IMF CITES OVERHEATING ECONOMY, CREDIT BUBBLE

C O N F I D E N T I A L SECTION 01 OF 04 ADDIS ABABA 001189 SIPDIS SENSITIVE SIPDIS DEPARTMENT FOR AF/E, AF/EPS, AND EEB/IFD/OMA - JWINKLER TREASURY FOR VIRGINIA BRANDON AND JOHN RALYEA USTR FOR BILL JACKSON, CECILIA KLEIN, AND BARBARA GRYNIEWICZ COMMERCE FOR ITA BECKY ERKUL USAID FOR AFR/EA, AFR/SD, AND DCHA/FFP/EP FSI FOR LISA FOX E.O. 12958: DECL: 04/27/2018 TAGS: ECON EFIN ETRD PGOV ET SUBJECT: IMF CITES OVERHEATING ECONOMY, CREDIT BUBBLE REF: ADDIS 910 ADDIS ABAB 00001189 001.2 OF 004 Classified By: Ambassador Donald Yamamoto for reasons 1.4 (b) and (d). SUMMARY -------------- ¶1. (C) IMF Senior Resident Representative Arnim Schwidrowski (strictly protect) expressed to Pol/Econ Chief growing concern about Ethiopia's "overheating" economy, increasingly tenuous foreign reserves level, mounting inflation, and increasing signs of a credit bubble in a wide-ranging April 21 discussion. Schwidrowski called the Ethiopian Government's (GoE) claims of sustained over ten percent growth rates "highly dubious," debunked the prevailing hypothesis that domestic inflation -- particularly food inflation -- stems from high world commodity prices, expressed concern that off-budget public enterprise activities are driving the budget deficit well beyond the level in official figures, and noted that the heavy state role in the economy is responsible for supply side rigidities that prevent market-driven reactions to accommodate economic developments. Schwidrowski suggested that the looming IMF Article IV consultations with Ethiopia (scheduled to begin May 12) will focus on the Ethiopian economy's "massive liquidity," oligopolistic supply dynamics, statist foreign exchange regulations, and excessive spending by public enterprises. Despite the Prime Minister's public embrace of state-driven responses to market inefficiencies (reftel), Schwidrowski argued that the GoE is "seriously rethinking" its approach to market competition because the overheating economy will not allow it to further avoid the impacts of the prevailing state-driven approach. In light of the economy's precarious condition, Embassy Addis strongly urges Washington to oppose IMF considerations to close its Addis Ababa office. End Summary. BOOM, BUBBLE,...BUST? -------------- ¶2. (C) While IMF Senior Resident Representative Arnim Schwidrowski called the GoE's claims of sustained growth rates of over 10 percent for the past four-to-five years "highly dubious, nice, round numbers," he argued that there is no doubt that the Ethiopian economy has experienced a boom. Still, despite two and a half years in country, he confided that the only specific driver of that boom that he could identify is the sustained, and steadily increasing, pattern of foreign inflows. Among these he cited: a doubling in foreign/diaspora remittances in the past four years to $2 billion annually, a steady increase in budget support aid to $1.5 billion per year, a slow growth in foreign direct investment to $0.5 billion per year, and a steady increase in foreign assistance channeled through NGOs of roughly $0.5 billion per year. Together, these inflows contribute over twenty percent of Ethiopia's GDP and represent a huge driver for domestic demand which are expected to continue. The other driver behind Ethiopia's sustained positive growth over the past four years has been good rains that have resulted in strong harvests. ¶3. (SBU) While the economy has certainly been growing, chronic challenges in its macroeconomic fundamentals have become increasingly evident over the past one-to-two years. Within the banking sector, real interest rates have remained significantly negative, and often well into the double digits, over the past two years. The headline inflation rate, which has been in the upper teens for over a year, hit 29.6 percent on an annualized basis in March 2008 and food inflation hit 39.4 percent in March. The Birr's official ADDIS ABAB 00001189 002.2 OF 004 exchange rate against the U.S. dollar has fallen by 12 percent over the past year and, until the March 13 police crackdown drove the parallel foreign exchange market underground, the parallel rate of 10.5 birr:1 dollar reflected that it remained overvalued by approximately 12 percent. While the Prime Minister lauded the GoE's fiscal discipline in his March 18 address to Parliament (reftel) noting a mere 2.5 percent of GDP budget deficit, Schwidrowski argued that the Prime Minister's figure ignores off budget public enterprise spending which, if included, would put the deficit closer to 4-4.5 percent of GDP. Schwidrowski further cited the country's precarious foreign reserve level, or the GoE's "closest held of state secrets" as he described it, which he speculated stood at less than the equivalent of the value of two and a half months of imports. (Note: On April 22, Caterpillar company representatives told Embassy officers that the Commercial Bank of Ethiopia had told them to hold off on submitting requests for import permits due to the lack of foreign exchange. End Note). ¶4. (SBU) Schwidrowski noted particular concern about the emergence of a credit bubble in Ethiopia. Citing "massive liquidity" in the economy and the long-held practice among Ethiopia's state banks -- which represent roughly 80-85 percent of the financial services sector -- of lending for political, rather than creditworthiness reasons, Schwidrowski argued that "real interest rates do not matter, only margins." While the national rate of non-performing loans has dropped considerably to around 20 percent, that remains far to high. Once monetary actions mop up excess liquidity in the market, making the repayment of debt contingent on actual profitability, Schwidrowski speculated, the bubble will burst with a significant impact on the economy and public. ¶5. (SBU) While the Prime Minister attributed a significant portion of Ethiopia's inflation, particularly food inflation, to world prices, the IMF ResRep debunked this argument as a "myth." Apart from petroleum products, Schwidrowski noted that commodities (including cement and steel to feed Ethiopia's continued construction boom) constitute only about five percent of Ethiopia's imports, with the vast majority being capital goods and manufactured products for which world price increases have been much more moderate. While Ethiopia remains virtually completely import dependent to meet domestic demand for rice, the overwhelming majority of Ethiopia's imports of other cereals comes in the form of foreign assistance rather than subject to world price fluctuations. As a result, domestic Ethiopian cereal prices, with the exception of rice, remain below import parity showing that the country's grain markets are "effectively delinked from world prices." While some have argued that farmers' increased buying power may explain the price increase, Schwidrowski dismissed this argument noting that such a dynamic would explain a reduction in grain price volatility, but not the ever mounting absolute grain prices. Instead, Schwidrowski argued that the food inflation levels over the past two years, in the face of reports of better harvests, is more an indicator of a high income elasticity of demand for food in Ethiopia, (i.e. as Ethiopians earn more money, they spend it on more and better food, thus driving up prices). WHAT'S NEEDED -------------- ¶6. (SBU) While Ethiopia has not had an agreement with the IMF for several years, Schwidrowski noted that the GoE generally does heed IMF recommendations within the country's own development model. He noted that the next round of Article ADDIS ABAB 00001189 003.2 OF 004 IV consultations, expected to commence on May 12, will likely touch on GoE monetary policy responses to excess liquidity and hoped that they would present strong recommendations affecting exchange rate policy. Schwidrowski commended the March GoE decision to raise banks' reserve requirements to 15 percent of deposits as a step in the right direction. The big challenge, though, in light of GoE secrecy of public enterprise accounts -- not to mention those of party-affiliated conglomerates -- and their impact on the budget deficit, is how to push the GoE to reign in public enterprise spending and less-than-meritorious lending to public enterprises by state-run banks. ¶7. (SBU) Schwidrowski further cited the GoE's exchange rate regime as a threat to economic stability. He described the National Bank of Ethiopia's (NBE, Ethiopia's central bank) exchange rate process as a de facto crawling peg in which NBE informs bidders what rate bids it will accept, and traders offer bids in that range. Despite the detriment posed to Ethiopian exports, the NBE insists on maintaining an overvalued exchange rate. Further, to retain the foreign exchange firmly in government control, NBE regulations preclude commercial banks from trading foreign exchange outside of a margin of 0.0001 Birr beyond the official NBE rate, effectively making such transactions unprofitable and keeping the private sector outside of the foreign exchange business. While Schwidrowski argued that he does not expect a complete liberalization of the exchange rate regime resulting in a precipitous free-fall after a modest, one-time adjustment, he noted that the current overvalued Birr combined with heavy enforcement of the parallel market risked only driving the parallel market underground and exposing it to greater risks. ¶8. (C) More broadly, Schwidrowski expressed concern that Ethiopia's heavy state role in maintaining an "oligopolistic supply system" resulted in rigidities that impeded the market from responding quickly to demand-driven shifts. Instead, GoE actions only come after shifts have grown so large that they require big shocks to realign supply with demand. Still, he was optimistic that reality has begun to hit GoE officials forcing them to rethink the extent and depth of the government's role in the economy, the need to foster the private sector, and the merits of market competition. When asked who within the GoE wield greatest influence in dictating economic policy, Schwidrowski immediately noted Economic Advisor to the Prime Minister Ato Newaye Kiristos Gebre-Ab. He noted skepticism about the influence of Minister of Finance and Economic Development Sufian Ahmed and Trade and Industry Minister Girma Birru. Sufian, he said, is politically astute and has good economic policy intuition, but is more the overseer of the implementation of economic policy rather than the analyst and decision driver. A bit more torn on Girma, he argued that while some view Girma as playing a "constructive" role, many believe that he is simply the ruling party's lip service man "authorized to say the word market." ¶9. (SBU) When asked to comment on the future of his own office, Schwidrowski skirted the question. He noted that while the IMF's "house keeping" effort has chosen to close ResRep offices in countries without a formal IMF program, there is certainly a need for a resident presence in Ethiopia as drop-in consultations would not be capable of accessing useful information and understanding the nuance of the economic climate. He noted that a recent consensus letter from the Donor Assistance Group of aid agency heads in Ethiopia to IMF headquarters urging the reconsideration of the decision, and GoE requests to that effect during the recent Bank/Fund spring meetings had been useful in causing ADDIS ABAB 00001189 004.2 OF 004 the IMF to take another look at that decision. COMMENT AND ACTION REQUEST -------------- ¶10. (SBU) Schwidrowski's comments only reconfirmed the perception increasingly evident to Embassy Addis: the Ethiopian economy is on shaky ground. While exchange rate, inflation, interest rate, and price indicators call the macroeconomic foundations into question, modest liberalization of the business climate, increased exports, and reliable foreign transfers help keep it afloat. Weather forecast indicators, however, suggest that the four-year trend of good rains may be in jeopardy with the 2008 short rains having already been below normal and poor prospects for the summer's long rains. If the prediction holds, the 45 percent of the economy (and 80 percent of the population) that depends on agriculture will take a strong and immediate hit. Such a scenario would only exacerbate the inflationary pressures on the population which have already begun to evidence themselves in the form of public demonstrations. Schwidrowski echoed the Embassy's concern that it would only be a matter of time before the economic pressures morph into political pressures and a source of domestic instability. Embassy Officers look forward to meeting with the coming Article IV consultation team in May. Embassy Addis requests that Washington strongly encourage the IMF headquarters to refrain from closing its office in Ethiopia as the continued IMF presence bolsters bilateral efforts to press the GoE to further open its economy. This sentiment has also been shared with Post by the World Bank ResRep and a variety of other donor partners. End Comment. YAMAMOTO