that Ethiopia does succeed in significantly reducing its imports, while the exchange rate is sufficiently floating. Then our demand for U.S. dollars would decline, and so would the birr value of those dollars. And a stronger birr would make the local prices of exports lower than they would have been otherwise, possibly hurting exports. One, then, can’t help remembering the Nobel Prize-winning economist Paul Krugman’s quip: “Squeezing any one piece of the trade deficit is like pushing on a balloon: It just expands someplace else.”
Can a real depreciation of the birr have a decisive positive impact on the current account if sufficient time is allowed to pass? The IMF certainly thinks so. After all, it is providing us with loans in foreign currency to finance trade deficits during the period before our trade account can be expected to respond as intended. True, favorable technological and structural changes also occur in the long run. But the fact that devaluation has not improved the trade balance during the past 35 years, coupled with the weak exchange rate-trade flows link, is a reason to be skeptical.
All this said, our policymakers are not devoid of options to try to improve the trade account. We know the latter can improve only if national income grows by more than the growth in domestic spending, or only to the extent that national savings rise relative to domestic investment. So, checking our investment spending is neither desirable (since Ethiopia has productive investment opportunities) nor feasible. The same is true for foreign capital inflows, which we need for our economic expansion. That leaves accelerating national savings as the more attractive route to financing the resource gap. But which saving should be accelerated – private or public?
Less painful to the public would be raising private saving – by lowering taxes, increasing government transfer payments to households, and/or pushing the savings-deposit interest rate upward. But, alas! the government has already embarked on the more painful course, namely accelerating its own saving by reducing the budget deficit. It is painful because fiscal policy has been tightened severely to hold back domestic spending that already denotes poor standard of living. And this is on top of the pain caused by a consumer-price surge directly attributed to devaluation – one that many Ethiopians, especially those in urban centers, have endured over the past two years. More to the point, slashing government deficit has a negative impact on private saving, possibly causing national savings to rise very little or not at all, while investment may also go up concurrently, keeping the current account from unambiguously improving in the end.
So returning to the original question, no, there is no external balance miracle that a flexible exchange rate will conjure up. For that matter any type of exchange rate regime is only one piece of the current account jigsaw. And for Ethiopia, the most vital pieces arguably ie outside Forex. But all elements must fall into place if foreign trade is to adjust to the policymakers’ liking.
