Introduction
Money was invented to end the cumbersome method of trade exchange through barter. In barter a lot of time and energy is expended in trying to find at least two persons who want each other’s tradable goods, i.e., barter requires a coincidence of wants or needs. In addition, there is the question of the barter exchange rate or terms of trade. How many loaves of bread should a pair of shoes fetch?
Initially, the value of paper money was linked to gold whose unit price remained relatively stable over time. Hence, paper currency units were expressed in terms of grams of gold or fractions thereof whose prices were in turn determined by supply and demand on the free market. Hence, under Emperor Haile Selassie one Ethiopian dollar (now Birr) was about 0.3 gram of fine gold.
However, the gold and gold/foreign exchange backing of the Ethiopian Birr was in due course abandoned particularly both under the Mengistu and Meles regimes, although under Mengistu the 2.07 Birr per US dollar exchange rate was maintained throughout the period. Nonetheless, debasement and devaluation of the Ethiopian Birr particularly under the Meles regime continued apace via excessive currency expansion largely via outright excessive currency printing. This in essence is the underlying reason why the issue of monetary policy, always a matter of great importance, has become particularly crucial in recent years.
As local currency is printed by the government of any sovereign country, rather strict rules must be observed as regards its physical emission or issue. It is a matter of common sense that particularly dilapidated currency rules must be replaced and that an increase of physical production must be matched by a proportionate increase in currency lest price deflation (a fall in prices) should cause untoward economic consequences. (Incidentally, price deflation could be even more serious than price inflation).
Add to this the issue of money creation by deposit banks (commercial banks) on the basis of fractional reserves through credit extension. For example, a deposit bank which receives one million Birr in the form of bank deposits could lend up to ten million Birr using the one million Birr as reserves.
The borrower of the ten million Birrr creates deposits of ten million Birr (less his immediate cash needs) which is counted as money, boosting the volume of what is known as broad money. According to Ethiopia’s monetary definitions there are five major categories: narrow money which comprises money in circulation and demand deposits (M1) and broad money which is composed of M1 plus savings and time deposits (the so called quasi money).
Another monetary aggregate termed reserve money (also called high powered money) is made up of bank reserves and money in circulation. Monetary policy is concerned with the behavior of individual and aggregate monetary variables over time (together with the velocity of money in general) and their impact on prices, rate of exchange, physical production, employment, etc.
What is Monetary Policy?
The ideal objective of monetary policy is to promote maximum economic growth and employment through the expansion of productive domestic credit in an overall economic environment of minimal inflation and sustainable exchange rate stability. It is a matter of common sense that new currency may be issued to replace worn-out currency notes, to accommodate additional physical production and to convert extra foreign exchange acquired through a net balance-of-payments surplus. The main problem associated with monetary policy arises from the estimation of the productivity of the totality of domestic credit, the main source of monetary expansion in the economy.
In other words, if monetary expansion (via domestic credit expansion) is greater than physical production expansion due to low domestic credit productivity in terms of output growth, then inflation and exchange rate instability (in this case depreciation) is likely to be more than the expected minimal magnitude, thus causing untoward economic consequences. Hence, monetary policy in its successful interpretation is the maintenance of monetary expansion via domestic credit extension consistent with the physical output (GDP) expansion in such a way that in particular inflation and exchange rate instability are kept at a minimum.
Monetary Policy Instruments and Monetary Policy Stance
In a country’s monetary policy there are certain specific levers with which to control monetary expansion in the economy. These monetary policy instruments are classified into two broad categories, namely direct and indirect instruments. The most important direct monetary policy instrument is direct quantitative credit control, which actually means putting a cap on the total amount of credit (both private and government) to be extended within a given period of time, mostly within a year.
Indirect monetary policy instruments include: the rate of interest, reserve requirement, open-market operations, moral suasion, etc. These are usually characterized as indirect because they tend to affect credit not directly as in the case of capping total credit, but indirectly by influencing the cost of capital, the money creation capacity of deposit banks, the absorption or release of liquidity in the economy through the sell or purchase of securities, etc.
On the other hand, the monetary policy stance of an economy may be described as being expansionary or contractionary depending, respectively on whether the monetary policy instruments mentioned above are relaxed or tightened to attain the desired economic objectives. If, for example, economic growth slows down or there is no growth and high unemployment also prevails, but there is no inflation or currency depreciation, the monetary policy stance may well be engineered to be expansionary through lowering interest rates, selling securities and decreasing reserve requirements. But under a condition of stagflation (stagnation plus inflation) as is generally agreed to be the case in Ethiopia at present, the situation cannot be remedied via an expansionary monetary policy stance. In fact, the situation could be further exacerbated by such a policy stance.
Has there ever been a transparent monetary policy in Ethiopia?
The Short and simple answer is No! Under Emperor Haile Selassie and under the wise leadership of the then Governor of the National Bank of Ethiopia (NBE), H.E Ato Minassie Lemma, the monetary policy of the country used to be described as a conservative, generally understood to mean leaning towards the contractionary end of the monetary policy spectrum.
The Governor’s contemporary, leading the Ministry of Finance, H.E Ato Yilma Deressa, a graduate of the London School of Economics, was once reported to have responded to a query “How is your economy doing?” thus, “We have held it tightly in control, so that it won’t move backwards, nor forwards!” This would indicate some degree of irrational fear of monetary expansion and thus a tendency to be skeptical of the virtues of an expansionary monetary policy stance through the extension of productive bank credit.
Under Mengistu’s socialist experiment, the brilliant Governor of the NBE, Ato Tadesse Gebre Kidan, stuck to the socialist planning principle of matching credit extension (monetary expansion) to a proportionate expansion of physical production and once boldly defended his position against extending a 30 million Birr loan to a certain coffee plantation project (Bebeka) in the presence of President Mengistu by saying, “Mr. President, honestly speaking, I don’t believe in this project”.
However, the President, being in favor of the project, was said to have reprimanded the Governor with a retort that went something like “I didn’t ask you your religion! You’d better do as I say!” Eventually, Governor Tadesse was vindicated; the project failed miserably owing to unsuitable soil! But it was already too late for the extended portion of the said credit not to have caused some inflation. As a matter of fact, inflation was quite significant under the Derg regime, particularly towards the end of the
period, but the then raging civil war was the major cause rather than an imprudent currency printing spree under normal circumstances (currency printing is inevitable in a civil war situation when tax collection is severely crippled).
Melese Zenawi’s reign was a totally different kettle of fish. The Governor of NBE of the day did his bidding slavishly printing currency like mad, removing statutory limits on government borrowing from the central bank, undermining the relative autonomy of the NBE by making it answerable to the Prime Minister rather than to the parliament and disbanding the belatedly established monetary policy committee of the NBE.
Half-hearted and lukewarm attempts were made to manipulate the rate of interest (deposit rate) and banks’ reserve requirements, but they were patently ineffectual. In fact, the minimum deposit rate which is subject to NBE policy manipulation has to this day remained well below the prevailing inflation rate, indicating that monetary policy, as it is known the world over, does not exist in Ethiopia.
As a matter of fact, the NBE’s cost of currency printing in foreign exchange (Ethiopia does not have a security printing institution) escalated so much that secret negotiations were once reported to have been going on with neighboring Sudan to undertake the currency printing job at a lower cost. It is a measure of the degree of desperation on the part of the NBE to choose a country for the delicate task of security printing where security in general is still at a premium!
A Genuine Monetary Policy for Ethiopia
A reasonably convincing proof that there has really never been a genuine monetary policy in Ethiopia, particularly since the Derg era is that cumulative inflation has now sky-rocketed to over 4,000 percent and that the national currency (the birr) has depreciated by over 94 percent. As the great American economist Milton Friedman had long postulated, “inflation is always and everywhere a monetary phenomenon”, and in Ethiopia the oversupply of the local currency (NBE’s currency printing being the source of the monetary base or reserve money) has been the major factor behind inflation and currency depreciation and formal devaluation.
Unproductive domestic credit expansion has not resulted in a commensurate expansion in physical production, thereby creating a relative shortage of goods and services and a relative overabundance of money in its various forms, which, of course, is the basic recipe for the building of inflationary pressures in the economy.
Hence a fundamentally sound monetary policy should aim at putting in place an institutional framework for vetting and ascertaining the relative quality of bank loans and credits both to the private and government sectors through a system of rigorous credit risk analysis and project study and appraisal.
As may well be surmised, the underlying cause of relatively high inflation and currency depreciation has essentially been the poor quality, in terms of productiveness of bank loans and credit extended to various borrowers in the economy. Of course, the main culprit has been the government which has borrowed not only for increasingly wider budget deficits but also for government development projects (including infrastructure projects) of highly dubious viability and profitability.
To this end, the major details for formulating a sound monetary policy for Ethiopia include the following:
• Appointing a highly competent and experienced governor for the National Bank of Ethiopia capable of giving a nuanced analysis of the macroeconomic and monetary situation in the country, particularly emphasizing the inter-relationships between and among monetary variables and their singular and collective impact on macro-economic variables including real economic growth, employment, investment, the rate of exchange, inflation, etc.
He/She should also be able to read the prevailing economic situation correctly and make necessary monetary policy interventions to steer the economy in the right direction by making use of the range of policy instruments available to him/her in a scrupulously professional manner undeterred by the cacophony of political interests that may arise;
• Re-establish a strong monetary policy committee with the Research Dept as its secretariat;
• Compile accurate and reliable statistics on monetary variables and particularly relevant macro-economic and micro-economic data and conduct analysis and projection work;
• Make the NBE answerable to Parliament to strengthen its relative autonomy;
• Re-introduce the former statutory limits on government borrowing from the NBE;
• Strengthen the NBE’s oversight and regulatory duties with regard to other banks, particularly on the quality of loans and credits extended;
• Set realistic inflation and exchange rate stability targets and attempt to enforce them through concrete monetary policy instruments;
• Transition the economy from a negative interest rate (vis-à-vis inflation) to a positive interest rate phase;
• Attempt to ensure that overall currency expansion is consistent with replacement of worn-out currency notes, increase in physical production, balance of payments surpluses and the inflation target and the exchange rate fluctuation target.
At the end of the day, though, the high quality of bank and micro-finance credit so ascertained through a sound monetary policy is the engine of economic growth that Ethiopia has long sought for and has so far failed to find! Let us, therefore, make every effort to formulate a sound and prudent monetary policy and achieve the Holy Grail of real economic prosperity!
The Ethiopian Herald, June 2/2019
BY TEKLEBIRHAN GEBREMICHAEL
