Ethiopia’s FX Black Market – Why Not Just Free The Exchange Rate?

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Ethiopia has been cracking down on the black market in foreign exchange in that country. A more sensible idea would be to simply move to a single free market foreign exchange rate – that in itself meaning simply free the market from the current restrictions.

The reason why not to do this is that it removes the privilege that the state sector – and thus all those who benefit from that sector, up to and including politicians – gains from the current controlled market. But it is exactly that privilege, those restrictions, which produce the current black market and the associated difference in exchange rates. This analysis works both ways. We expect that restrictions will produce a black market, the observed existence of a black market proves that the restrictions are damaging.

That this is necessary shows that it would be better to dismantle the controls:

The Addis Ababa Federal Police has raided the foreign exchange black market shutting down all suspected stores located around Gandhi Hospital and Ethiopia Hotel. The stores, believed to do the illegal business,have been shut since late last week and are now guarded by the police to prevent from evidence tampering. Consequently, the police have confiscated equivalent to USD 5 million. According to sources, there were several arrests made at the scene, when the police suddenly appeared and shutdown the operation. Some were taken for questioning, while few are still in police custody until police conduct a thorough investigation. Like most developing nations, Ethiopia still imports most products from abroad, in particular from China and Turkey leaving most entrepreneurs to rely on the black market for forex.

There’s no reason at all why a dependence upon imports should lead to there being a black market. The UK has very much greater import penetration than Ethiopia does and no black market in foreign exchange. One is simply not the cause of the other. This though is a useful sign:

While US dollar note is equivalent to about 28 Birr using official intermediaries; in the black market, it is exchanged up to 38 Birr, depending on the quantity of the bank notes.

A 30% price difference? This is telling us that the restrictions on FX are damaging. Here’s how:

Foreign exchange shortages due to weak export performance and high demand for foreign currency will continue to present significant market challenges, particularly for potential Ethiopian buyers of U.S. goods and services. Private sector actors widely complain about the shortage of foreign exchange and point out the adverse implications on their businesses. As a result of the critical shortage of foreign currency, NBE regulations require commercial banks to allocate foreign currency to importers based on GTP II priorities. State owned enterprises and government sponsored infrastructure projects usually are given priority over the private sector when competing for access to foreign exchange. The foreign exchange crunch has intensified recently with delays of more than a year, especially to investors in non-priority sectors. Given the poor performance of exports in past years and growing demand for import of capital goods, foreign exchange availability will continue to be a challenge for businesses in the future. Local sourcing of inputs and partnering with export-oriented partners are strategies employed by the private sector to address the foreign exchange shortage.

What FX there is is allocated by government, not by price. This takes us into the usual and universal problem of government projects and allocation being less effective, less efficient, than that private sector. That difference in exchange rates is itself a good guide to how much less efficient.

It’s worth noting that an exchange rate which is too high – which is what that official rate is – is an artificial subsidy towards imports and away from domestic production. It also hampers exports as well. Neither really being what a developing country like Ethiopia should be trying to do, dissuading exports and encouraging imports.

It would be far better to simply have no such regulations about foreign exchange. Those who wish to exchange may do so as they wish and at whatever price they wish. At least if that were true we’d know that the price actually is balancing supply and demand, the first step to rational economic decisions.