Q Overview of Ethiopian Economy Ethiopia is the second most populated country in

Africa with an estimated population of more than 83 million people. Ethiopia is one of the least
developing countries which ranks 157 out of 169 countries on the United Nations Development
Program‘s 2009 Human Development Index. According to a recent survey nearly 30% of the country’s
population live below the poverty line MoFED (2011). The Ethiopian economy is based on agriculture,
which in 2009accounted for about 42 percent of the gross domestic product (GDP), about 80 percent of
total employment, and nearly 80 percent of foreign currency earnings (MoFED, 2009). Ethiopia's major
exports include coffee, oil seeds, 16 gold, chat, flowers, pulses, and live animals. Coffee is the leading
export, constituting 30.6% of total exports by value in the year 2009 (MOFED, 2009). Generally, the
overall economic growth of the country has been highly associated with the performance of the
agriculture sector. Recently the industry and service sectors have been increasing their share of the
GDP. The industrial sector, which mainly comprises small and medium enterprises accounted for about
13 percent of GDP in 2009. In the same year, the services sector accounted for about 44 percent of GDP
(see Table 2.2)

Ethiopia economic structure is unique in Africa. It has no oil or mining sector and
virtually no private investment. With the country lacking basic growth
components, Ethiopian economy is highly dependent on agriculture. In 2001, the
country qualified for international aid under HIPC (heavily-indebted poor
countries) initiative. Since then, the International Monetary Fund (IMF) is the
leading foreign aid provider for the country.

Ethiopia Economic Structure: GDP

Composition

The Ethiopia economic structure is highly centralized. The government owns all
the land and leases to citizens for long periods. Due to this fact, the business
sector cannot use land as collateral for acquiring loans. Political instability and
involvement in the Eritrean civil war during 1998-2000 is also responsible for this
underdeveloped industrial sector.

Previously, the government used to transfer state property to state-owned

enterprises in the name of privatization. Since 2003, the IMF intrusion has
compelled government to undertake strategic economic reforms.
Abstract
Ethiopia is one of a number of SSA economies that adopted state-led development strategies in
the 1970s
(others include Angola and Mozambique), and suffered from intense conflict (leading to the fall
of the
Derg regime in 1991). The then new government was therefore faced with the twin tasks of
reconstructing the economy, and embarking on the transition to a market economy in early
1990s. As part
of this process, state banks have been reorganised, the role of the private sector in the financial
system
has been expanded, interest-rate controls have been liberalized, and the central bank has been
given new
powers of financial supervision. Financial reform has been gradual, but nevertheless determined
despite
disagreement with the IMF over restrictions on the entry of foreign banks and the role of the
largest state
bank. This paper argues that gradual financial liberalization—while simultaneously investing in
regulatory capacity—is the appropriate strategy for maintaining macro-economic stability and
growth
in Ethiopia. In this regard, the Chinese transition strategy—in which significant control was
retained over the financial sector—can be a useful guide. However, since the sector cannot be
protected
forever and new and complex liberalization demands are in the horizon, the study suggests a
time-specific
strategy of capacity building for regulating and supervising the sector with cautious and partial
opening
of the sector using different modalities such as joint-ventures and management contract with the
objective
of efficiency, stability, shared growth and local ownershi

++++++++++++++++++++++++++++++++++++++++++++++++++++++

1. Overview

Ethiopia has one of the fastest growing economies in the world and the country's location gives it

strategic dominance as a business hub in the Horn of Africa, close to the Middle East and its markets.

Ethiopia's huge population of over 100 million people, makes it the second most populous nation in

Africa, after Nigeria. Although it is the fastest growing economy in the East Africa region, per capita

income remains below USD900. Ethiopia's government aims to reach lower-middle-income status by

2025. The government is implementing the second phase of its Growth and Transformation Plan (GTP

II). GTP II, which will run to 2020, aims to continue work on physical infrastructure through public

investment projects, and to transform Ethiopia into a manufacturing hub. Growth targets are an

annual average GDP growth of 11%; in line with manufacturing strategy, it also hopes the industrial
sector will grow by an average of 20%, creating jobs. Ethiopia's main challenges are sustaining its

positive economic growth by diversifying its economy and strengthening drought-resilience,

mechanisation and value addition in agriculture - which will help with accelerating poverty reduction.

Important measures were taken to address birr overvaluation, large external imbalances, foreign

exchange shortages, and rising external debt in recent quarters. Furthermore, the advent of a more

reform-minded leader bodes well for political and economic stability in the medium term.

6:1Ethiopia - Market Overview

Discusses key economic indicators and trade statistics, which countries are dominant in the
market, the U.S. market share, the political situation if relevant, the top reasons why U.S.
companies should consider exporting to this country, and other issues that affect trade, e.g.,
terrorism, currency devaluations, trade agreements.

Last Published: 11/5/2018

Ethiopia has a large domestic market of over 100 million people, making it the
second most populous country in Africa after Nigeria. Over the last decade,
Ethiopia has had one of the fastest growing economies in the world, with
average annual growth rates ranging from 7% to 12% (depending on data
sources). In 2017, Ethiopia’s real Gross Domestic Product (GDP) expanded
by 10.9 percent, and is expected to grow by 8.5%, according to the World
Bank.

The business climate is undergoing significant changes with significant policy

reforms implemented under the new leadership of Prime Minister Abiy Ahmed.
Government plans to privatize leading state-owned enterprises, announced in
June 2018, signal a greater openness to market based reforms and a new
flexibility to policymaking. The acute foreign exchange shortage remains the
leading challenge for U.S. suppliers, for which there is no quick fix.

While the economy is growing rapidly, presenting many opportunities, there

are also hurdles to doing business in Ethiopia. The 2018 World Bank’s Ease
of Doing Business report (EODB) ranked Ethiopia 161th out of 190 countries;
a drop of 2 rankings from that of last year. The World Economic Forum (WEF)
identified burdensome customs administrative procedures, the high cost of
logistics, and access to credit and foreign exchange as major challenges to
small and medium-sized enterprises (SMEs) in Ethiopia.

The agriculture sector has historically been the engine of the Ethiopian
economy, but it has recently given way to the service sector. The National
Bank of Ethiopia (NBE) notes agriculture, industry and services have
contributed 36%, 25.6% and 39.3% to GDP respectively in 2016/17 as
opposed to 36.7%, 16.7% and 47.3%, to GDP in 2015/2016. The agricultural
sector’s share of GDP shrank by more than 25% between 2005 and 2016,
while the service sector’s share grew by 27% during the same period. The
service sector’s share started falling sharply in 2016/17, giving way to the rise
of the manufacturing sector. The construction industry, particularly roads,
railways, dams and homes, is the main driver of growth in the industrial
sector, contributing more than half of the sector’s growth. Service sector
growth is mainly dominated by expansion in communication and transport
services, hotel and restaurant businesses, as well as wholesale and retail
trading.

In February 2018, Moody’s reaffirmed Ethiopia’s credit worthiness at ‘B 1,’

while S&P and Fitch maintained their original rating of ‘B.’ These ratings
reflect Ethiopia’s stable outlook and prospects for continued economic growth
in the short and medium term and are on par with neighboring Kenya and
Uganda. As a result of the 15% currency devaluation of October 2017 inflation
rose to double digit levels during the final quarter of 2017 and the first two
quarters of 2018. In July 2018, Ethiopian inflation stood at 14 percent.
Real interest rates are largely negative. The minimum bank deposit rate of
5.00%, bond yield of 3.67%, and Treasury bill yield of 3.67% are lower than
the inflation rate. The NBE controls the exchange rate and has officially
devalued the Birr by approximately 97% against the U.S. dollar between
January 2009 and January 2016. In October 2017, the National Bank of
Ethiopia (NBE) devalued the birr by 15 percent relative to the U.S. dollar,
thereby reducing overvaluation and enhancing competitiveness. As of August
2018, the official exchange rate stood at 27.45 Birr per dollar. The Birr has
continued to follow a steady depreciation, with the NBE following a controlled
floating exchange rate policy. The parallel black market exchange rate for the
same period was approximately 32.00 Birr per dollar, a premium of 16.5%
over the official rate.

Ethiopia faces a growing trade deficit with total imports steadily increasing on
average by 12.5% per year between 2004/05 and 2016/17. The rise in imports
has exacerbated the trade deficit, which ballooned from $3.6 billion in 2010/11
to $13.27 billion in 2016/2017. Ethiopia’s total merchandise exports were
$2.67 billion in 2016/2017, while imports for the same period expanded to
$15.8 billion.

Private sector access to foreign exchange (U.S. dollars) is severely

constrained by a large trade deficit and ambitious government infrastructure
projects funded by foreign debt, which enjoy priority in allocation of foreign
currency.
According to the NBE annual report, 38% of total imports ($6 billion) was
spent on capital goods and 31% ($4.9 billion) on consumer goods. U.S.
exports to Ethiopia in 2017 were $877 million accounting for only 7% of
Ethiopia’s total imports. Ethiopia’s imports from the US have increased
steadily throughout the past decade, representing approximately a fivefold
increase from 2007 to 2017.
In 2016/2017, Ethiopia's major exports included coffee (30%), oil seeds
(12%), cut flowers (11%), pulses (10%), gold (9%) and chat (qat) (9%).
Ethiopia’s total export earnings by value declined by 1% in 2016/2017 from
the previous year. Depressed commodity prices is the leading cause of this
drop in exports.

Financial institutions are the intermediary that channels the savings of individuals, businesses, and
governments into loans or savings. As far as the financial sector is concerned, Ethiopia's financial
sector is fairly underdeveloped. Since then several banks and financial institutions have been
established with different proclamations and regulations. The three state owned enterprises, namely
the Commercial Bank of Ethiopia (CBE), the Development Bank of Ethiopia (DBE), and the
Construction and Business Bank (CBB) dominate the financial sector. With the liberalization of the
banking sector in1994, six private banks have been established. In addition, there are several
insurance companies and contractual savings funds. DBE is a specialized financial institution, which
provides finance for agricultural and industrial development projects. This paper analysis the
performance of Ethiopian Financial Sector with the following objectives:
1) To study the growth and working of banking sector;
2) To study how well the Ethiopian Insurance Corporation (EIC) functioning for the economic
development of the country;
3) To analyses the role played by the micro financing institutions for the poor.
The evaluation findings suggest several implications for future practice and research on financial
sector in Ethiopia

Q6:1:1 2.5 Overview of Financial sector in Ethiopia The financial sector in Ethiopia consists of formal,
semiformal and informal institutions. The formal financial system is a regulated sector which comprises
of financial institutions such as banks, insurance companies and microfinance institutions. The saving
and credit cooperative are considered as semi-formal financial institutions, which are not regulated and
supervised by National Bank of Ethiopia (NBE). The informal financial sector in the country consists of
unregistered traditional institutions such as Iqub (Rotating Savings and Credit Associations) Idir (Death
Benefit Association) and money lenders. The components of each category are discussed in detail in the
following headings. 2.5.1 The Formal Sector The major formal financial institutions operating in Ethiopia
are banks, insurance companies and microfinance institutions. 24 (i) Formal Banks Banking in Ethiopia
started in 1905, with the establishment of the Bank of Abyssinia that was owned by the Ethiopian
government in partnership with the National Bank of Egypt then under British rule. But a well structured
banking system started to evolve starting in the 1940s-after the Italian departure. A government owned
bank-the State Bank of Ethiopia-was established in 1942, and a number of foreign bank branches and a
private bank were operating in competition with the government owned commercial bank until they
were nationalized and merged into one government owned mono-bank in 1976. The competitive
banking situation that started to flourish during the 1960s and 1974s was nipped in the bud by the
command system that reign over the 1974-1991 periods. Following the change of government in 1991,
and the subsequent measures taken to liberalize and reorient the economy towards a system of
economy based on commercial considerations, the financial market was deregulated. A proclamation
number 84/94 was issued out to effect the deregulation and liberalization of the financial sector, and a
number of private banks and insurance companies were established following the proclamation.
Directives issued in subsequent years further deepen the liberalization mainly including the gradual
liberalizations of the interest rate, foreign exchange determination, and money market operation.
Currently, there are 17 banks operating in the country, of which 13 are private banks while the
remaining three are state owned banks, namely Commercial Bank of Ethiopia (CBE), Development Bank
of Ethiopia (DBE) and Construction and Business Bank (CBB). The total number of bank branches in the
sector reached 970, with a larger 25 concentration of them(more than 40%) located in the capital city,
Addis Abeba (NBE, 2009). Ethiopia is still one of the most under banked countries in the world with one
bank branch serving over 82,000 people. Although one can observe a strong growth and revival of the
private sector since liberalization in the 1990s; yet, the state-owned banks seem to dominate the
industry. As of the year 2009, the state owned banks account for 67% of total deposits and 55% of
outstanding loans and advances and 55 percent of the capital. More specifically, the state‐owned
Commercial Bank of Ethiopia (CBE) - the largest bank in Ethiopia alone controls about 43% of the branch
networks, nearly 40% of the capital , about 46% of the outstanding loans and advances, and about 58 %
of the deposits of the commercial banks. Table 2.4 provides the share of capital and branch network of
Ethiopian Banks as of the year 2009.

Despite some improvement in the sector in the last couples of years, Ethiopian banking remains in its
low status. For instance, the estimates of Bank‘s recent Financial Sector Diagnost show that less than
10% of households have access to formal credit (African Development Bank, 2011). In general, the
sector is characterized by small banking, limited range of services, absence of capital markets and the
sector largely remains closed to foreign investors. (ii) The Insurance Company Likewise to banking,
Ethiopia’s insurance industry is undeveloped. Its emergence is traced back to the establishment of the
Bank of Abyssinia in 1905. The Bank had been acting as an agent for foreign insurance companies to
underwrite fire and marine policies. Before liberalization the command economy including political
instability had been the stumbling block for the growth of the financial sector in Ethiopia. The 1990’s
ushered in economic liberalization that led to the revival of private sector participation in the financial
sector. This has led to the formation of a number of private insurance companies. According to the
National Bank of Ethiopia (2010) there were 14 insurance companies with a total of 221 branches
operating in the country. In terms of ownership, all insurance companies except the Ethiopian Insurance
Corporation (EIC), are privately owned. Private insurance companies accounted for 69.5 percent of the
total capital, while the remaining share was taken up by the single public owned enterprise, the
Ethiopian Insurance Corporation. Of the total insurance branches, 50.7 percent are concentrated in
Addis Ababa. Private insurance companies owned 81.4 percent of the total branches. 28 According to
Gebreyes (2011) the insurance market is undeveloped, uncompetitive and there exist paucity of
information on the kind of life insurance that is currently present. The current practice of bulk of
insurance coverage and business in Ethiopia is targeting the corporate market and focuses mainly on
general insurance with a very limited coverage in life insurance. The insurance sector is dependent on
the banking sector for much of its new business. Most Ethiopian insurance companies have sister banks
and it's common for these banks to refer their clients to their sister insurance companies, but this is
largely restricted to credit life insurance products. Moreover, insurance companies tend to derive a large
portion of their total income from investments in banks (Smith and Chamberlain, 2009).
(iii)Microfinance Institutions The emergence of Microfinance institution is a recent phenomenon in
Ethiopia compared to other developing countries. The first microfinance service in Ethiopia was
introduced as an experiment in 1994, when the Relief Society of Tigray (REST) attempted to rehabilitate
drought and war affected people through the rural credit scheme. It was inspired by other countries’
experiences and adapted to the conditions of the Tigray region (northern part of Ethiopia). In the second
half of the 1990s, as a result of its success, the microfinance service was gradually replicated in other
regions (Berhanu and Thomas, 2000). Similar to microfinance approaches in many other parts of the
world, MFIs in Ethiopia focus on group-based lending and promote compulsory and voluntary savings.
They use 29 joint liability, social pressure, and compulsory savings as alternatives to conventional forms
of collateral (SIDA, 2003). These institutions provide financial service, mainly credit and saving and, in
some cases, loan insurance. The objectives of MFIs are quite similar across organizations. Almost all
MFIs in the country have poverty alleviation as an objective. They focus on reducing poverty and
vulnerability of poor households by increasing agricultural productivity and incomes, diversifying off
farm sources of income, and building household assets. They seek to achieve these objectives by
expanding access to financial services through large and sustainable microfinance institutions. The
Ethiopian microfinance industry has undergone tremendous growth and development in a very short
period of time (Micro Ned, 2007, Amaha 2009), As of 2009, the 29 MFIs licensed by the National Bank of
Ethiopia succeeded in reaching more than 2.3 million clients and delivered about 7 billion Birr in loans.
They also mobilized about 3.8 billion Birr of savings. In the same year, the sector has a total asset Birr
10.2 billion and total capital of Birr 2.9 billion. Despite the notable achievements, the operating MFIs
reach less than 20% of the total microfinance demand in the country (AEMFI, 2010). Turning to market
concentration, the three largest MFIs, namely Amhara, Oromia and Dedebit Credit and Savings
institutions accounted for 67.1 percent of the total capital, 81.4 percent of the savings, 74.0 percent of
the credit and 76.2 percent of the total assets of MFIs. 30 2.5.2 Semiformal – Saving and Credit
Cooperatives In Ethiopia there are three types of saving and credit cooperatives, namely Institution
based SACCOs; Community based SACCOS; and SACCOs sponsored by NGOs. Savings and credit
cooperatives are type of organizations providing financial services to the poor in rural areas of Ethiopia.
These include multi-purpose and credit and saving cooperatives. Unlike other formal financial
institutions (banks and micro finance institutions), saving and credit cooperatives are owned, controlled
and capitalized by their members. This implies that the savings and credit cooperatives are not
subjected to supervision and regulation of the National Bank of Ethiopia. The ministry of cooperatives is
responsible for the coordination of their activities. One of the principles of SACCOs is that lending is
limited to only members of the cooperatives and the amount of loan depends on the level of individual
saving deposits. One of the weaknesses reflected in the co-operative sector is poor administrative and
financial management. On the other hand the government through the relevant ministry is not
adequately equipped to monitor and control the cooperative movement. Savings and credit
cooperatives in Ethiopia are not permitted to take deposits from nonmembers. Many rural saving and
credit cooperatives provide loan services for agricultural inputs, animal fattening and in some cases for
off farm activities. Loan disbursement policies are prudent, only those with sufficient savings and
collateral can lend. The majority of loans are provided for a period of one year or less. Usually interest
on loans is higher than charged by commercial banks but often lower than that of MFI’s 31 and
definitely lower than the money lenders rate. At the end of 2006, almost 5 500 SACCOs served more
than 380 000 members with savings and credit services. According to the Cooperative Agency (CA),
SACCOs mobilized 994 million Birr (US$111 million) from member contributions. The average deposit
size of a single SACCO member is 2 626 Birr (US$293). 2.5.3 Informal Finance In both rural and urban
areas in Ethiopia, it is common that neighboring family households organize themselves and develop
their own institutions, popularly known as Community-Based Organizations (CBOs). The nature of the
CBOs highly varies from social, religious and financial concerns, but are all aimed to address the needs of
the people. In most communities, membership in traditional community associations such as iddirs,
iqqubs and mehabers are very common. More importantly, these traditional institutions also play a
crucial role in savings and beneficiary mobilization in the informal financial sector. According to Micro
Ned (2007), the outreach of the informal financial sector is high; more than two thirds of the population
have access to an informal finance provider, whether it is from money lenders, friends/relatives, or from
one of the three popular systems (iddirs, iquips and mehabers) of informal finance. The price of informal
credit fluctuates greatly from 10.5% per month on average from money lenders and traders to 0% from
relatives and friends (ibid). 32 According to Micro Ned (2011), the informal finance has been popular
due to three main reasons. First, it has more often than not been the only form of service delivery
available. Second, loan processing is quick and not too many questions are being asked about the
application of the borrowed sum. Third, in the case of Iddir and Iqqub, loans are provided in the context
of social intermediation and self-organization. The capacity of these traditional systems, however, is
limited (Ibid). The three most common informal finance or traditional institutions are discussed in detail
in the following subheadings. Iddirs An Iddir is the most common informal institution in Ethiopia,
common in both rural and urban areas. It is an association made up by a group of persons united by ties
of family and friendship, by living in the same district, by jobs, or by belonging to the same ethnic group
and as an object of providing mutual aid and financial assistance in certain circumstances. It is primarily
a burial society whereby savings are made to cover the cost of funerals, but also weddings. Whenever a
death occurs among its members, the organization raises an amount of money to handle the burial and
other related ceremonies. It further aims to address different community concerns and provides various
services to its members. Membership is regularly by residence, whereby members pay a small monthly
fee (Pankhurst and Mariam, 2000). In practice Iddir is a sort of insurance programme run by a
community or a group to meet emergencies. Iddir, unlike the insurance system is very popular among
people because it is culturally appropriate, flexible, easily accessible and cost-effective. It is basically a
non 33 profit making institution based upon solidarity, friendship, and mutual assistance among
members. In general, individuals tend to join iddirs when starting to have a family. Membership of iddirs
is also increasingly widespread particularly among the poorest members of society, who are in most
need of their support. Only new migrants without a fixed address and those who cannot afford the fees
(the most impoverished of society) lack membership, and are consequently without the only form of
social insurance that currently exists in Ethiopia (Ibid). Most of the associations are however not
officially registered due to the high cost of registration. As a consequence, most iddirs remain unable to
open bank accounts, obtain credit, or become partners with the government or NGOs in development
activities (ibid). Concerning its organizational structure, nearly all iddirs have a secretary and a treasurer
as well as a chairman and judge. Due to its impartial membership structure, it is often said to be
Ethiopia’s most democratic and egalitarian social organization where membership is open to anyone
regardless of religion, socioeconomic status, gender and ethnic affiliation (Johansson, 2010) During the
current rule of the Ethiopia Peoples Revolutionary Democratic Front (EPRDF), the potential of iddirs as a
vehicle for development has been further acknowledged by both the government as well as by
nongovernmental institutions (NGOs). From the government’s point of view, the general recognition of
civil society’s role in development has led to that iddirs have been accepted as possible partners for
successful and sustainable development (Pankhurst et al., 2009). 34 Iqqubs Iqqubs have played a
significant role especially for the informal sector in Ethiopia. An iqqub is a traditional saving and credit
association (Rotating Saving and Credit Association), of which its purpose is basically to pool the savings
of their members in accordance with the rules established by the group. Members usually deposit
contributions on a weekly or monthly basis, and lots are drawn by turns so that the one who wins the
chance gets the total sum. This process continues on a regular basis until the last member receives
his/her share or what she/he has been saving through the months and the whole process starts again.
Mehabers Another common CBO is the Mehaber, which is a religious, informal institution that aims to
raise funds for medical and burial expenses. It is widespread among the Orthodox Christians of Ethiopia,
as it typically draws its members from the church. Members usually meet on a monthly basis for food
and drink, and commonly support each other in times of difficulty (Pitamber, 2003).

The Ethiopian financial sector/policies have evolved through three stylized stages: first, financial
repression and fostering state-led industrial and agricultural development through preferential credit (in
the socialist regime); second, marketled development through liberalization and deregulation (post
1991); and third, financial inclusion through allowing private banks and MFIs (since second half of
1990s). Proclamation No. 84/1994 that allows the Ethiopian private sector to engage in the banking and
insurance businesses and proclamation no. 40/1996 in 1996 that allows the establishment of MFIs mark
the beginning of a new era in Ethiopia’s financial sector and opened the opportunity for an inclusive
financial sector in Ethiopia. Currently, the Ethiopian financial sector consists of 3 public banks1 including
the Development Bank of Ethiopia (DBE), 16 private banks, 14 private insurance companies, 1 public
insurance company, 31 microfinance institutions and over 8200 Saving and Credit Cooperatives
(SACCOs) in both rural and urban areas. The ownership structure of microfinance institution is mixed,
with the big microfinance institutions partially owned by regional states, some by NGO’s and some by
private owners. The government-owned Commercial Bank of Ethiopia (CBE) is the dominant commercial
bank and accounts for 70% of total assets of banks as of May 2013 (See IMF 2013:20). The balance, 30%,
is accounted by the other 15 banks. Unlike many government-owned commercial banks, CBE is relatively
well run and profitable. The entry of the private sector in the financial sector has created better
opportunities for enhanced access to financial services in the country directly through their operations
and indirectly through the spillover effect on public financial institutions. As argued by Getahun (2009)
the emergence of private banks with the spirit of competition and emphasis on profitability has led to
major shift in the focus of public banks towards a more profit oriented approach. According to him, the
Government has restructured these banks granting full operational autonomy, recapitalizing them and
cleaning their balance sheets from bad debts accumulated in the previous socialist directed credit
delivery system. 1 The state-owned CBE is the dominant commercial bank and accounts for 70% of total
assets of banks as of May 2013 (See IMF 2013:20). The balance, 30%, is accounted by all the 15 banks.
Financial inclusion, regulation and inclusive growth in Ethiopia 4 Despite those encouraging changes in
its structure, the Ethiopian financial sector is not diversified in terms of the type of institutions delivering
the service and the type of financial products being delivered. The financial service is dominated by a
cash based system. Moreover, there is no stock market and the financial market comprising the
interbank money and foreign exchange markets as well as the bond and TBs market is at an infant stage
accommodating limited amount of transactions (see Table 1). It is worth highlighting that the financial
sector in Ethiopia is highly regulated and completely closed from foreign companies. The complete
closure of the financial sector to foreign companies has limited the opportunities for competition in the
financial sector. Also, there will be a missed opportunity in terms of capital injection, foreign exchange
access and banking technology and skills. The GoE has been trying to justify such a closure on account of
possible domination of the financial sector by foreign banks as the former is quite at its infant stage and
the regulatory capacity of the central bank is quite limited.

Q 6:1:2 Regulating the new financial sector

Financial markets are inherently imperfect, characterized as they are by asymmetric information in the
relationship of borrower to lender (Bascom 1994, Stiglitz 1994). In Ethiopia this imperfection is
aggravated by the institutional under-investment of the Derg era. Public and private banks are only now
developing the capacity to evaluate loan risks in the context of a market economy and are yet to offer
the full range of financial instruments required by potential clients (which vary from large commercial
enterprises to micro-entrepreneurs). The supporting framework of commercial law and accounting
practice—both essential to sound financial systems—are highly underdeveloped in Ethiopia, as in
Africa's other transition economies. For these reasons, investment in NBE's capacity to regulate the
financial system in the public interest must be a high priority. Under the Derg, regulation consisted of
enforcing interest-rate controls and the allocation of credit and foreign exchange according to the
dictates of the planners. Now NBE must learn the skills of prudential regulation and supervision
appropriate to a market-based financial system (also the case in Eritrea).1 This requires the monitoring
of capital adequacy and restrictions on bank portfolio choices (to avoid large loan exposures and 'insider
lending'). It also requires the imposition of disclosure standards (including the publication of audited
accounts), the provision of deposit insurance and lender of the last resort facilities and intervention in
distressed banks (Bascom 1994: 170, Polizatto 1993: 173). This is a challenging set of tasks, and the
necessary institutions take years to build (see Sheng 1993). 1 Polizatto (1993: 174) defines prudential
regulation as the ‘... codification of public policy towards banks, while banking supervision is the
government's means of ensuring the bank's compliance with public policy’. 8 In 1996, NBE established a
new division to undertake regulation and supervision. Its first task was to draw up a set of guidelines
(NBE 1996b). These codify what is expected of banks and of NBE itself. Among its tasks, NBE licenses and
approves external auditors to prepare regular accounts for financial institutions; this is important since
private-sector capacity in auditing is itself a nascent and therefore inexperienced industry in Ethiopia.
NBE's supervision consists of both off-site surveillance and on-site examination. NBE's off-site
surveillance mechanisms require banks to submit key financial data— such as the composition of
lending and the scale of non-performing loans—on a regular basis in order to identify all the risks to
which each bank is exposed. Commercial banks are legally required to make 100 per cent provision
against ‘bad’ loans (those with no collateral) and 50 per cent provision for 'doubtful' loans (those for
which repayment is more than one year late, and for which there is no adequate security). Close
attention is paid to credit concentration—over-exposure to a small number of borrowers has
undermined many developing financial systems—and the total liability of any one borrower must not
exceed 10 per cent of the net worth of the bank according to NBE regulations. This also encourages
banks to seek out new customers, an incentive that is important to raising private sector investment and
thereby achieving reconstruction. On the liabilities side, NBE's directives require banks to maintain liquid
assets of not less than 15 per cent of their total demand, savings and time deposits with less than one
month to maturity. Banks must report their weekly liquidity position to NBE as a further safeguard to
protect depositors. The information that NBE collects from its off-site surveillance is used to score the
bank on its performance—ranging from 1 (unsatisfactory) to 5 (strong)—and the results are reported to
NBE's Governor and its board. Off-site surveillance is only as good as the reports that banks submit to
NBE. Therefore NBE also has comprehensive on-site examination powers under which banks are subject
to annual inspection, and can be visited at any time without notice. Therefore on paper, NBE has a
comprehensive set of supervisory and regulatory tools at its disposal. However, effective supervision
needs considerable human capital investment; Caprio (1996: 4) notes that '... experienced supervisors
estimate that it could take many countries 5-10 years of substantial training before their supervisory
skills would be near the capacity found in industrial countries'. NBE's supervision department is only
three years old and it is short of the necessary human resources. Those abilities are in demand by the
private sector itself (including the banks), and therefore ways must be found to recruit and retain
experienced staff in NBE (donors, including the IMF, have provided assistance, mainly in the form of
training). In consequence, although all banks have been examined on-site since the supervision
department's inception, this has not been as frequent as its procedures require. Moreover, the
valuation of bank assets has not been a straightforward process. Nevertheless, NBE's supervision
division has 'teeth'; in 1997 it pressed CBE to tighten its loan collection procedures, and by 1998 CBE's
stock of non-performing loans was down to 24 per cent of total loans compared with 35.8 per cent of
total loans in 1996 (GOE-IMF 1998).2 2 The scale of CBE's non-performing loans is not unusual in
transition economies—see Gros and Steinherr (1995: 208) on Eastern Europe and the FSU—reflecting as
it does the inheritance of illconceived lending from the time of the Derg. 9 5 The second phase of
financial reform After the 1994 financial liberalization measures, the authorities concentrated their
efforts on building regulatory capacity in the financial sector as well as on other priority areas of
economic transition, in particular further liberalization of the foreign exchange system and trade
liberalization. But financial liberalization accelerated again when loan interest rates were decontrolled in
January 1998. A minimum floor on bank deposit rates is retained—6 per cent at present—so that
deposit rates remain positive in real terms (inflation is currently about 2 per cent). This floor ensures
that the excess liquidity of the banks does not lead them to impose low rates on depositors, thereby
undermining the recovery of the savings rate (which rose from 2.7 per cent of GDP in 1991 to a high of
8.6 per cent in 1997, before falling back again to 4.5 per cent in 1999—see Figure 2). The floor can be
removed when excess liquidity is finally eliminated. With a stronger banking system and an improving
macro-economic situation, further institutional investment could take place. For example, an interbank
foreign exchange market began operation in 1998, enabling banks to manage their foreign-exchange
requirements more efficiently. At the same time, a framework was established for an interbank money
market, in which banks and non-bank financial institutions can borrow and lend at market-determined
rates. This measure should reduce the level of excess liquidity in the banking system; in particular CBE
will be able to lend overnight to other banks thereby enabling them to meet any shortfalls in their
reserve positions with NBE. The interbank market will facilitate indirect instruments of monetary policy
(such as open market operations using government paper) to influence liquidity and interest rates (GOE-
IMF 1998). These steps are crucial to creating a modern, market-based, financial system. Nevertheless
two problems arise. First, African inter-bank markets are often dominated by a small number of banks;
this can result in oligopolistic practices that reduce marketefficiency and disadvantage smaller, and
newer, banks—thereby constraining financial development. In Mozambique, for example, one
commercial bank accounts for 70 to 80 per cent of the inter-bank exchange market (Lum and McDonald
1994). It is therefore important for Ethiopia's regulators to closely monitor the efficiency of the new
interbank markets. Second, inter-bank transactions are uninsured, thereby creating a systemic risk
(Dewatripont and Tirole 1994). Indeed, FSU interbank experiences highlight the dangers for Ethiopia.
Former state banks, flush with excess liquidity but inexperienced in lending directly to private
enterprises, lent instead to new private banks in the belief that this was less risky (Roe et al. 1998: 18).
But the poor quality of the loan portfolios of the new banks exposed the large banks to as much risk as
direct lending, and the interbank market spread financial distress throughout the system. Africa's banks
and their regulators can therefore learn much from the problems encountered in the FSU's financial
transitions. Effective implementation of NBE's code of conduct for the new interbank markets will be
critical to financial stability