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From Zero to Hero

Amen Teferi

12-04-15

Ethiopia has experienced a growth acceleration since 2004 that enables it to catch-up with the rest of the world, as a part of a very successful broader development performance. Its trajectory is nothing but a traverse from zero to hero, following a development path that what the World (WB) opted to describe as the “Ethiopian Way.” The WB noted, “Ethiopia is coming closer to its goal of reaching middle income status by 2025.”

Now, coverage of Ethiopia promises a bright new future and the recent WB report depict it as a country with a promising future. Much of the promising economic news coming out of the West reflects that Ethiopia is benefitting from its policy independence, as it generally did not follow the recommendations of the Growth and Development Commission.

This is not the first time when the WB expresses its optimism about Ethiopia’s economy. About a decade and a half ago, Joseph Stiglitz, the then president of the World Bank, had recommended the leading architect of Ethiopia’s economy, Meles Zenawi, for his knowledge of economic principles.

That was time when some commentators were seeing the bright future of Africa noting the promise of the continent with coming of the new “progressive-minded” leaders. Thus, being the member of the new leadership that was emerging from Africa, Meles had represented the political reform, more grassroots participation in government, more transparent economic policies, and an end to tribal favoritism and conflicts.

However, that optimism did not last long.  The new image was soon tarnished by problems related with conflicts, despotism and persistent charges of corruption, among others. These chronic problems of the continent had dashed the strong hopes for economic and political reforms, which was compounded by social problems like HIV/AIDS that has ravaged the continent by cutting down many men and women in the prime of their lives. Fortunately, population projections show that in the next 25 years Africa will more than recover its population losses from the '80s and '90s. Nothing such daunting problems that Africa was facing, much of the media in the West questioned whether or not Africa would ever be able to recover and by 2000, the Economist, had described Africa as “The Hopeless Continent." 

That was then.

Now, while noting a number of difficulties that African nations have to overcome; nonetheless the coverage did not fail to highlight the promises. Investment companies have also begun to see Africa as having some of the world’s most promising opportunities for sharp economic growth. Hence, experts in the West have identified five most promising countries in Sub-Saharan Africa -which include Ethiopia- that are well ppositioned to take advantage of the potential economic growth.

The political and economic reforms that were in place nearly two decades has enable Ethiopia to trigger rapid economic growth. If Ethiopia manages to keep this momentum, it would play the role of being an economic powerhouse to the sub-region, by providing the Horn countries with goods and services, as well as investments.

As Ethiopia has routinely declared, it has a stake in seeing the standard of living rise in its potential trading partners and that this will continue to stimulate its economic growth in particular and the continent’s in general. Of course, Ethiopia represents a huge market that can drive economic growth and integration in the Horn of Africa region. We know that Ethiopia’s economic growth has been fueled by hydroelectric power, which enables it to export electricity to neighboring countries, which at the same time pave way for economic integration.

According to experts, while global demand for Africa’s natural resources will continue to attract investors, the growing gap between the rich and the poor could trigger social and political instability in the future if countries do not take measures to reduce economic disparity so that more people will benefit from the growth of national and regional economies. African nations should also be careful to direct a sizable portion of the surplus from their economic growth into infrastructure and economic diversity, so that nations will not be dependent on high commodity prices to sustain a higher standard of living over the long-term. Considering the abovementioned recommendations, Ethiopia is in a better position as the WB report has clearly indicated us. Ethiopia is one of the fastest growing economies in the world and its sharp and rapid economic growth is not shackled by economic disparity. WB said, “Ethiopia is one of the most equal countries in the world and low levels of inequality have, by and large, been maintained throughout this period of rapid economic development.”

According to the WB report, Ethiopia has directed a sizable portion of the surplus from its economic growth into infrastructure and this has contributed its economic growth. The report stated, “The strong contribution of infrastructure investment arises from a substantial physical infrastructure expansion combined with their high returns.

It is rapidly expanding its infrastructure as part of the second Growth and Transformation Plan, which the government believes would benefit the private sector. Ethiopia stands out during the 2000s for having registered very rapid infrastructure development. Using the data for 124 countries over four decades, the country was among the 20 percent fastest in terms of infrastructure growth over the past decade.

Although this is partly the result of starting from a very low level, these infrastructure growth rates also exceed those of fast growing regional peers with comparable income levels.” As we know, the public investments in the sector concentrate in providing basic infrastructure, such as energy, roads, and telecom.

Ethiopia’s growth acceleration, according to WB, was part of a broader and very successful development experience. Poverty declined substantially from 55.3 percent in 2000 to 33.5 percent in 2011. Despite rapid growth, Ethiopia remained one of the most equal countries in the world with a Gini coefficient of consumption of 0.30 in 2011. But progress went beyond monetary dimensions, said WB.

Similarly, life expectancy has increased by about one year annually since 2000 and is now higher in Ethiopia than the low income and Sub-Saharan Africa averages. In fact, Ethiopia also surpassed these peer groups in several other key development indicators, including child and infant mortality. As a result, the country has attained most of the Millennium Development Goals. Nonetheless, the WB report has underlined the need to promote shared prosperity as Ethiopia faces a challenge in promoting shared prosperity as the poorest 15 percent of the population experienced a decline in well-being in 2005-11 mainly as a result of high food prices.

Now, investors have their eye on Ethiopia, which is growing rapidly due to the economic policy of the government that it put in place two decades ago. However, the report explained that Ethiopia’s economy is vulnerable because it lacks diversity.

Ethiopian Way

Ethiopia is now consolidating its political system, as recently exemplified by its solid determination to promote good governance for the ruling has realized that the Ethiopian economy is, to some extent, hobbled by problems associated with good governance. Besides, problems associated with climate change have significant contribution to the erratic economic graph observed in the last two decades.

Ethiopia had demonstrated prowess in managing macroeconomic stability by repressing inflation and benefited from large-scale government investment in agriculture, industrialization, as well as infrastructure. While agriculture was the main growth contributor at the beginning of the take-off, gradually the services sector took over and in recent years, and a construction boom has complemented this.

WB also noted that Ethiopia as benefiting from a large population base and private consumption contributed to growth on the demand side with public investment becoming increasingly important.

Ethiopia’s rate of growth will not remain at its current astronomical levels, if it does not sufficiently diversify its economy. Ethiopia’s economic growth is based primarily on agriculture and service, but agriculture will remain to play a major role in the country’s long-term economic prospects and sustainability.

The Report

The WB report has addressed two questions: What explains Ethiopia’s growth acceleration? How can it be sustained? And the WB has find that Ethiopia’s rapid economic growth, concentrated in agriculture and services, which was driven by substantial public infrastructure investment and supported by a conducive external environment. The WB has proposed three policy adjustments are proposed that it believes would sustain high growth. These include, identifying sustainable ways of financing infrastructure, supporting private investment through credit markets, and, tapping into the growth potential of structural reforms.

Ethiopia’s economic growth has been remarkably rapid and stable over the past decade. The WB, citing to an official data, noted the Real GDP growth averaged 10.9 percent in 2004-2014. By taking into consideration population growth of 2.4 percent per year, real GDP growth per capita averaged 8.0 percent per year. The country moved from being the 2nd poorest in the world by 2000 to the 11th poorest in 2014, according to GNI per capita, and came closer to its goal of reaching middle income status by 2025.

This pace of growth is the fastest that the country has ever experienced and it exceeds what was achieved by low-income and Sub-Saharan African countries in that period. Recent growth was also noticeably stable, as the country avoided the volatility by spells of drought and conflict, which had plagued growth in the past. As a result, Ethiopia’s real GDP has tripled since 2004 although it remains well below regional and low-income levels.

“Encouragingly, Ethiopia has moved from being the 2nd poorest to the 11th poorest country in the world since 2000, according to GNI per capita (Atlas Method). It also moved closer to its goal of becoming a middle-income country by 2025 gradually narrowing the gap to the relevant income threshold. In sum, Ethiopia made a lot of progress, but it remains a poor country,” the report said. According to WB, Ethiopia facing a challenge in terms of promoting shared prosperity. Promoting shared prosperity requires fostering the consumption growth of the bottom 40 percent. Prior to 2005, Ethiopia made good progress on sharing prosperity: consumption growth of the bottom 40 percent was higher than the top 60 percent in Ethiopia.

However, this trend was reversed in 2005 to 2011 with lower growth rates observed among the bottom 40 percent. This can largely be explained by the effect of rising food prices in 2011, which hurt the real incomes of marginal farmers and urban dwellers.

 

On the other hand, the report acknowledged that he average household in Ethiopia has better health, education and living standards today than in 2000. Life expectancy increased by about one year per year that passed since 2000 and is now higher in Ethiopia than the low income and regional averages.

 

Substantial progress was made towards the attainment of the Millennium Development Goals (MDG), particularly on extreme poverty, undernourishment, gender parity in primary education, infant and child mortality, maternal mortality, HIV/AIDS, malaria and water access, though progress is lagging in primary enrolment and sanitation. Women are now having fewer births—the total fertility rate fell from 7.0 children per women in 1995 to 4.1 in 2014. At the same time, the prevalence of stunted children was reduced from 58 percent in 2000 to 40 percent in 2014.

 

As the report has noted, the share of population without education was also reduced considerably from 70 percent to less than 50 percent. Finally, the number of households with improved living standards measured by electricity, piped water and water in residence doubled from 2000 to 2011. Despite this impressive progress, the country faces deep challenges in every dimension of development.

 

Gear Shift

Accelerated economic progress started in 1992 with a shift to an even higher gear in 2004. Econometric analysis supports a story of two growth accelerations as average growth increased from 0.5 percent in 1981-92 to 4.5 percent in 1993-2004 and to 10.9 percent in 2004-14. The first ‘gear shift’ took place shortly after the political and economic transition of 1991 with the downfall of the communist Derg regime and the introduction of a more market-oriented economy.

The subsequent Ethiopian People’s Revolutionary Democratic Front (EPRDF) government, in turn, implemented a series of structural economic reforms during the 1990s, which paved the way for the second growth acceleration starting in 2004. Nonetheless, structural economic reforms have been largely absent from Ethiopia’s recent story of success, though they offer a promising growth potential if implemented.

Out of an average annual growth rate of 10.9 percent in the years 2004-14, the services contributed by 5.4 percentage points followed by agriculture with 3.6 percentage points and industry with 1.7 percentage points.

Economic Strategy  

According to the WB, Ethiopia stands out in many ways, including in the economic strategy that paved the way to success. Ethiopia’s economic strategy focused on promoting agriculture and industrialization while delivering substantial public infrastructure investment.

Ethiopia’s strong commitment to agricultural development is noteworthy as reflected by high government spending and the world’s biggest contingent of agricultural extension workers. While a strong push for infrastructure development at the early stage of development is far from unique, the way in which Ethiopia achieved this sets it apart.

Even if Ethiopia generally did not follow the recommendations of the Growth and Development Commission (2008), it did deliver the recommended impressive rates of public investment with the purpose of crowding-in the private sector.

Despite low domestic savings and taxes, Ethiopia was able to finance high public investment. It has kept government consumption low and garnered resources to finance budgetary public infrastructure investment and taped external concessional and non-concessional financing. According to the report, Ethiopia has employed three less conventional financial mechanisms: First, a model of financial repression that kept interest rates low and directed the bulk of credit towards public infrastructure. Second, an overvalued exchange rate that cheapened public capital imports. Third, monetary expansion, including direct Central Bank budget financing, which earned the government seignorage revenues.

The WB has labeled Ethiopia’s economic strategy as unique. It says that although Ethiopia gradually moved in the direction of a market-based system, it continued to intervene in most sectors of its economy thereby not adopting some of the key recommendation of the Growth Commission of ‘letting markets allocate resources efficiently.’

According to the WB structural economic reforms have been absent from Ethiopia’s growth strategy in part because of initial economic success. Although it was inspired by the East Asian developmental state model and shares some common features, it is also different from East Asian countries both in conception and outcomes, the report said. In this regards, it mentioned that agriculture features much more prominently in the Ethiopian strategy than in East Asia. It also added that Ethiopia’s economic success thus far has not been derived from the success of numerous firms drawn from the private sector as in East Asia.

According to WB, public infrastructure investment is facilitated partly by restrained government consumption and was the key structural driver of growth. In contrast to many countries in the region, the government deliberately emphasized capital spending over consumption within the budget and this was key for supporting growth.

This shift was facilitated by declining military spending following the 1998-2000 war with Eritrea giving rise to a ‘peace dividend’. Increased openness to international trade also supported growth as did the expansion of secondary education, though these effects were less pronounced.

Growth Driver

The growth acceleration period marked the rise of the services sector in Ethiopia. Services overtook agriculture to become the largest economic sector, the biggest contributor to economic growth, and is the second biggest employer. Within services, commerce, ‘other services’ and the public sector were the most important contributors to output and jobs. On the other hand, the Ethiopian services story is predominantly one of a rise in traditional activities, which require face-to-face interaction, rather than modern activities such as ICT or finance.

Ethiopia’s growth acceleration was also supported by positive demographic effects. The economic take-off coincided with a marked increase in the share of the working-age population giving a positive boost to labor supply. Ethiopia can also expect to capitalize on having a comparatively young demographic structure, as the growth sixteen to thirty-age bracket provides the potential for an expanded workforce.

This demographic group will rapidly adopt mobile technology, which is likely to increase both markets and productivity in the country. Up to thirteen percent of per capita growth in 2005-13 can be attributed to this ‘demographic dividend’ effect.

A continued rise in the working age population will support potential economic growth in the coming decades, but for the country to reap fully these benefits, it must accelerate the ongoing fertility decline and equip workers with marketable skills to be attractive to prospective employers. Both the manufacturing and services sectors would play an important role in absorbing this additional labor.

 

Agriculture

Ethiopia’s agricultural sector has recorded remarkable rapid growth in the last decade and was the major driver of poverty reduction. The sector is, by far, the biggest employer in Ethiopia, accounts for most merchandise exports and is the second largest in terms of output. The sector also contributed to most of the employment growth over the period of analysis. Although some labor shifted out of agriculture, substantial shifts are likely to take a long time. Critically, agricultural growth was an important driver of poverty reduction in Ethiopia: Each percent of agricultural growth reduced poverty by 0.9 percent compared to 0.55 percent for each percent of overall GDP growth.

 

Agricultural output increases were driven by strong yield growth and increases in area cultivated. Yield growth averaged about 7 percent per year while area cultivated increased by 2.7 percent annually. A decomposition of yield growth reveals the importance of increased input use as well as productivity growth. As in the Green Revolution, increased adoption of improved seeds and fertilizer played a major role in sustaining higher yields. While starting from a low base, these inputs more than doubled over the last decade. Total factor productivity growth averaged 2.3 percent per year.

 

The factors associated with agricultural production growth include extension services, remoteness and farmer’s education. A regression model was used to identify the likelihood of adopting modern technology. Farmers that received extension visits, less remote households and more educated farmers were more likely to adopt improved agricultural technologies.

Recent agricultural growth is largely explained by high government spending on extension services, roads, education as well as favorable price incentives. First, Ethiopia has built up a large agricultural extension system, with one of the highest extension agent to farmer ratios in the world.

 

Second, there has been a significant improvement in access to markets. Third, improved access to education led to a significant decrease in illiteracy in rural areas. Fourth, high international prices of export products as well as improving modern input - output ratios for local crops have led to better incentives. Other factors played a role as well, including good weather, better access to micro-finance institutions in rural areas, and improved tenure security. Recent poor rains in Ethiopia during 2014 and 2015 pose a major challenge to the country and the impact of climate change stresses the importance of continued investment in irrigation to reduce reliance on rain-fed production.

 

Projection

The WB has tried to project Ethiopia’s growth rate over the next decade. Following a decade-long spell of double digit growth on the back of a strategy and performance that seemingly emulates the East Asian developmental states, including China, one might assume that such high growth rates can be sustained in the future on the back of the same strategy that worked so well in the past.

 

But a country specific analysis of growth head and tailwinds suggest a balance of factors at play in Ethiopia. The likelihood of continued high growth in Ethiopia is buoyed by five factors: productivity-enhancing structural change, within-sector productivity gains (including agriculture), technological catch-up, urbanization, and FDI.

The demographic transition and a large domestic market offer important potential. These factors would need to be balanced against a number of ‘growth headwinds’ factors. Exogenous factors include geographical disadvantages and a slowdown of world trade.

 

Endogenous factors include: lagging agricultural productivity, low export size and diversification, a small financial sector, low levels of human capital and poor trade logistics. Most of these ‘inhibitors’ do not pose insurmountable hurdles but collectively they could dampen Ethiopia’s chances of maintaining its growth rate over the course of the next decade.

 

To sustain high growth, three policy adjustments are proposed. This includes (1) supporting private investment through credit markets; (2) identifying sustainable ways to finance infrastructure, and; (3) tapping into the growth potential of structural reforms. We discuss each of these in turn. Arguably, the Ethiopian economy would benefit from a shift of domestic credit towards private firms. If the aim of government policy is to enhance the productivity of private firms, then it is important to understand what the firm-level constraints are.

 

If firms really need credit more than access to new roads or better telecommunication to grow and prosper, then government policy would need to support the alleviation of the credit constraint at the firm level. Since public infrastructure investment is partially financed via the same domestic savings pool, it is clear that infrastructure financing competes directly with the financing of private investment projects.

 

Two policy reforms could potentially address the challenge of private sector credit. The first would be to continue the existing system of financial repression, but to direct more credit towards private firms. In that way Ethiopia’s financial system would become more similar to Korea, where the bulk of credit was directed towards private priority sectors. A second reform involves a gradual move towards a more liberalized interest rates that better reflect the demand and supply for savings/credit and encourage more savings. In terms of reform sequencing, Ethiopia has already followed international best practice through its ‘trade-first’ approach, although it has proceeded very slowly. Economic theory, country experience and best international practice would generally suggest the following sequence of reforms: (1) trade liberalization; (2) financial sector liberalization, and (3) capital account opening.

 

That said, every country experience has been unique and reforms have to be customized to their specific country setting. It is noteworthy that Ethiopia has so far liberalized its merchandise trade, but not yet its services trade. The next possible step on the reform path may be to engage in services trade and financial sector liberalization. Although there are economic benefits to reforms as well as an emerging consensus about their sequencing, policy makers are often concerned about risks. While the average longer term net benefits seem to be positive, there is no guarantee that all countries will automatically benefit from reforms. Ethiopia has the added advantage of being in a position to learn the lessons of successful as well as painful experiences of other countries. Still, there are important pitfalls on the reform path (e.g. regulatory frameworks need to be well developed before liberalizing domestic finance) and these would need to be studied more carefully if Ethiopia were to re-initiate the structural reform agenda.

 

At some point, we argue, the costs of pursuing the current policy would outweigh its benefits. For example, the loss of external competitiveness associated with an overvalued exchange rate may outweigh the benefits in the form of cheaper public capital imports.

 

A deterioration in these indicators may precede a slowdown in growth and provide early warning to policy makers that the current growth model has run its course. Policy makers are encouraged to be proactive and initiate reform efforts now as opposed to waiting until growth slows down.

 

With the recent launch of the Second Growth and Transformation Plan and the recent appointment of a new economic team, the timing is right to consider the proposals of this report.

 

Encouragingly, the GTP2 envisions a strong increase in the tax revenue to GDP ratio in a bid to raise domestic savings and identifying alternative and more sustainable ways to finance infrastructure. In a similar vein, the private sector is expected to play an important role in supporting infrastructure provisions in ways that reduced the need for public borrowing. The new strategy also stresses the role of the private sector as the ultimate engine of growth and emphasizes the need to maintain a competitive real exchange rate.

 

Moreover, domestic savings are to be mobilized by ensuring that the real interest rate remains positive. The WB said “The analysis and proposals put forward in this report are aimed to support the Government of Ethiopia in achieving these goals in its quest towards becoming a lower middle-income country by 2025.”

 


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