It has finally happened. After many rumors and reports, Ethiopia’s currency devaluation has become a reality.
. . .
On Monday, the National Bank of Ethiopia lifted restrictions on the foreign currency market. This move, which is known as floating a currency, is part of the government’s strategy to secure over $10 billion in funding from the IMF and World Bank and to restructure the country's debt following a default in December. International bodies have shown support for the move, with the World Bank approving a grant of 1 billion dollars on Tuesday and the United States Embassy stating approval for the move. Now, there’s much talk about the advantages and disadvantages of floating the Birr. But before that, let’s see what it means to float a currency.
To Float a Currency
The United States Dollar is not just another currency; it’s a resource. One of the metrics of a country’s economic strength is the amount of foreign currency reserve it has. That reserve is usually in US Dollars. In a country like Ethiopia, which has a nascent manufacturing sector and thus relies heavily on imports, the US Dollar is imperative to have in great amounts. Unfortunately, that’s not the case for Ethiopia, and thus something needed to be done.
Up until recently, Ethiopia employed a fixed exchange rate system, where the National Bank determined the value of the birr. The government actively intervened in the foreign exchange market to maintain this rate, buying and selling currencies as necessary. The intention behind this policy was to create a more predictable and stable economy. For importers, a fixed exchange rate provides certainty about import costs, unlike a floating exchange rate, which fluctuates.
However, despite these intentions, the fixed exchange rate policy has not benefited Ethiopia. The country struggles with inflation and a severe foreign currency shortage, exacerbated by a parallel black market that diverts foreign currency from Ethiopia’s reserves.
It is important to remember, however, that devaluation is not new to Ethiopia. In 2017, the National Bank devalued the birr by 15%. But this was still a fixed exchange whose devaluation was set by the National Bank. What makes the current devaluation different is that the National Bank or any other central body has no power in determining how far the birr falls. Who does? You may ask. And the answer to that is the market.
The Market
When a currency floats, its value is determined by the forces of supply and demand in the foreign exchange market. This means that the exchange rate can fluctuate based on various factors, including economic conditions, investor sentiment, and geopolitical events. None of these factors are currently in Ethiopia’s favor. This has left some people anxious about the future of Ethiopia’s economy.
Trade-Ups: The pros of floating currency
One guaranteed benefit for Ethiopia from this transition is improved access to foreign currency. Beyond aid and grants, Ethiopia can attract dollars from investors. In other words, Ethiopia can import capital. This is great news for Ethiopia’s businesses, which often struggle from lack of funding. Furthermore, as the country digitizes its economy and modernizes its infrastructure, it could become an ideal destination for travelers. A higher exchange rate for the birr will attract foreigners to spend their dollars in Ethiopia, significantly benefiting service providers. However, there’s a flip side to this.
Trade-Offs: The cons of floating currency
Even the US Embassy has described the devaluation as "difficult but necessary." This is because the devaluation is likely to lead to higher import costs, which can exacerbate inflation and increase the cost of living for ordinary Ethiopians. Additionally, businesses reliant on imported goods may face higher operational costs, potentially leading to reduced profitability or even closures. The government has hinted towards some preparations to mitigate these challenges, but regardless, times will be tough for the majority of Ethiopians.
While floating the currency presents an opportunity for Ethiopia to stabilize and grow its economy, it also comes with significant risks. The success of this policy will depend on the government's ability to manage the transition effectively and to support its citizens through the inevitable challenges. It’s also worth noting that investors don’t throw their money wherever a currency floats. Additional work needs to be done to inspire investor confidence and market Ethiopia as a worthwhile investment. Only time will tell if this bold move will serve as the life jacket that keeps Ethiopia’s economy afloat or if it will be a plunge into deeper economic waters.
