Reflections of Devaluation

This new year Ethiopia seems to ready itself to devalue its exchange rate to unlock IMF’s and World Bank’s assistance. Here are 12 points about ‘devaluation’ for people to keep in mind.

Underlying Factors

1. Devaluation swiftly diminishes the wealth of an entire nation. While history might showcase instances of devaluation favoring a small group, there are no instances where devaluation benefited most of the population.

2. There is a class dynamic to this process: the rich can transfer their wealth to other currencies or assets that maintain their purchasing power, while the commoners have limited means to do the same. In fact, as discussions on currency crisis continues, I’ll be amazed if the wealthy have not yet transferred their assets overseas to escape the looming devaluation. After the Birr is devalued and assets have crashed in value, they (the rich) will return to the domestic economy and scoop up assets at fire-sale prices.

3. Ethiopia’s devaluation trouble stems from in its huge deficit: it earns fewer hard currencies through exports than it spends on flashy imports, leading to a trade deficit that’s ballooning like crazy. By the way, it’s often argued that the exchange rate doesn’t significantly impact exports and imports in the Ethiopian economy. This is because the nation heavily relies on imported goods and vital inputs for agricultural production. If and when the policy of devaluation is implemented, production costs increase, potentially stunting domestic production growth.

4. In Ethiopia the basic needs of the poor are partly met by budgetary expenditures. There is a common argument that devaluation taxes the poor in three ways: by reducing the real wage, increasing unemployment, and reducing government services and entitlements. A reduction in the real incomes of the poor may not be tolerable and government expenditures on health, education, and food subsidies may have to be maintained in real terms.

5. Devaluation will also lead to an increase in other government spending, as the expenses related to imports and debt payments rise. This will demand greater revenue increases to cut down the budget deficit. Although devaluation will also boost government income – via higher tax earnings from trade and incomes, as well as increased profits from state-owned businesses – the effect on expenses is more immediate and typically tends to be greater.

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How Devaluation Works

6. Many countries lacking foreign currency seek outside help and debt relief to adjust their financial situation. Depreciating the exchange rate (devaluation) is often a part of this plan. However, this move continues to spark debate, especially in programs supported by institutions like the IMF and the World Bank. The effectiveness of devaluation in Ethiopia hinges on its ability to boost export growth. If imports were already limited, devaluation might not lead to the anticipated decrease in imports when prices rise, especially if there are few options for local replacements. Furthermore, increasing exports may also rely on higher imports of raw materials, machinery, and spare parts to revamp neglected machinery and facilities. Therefore, in the short term, a devaluation could worsen the current account balance because import volumes will surge right away, whereas export growth will take a significant amount of time to materialize. Besides, the money advanced by the IMF is not a grant but a loan. Expanding debt is not cost-free; not only does it require paying interest, but as interest payments rise there is less money for consumption and investment. Now, if debt expands while the income that is leveraging the debt stays slow or flat, eventually most of the income will be diverted to servicing this debt. That leaves little to no income for capital investment, and the economy starves itself to death. Only those collecting the interest, i.e. the IMF and its partners profit from this death spiral. Indeed, it’s much easier to create credit than it is to actually increase the production of goods and services in the real world.

7. Ethiopia’s past performances with devaluation unveiled a spicy twist – high inflation whirling into both local and global markets. It even cranked up the rate of growth of import while slamming the brakes on export growth. Seems like the last devaluation dance didn’t quite hit the economic groove!

8. The main perk of devaluation is that it’s quicker (done just in one stroke) and easier than just controlling how much people spend. When a country’s money is devalued, the costs of things bought and sold internationally go up. Indeed, devaluing the Birr has all sorts of other pernicious side effects, too. What happens to the price of imported oil, for example? It doubles! The costs of local stuff will also increase, at least in the short run. This can probably mean more profits for businesses already selling things abroad. However, nurturing the development of new exporting companies isn’t a simple feat. Establishing the necessary supply chain for basic manufacturing will have a long gestation period, and producers may need time to regain confidence after the policy changes. Considering the array of challenges the country is facing – hot wars, high inflation, soaring unemployment, reduced investments, contraction in world trade, protectionism and more – revving up the export engine will indeed be a daunting undertaking.

9. For devaluation to work well and shift resources from local to international sales, the price changes should stick around for a while so, for example, exporters look for cheaper local stuff instead of buying expensive imports, which cuts down on costs of import and boosts local business. If local costs go up too much, it could spoil the good profits made from export.

10. When people spend less, the demand for all goods drops. If the country keeps a handle on how much people spend, prices shouldn’t rise much after the initial increase from selling more things abroad. But all these changes take time and might further increase unemployment, inflation, and augment demand for hard currency from those wealthy operators as a way to protect against higher prices, or if more devaluation happens.

READ ALSO: Navigating Ethiopia’s Economic Challenges

The Difficult Choices – What to do?

11. Steer clear of devaluation. This government primary focus should be on strengthening the unity of the nation and quickly resolve the conflict in the North through negotiations. Prioritizing ‘prosperity’ becomes impractical when a substantial portion of the country’s revenue is funneled into military spending and warfare. Second, it should redirect the war funds to enhance the production of tradable goods for international trade, while also controlling and managing the costs of local inputs and production factors. Third, the government should consider separate exchange rates for expatriate remittances, tourism, and nontraditional exports. This indicates an acknowledgment that price incentives are necessary to encourage earning more foreign exchange. Fourth, the focus should be on using financial policies to decrease the demand for goods and services to align with the country’s income, while promoting a shift in domestic demand for tradable goods and providing producers with incentives for expansion. Fifth, (and I will stop here) stop investment in projects that do not yield an actual increase in goods or services. Building a luxury apartment, or a park in the middle of a field may add to the nation’s gross domestic product, but it doesn’t create any new goods or services; it’s simply another form of consumption. Given all the mentioned interventions and additional strategies, we should be wary of claims that Ethiopia can resolve its foreign currency shortage on the back of a devaluation…. It isn’t that easy!

12. It isn’t that easy… because it requires sacrifices from the population and exceptional leadership.

Good Luck to us!!