THE IMPACT OF EXTERNAL DEBT ON ECONOMIC GROWTH IN ETHIOPIA

By

Abinet Gebrekidan

Lecturer & Planning and Programming Officer

Adama University

A PAPER SUBMITTED TO THE 4^TH INTERNATIONAL CONFERENCE ON ETHIOPIAN ECONOMY

April, 2005

ADDIS ABABA

CHAPTER ONE

INTRODUCTION

1.1 STATEMENT OF THE PROBLEM

Perhaps one of the most important constraints on the resumption of growth in Ethiopia has been the external debt burden. Ethiopia is one of the developing countries classified as HIPCs. The external debt of the country which was 1344.7 million Birr in 1970 rose to 30212.7 million Birr in 1996. These were about 151.8 percent and 1139.8 percent of the export earnings of the Ethiopian respectively for these years. External debt as a percentage of GDP was 10.5 percent and 80.2 percent for the year 1973 and 1996 respectively.

In the year 2000, debt service due as percent of export was 56.3 while actual repayment was only 25.2 percent. During the same year, debt as percent of export was 556.9 while debt as percent of GDP was 92.3. In servicing its external debt, Ethiopia has been put in extremely distressed fiscal positions; the result was severely compressed development budgets and a shrinking fiscal base for essential public services.

During fiscal year 2003/04, a total of Birr 659.4 million paid out to settle external loans of which 60 percent for the payment of principal while interest payment accounted for the rest balance (40 percent). As compared to the previous fiscal year, the amount of external debt service payments increased by about 22 percent. During the same fiscal year, Birr 677.9 million debt-relief (64.6 percent principal and 35.4 percent interest) obtained from external creditors. As a result, the ratio of external debt services to export earnings declined from 13.1 percent in 2002/03 to 12.7 percent in 2003/04 (MoFED, 2004).

The country’s external outstanding debt including arrears, as at end of fiscal year 2003/04, reached 7.2 billion USD (about 62.1 billion Birr), showed a 6.2 percent increase over the level of the preceding fiscal year. The increase mainly attributed to the increase (by 9.5 percent) contracted from multilateral organizations. As at the end of fiscal year 2003/04, from the total external debt stock, the amount owed to multilateral creditors stood at 65 percent while that of Paris club, the Non-Paris club and commercial creditors stood at about 26 percent, 8 percent and 1 percent respectively (ibid).

The ratio of external debt stock to GDP at current market prices, however, declined to 89.7 percent in 2003/04 from 101.7 percent of 2002/03. Similarly, the ratio of external debt-to-exports, declined from 1377.9 to 1336.7 percent during the same period. Thus, the country's external debt position said to be still unsustainable since the government could not meet its external obligations in full without rescheduling its debt, seeking debt relief or accumulating arrears over the medium or long term.

It would be extremely difficult to attain long-run sustainable growth, if not impossible, without addressing the debt overhang problem. The channels through which debt overhang translates into a drag on growth are multifaceted. First, the rising debt-service ratios in the face of rapidly growing debt stock reduce the availability of resources for initiating growth. Second, in the face of stagnating exports, rising debt-service payments have entailed either payment defaults or a drain on scarce foreign exchange needed to import machinery and inputs of production.

1.2 OBJECTIVES OF THE STUDY

The prime concern of this study is to focus on investigating the impact of Ethiopia’s external debt on economic growth of the country. Specifically, the objectives are to:

1. Examine structure, type and composition of Ethiopia's external debt in three different regimes

2. Identify the transmission mechanism of external debt influences on economic growth of the country

3. Empirically investigate the link between external debt on economic growth in Ethiopia using time series estimation method

4. Draw policy implications based on the findings of the study for macroeconomic management of external debt situation.

1.3 SIGNIFICANCE OF THE STUDY

So far, little has been done on the impact of foreign debt on economic growth in Ethiopia. But, a number of studies have been undertaken based on cross-country analysis of less developed countries (LDCs). Cross-country analysis is an approach in which each country is treated as a sample point assuming that the impact of foreign inflow is constant across countries, that is the same in all LDCs. Most studies in this area consider only a small number of explanatory variables in trying to establish a statistically significant relationship between debt and growth. However, economic theory doesn't provide a complete specification of which variables are to be held constant when statistical tests are performed on the relation between debt and growth (Cooley and LeRoy, 1981). For instance, Ajayi (1991) on Nigeria, Koussy and Bohoun (1993) on Ivory Coast and Befekadu (1992) on Ethiopia and a host of others. However, most of these studies used models that are largely ad hoc.

One of the basic significance of this study is that it employs an econometric model with strong theoretical underpinnings that relate external debt and growth. Second, given the dearth of empirical studies on the relationship between debt and economic growth in Ethiopia, and the growing concern of the subject of debt, it would be useful to explore the aforementioned issues and come up with result that would help in the policy building up of the Ethiopian economy.

Thus, the outcomes of this study may be used to fill this gap through analyzing the impact of external debt burden on economic growth. The empirical findings of this study are also expected to have insightful implications for policy.

1.4 SCOPE AND LIMITATIONS OF THE STUDY

The study would explore the possible ways through which external debt burden affects growth and also inspect the direction and examine the transmission channels of this relationship. To achieve this objective, the period range from 1963/64 to 2003/04 is chosen. The period begins in 1963/64, a date chosen not only the appearance of dark spots on the economy but also because it marks the beginning of the country’s indebtedness. In addition, the whole period is chosen because published data was available for all the variables involved in the model.

The results of this study could be limited by the quality of the data series available. As a result of the difficulties in obtaining quality data, more than one source was sometimes employed to obtain the data series. This limitation arises from the problem of inconsistency of data as reported by different institutions. Even data from the same institution shows different figures for the same year. Besides, some important variables were missing i.e. difficult to get all the acquired variables either from domestic or international sources. With this regard, there is no data available for national consumer price index (CPI), which can be used to calculate inflation rate. The Addis Ababa CPI is used as a proxy for the national CPI. The Addis Ababa CPI has one problem that there are two series with two series with two different base years (1963 and 2000).

CHAPTER TWO

MACROECONOMIC PERFORMANCE OF THE ETHIOPIAN ECONOMY

2.1 REAL GDP AND ITS SECTORAL CONTRIBUTION

According to the World Development Indicators 2003, with gross national income per capita of USD 100 in year 2001, Ethiopia was ranked 206^th exceeding Democratic Republic of Congo (one with gross national income per capita of USD of 80) (World Bank, 2003). This is a very low figure even compared with other developing countries. Using the conventional measure of poverty (1 USD a day), about 44 percent of Ethiopia’s population falls under the poverty line, which is close to the African average but very low by LDCs standards. By any standard, the country is one of the poorest nations in the world.

During the Imperial era, the economy had been growing at a linear growth rate of 4.1 percent per annum while population and per capita income was growing by 2.3 percent and 1.8 percent per annum, respectively. Even though agriculture had a great share to GDP (i.e. 60.8 percent), it accounted only 31.2 percent of the growth of GDP. In the same period, the values added in the agricultural sector were growing by 2.1 percent while the other sectors were growing by more than 6.8 percent per annum.

The performance of the Ethiopian economy during the Derg period has been unsatisfactory on account of civil war, recurrent drought, high population growth and inappropriate economic policy and management. The average GDP growth for the Derg period was 1.9 percent per year compared with an average population growth of 2.8 percent per annum that leads to a decline in per capita income. During that period (1974/75-1990/91), the growth performance of the economy was dismal. In this period, the GDP growth rate of 2.1 percent per annum was not even enough to keep the level of per capita income constant with a population growth rate of 2.8 per annum, per capita income declined by about 0.7 percent (Alemayehu, 2002).

Post 1991, the new regime adopted typical structural adjustment policies with the support of the Bretton Wood institutions. Therefore, in terms of economic policy, this period witnessed a marked departure from the previous ‘Socialist’ system of command economy that represses private sector. As a result, during this period, relatively good economic performance is recorded though it experienced fluctuations. On the average, the economy and per capita income have been growing by about 5.04 and 2.06 percent per annum respectively during 1991/92-2000/01. If there had not been frequent drought and the Eritrean regression of May 1998, the growth rate of GDP would have been expected to be higher (Befkadu and Birhanu, 2000/01).

Ethiopia’s real GDP growth rebounded strongly by 11.6 percent during 2003/04, as agricultural production recovered fully from the drought-affected levels of 2001/02– 2002/03. Real GDP declined by 3.8 percent in 2002/03 following modest growth in 2001/02 (See figure 2.1). The drought in 2001/02-2002/03 was the most severe since 1984/85, with cereal production declining by 6 percent in 2001/02 and 26 percent in 2002/03. As a result of food shortages, inflation accelerated to 15 percent in 2002/03 from negative 7 percent in 2001/02, although core inflation remained stable at around 3 percent, consistent with core inflation projected at the decision point (NBE, 2002/03).

Figure 2.1 Real GDP Growth Rate

2.2 PUBLIC SECTOR

The Ethiopian government fiscal position has showed a significant change over the last four decades. The government budget, which was in surplus in 1950s and 1960s, has adapted to continuous and growing deficit (MEDaC, 1999; Befekadu and Birhanu, 1999/2000). Compared to other African countries like Kenya, Zimbabwe and Burundi, the overall deficit including grant as percentage of GDP is among the highest in Ethiopia over the period. Although domestic financing is equally important source of financing, the switch to foreign ones in fear of negative consequences like inflation, however, has resulted in growing debt burden, which was averaged to 96.9 percent of GDP over the period 2001/01 to 2002/03.

In Ethiopia it is quite clear that the government budget balance has never been in surplus since 1970s. Moreover, the extent of the deficit has undergone significant changes over the different periods. During the period 1955-65 balanced budget were maintained more or less while between 1965-74 deficits were kept small as the result of fiscal conservatism. Afterwards a large and persistently rising fiscal deficits were sustained. The budget deficit has also remained significant even after the introduction of various reform programs in 1992/93. In 1999/00 government expenditure was around 32 percent of GDP while total government revenue was 19.4 percent of GDP. This clearly indicates that there is an excess of government expenditure over revenue, which leads to huge budget deficit.

In 1998/99 and 1999/00 this fiscal deficit increased to 9.6 percent and 13.6 percent of GDP, respectively. This is due to the break out of war with Eritrea in 1998 and the natural disaster in the same year. In 2000/01 this figure decreased to 8.2 percent of GDP. Based on updated estimates, in 2003/04 the fiscal deficit (including grants) is likely to be about 4.8 percent of GDP. In nominal terms, revenue surpassed the program target because of strong indirect tax receipts stemming from buoyant import growth and improved customs administration, which more than offset lower-than-projected direct taxes that reflected weak corporate profits following the drought of 2001/02. Moreover, donors provided more external grants and less project loans, given the vulnerable debt situation. The external current account deficit (including grants) is estimated to narrow to 4 percent in 2003/04. However, deficits had been financed from both external and domestic sources. External sources include external borrowing and grants while domestic sources include borrowing from banking system and non banking sources.

2.3 EXTERNAL DEBT

The poor performance of the Ethiopian economy has made external assistance a prominent feature of the country’s economic structure. Since 1974, at which Ethiopia applied for loan from the IMF, the country has frown more and more dependent on external assistance and has reached a stage where it cannot function without it (Befekadu and Birhanu, 1999/2000).

Ethiopia’s external debt has changed significantly in its magnitude, structure and composition over the last quarter of the 20^th century. To put it in a historical context, the size of the debt and its composition has changed since the mid 1970s. During the Imperial regime the size of the debt was modest. The magnitude of the debt in 1975 when the Imperial regime fell was only USD 371 million. But by the end of 1991, it reached USD 8790 million. More than half (USD 4744 million or 54 percent) of the total debt was contracted for defense purposes. Consequently, the major share (74.6 percent) of the debt was owed for bilateral creditors in which the Former Soviet Union alone accounted for about 78 percent of the total bilateral debt. In contrast to the composition of the present debt, the share of Multilateral Institutions in the total debt was only 16.8 percent during the previous regime (Teklu, 2000).

According to IMF figures, Ethiopia’s total debt stock at the end of fiscal year 2002/03 was about USD 6.8 billion (or USD 4.5 billion in net present value (NPV) terms). This debt is huge relative to the size of the economy and the performance of exports. That is, this constitutes about 100 percent of GDP or about 246 percent of exports. Even after the scheduled debt relief under the initiative is applied, the IMF projects that Ethiopia’s outstanding debt in NPV terms will be reduced to USD 3.9 billion or to about 90 percent of the current GDP in nominal terms (Haile, 2005).

Ethiopia’s debt grew at an average rate of 13.18 percent during 1970-74 (Imperial regime). The debt service grew at 3.11 percent during this regime. Infrastructure was given a major share in utilizing the long- term debt, which constituted 100 percent of the total debt. During the second regime (1974-91), imprudent economic policies led to inefficiencies in investments. As a consequence external debt increased by 13.21 percent and the debt service by 7.18 percent. Debt indicators have shown phenomenal increase during this period (Table 2.2), while debt servicing as a ratio of exports declined by 1991.

Table 2.2 - Summary of External Public Debt (in millions of birr)

External debt*	1991/92	1993/94	1995/96	1997/98	1999/00	2000/01	2001/02	2002/03
disbursed	6551.4	25722.2	27088	27916.88	44647.5	46268.8	52809.74	58591.82
undisbersed	Na	na	na	na	na	na	na	na
Drawings(gross)	566.4	2378.8	1611.3	1094.5	1432.4	27488.6	4613	3889.6
Repayment (1)	-126.5	-400	-488.5	-695.967	-998.9	857.8	857.8	-650.41
Debt servicing(2)	837.4	1832.5	1714	1370.7	2227.7	1680.6	1680.6	1251.2
Principal	649.8	1417.8	1189.3	970.7	1748.2	1163.6	1163.6	781.9
Interest (3)	187.6	414.7	524.7	400	479.5	517	517	469.3
Debt service ratio	82.5	56.9	34.5	19.2	27.8	21.1	14.7	12.5
Ratio of external debt to GDP (%)	31.5	90.8	71.4	62	86.1	89	103.4	102.9

*excludes state defense credits and ruble dominated debt

(1)-on cash basis; includes repayments of trust fund loans, and repurchase from IMF.

(2)-on accrual basis; includes repayments of trust fund loans, and repurchase from IMF.

(3)-includes IMF charge interest.

Source: National Bank of Ethiopia Annual Report 2002/03

During 1992 to 1998, the foreign debt of Ethiopia grew by 10.41 percent while the debt service dropped by 25.03 percent. Out of the total debt during this period, the long-term loan was 95.2 percent, the short-term debt was 4.23 percent and the IMF credit was 0.56 percent. According to World Bank (1998) Ethiopia’s long term debt increased from 169 million USD in 1970 to 8843 million USD in 1991. This huge increase was due to increasing public finance deficit and current account deficit during the Derg regime. After the 1991 reform the external debt stock increased from 9003 million USD in 1992 to 9483 million USD in 1996.

As noted above, Ethiopia is one of the severely indebted countries, even by the standards of HIPCs of Sub-Saharan Africa. Even though slightly decreased in recent years, owing to some cancellation and rescheduling, and mainly due to the granted debt relief amounting to USD 1.3 billion (in NPV terms) under the HIPC initiatives, the remaining balance is still high relative to GDP. The largest share of this debt is owed to the World Bank Group (IDA). Specifically, out of the total stock of debt outstanding, about 65 percent is owed to the IDA group of creditors.

CHAPTER THREE

EXTERNAL DEBT AND ECONOMIC PERFORMANCE: LITERATURE REVIEW

3.1 THEORETICAL LITERATURE

Economic theory suggests that reasonable levels of borrowing by a developing country are likely to enhance its economic growth. Countries at early stages of development have small stocks of capital and are likely to have investment opportunities with rates of return higher than those in advanced economies. As long as they use the borrowed funds for productive investment and do not suffer from macroeconomic instability, policies that distort economic incentives, or sizable adverse shocks, growth should increase and allow for timely debt repayments.

Thus, some considerations suggest that, at reasonable levels of debt, further borrowing would be expected to have a positive effect on growth. Others stress that large accumulated debt stocks may be a hindrance to growth. Both these elements together imply that debt is likely to have nonlinear effects on growth. External debt has an inverted U-relationship with growth. The effect is initially positive, but as debt ratios increase beyond point A, debt eventually slows growth. When debt reaches point B, the overall contribution of debt turns negative (See figure 3.1 below).

Turning to the effects of large external debt on growth, there are both direct and indirect channels (Elbadawi et al, 1996). In the direct channel, debt accumulation expressed as a ratio of debt to GDP stimulates debt initially, while past debt accumulation (debt overhang) impacts negatively on growth. These two channels produce a debt-Laffer curve, which shows that there is a limit at which debt accumulation stimulates growth. When this limit is reached further debt accumulation impacts negatively on growth. The third channel works through a liquidity constraint where debt service payment obligations reduce export earnings available for expenditures and thus impacts negatively on growth.

Figure 3.1

Notes: HIPC denote highly indebted poor countries; NPV denotes net present value.

There are also a few models that combine both these elements and imply that debt may have nonlinear effects on growth. Cohen (Cohen and Sachs, 1986; Cohen, 1993) presents an endogenous growth style model where capital accumulation is the sole force driving growth.

Worldwide events in the 1970s and 1980s - particularly the oil price shocks, high interest rates and recessions in the developed countries, and then weak primary commodity prices – are usually referred to as the major contributors to debt explosion in the developing countries (IMF, 2000). The external debt crisis of Sub-Saharan Africa, like its Latin American counterpart, is not yet over. A significant number of countries in SSA have, in general, adopted a development strategy that lies heavily on foreign financing from both official and private sources. This, unfortunately, has meant that for many countries in the region the stock of external debt has built up over recent decades to a level that is widely viewed as unsustainable.

Relative to exports and economic activity (measured by the GNP), SSA’s debt is the highest of any region in the world (Klien, 1987; Iyoha and Iyare, 1994; ILO, 1995). According to the ILO (1995:3),

Africa’s external debt is the highest in the world as a proportion of GDP; some countries in the region are spending more than half of their export earnings to service foreign debts. The debts of many African countries are so large in relation to their foreign exchange earnings potential that would be impossible to pay them off even if growth resumed and was sustained at unrealistically high levels. Largely as a consequence of debt servicing, flow of capital from Africa is significantly more than flow of new capital to the region.

The external indebtedness of African countries is becoming more acute for a number of reasons (Ajayi and Khan, 2000). First, the external debt is enormous relative to the size of the economy and has led, in many cases, to capital flight and the discouragement of investmen