The bottom line is simply this: the price at which you can legally exchange the local currency for foreign currency is no longer fixed by the government. This doesn't mean all finance is deregulated, you still need licenses to be a bank or other financial service provider. But last week, the price of dollars was 57 ETB/USD and any other price was technically illegal. Today it can be anything. 47, 57, 67, 97, 100... It is up to the banks and their customers to agree on a price, like buyers and sellers of anything else. The price itself is no longer a crime. Free at last!
Last year, in my post entitled "The mother of all distortions", I wished for exactly this:
The government could simply revoke the law that says Abebe, Berhane and the banks are not allowed to exchange their USD for ETB at whatever price they agree to. That's what is meant by jargon like "float" or "unification", "liberalization", etc. Just let the two parties agree on a price. No other laws need to change. Any product that is illegal can remain illegal. Banking licenses don't need to change. Just decriminalize voluntary price. That's it.
And, surprise! That is actually the current Ethiopian government's position. Don't take my word for it. It said so in 2019: Ethiopia: Central Bank announces floating exchange rate regime. And again in 2020: Ethiopia Plans New Key Rate, Floating Currency to Boost Economy. Even now in 2023, exchange rate unification remains the goal. But the policy is "gradual", and 4 years in, the peg remains and the gap is growing. So what are we waiting for? Why don't they just waive this magic wand today?
[...]
To be blunt, the political cost of doing the right thing is very high.
So let's applaud the government for finally doing it. A very courageous move.
Defenders of the status quo
As expected, there has been a lot of discussion of this historic change. Much of it is excellent and constructive. The press has been vigorous, quick and has offered diverse views. Today I want to focus on a subset, the hard core defenders of the old status quo who are crying bloody murder. Intentionally or not, they are ensuring that the political cost we discussed above is paid in full! Their arguments are predictable. In fact I haven't yet heard any that are not already debunked (or rather "pre-bunked") in my aforementioned article. It would be tragic if these fallacies caused a political failure of this reform. So here's my modest contribution: by responding to some of them directly, maybe I can help the probability of success a tiny bit. But first, since I won't be repeating the details, if you haven't yet read my article, now would be a good time to go and read it. I'll wait...
Ok are you back? Once more unto the breach dear friends!
One of the loudest opponents of this freedom is Alemayehu Geda. A few hours after the initial statement, on Sunday evening, before the change actually took place on Monday, he was already out on the radio and social media attacking the reform. Here's what he had to say (I will put his claims in italic, since as you can guess, I'm about to rebut them).
Proposition AG1: Ethiopia imports more than it exports. If the exchange rate is freed, things that were imported at 50 ETB/USD will now be imported at 100 ETB/USD and so imports will be more expensive. This will cause inflation. Inflation will cause the currency to weaken further. And as the exchange rate goes up the prices will go up even more. And so we will have an unstoppable spiral of general price inflation and currency weakening.
If you follow his argument carefully, you will realize it it mixes up cause and effect, and then loops back in a circular argument. It's like saying: "Wet streets cause rain. This rain in turns causes the streets to get more wet. And the wetness of the streets causes more rain to fall. Because of these wet streets, soon there will be a hurricane!" Sounds scary. Indeed we've all noticed the close correlation between rain and street wetness! But in reality, it is more like astrology than meteorology. Econstrology.
To show why, let me ask some questions. Excuse me Professor, of course we all know the peg was keeping the rate artificially low, so when freed, it will naturally go up close to the "black" market rate. And you are saying inflation will go up if the government allows this. Then does that mean inflation would go down if they pegged the rate lower? Maybe even deflation? If the peg went to 50, 40, 30, ... 0.01 Birr per Dollar, would the cost of living would get lower and lower? The central bank has a magic keyboard that lowers the cost of living? What about the huge fraction of imports priced according to the black market exchange rate. If the new free market rate holds at or below the old black market rate, why would prices go up on those?
One more question Prof! You then say if inflation goes up, the currency gets weaker. How does that work? Let's say we collectively spend 100 Birr every day. And we spend 50 Birr to buy domestic products, and 50 birr to buy US dollars to import stuff. If suddenly we have to spend say 65 on domestic stuff, now we only have 35 birr left to buy dollars with. Therefore there is less demand for dollars. How can that make the price of dollars go up? Conversely, if the dollar is more expensive we should have less money for the domestic stuff, so their price should go down. But you are saying both go up together... Very strange! Clearly if both were to go up together, there would have to be something else causing it (hint: money supply. But more on that later).
Clearly there's a bug in your model. Here's what was really happening. There was two foreign exchange markets. The official one which is pegged by law and the "black" market which I will simply call the market. The price of foreign currency on the market was double the official price. For forex coming in, legally, you had to "surrender" your forex and get only 50% of the market value in Birr. Similarly for dollars going out, if you could get forex legally, you were basically getting a 50% discount on the market. And it is illegal to evade it. In other words, mathematically it is exactly like a tax and a subsidy. No magic wealth creation by fixing the price. Purely a mechanism of transfer. Taking money from exports and foreign investments, and giving it to consumption of imports. Meanwhile local producers who need forex for their capital investments were getting starved. So as a share of the whole economy: exports decrease, investment decreases, manufacturing decreases, and import consumption increases. More dollars go out and fewer dollars come in. This in turn increases the gap between the market and the official rate, so the implicit tax/subsidy effect gets bigger and the whole problem accelerates. This is the real spiral, and it is the reverse of your spiral. Your model is right to point out the correlation, but it has cause and effect backwards. Wet streets do not cause rain!
So, whither inflation? Shouting "everything will go up! panic!" is incorrect. All else being equal, the price of things that were implicitly subsidized by getting forex priority will go up, and the price of things that were implicitly taxed will go down. But of course not all else is equal, other variables will change. If the government wants to subsidize fertilizer imports, it will have to do so explicitly, as government spending, with the choices and trade-offs that implies, not implicitly via distortion of the currency. This is the healthier way. Explicit and transparent. Implicit subsidies are prone to capture by special interests, and end up being regressive and corrupt.
Another thing that can change is money supply. On that note, let's go to the Prof's second major point.
Proposition AG2: Government budget includes a number of things paid for in foreign currency. So that portion of it will double. Tax collection is already down in the last couple of years, because of war etc..Where will it get the money? And the white people want the government to cut spending and increase taxes. The economy can't support that. This will lead to printing and inflation. Ethiopians are poor. Now they will be poorer.
Ok this is partially true. When government prints more money, when the amount of Birr increases faster than the real economic activity, then we get inflation. More money / same stuff, means more money per unit of stuff, i.e. prices go up. It is possible government will just print more Birr and this would lead to inflation. The part that is not true is the implication that reforming the exchange rate will automatically cause the government to print more Birr. You have to ask: what actually creates the temptation to print more, and will the temptation be stronger now? In fact Ethiopia already had very high inflation, running at around 30% per year, before this reform! One of the reasons is that the currency distortion was killing real productivity, increasing implicit and explicit tax evasion. In those conditions, the government is tempted to print more as quick fix, like an addict taking more drugs to avoid dealing with a painful reality. So the old currency regime was contributing to inflation! Now this reform, by improving productivity, should reduce inflationary tendencies in the long term.
To be clear, the reform does not silence the siren song of the money printer. The transition will be disruptive. There will be winners and losers in the short term. The old winners of the letter of credit privilege game will now be on equal footing with everyone else. The old losers, those who were generating forex and were forced to convert below market rate, will now get more of the benefit of their efforts. Manufacturers will have an easier time with imported equipment and inputs. Banks and merkato traders will speculate on whether the new policy will hold, and this will add volatility in prices and supplies. It will take a bit of time for things to settle down. Until then, it will be tempting for the government to spend more to smooth some of the bumps, whether newly borrowed money or printing.
For this reform to succeed, the government must resist the temptation. If it does succeed, it will lead to more efficiency and fairness, a more productive economy and therefore less poverty. As it turns out, the central bank (NBE) has actually been systematically reducing the Birr money supply for the last few months. Not to be too technical, but they "drained liquidity out of the system" by lowering the maximum amount of lending as a fraction of banks' balance sheets. This is basically the opposite of printing money. So even though so the temptation will be there, there's reason to be optimistic that this reform is well prepared and the discipline to see it through will be there.
Now his third and final point is the following.
Proposition AG3: The people are poor. Cost of living is high. 70% of the population earns less than 50 dollars [a month]. Inflation makes life harder for the poor.
That doesn't even need rebutting. It's just stating the obvious. But it is not derived from the subject at hand. No reason is given why this reform will increase poverty or reduce it. This is a rhetorical tactic called "motte and bailey fallacy". Continuing our previous analogy, it's like saying: "Wet streets cause rain and rain causes hurricanes. Hurricanes are terrible!" Then if an opponent says "No, wet streets don't cause rain!" then he can respond with "Oh so you like hurricanes, you horrible person!" In this case, if you point out the incorrectness of his argument about the forex regime, this allows him to say "Oh so you want more poverty!"
One more thing. In Proposition AG2, there was a passing jab at "ፈረንጆቹ" (i.e. the white people)... He's just using that as shorthand for the IMF, western governments etc. And the IMF is of course the most toxic brand in the third world. If the IMF says the sky is blue, you can get a lot of political mileage by saying the sky is green. But that's empty rhetoric. The reality is the IMF is more like a pharmacist and third world governments are addicted to prescription drugs. And this pharmacist (or drug dealer if you prefer) says: you really should stop the addiction, but I'll give you a little dose to wean you off, if you promise to reform yourself. Most of the time, the reforms fail. This has been going on for decades and everyone hates the IMF as a result. But nobody ever cured an addiction with righteous indignation about the pharmacist. Ultimately the addicts need to repair themselves. IMF loans can be addictive and destructive in the long term. But if used correctly in the short term with exception discipline, they can also help wean the government off the addiction. So please dear friends, don't fall for the old "Whitey made them do it!" attack. Just think from first principles about this reform.
Finally, when asked if there's anything positive, the Prof acknowledges that it may close the gap with the black market for remittances (true). But then he simply asserts that exports can't increase! He says exports have other problems like shortage of foreign currency (duh!). He also blames customs, bureaucracy, corruption and lack of peace in the country for harming exports. That's all true.
For example:
- Customs is hell. This week the customs commission suddenly decided to freeze imports of capital goods including those that are en route and those that have already arrived and been cleared. This is a devastating cost to many businesses, including some that would be generating forex.
- Land transportation from Djibouti to Ethiopia, both trains and trucks, is plagued by congestion and insecurity.
- The Houthi blockade of the Red Sea is extremely costly for trade to/from Ethiopia.
- Political problems and violence handicap many parts of the economy, including exports.
All that is true. Doing business in Ethiopia remains unfathomably difficult. But none of that is a reason for opposing this particular reform. On the contrary, it *will* improve a lot of it. Much of the incomprehensible torture that you go through in customs or investment licenses, for example, is based on forex things like franco valuta, bank permits, etc. Having a freely exchange currency will definitely eliminate this important source of red tape and corruption.
To conclude, the professor despairs that he's been a prophet but the government is not listening to him. But what he doesn't say is that his approach was actually implemented for the last 50 years! And even though this reform has been the goal since 2019, such arguments have delayed it for 5 years. So Prof, congrats on your team's five decade policy victory streak. Now please have the humility and honesty to admit that your approach was tried and failed.
Five decades is a long time. Over 95% of the population has never known a life where changing currency from one to another is no big deal, like in Europe, or America or indeed much of Africa. I'm confident Ethiopians will adjust to this little bit of extra freedom, and the benefits will accrue slowly but surely.
P.S. A personal note to Prof Alemayehu. If you ever read this, first thanks for reading and second, let me be clear, this is not personal. In fact by picking on you, I'm recognizing you as one of the chief public defender of the old system. You are widely respected. I just think you are wrong. Second, even though we don't know each other, you've made a couple of condescending public comments about my previous article, essentially calling me a simpleton. Since you blocked me, I never got to thank you. I took your insult as a compliment. My goal is always to make things as simple as possible!
P.P.S. This post is too long so I'm stopping at the polemic. In a follow-up post, I will give some concrete predictions and maybe even offer some bets! A preview:
I expect
— Nemo Semret (@nemozen) July 29, 2024
1. bank rates will rapidly converge to the current parallel market rate, maybe a bit lower.
2. market rate will not go down but it will rise more slowly, over the next 6 months, % change of ETB/USD will be less than the last 6 months.
3. longer term, ETB will strengthen pic.twitter.com/lJz0yg81z7
