ETHIOPIA: INFLATION AT RECORD LEVELS

UNCLAS SECTION 01 OF 02 ADDIS ABABA 002983

SIPDIS

SIPDIS

E.O. 12958: N/A
TAGS: ECON ETRD EINV EAGR ET
SUBJECT: ETHIOPIA: INFLATION AT RECORD LEVELS



1. SUMMARY: Except during episodes of drought and macroeconomic
shocks, Ethiopia historically has seen low rates of inflation.
However, the recent rise in inflation, especially food inflation,
during times of good agricultural output run counter to historic
trends. The Government of Ethiopia (GOE) has taken measures
including instituting a surtax and raising civil service salaries to
combat the effects of rising prices, but the effects are
questionable. END SUMMARY

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UNUSUAL INFLATION
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2. Food items (mainly cereals) constitute over 60 percent of the
weight in the computation of Ethiopia's Consumer Price Index (CPI).
Historically, bumper crops lead to low inflation while droughts and
other shocks that lead to reduced agricultural output raise grain
prices and put pressure on inflation. Thus, trends in the CPI
largely depend on productivity in agriculture and its seasonality
which is less controllable by fiscal and monetary policy stance.


2. The CPI in the past two years was however in paradox to this
historic trend. Official statistics indicate that, on the average,
agricultural value added grew annually by 14 percent in the past
three years while annualized moving average CPI inflation rose
steadily, reaching 18 percent in July 2007. People on a fixed
income bear the brunt of the inflation. In an effort to curb the
rise on prices, the GOE has been trying to understand its causes and
taking counter measures. The GoE's principal policy responses
include 1) levying a surtax and using the proceeds to purchase
subsidized wheat for distribution to the urban poor and 2) raising
salaries of civil servants. The surtax appears to have been
inconsequential as prices are still on the rise while the impact of
the salary revision remains to be seen as it was implemented very
recently.

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POSSIBLE CAUSES OF THE PRICE ESCALATION
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3. Different explanations are given by the GOE, opposition parties,
the IMF, and individuals for the steady rise in the inflation rate.
The GOE argues that the prevailing inflation came about due to
demand side pressures. According to the GOE, factors contributing to
excess demand include an increase in farmers' income, a shift in
production by some farmers towards production of cash crops mainly
for exports (thus shifting from producers to consumers of cereals
and increasing demand),hoarding grains for speculation,, merchants
expecting higher profit margins, the export of cereals, and an
increase in the prices of imported commodities.


4. Some institutions and individuals also focus on the demand side.
They argue that GOE intervention in grain marketing, hoarding,
reliability of the official growth statistics (particularly,
agricultural value added data which are based on pre-harvest
estimates and subject to biases),monetary expansions (especially
massive investment in infrastructure) and government spending are
some of the factors behind the pressure in aggregate demand. Still,
some studies have suggested that inflation in Ethiopia is a supply
side problem and the prevailing inflation is a result of
expansionary output and price policy of the GOE that induces demand
to trigger economic growth.

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MEASURES TAKEN TO CURB INFLATION
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5. An IMF mission that visited Ethiopia in February 2007 observed
profound imbalances in the economy such as rising inflation;
significantly high real negative interest rates. The mission advised
the government to pursue demand dampening measures and growth
enhancing structural reforms to ensure macroeconomic stability and
sustain growth.


6. The GOE has attempted to curb inflation in a piecemeal manner by
banning exports of cereals, levying surtax on selected imported
goods and using the proceeds to distribute subsidized wheat to low
income urban dwellers, taking administrative measures on speculating
merchants, making adjustments to interest rates and reserve
requirement ratios of commercial banks, and increasing civil service
salaries. Assuming that the rise in the inflation was a result of
cereal exports, the GOE banned exports of certain grains early in

2006. The National Bank of Ethiopia (central bank) raised the
minimum deposit interest rate from 3 to 4 percent and the reserve
requirement ratio of commercial banks from 5 to 10 percent in July

2007. The GOE also warns merchants against hoarding grains and
speculating for higher prices.


7. On April 11, the GOE imposed a 10 percent surtax on selected
imported goods generate funds to stabilize the domestic grain price.

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Essential imports such as fuel, fertilizers, medicine, trucks,
passengers' buses and other investment goods are exempted from the
surtax. Hence impacts of the tax on investment and the on low and
medium income groups is assumed to be minimal, according to the
Finance Ministry. The GOE plans to collect billions of Birr from
the surtax and use this money to subsidize grains to low income
urban dwellers. Some economists disagree with the GoE arguing that
by increasing the cost of some imports, the surtax risks further
feeding inflation.


8. Additionally, the GoE recently increased salaries of civil
servants. The salary increment ranges from a minimum increase of
17.5 percent for mid-level officials to 36.2 percent for high and
low salary bands. It also includes up to a 70 percent increase for
medical doctors and university professors. Similar adjustments will
follow to employees of public enterprises. The GoE also raised
pension payments including a 60 percent increase from USD 11 to USD
17.70 per month rise in the minimum pension. The total cost of the
salary revision is estimated at $200 million per annum.


9. Analysts see this as a nominal, cost of living, wage increase
rather than a real wage improvement that should come as a result of
the continuous structural transformation of the economy. They view
the current salary adjustment will exacerbate the existing
inflation, due to businesses raising prices. Prices of some
consumer goods have already gone up following announcement of the
salary increase. Analysts recommend that the GOE pursue its reform
agenda in liberalizing and transforming the structure of the economy
in the areas of finance and telecom and expanding its tax base from
the current coverage of 13 percent of GDP to at least the African
average of 29 percent.

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RESULTS- SURTAX NOT HAVING
DESIRED EFFECT; IMPACT OF
SALARY INCREASE TO BE SEEN
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10. Despite various measures taken to abate rising prices, inflation
remains a threat to the livelihoods of low income Ethiopians,
macroeconomic stability, and long term investments. Annualized
headline inflation has steadily risen over the past two years,
increasing from 3.9 percent in January 2005, to 18 percent in July

2007. Despite surtax food inflation increased from an annualized
rate of 3.8 percent in January 2005 to 13.7 percent in January 2006,
14.8 percent in January 2007 and 20.2 percent in July 2007. The
impact of the recent salary revision of civil servants is feared to
aggravate the pressure on prices leading to built-in inflation.


12. COMMENT: The ever increasing inflation will undoubtedly
negatively impact long-term investment through eroding confidence of
investors and putting macroeconomic stability in danger. People
whose income is fixed in nominal terms are bearing the burden while
the recent revision in salaries and wages may aggravate the price
hike. Emphasis should, thus be given to improving production rather
than further creating demand which has significant impact in
sustaining growth and fuelling inflation. The measures taken so
far appear piecemeal and their impact in reducing inflation is not
visible. Improving supply rigidities and increased private
investment would enhance production of goods and services that will
counter balance demand pressure. END COMMENT

YAMAMOTO