For decades, Ethiopia maintained a rigidly pegged exchange rate, tethering its currency, the birr, tightly to the dollar. While providing exchange-rate stability, this policy of artificially overvaluing the birr discouraged exports and encouraged imports. The birr's overvaluation made Ethiopian exports more expensive abroad while making foreign goods cheaper at home.
International financial institutions like the IMF and World Bank had long argued for exchange-rate flexibility. A floating birr aligned to market forces, they said, would be more conducive to long-term growth. By finding an exchange rate reflective of economic fundamentals, exports would receive a competitive boost and imports could be moderated.
This month, the Ethiopian authorities have at last loosened the dollar peg. On the first day of free-floating, commercial banks allowed a 30% birr depreciation. While exchange-rate volatility was inevitable during this transition, the plunge was an abrupt awakening. We support exchange-rate reform in principle. A realistic birr valuation is necessary to rebalance Ethiopia's trade-dependent economy and incentivize local industries. In time, a floating rate should attract foreign capital by reducing exchange risks.
However, the swift initial adjustment underscores potential difficulties that require deft management. Ethiopia's productive capacity remains underdeveloped, exports are modest and reserves limited. Rapid currency movements risk instability as import costs spike, straining household budgets, businesses and fueling inflation.
Sustaining public trust after past unrest demands buffering citizens from hardship and maintaining cohesion. Complementary policies are now vital to smooth the transition. Subsidies on essentials can ease costs for vulnerable import-dependent families. Forex reserves must grow through exports and investment to moderate currency swings.
Making more greenbacks available to manufacturers and importers is also vital to keep goods flowing. Expanding production domestically can take the import sting out of a weaker birr. Tax incentives and financing must be on hand to help industries ramp up import substitution. If supply gaps can be quickly reduced, inflationary pressures should ebb.
Most importantly, stability demands addressing conflicts and ensuring reforms benefit all communities equally. With prudent calibration of economic priorities and social safeguards, Ethiopia can realize exchange-rate flexibility's gains while sustaining broad-based growth and development. The success of this pivotal reform depends on navigating short-term challenges to solidify public conviction in Ethiopia's shift to a market-oriented model.
