Financial
Sector Reforms in Ethiopia and the Challenges Ahead
Lakew Alemu (Dr.)
Awash
International Bank, May, 2001
1. Objectives
of Financial Sector Reforms
In Ethiopia, financial sector
reform was initiated back in 1992 as one of the important components of the
economic reform programme under the Structural Adjustment Programme (SAP).
The main objectives of the
financial sector reform were:
1. To deregulate financial sector activities
with a view to improve mobilization of domestic resources for investment.
2. To improve the efficiency of financial
intermediation through greater reliance on market forces in resource allocation.
3. To create conditions for the use of market
oriented instruments in the implementation of monetary polices.
The core target of the reform
objectives was however to promote saving, investment and economic growth.
2. Reform
Measures Undertaken
In its attempt to achieve the
above reform objectives, the government has introduced a number measures, of
which the major ones are the following:
1. Adjustment of the exchange rate through
devaluation of the birr.
2. Abolishing sectorally discriminating
lending rates.
3. Reduction of directed credits to
inefficient state enterprises.
4. Allowing the establishment of local
private banks and micro- financing institutions.
5. Adopting regulatory and supervisory
frameworks for banks and financial institutions in areas such as capital adequacy,
information disclosure and accounting requirements.
6. Strengthening the capital base of state owned
banks (Development Bank of Ethiopia).
7. Introducing foreclosure law to facilitate
quick recovery of non- performing loans by banks.
8. Improving access to forex for imports
through auctions and partial transfer of forex functions to commercial banks.
9. Introducing forex earnings
retention/utilization scheme for exporters.
10.
Introducing a market for short-term government debt instrument (treasury
bills of different maturity and bonds).
3. Implications
of the Reforms in the Financial Sector
Both theory and empirical
evidences tell us that savings, investment and growth are determined not only
by financial sector reforms but also by factors such as structural reforms in
the real sector and by fiscal policies.
Certainly, the reform
efforts of the past years have had certain impacts on the growth of the economy
as a whole and on the financial sector in particular.
According to the official
data from the National Bank of Ethiopia, during 1995/96 to 1999/2000 real GDP
has grown on the average by about 3.8% annually. Investments in the private
sector had been rising steadily except for the last two years, when declines
were observed mainly on account of the border conflict with Eritrea. As far as
investment and growth as a whole are concerned, these results are encouraging,
but they are not satisfactory compared to the high rate of population growth
which on the average was about 3% in the past 5 years.
Looking at the resource
mobilization aspect of the financial sector, we observe that significant progress
has been achieved after the reforms. This is reflected in the expansion of
total banking liquidity {deposit) which stood at birr 20.4 billion at the end
of June 2000 compared to birr 4.9 billion at the end of June 1992. As regards
resource allocation for investment purposes, the banking sector has disbursed a
growing volume of credit to the private sector which is a sign of improvement
of resource allocation.
It has also been observed
that a certain level of efficiency of financial intermediation has been attained
after the financial sector reforms. This is evidenced by the declining trend in
the ratio of reserve money to deposits which was about 4% in 1999/2000 compared
to 9% in 1995/96.
On the other hand, the
extent and depth of financial intermediation has not shown visible improvements
during the past 5 years. The ratio of money supply (m2) to GDP has remained
more or less at the same level (41% ) for the period from 1995/96 to 1999/2000.
Competition which was
unknown in the banking sector before the reforms has now unfolded and is
becoming visible with the emergence of private banks in the past few years.
Competition in financial sector is desirable, because it enhances operational
efficiency and reduces intermediation costs of the competing banks.
In addition to private
commercial banks, the growth of micro- finance institutions in the country has
also been remarkable. As at the end of March 2000 the number of these
institutions was 16 with an aggregate deposit of birr 130 million and a loan
portfolio of over birr 550 million to poor rural and urban entrepreneurs.
In conclusion, we can say
that the financial sector reforms have been effective in that they have encouraged
competition among existing banks, improved the tempo of resource mobilization,
and created conditions for better allocation of resources to the private sector
which has started to play an important role as engine of growth in this
country.
4. Factors
Affecting the Growth and Functioning of the Financial Sector in Ethiopia
Despite encouraging reform efforts so far undertaken
in the financial sector and the positive achievements observed, there are
certain factors which affect the growth of a well functioning banking system in
our country.
At the current stage of its
development, the domestic financial sector falls short of achieving the required
level of dynamism, efficiency and depth. There are a variety of contributory factors
for this. Some are specific to the financial sector, while others are of macro
nature. These factors are briefly explained below.
4.1. Specific Factors
4.1.1. Dominant Role of the Government in the
Financial Sector
Currently, government banks
control over 90% of the local financial market. This situation may hinder the
growth of a well functioning banking system because the young private banks are
not in a position to properly compete with the dominant banks.
Monopolization of the financial sector and entry
barriers against foreign banks will weaken competition. One can argue that weak
competition might increase profitability of existing banks, but that would be
at the expense of growth and efficiency of the sector.
Another problem related to
the dominance of ownership in the banking sector is that institutions in the public
sector are not encouraged to do their banking business with private banks of
their choice. Today this is an existing reality in this country.
4.1.2. Administered Interest Rate
Currently, interest rates
are partially determined by the supervisory authority, i.e. the National Bank
of Ethiopia (NBE). Currently, the minimum floor for savings is 6% and for loans it is l0½% with a tight margin of only 4½%. In my opinion, this is not congruent
with potential risks banks are exposed to (credit, market, operational).
Here, I am not proposing
structured interest rates. Interest rates with different tiers may cause market
fragmentation and might lead to an inefficient allocation of resources.
Moreover, low lending
interest rates may cause inefficient resource allocation and discourage savings
thus negatively impacting resource mobilization. It is believed that full
deregulation of interest rates improves competition in resource mobilization
and efficiency of resource allocation.
4.1.3. Supervisory/Regulatory Mechanisms
Close supervision of
banking institutions is necessary and very important because of the risk
inherent in the business.
Regulation of banks
normally involves setting capital adequacy levels, defining single borrowers’
loan limits, prohibiting majority holdings in private banks, requiring information
disclosure or reporting, requiring adherence to monetary policy instruments
(reserve and liquidity ratios), conducting periodic supervision of overall
activities of financial institutions, etc.
Currently, these
supervisory mechanisms are already in place, but their effectiveness is still
under question.
Regulatory and supervisory
mechanisms and instruments of the supervisory authority need to be
well-designed and effective. Shortcomings in this area may result in risks for
the institutions.
The National Bank of Ethiopia should therefore
further strengthen its supervisory arm in terms of professional competence and
ensuring the effectiveness of its regulatory mechanisms.
4.2. Macro Issues
4.2.1. Stable Economic Growth
The macro environment under
which the financial sector operates has a significant bearing on its efficiency
and effectiveness.
When macro economic issues
such as prices, inflation, investment policies, exchange rate, trade policies,
employment conditions, etc. tend to be unstable or volatile and unpredictable,
the business community reduces its borrowings from the banking system to avoid
risks. This means low tempo of savings and investment activities in the
country.
Lack of policy clarity and
uncertainty about the future course of direction creates doubts in the minds of
potential investors regarding expected risks. This will finally affect the
process of economic growth, without which a modem financial sector cannot
develop.
4.2.2. Weak Legal/Court System
Absence of appropriate
legal framework or poorly functioning court system hinders the proper running
of the financial system. Existing problems include:
· Lag in the enforcement of contracts related
to negotiable instruments ( e.g., checks);
· Constraints regarding pledge of movable
property as collateral and;
· Difficulties related to the implementation
of the Foreclosure Law and transfer of property rights erode the confidence of
the business community in activities of the financial institutions.
Efficient court system and
fast dispute resolution by courts will promote efficiency of financial
intermediation and public trust and confidence in the financial system.
4.2.3. Weak Infrastructure
The financial sector
requires the availability of basic infrastructure. For instance, monetization
of the economy or integration of financial markets within the country will be
constrained, if there is no possibility for rapid transfer of funds and
information by banks.
The size of the financial
sector and its ability to function properly depends on adequate infrastructure,
both physical and human.
Similarly, if professionals
such as accountants, auditors, financial analysts are in short supply, it would
be difficult to produce reliable information on the viability and reliability
of financial intermediation, particularly in the area of risk management.
4.2.4. The Need to Develop Money/Capital Markets
The basic aim of monetary
policy is to maintain price stability, by ensuring that the growth in money supply
does not exceed the demand for money. In reality , however, the rate of growth
of money supply is not identical to that of credit due to investment
opportunities and government borrowing.
It is therefore necessary
to develop other financial assets and markets on which the financial assets
will be sold and bought. These are money and capital markets. These markets
provide relatively cheap source of finance both on a long term and short term
basis.
Legal and regulatory
framework for marketing shares, stocks, bonds, treasury bills, CD’s, etc. has
to be developed on the basis of the experience gained so far. The activities of
the Steering Committee on the formation of a Stock Exchange in the country is
an encouraging step in this direction.
Given the existing low
level of domestic savings and an extremely backward economy, the domestic financial
sector cannot adequately meet the needs of the private sector for both short
and long term investment finance. This requires preparation of conditions for
the existence of institutional investors such as mutual fund mangers, brokerage
houses, trust funds, finance companies, etc. to further improve mobilization
and allocation of resources to accelerate economic development.
5. Conclusion
A healthy financial system
is the one which effectively fosters resource mobilization for capital accumulation
and determines efficient allocation of
resources. It is important to remember that success of any financial
system, in its resource mobilization and allocation functions, depends on its
ability to offer the public a variety of assets (money as a medium of exchange,
earning assets, pension funds, etc.) corresponding to the various needs and
preferences of economic agents.
A clear understanding and
recognition of this fact is very important to formulate appropriate policies to
enable the financial system to function properly and efficiently.
A set of macro-economic and
sectoral policies supported by dependable legal and institutional infrastructure
are very important and necessary for the development of a sound and rational
financial system in Ethiopia.