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Implications of international developments on the Ethiopian economy

Saturday, 19 July 2008

Inflation and commodity prices The continued robust growth in the global economy is expected to sustain the current high growth of Ethiopia’s export earnings by boosting demand for export commodities. Very high oil prices in the international market, however, continue to pose the major risks to the domestic economy. According to a recent report of the National Bank of Ethiopia (NBE) the sustained rise in oil prices is expected to increase the country’s oil import bill, thereby exacerbating the current account deficit. In addition to this, higher oil prices in the international market are bound to affect domestic prices. This, in turn, would play a part in contributing to the already high rate of inflation in the economy. The continued weakening of the US dollar against other major currencies is expected to improve the external competitiveness of the country. However, it is also expected to raise the cost of imports denominated in currencies other than the US dollar, particularly the euro. During their seventy-eighth meeting held on October 19, 2007, in Washington, Ministers of the Inter-Governmental Group of Twenty-Four on International Monetary Affairs and Development discussed financial market turbulence and economic outlook, voice and representation in Bretton Woods Institutions (BWIs), World Bank group's long-term strategy, the climate change agenda, and other issues. With regard to the first issue, the ministers underlined that uncertainties persist in the outlook of the world economy and that the balance of risks appears to be on the downside. Ministers stressed the importance of vigilance and of distilling lessons from the recent turbulence. They also noted the need to improve the Fund’s surveillance of advanced economies, putting as much focus in evaluating their vulnerabilities as it does in emerging market economies. In the current financial context, Ministers also highlighted the importance of addressing the potential impact of volatile capital flows and noted that emerging markets and developing countries would be in a better position to face this challenge if they could have more confidence in receiving timely multilateral financial support. They also underlined that active policy coordination is critical to prevent the emergence of a larger crisis. Ministers expressed concern about the rising sentiment of protectionism in trade and investment in advanced countries and underlined the importance and urgency of a successful conclusion of the multilateral trade negotiations and called upon the IMF and the World Bank to work with the WTO in making a strong case for the elimination of agricultural subsidies and improvement in market access by advanced countries. Regarding the second issue, ministers reiterated the importance of a significant redistribution of voting power in favor of emerging market and developing countries as a group and stressed that this redistribution should not be at the expense of other emerging market and developing countries. NBE's report indicated that ministers agreed that a redistribution of quotas should be the direct outcome of a simple, transparent and robust formula and should include a GDP blend with a strong component measured in purchasing power parity terms, correct the measure of variability and increase its weight relative to openness to better reflect vulnerability. They also stressed the importance of implementing a regular process of quota reviews and adjustments independent of liquidity needs and a tripling of basic votes in order to enhance the voice of low-income countries. Furthermore, they called for consideration of a “double majority” rule for all policy decisions taken by the IMF. While recognizing the enhanced contribution of middle-income countries to IDA through the very substantial increase in transfers from IBRD and IFC, Ministers stressed that such transfers should not in any way be considered as a substitute to the commitments by IDA donors. Ministers reiterated the need for merit and broad geographic representation based selection of the heads of the two institutions. Ministers agreed that globalization is development challenge of the time and the appropriate frame for reshaping the World Bank’s long-term strategy. Ministers look forward to engaging in the discussions on how to translate the broad strategy that is emerging into a concrete program of action. With respect to the third issue, ministers observed that the World Bank Group should be structured as a development cooperative, with better coherence and synergies between the different parts of the Group. To support low-income countries and fragile states, Ministers called upon all IDA donors to raise the goal for IDA-15 and upon IFC to expand its support to the private sector in low-income countries especially in sub-Saharan Africa. On the fourth issue, ministers stressed that any approach to climate change must take into account the fundamental issues of equity on energy access, climate mitigation and climate adaptation by noting that per capita carbon emissions in developing countries are a fifth on average of advanced countries. Ministers emphasized that energy supply and services is critical for economic growth and improving living standards for all developing countries and noted that developing countries are likely to suffer the earliest and hardest from climate change that appears to some extent unavoidable. They therefore stressed the need to develop and implement an approach that would produce effective and equitable outcomes. Furthermore, innovative and additional financing mechanisms are needed to expand energy supply and access and greater international cooperation to develop and transfer low-cost technologies to developing countries. Inflation has been contained in the advanced economies, but it has risen in many emerging and developing countries, reflecting higher energy and food prices. Inflation in advanced economies is expected to decline to 2.1 percent in 2007 while inflation in emerging markets and developing countries is to rise to 5.9 percent from 5.1 percent in 2006. The report added that global credit market conditions have deteriorated sharply since late July as a reprising of credit risk sparked increased volatility and a broad loss of market liquidity. Initially, rising delinquencies on U.S. sub-prime mortgages led to a spike in yields on securities collateralized with such loans and to a sharp widening in spreads on structured credits, particularly in the United States and the euro area. From mid-August, rising uncertainty about the amount and distribution of associated valuation losses and concerns about the off balance-sheet exposures of financial institutions have added to market strains. The result has been a drying up of high yield corporate bond issues, a sharp contraction in the asset-backed commercial paper market, a dramatic disruption of liquidity in the inter-bank market, and stress on institutions funded through short-term money markets. Prior to the recent turbulence, central banks around the world were generally pushing up policy rates to head off nascent inflationary pressures. However, in August, faced by mounting market disruptions, central banks in the major advanced economies injected liquidity through open market operations to stabilize overnight interest rates. They also facilitated access to their discount windows, and in the United Kingdom, the authorities extended deposit insurance coverage to reassure depositors after a bank experienced difficulties. In September 2007, the Federal Reserve reacted to rising risks to growth by lowering the federal funds rate by ½ percentage point, and market participants expect further reductions in the coming months. Moreover, expectations of policy tightening by the European Central Bank (ECB) and the Bank of Japan (BoJ) have been rolled back. Central banks in a number of emerging market countries (e.g., Argentina, Kazakhstan, and Russia) also provided liquidity to relieve strains in inter-bank markets, but for others the principal challenge has continued to be addressing inflation concerns (Chile, China, and South Africa have all raised interest rates since August). In the commodity market, prices have generally been increasing during the first eight months of 2007. The IMF commodities and energy price index rose by 21 percent during this period largely driven by resurgence in oil prices and rising metals and food prices. Oil prices rose to all time highs and came close to USD 100 per barrel in September 2007 as a result of sustained demand growth in the face of limited supply. Food prices have also been rising driven by strong demand - particularly for biofuel production - and supply shortfalls. Oil prices remained high as a result of continued geopolitical and supply risks coupled with stronger demand especially from China, the Middle East and the United States. On the other hand, prices of metals and food are expected to moderate. After falling for most part of the year, the U.S. dollar temporarily regained some ground in August in the context of recent financial turbulence, but has since resumed a weakening trend, against the background of a wide current account deficit, a slow-growing economy, and the cut in the federal funds rate. In contrast, the euro has continued to strengthen. The pound sterling and the Canadian dollar have also appreciated in real terms. Despite Japan’s rising current account surplus, the yen depreciated somewhat more rapidly through June as continued low interest rates and a waning home bias of Japanese investors encouraged capital outflows. However, it has rebounded since then, as heightened market volatility has prompted some unwinding of yen carry trades.

 

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