- Experts Debate Ethiopia’s Credit Limit Policy Impact
Ethiopia's central bank enacted stringent measures 10 months ago to reign in rampant credit growth and surging inflation by imposing a 14 percent cap on commercial bank lending. This policy has proven successful at slowing money supply expansion and reducing consumer price pressures, with inflation falling from over 30 percent to its current level of 23.3 percent. However, lenders are feeling the strain on loan books and interest income as credit growth declines. Experts caution that prolonged restrictions could distort resource allocation and disproportionately impact new banks and industries like manufacturing. As the one-year anniversary approaches, the National Bank of Ethiopia must determine whether to relax the constraints and risk reigniting inflation or keep tight limits that may inhibit longer-term economic objectives, as BirrMetrics journalists report.
It has been one year since the National Bank of Ethiopia (NBE) took the unprecedented step of imposing stringent new rules aiming to rein in Ethiopia's spiraling inflation rate. On August 11th, 2023, the central bank implemented an immediate policy capping annual growth in commercial bank lending at 14 percent - a drastic move seen as necessary to counter years of unchecked credit expansion that analysts said was overwhelming the economy with excess cash and undermining anti-inflation efforts.
Now as the one year mark approaches and the latest inflation figures are released, the NBE finds itself at a crossroads. It must decide whether to relax the restrictive credit limits that have successfully cooled price increases, at the risk of rekindling inflation, or maintain tight constraints and potentially inhibit longer-term growth objectives. With much at stake for both macroeconomic and financial sector stability, the post-implementation impact of the policy is under intense scrutiny.
By most accounts, the credit cap has succeeded in its primary goal of slowing money supply growth and reducing inflationary pressures. Consumer price increases, which had soared to over 30 percent in the months prior to the measure's introduction, have trended decisively lower since. According to the most recent data from the Central Statistics Agency, year-on-year inflation fell to just 23.3 percent in April 2024 - the lowest level in close to three years.
The decline was broad-based, with both food and non-food inflation moderating significantly. Non-food price rises, seen as a proxy for demand-pull inflation, plummeted to under 20 percent for the first time in years. The NBE has attributed the overall decline directly to achievements of its monetary strategies focused on reining in excess liquidity flows, with the credit cap playing a central role.
Commercial bank loans, which had previously been growing rapidly at rates of 50-60 percent per year, have now slowed down to less than half that pace, aligning with the 14 percent limit. This has resulted in a decrease in the growth of money supply. In August, M2 (a measure of money supply) expanded by 49.5 percent, but by the end of 2023, it had slowed down to 28.7 percent, as reported by the central bank. These figures suggest that commercial banks have adhered to the lending limit and have tightened their overall credit extension.
Simultaneously, the annual increase in reserve money, which represents the most liquid part of the money supply including currency in circulation and bank reserves, has eased from 33.4 percent to 18.7 percent during the same period. This indicates a moderation in the formation of base money. Other indicators also point to a slowdown in the underlying growth of cash. The annual rate of currency issuance declined from 19.8 percent in August to just 6.7 percent by December. This indicates a reduced demand for physical cash in day-to-day transactions.
Nonetheless, the banking sector is feeling the pinch of the ongoing constraints. Total loan books have risen in the low teens percent as permitted. The falling interest income stream has pressured margins. Access to financing has also tightened for some. Banking expert Abraham Terecha points to rising credit rationing as large lenders' limited funds get scooped up by favored clients, leaving new and smaller firms with dwindling options. "This could distort credit allocation and hamper entrepreneurship," he said.
Abdulmenan Mohammed, a financial analyst with over 20 years' experience, acknowledges the credit cap helped lower inflation. However, he says “credit cap is a desperate measure, and it should not continue for an unlimited period.” Abdulmenan notes caps distort resource allocation and even spark corruption.
Long-time banker Worku Lemma concurs the limits served their purpose but also have shortcomings. “While it will not cause much worse damage in the short term, it could negatively impact newer banks and start-ups entering the industry,” he says.
Over 20-year banker Worku cautions constraints, while necessary temporarily, may disproportionately affect newer banks if prolonged. "Their opportunity to grow market share gets quashed against larger incumbents who dominate limited available loans under the caps," he said. For certain industries as well, reduced bank intermediation is squeezing investment, according to him.
The manufacturing sector, already beset by longstanding issues, is a particular concern according to financial analyst Abdulmenan. Specifically regarding Ethiopia's private sector, Abdulmenan adds that "except for state banks, the private banks are less keen on providing finances to the manufacturing sector. With the credit cap, the availability of finance for the manufacturing sector will be tight unless the borrower has a strong relationship with the banks. This will affect the manufacturing sector, which is riddled with so many problems."
Abdulmenan cautions that "the longer the credit cap stays, the more it will negatively affect banks' performance." While they may charge higher interest and fees, the lost interest income from lending limits could be much greater. Banks also have limits on how high they can raise rates before borrower demand falls, according to him.
On the ground, the contrasting effects of monetary tightening are evident among businesses navigating the post-pandemic recovery. Some larger, well-established enterprises say credit availability has not been a substantial impediment to date with their long-held banking relationships still availing working capital needs. But others perceive increasing constraints pervading sectors like export manufacturing and construction.
A top coffee exporter notes access to project financing has become "severely limited" due to caution among banks whose lending wings have shrunk under the policy. Rising interest rates imposed to offset falling volumes are adding costs. At the same time, imported inputs are climbing in price on a weaker Birr, pressuring margins. Maintaining growth and employment is tough in this setting, he contends.
Yet others see the stabilizing impact on costs of toning down inflation as outweighing tighter financing channels in their circumstances. One commodities trader says imported goods that make up a large input share are now more affordable thanks to slower price increases. And end consumers' stronger purchasing power also lifts his revenues when inflation abates.
The overall business environment thus remains complex, with winners and losers emerging across sectors based on specific competitive conditions. Achieving a delicate policy balance that guards macro stability while keeping credit flowing will continue testing policymakers as they evaluate response options.
Further complicating the policy landscape are ongoing domestic political transitions and shifting external dynamics. On the fiscal side, Ethiopia's new administration has prioritized reforming bloated state spending since last year, reducing central bank advancements that previously amped up broader money supply growth. However, execution of ambitious deficit targets depends on challenging subsidy and payroll overhauls.
Abroad, higher global interest rates triggered by aggressive tightening in advanced nations are pulling capital away from emerging markets like Ethiopia as yields rise. This puts downward pressure on the Birr and amplifies imported inflation if left unchecked. At the same time, external demand that was rebounding has lately begun flagging again due to synchronized global slowdown.
In the meantime, as another fiscal year draws to a close with consumer price increases continuing a steady downward glide, the NBE will soon face a decision on the policy's future direction. Success in taming inflation after years of rising costs has provided immense relief. Sustaining that achievement through prudent policy while avoiding the financial sector distortions warned of by Abdulmenan will define authorities’ next chapter. As the expert notes, credit caps can cause issues like credit rationing and corrupt practices and interest rate hikes if maintained too long.
