Ethiopia is undergoing a pivotal economic transformation as it implements bold macroeconomic reforms aimed at stabilizing the economy and fostering sustainable growth. Since July 2024, the government has embarked on a comprehensive agenda to liberalize the foreign exchange market, enhance monetary and fiscal policies, and encourage private sector-led development.

To gain deeper insights into these reforms and their implications, Capital sits down with Dr. Tewodros Makonnen, Senior Country Economist for Ethiopia at the International Growth Centre (IGC). With extensive experience advising Ethiopia’s National Bank and a strong background in economic policy research, Tewodros offers a nuanced perspective on the challenges and opportunities facing the country.

In this exclusive interview, Tewodros discusses the progress made so far, the hurdles that remain, and the outlook for Ethiopia’s economic future as it navigates a complex global and domestic environment.

Capital: The country is undergoing crucial economic reforms not seen in the past five decades. However, some scholars argue that these reforms align with a neoliberal agenda that could negatively impact the nation. How do you justify supporting the government in this reform?

Tewodros Mekonnen: Different countries pursue distinct growth trajectories. While ideologies offer certain benefits, I believe we should not rigidly adhere to any single doctrine as if it were an absolute truth. The real world is dynamic and necessitates bold, pragmatic decisions. Historically, even liberal economies have experienced significant government intervention in their economic development before allowing for private sector participation—this was evident during the 2008 financial crisis and the COVID-19 pandemic. China’s developmental model over the past half-century also illustrates the importance of state-guided growth alongside private-sector involvement.

Ethiopia must develop its own growth philosophy, informed by research and tailored to its unique context. This isn’t about labeling policies as “liberal” or “socialist,” but rather ensuring sustainable growth through a balanced approach. Our recent economic reforms address past weaknesses while building on the progress made over the last two decades.

Capital: What is the primary function of the International Growth Centre (IGC), and how has it contributed to Ethiopia’s economic development?

Tewodros Mekonnen: The IGC serves as a bridge between policy and research, conducting in-depth studies at the request of the government and policymakers. We focus on four key areas: Firm Effectiveness—enhancing corporate efficiency in collaboration with entities like the Investment Commission, Ministry of Industry, and Ministry of Agriculture; Cities—supporting urbanization strategies for the Ministry of Urban and Infrastructure and the Addis Ababa City Administration; State Effectiveness—evaluating government service delivery, tax systems, and bureaucratic capacity; and Energy and Environment—working with the Ministry of Planning and energy utilities on sustainable development.

Our research provides evidence-based recommendations to shape policy.

Capital: How have the government’s research priorities shifted since the political changes seven years ago?

Tewodros Mekonnen: Initially, at the government’s request, the IGC focused on industrial parks and labor markets.

The IGC arrived in Ethiopia when the development of industrial parks was a pressing issue. We emphasized the efficacy and efficiency of these parks, as well as labor concerns, and also researched condo housing under the jurisdiction of cities.

Our focus on state efficacy highlighted bureaucratic deficiencies related to good governance and government efficiency.

The IGC has conducted highly productive research on the Ethiopian labor market, which is crucial for the government to develop appropriate policy guidelines.

Macroeconomic reform emerged as a new issue, yet the government showed little initial interest. The administration asserted that, as a developmental state, macroeconomic institutions should concentrate on promoting the developmental philosophy, resulting in heavy government regulation.

However, the policy-dominated macroeconomy faced significant challenges, including excessive inflation, a severe scarcity of foreign currency, and substantial foreign debt.

Since the government has shown interest in seeking solutions since 2018, we have been encouraged to conduct various in-depth studies on economic reform. We completed two studies on inflation and two on foreign exchange, providing potential solutions to these issues.

Leading this excellent research was Christopher Adam, a professor of development economics and a former head of the University of Oxford’s Department of International Development.

Capital: Did the IGC’s work influence Prime Minister Abiy Ahmed’s acknowledgment of the UK government during the July 2024 reform announcement?

Tewodros Mekonnen: Although the IGC contributed, the UK government supports Ethiopia through various channels, making it challenging to attribute the Prime Minister’s gratitude solely to our efforts.

Capital: Why is this change so important to Ethiopia?

Tewodros Mekonnen: Historically, the Ethiopian government has played a significant role in driving economic development, mainly through public investment in infrastructure and social services such as healthcare and education. Funding for these initiatives primarily came from the Commercial Bank of Ethiopia (CBE), which provided loans to state-owned enterprises. Additionally, private financial institutions were often required to finance government projects through various mechanisms. The government also imposed strict foreign exchange regulations, including retention policies, which hindered market dynamics and limited private sector growth by restricting access to finance and foreign currency.

Government spending, especially on large-scale investments, has long been marred by principal-agent problems, leading to corruption and mismanagement. In a developing economy like Ethiopia, these inefficiencies can have dire consequences. Acknowledging this, the government recognized the need to rebalance its role in the economy by fostering greater private sector participation.

One area of mismanagement was the provision of untargeted subsidies—such as those for electricity and fuel—which benefitted both the wealthy and the poor indiscriminately. Furthermore, large public projects were frequently plagued by corruption and malpractice. To tackle these issues, reforms were proposed to promote private sector involvement in public-benefiting investments as the sector took a more prominent role in the economy.

This led to crucial questions: How can a balanced economic policy framework be established? What institutions should support this transition? In response, the government launched its first phase of reforms in 2019, including the suspension of direct advances from the National Bank of Ethiopia and CBE, which provided funding to state-owned enterprises. Instead, government spending would align with actual revenue receipts.

New funding mechanisms were introduced, supported by the development of market-based treasury bills and the establishment of capital market instruments. However, these reforms faced disruptions due to the COVID-19 pandemic and the conflict in northern Ethiopia. Initially, the government had committed to fiscal restraint and tight monetary policy during the three-year Homegrown Economic Reform Agenda (HGER), but it resorted to significant direct advances—totaling 270 billion birr in just two years—resulting in soaring inflation (34%) and undermining the reform agenda.

The second phase of economic reforms was delayed by over a year, partly due to disagreements between the government and international partners, including the IMF, regarding the timing of foreign exchange liberalization and other issues. To regain control over inflation and restore monetary stability, the government required time to reduce borrowing by state enterprises, phase out direct advances, and implement static budgets—measures finally adopted in the 2023/24 fiscal year.

The reform was fully implemented by July 2024 after ensuring all preparations were completed.

While some experts warned of potential market instability, the government’s prior fiscal discipline helped avert the economic disruption many had anticipated following the exchange rate liberalization.

The original blueprint for Ethiopia’s economic reforms remains relevant, and this time, steadfast implementation is essential. The transition toward private sector-led growth, combined with disciplined fiscal and monetary policies, is crucial for sustainable development. Moving forward, establishing robust institutions and ensuring transparent governance will be vital for achieving long-term economic stability and growth.

Capital: What are your observations since the reform’s implementation?

Tewodros Mekonnen: Many financial errors were made in the past, and the nation has printed money, reversing the 2019 changes. Consequently, any adjustments going forward are likely to be painful.

Although the opportunity to implement the foreign exchange (FX) market was missed during the previous reform period, it would have been better to introduce it later, after several significant economic changes.

When the market opened, there was considerable concern that inflation might double. However, a strict monetary policy helped alleviate some of that anxiety. As you may recall, the government and the IMF allocated significant funds for safety nets, but the impact was minimal.

At the IGC, we have been closely monitoring this transition. We have also taken note of other countries’ experiences, which vary widely but show some similarities. In nations that implemented similar forex regime changes, the market was extremely volatile for the first six to seven weeks before stabilizing. Achieving a balance between the official exchange rate and the black market is a complex process. Surprisingly, when Ethiopia made this change, the parallel market currency rate remained unchanged. Thanks to the new legislation, banks managed to reduce their charges from 100% to 8%.

There are signs that the market is not functioning according to free market principles, raising questions about its actual operation. It was expected that bank rates would fluctuate alongside the parallel market, similar to trends observed in other countries. Therefore, it is essential to reassess the current situation. Although prices have increased, they have done so beyond expectations. While market prices for cars and real estate remain stable, they sometimes fall short of predictions. The government’s tight fiscal and monetary policies are closely linked to price stability and can even lead to price reductions in some cases.

Capital: Why do banks receive higher rates during NBE auctions but do not compete with the parallel market?

Tewodros Mekonnen: Banks have significant foreign exchange liabilities, and when the market-based exchange rate was implemented, the difference in local currency doubled. This made them apprehensive about potential devaluation. To compensate, they charge over 10 percent on foreign currency sales, which is higher than in other countries. When we consider service fees and other expenses, the gap between the parallel market and the effective exchange rate is quite narrow. As is well known, interest, rather than foreign exchange transactions, is the primary source of bank income. However, banks increase service fees to offset losses and generate revenue. This raises my question: why don’t they compete with black market prices?

I suggest that banks should narrow the gap with the parallel market, even if it means absorbing losses temporarily. As remittances and exports flow to them, doing this would strengthen their assets against their liabilities. They could also slow down the pace of their foreign exchange sales to further bolster their position and reduce the disparity between assets and liabilities. If they take these steps, they will transition more effectively. However, I don’t see banks pursuing such strategies. Instead, they continue to adhere to the Central Bank’s lower and static exchange rate approach, which is contrary to the open market concept. I am uncertain why banks are behaving this way, but it indicates that the market is not functioning properly.

Capital: What guidance would you offer regarding this?

Tewodros Mekonnen: Banks play a crucial role in signaling market activity, as this is essential for the market’s functionality. Without this signaling, changes may not be fully realized in the near future.

Capital: What have you observed about the market’s evolution since the reform was implemented?

Tewodros Mekonnen: Other economic sectors, such as the export industry, are still developing. Exports that were previously sold illegally are now entering the legal market, which has led to an increase in export revenue so far. To determine if the reform has positively influenced the export market, new products should be introduced. Nine months is sufficient time to evaluate the foreign exchange (FX) market. Although it was opened, it has not been functioning properly. The initial focus during the reform was on foreign exchange issues. However, new challenges have emerged, including corruption, tax concerns raised by businesses, and the effectiveness of government services.

At the same time, the government asserts that it should enhance tax collection since it can no longer rely on direct advances as it once did. The primary aim of the applied macroeconomic reform is to change legislation, but resolving issues like tax administration, corruption, and improving public services may take time. Therefore, inclusive reforms will be necessary to support the macroeconomic transformation, which could require a considerable amount of time.

There is a societal expectation that improvements will be immediate once the reform is fully implemented, but this is not the case. While macroeconomic reform is a critical step forward, it is not sufficient on its own. Some policy shortcomings need to be addressed, and this process will also take time.