Sector Reform in Ethiopia: An Abstract
School of Business and Leadership,
Dominican University of California San
Asayehgn, Ph.D. School of Business and Leadership
, Dominican University of California, San Rafael,
fragile and inefficient state-dominated banking
sector that existed in Ethiopia during the
military government (1974-1991) was a major
hindrance to economic growth.
Since it took power in 1991, the current
government has implemented a number of reforms.
For instance, in 1994, the government legalized
domestic private investment in the banking
addition, it restructured the two development
banks as commercial banks, and introduced a new
Banking and Monetary Proclamation that gave more
autonomy and further clarified the National Bank
of Ethiopia’s activities as the regulator and
supervisor of the banking sector.
the process has taken two decades, the banking
sector remains repressed since the reform process
has been painstakingly slow and the policy
measures implemented so far are not fully
adequate. To date, these measures fall short of
significantly improving the banking sector.
It is not yet competitive and efficient,
nor is it capable of accelerating the economic
growth of the country which remains marginal. The
government’s concern that financial
liberalization may lead to a banking crisis that
may culminate into an economic crisis is also
studies provide evidence that as regulatory and
supervisory tools are upgraded and as supervision
becomes increasingly vigorous, the probability of
a banking crisis significantly diminishes. It is
time to recognize this contradiction and it would
be wise to begin the process of vigorous reform to
achieve financial strength. Global experience
suggests that greater competition among domestic
and foreign banks can bring greater benefits in
the form of improving efficiency. Fundamental
market-oriented measures are therefore needed to
further strengthen the financial sector in order
to accelerate Ethiopia’s economic growth.
Therefore, the policy implications drawn
from the study suggest that the Ethiopian banking
sector needs to be tuned to the following
additional market-oriented reforms in order to
benefit positively from the harmonization of
financial intermediation with economic growth.
These measures include 1) the privatization of the
dominant state-owned Commercial Bank of Ethiopia;
2) permitting entry of foreign banks; 3) allowing
market forces to determine interest rates and the
exchange rate of the ETB, and 4) upgrade the
regulatory and supervisory ability of the National
Bank of Ethiopia to restore the public’s trust
in the banking sector.
Privatization of State-owned Banks to Level
the Competing Field
the government’s decision to allow private
domestic banks to be reestablished, reversing the
nationalizing policy of the socialist military
government, a lion’s share of banking business
remains dominated by three state-owned banks, the
Commercial Bank of Ethiopia, Development Bank of
Ethiopia, and the Construction and Business Bank.
In the Ethiopian banking sector, loans are not
priced competitively by taking into consideration
the risk of the borrower and the return of the
loan to the lending bank.
Instead Ethiopian banks in general follow
the loan pricing policy adopted by the Commercial
Bank of Ethiopia.
In the absence of market forces in the
credit market, credit is inevitably directed to
inefficient borrowers outside the productive
sector of the economy.
This practice inevitably denies capital to
efficient firms and contributes to the build-up of
non-performing loans in the state owned bank’s
studies such as La Porta et al (2002) indicate
that the performance of privately owned banks is
better than state-owned banks.
According to the survey conducted by Access
Capita, in Ethiopia bank concentration defined as
the asset share of the three largest banks was 100
percent in 1994 and down to 93.6 percent in 1998.
It progressed further downward to 69.6
percent in 2006. This implies that the share of
government owned banks also declined.
According to Kiyatta et al., in seven out
of nine years private banks had a higher ROA than
state- owned banks. This is due to several
factors: the spread has increased for both public
and private banks and private banks have higher
spreads than publicly owned banks.
Therefore, since privately owned banks are
superior in terms of efficiency and profitability,
publicly owned banks need to be privatized.
Opening the Ethiopian Banking Sector to Foreign
heavy pressure from the United States Government,
as evidenced from Wikileaks messages, the
Ethiopian government continues by law to prohibit
the entry of foreign banks to the country.
Barriers to entry in the banking sector
reinforce inefficient state-owned enterprises by
shielding them from competition.
The government’s concern is that if
foreign banks were to be allowed to operate in
Ethiopia, it may lose of control over the economy.
This position is based on the infant industry
foreign bank entry at this time would prevent the
domestic banks from being weakened because of
unfair competition from foreign banks.
important questions must be answered when
examining the issue of foreign bank entry to
will foreign banks invest in Ethiopia if the
government reverses its stand and permits their
once foreign banks start operations in Ethiopia
will they be assets or liabilities to the country?
The answer to the first question is an unqualified
“yes” since Ethiopia presents a huge potential
for bank profits for a number of reasons.
begin with, foreign banks have a number of
advantages compared to domestic banks.
By servicing client’s active in more than
one country, they can achieve benefits from
spreading best-practice policies and procedures.
Second, they may be able to diversify risk
better, allowing them to undertake higher risk,
but also with potentially higher returns on
investments. Third, foreign banks have advantages
in the form of more diversified funding sources,
including having access to external liquidity from
their parent banks, which may lower their funding
costs. Finally, by being larger they may achieve
other scale advantages such as utilizing more
advanced and sophisticated risk assessment models
to give them a competitive edge over fragile
the same time, foreign banks are likely to incur
additional costs and face more obstacles when
compared to domestic banks. They may have less
information compared to local banks on how to do
business in Ethiopia, putting them at a
disadvantage, at least until they have been in the
country for some time.
Moreover, foreign banks might be exposed to
discrimination by individual customers.
Additionally, diseconomies might arise because of
an institutional environment that is culturally
these costs remain a small fraction of the huge
revenue benefits they are likely to generate by
operating in Ethiopia.
As Aghion and Howitt (1998) pointed out,
successful foreign banks that have learned to work
in a competitive environment with demanding
customers in their home countries have learned to
innovate, pursue new business segments, and adjust
to changing circumstances. Greater competition in
their home countries can lead to more efficient
operations in Ethiopia.
Gregorian and Manole (2006) and Berger,
Hansen and Zhou (2009) after examining the role of
foreign banks in developing countries have found
that foreign banks outperform domestic banks.
The current state of development of the
financial sector in Ethiopia is also a factor that
could have a favorable impact on the profitability
of foreign banks.
In Ethiopia, where a large part of the
population does not yet have access to banking
services, it is easier for foreign banks to gain
market share and therefore likely easier to make a
Finally, according to Berger and Humphrey
(1997), size has been found to be an important
factor for explaining performance of any bank.
By being comparatively larger, foreign
banks may achieve other scale advantages; for
example they may afford more advanced and
sophisticated risk assessment models giving them
superior risk management skills.
When studying foreign banks in developing
countries, Claessens, Demirguc-and Huizinga (2001)
point out that in a country like Ethiopia where
the banking sector is inefficient, banking
practices are outmoded, and credit is not
allocated on commercial criteria, foreign banks
may be able to reap higher profits than domestic
Mico, Panizza and Yanez (2007) find that foreign
banks do tend to have higher profits than domestic
banks in developing countries.
Also, Gregorian and Manole (2006) have
found that foreign banks outperform domestic
answer to the first question of whether or not
foreign banks will be willing to invest in
Ethiopia is an affirmative “yes” because it
will be profitable for them to do so and globally
competitive banks will seek to exploit the profit
potential to their advantages.
answer to the second question, whether or not the
participation of foreign banks would be an asset
or a liability to Ethiopia, is also clear and
Foreign banks will be an asset since they
will promote competitiveness and efficiency in the
However, as far as the current government
of Ethiopia is concerned, foreign banks are viewed
as a liability to the country.
As a consequence, entry of foreign banks is
prohibited. The government’s rationale is based
on the infant industry argument as follows:
First, since the banking sector in Ethiopia
is young it will not be able to compete with more
mature foreign banks that have more capital,
professionally qualified and seasoned
managers and employees, and better reputations.
there is evidence in the literature about the
association between financial liberalization and
Such studies include Williamson and Mahar
(1998), Kaminsky and Reinhart (1999),
Demirguc-Kunt and Detragiache (2001), Weller
(2001), Eichengreen and Arteta (2002) and Noy
and Detragiache (2001) find that financial
liberalization is strongly and positively
correlated with the probability of a subsequent
banking crisis. This is especially true in a
country like Ethiopia where the institutional
environment is weak.
Weller (2001) finds that a banking crisis
becomes more likely after domestic financial
Noy (2004) considers interactions between
domestic liberalization and supervision and
concludes that banking crises occur as a result of
weak supervision after liberalization.
Third, since foreign banks, if allowed to
operate in Ethiopia, are likely to engage in cream
skimming behavior, preferring large scale
operators for clients, such as commercial
agriculture, big industrial, real estate and
service establishments. They inevitably will skew
credit allocation in favor of these very large and
Fourth, foreign banks may concentrate on
lending rather than mobilizing of savings.
Finally, the government believes that at present
Ethiopia is poorly endowed with the financial
experts to design and operate the regulatory and
institutional structures needed to supervise the
Although assistance from IMF/World Bank can
help redress the shortage, the ultimate success of
banking reform ambitions will stand or fall by
Ethiopia itself. Ethiopia continues to experience
a significant brain drain begun in 1974 and does
not have the capability to effectively oversee the
operations of foreign banks at this time.
The infant industry argument seems to be an
excuse for a concern held by some Ethiopian
According to them, since foreign banks
serve as conduits for inward and outward flows
they would facilitate the outflow of capital
whenever they felt that a banking crisis was about
to emerge. An
outflow of capital could develop into full-blown
economic crises leading to political instability.
The government does not want to take chances and
According to Demirguc-Kunt and Detragiache
(1998) banking crises tend to erupt when the
macroeconomic environment is weak, particularly
when growth is low and inflation is high.
Since Ethiopia’s economy is characterized
by low growth and high inflation, the danger of
political instability remains real.
Contrary to the government’s view, the
potential benefits that can result from opening
the sector for foreign direct investment remain
substantial. First, foreign bank participation may
have the potential for a positive impact on the
efficiency of the Ethiopian banking sector.
Competition demands that domestic banks
continuously upgrade their skill and technology
levels to stay in business.
Second, entry of foreign banks may improve
bank regulation and supervision.
According to Goldberg (2007) the entry of
foreign banks in emerging markets that are
healthier than domestic banks implicitly allows
the introduction of stronger and more prudent
regulation, increasing the soundness of the local
banking sector. Third, the entry of foreign banks
to Ethiopia will strengthen the financial sector
and may have a positive impact on economic growth.
Demirguc-Kunt, Levine and Min (1998) and
Mattoo, Rathindran, and Subramanian (2006) have
found a positive correlation between financial
sector openness and economic growth.
Also, Beck et al. (2004), Levine, Loayza
and Beck (2000) and La Porta (2002), Lopez-Silanes,
and Shlefer (2002) concluded that an increase in
bank concentration was an obstacle in obtaining
financing for growth.
Allowing Market Forces to Determine Interest Rates
as well as the Value of the Ethiopian Birr (ETB)
government interference in the banking business is
critical for the efficient mobilization of savings
and allocation of deposits to profitable
Examples of government interferences that
have disrupted the banking sector include the
following: first, the deposit rate on savings is
set by the National Bank of Ethiopia.
Until December 2, 2010 the deposit rate was
4 percent. Since
the inflation rate averaged 19 percent during the
last 5 years, the real negative savings rate
amounted to 15 percent.
Although the National Bank of Ethiopia
increased the deposit rate from 4 percent to 5
percent effective December 2, 2010, this move did
not lead to a higher level of savings. This would
be avoided if all interest rates were allowed to
be determined by the market.
As a consequence, Ethiopia’s savings rate
in 2009, according to the World Bank, was 2.3
percent of Gross Domestic Product, which compares
poorly to the 25.7 percent rate achieved by Sudan.
the government imposed credit ceilings on private
banks, which reduced the volume of credit.
This measure contributed significantly to a
reduction of the inflation rate, from 64 percent
to 2.7 percent.
It was removed on April 1, 2011.
Third, private banks are now required to
offer 27 percent of their loans to the government
and do so at an interest rate of 3 percent.
This directive is estimated to divert about
ETB 11 billion from the private to the public
sum is equivalent to a 2.4 preferment of GDP and
is estimated to cover the government budget
deficit this year.
As a consequence, credit will be tight and
enhance the banking sector’s ability to mobilize
deposits and efficiently allocate savings, all
interest rates should be market determined.
Currently, the National Bank sets the deposit
recently NBE has announced its decision to
increase the deposit rate from 4 percent to 5
percent, this is still below the level that can
allow financial institutions to mobilize deposits
and extend credit to support the growth of
business and the economy at large.
This requires higher interest rates above
the inflation rate to make saving a profitable
regard to determining the value of the Ethiopian
Birr (ETB), the gradual devaluation policy
followed by the government did not prove to be
it drove down the value of the ETB from US$ 0.4831
in 1992 to $0.0592 in 2011, Ethiopia continues to
experience widening current account deficits and
rapidly declining foreign exchange reserves.
At times the level of the reserve has
reached a precariously low level, equivalent to 2
to 3 weeks of imports.
order to free the exchange rate from the political
calculations of the government, and to enhance its
flexibility, defining ETB in terms of a basket of
floating currencies would lead to a better
In this regard, a basket of four key
currencies -- the British Pound, Euro Dollar,
Japanese Yen, and the US dollar -- would lead to a
This approach will indirectly determine the
value of ETB based on market forces. The basket
composition can be reviewed as needed to insure
the relative importance of currencies in the
world’s trading and financial systems.
The weights of the currencies in the ETB
basket would be revised based on the value of
exports of goods and services and the amount of
reserves denominated in the respective currencies
which were held by the member countries of the
International Monetary Fund.
Upgrade the Regulatory and Supervisory Capacity of
the National Bank of Ethiopia (NBE)
to several studies, financial liberalization
remains a contributing factor to financial crises.
However, according to empirical results,
this relationship is found to be true only in
countries where regulation and supervision are
determining factor for banking crises is not
financial liberalization but the quality of the
regulatory and supervisory apparatus.
The relationship between liberalization and
a banking crisis depends strongly on the strength
of capital regulation and supervision.
The probability of a banking crisis is high
in a country with very weak regulation and
By contrast, the probability of a banking
crisis decreases with liberalization in a country
with stricter regulation and vigorous supervision.
the government’s initiative to upgrade the
regulatory and supervisory capacity of the
National Bank of Ethiopia (NBE), and gains
achieved in improving the quality of NBE’s
staff, the progress achieved to date remains
As a consequence, the National Bank’s
supervisory capacity remains weak.
In its recent country report on Ethiopia
dated November 2010, the International Monetary
Fund “urged the Ethiopian Government to enhance
the ability of the NBE to recruit and retain
qualified staff to ensure the institutional
absorption of the technical assistance provided by
the Fund and other partners in this area.” With
a continuing brain drain significant progress in
this area is unlikely to take place in the near
the threat of a banking crisis may embolden the
government to continue with its policy of
prohibiting foreign bank entry.
the other hand, the government may give in to
pressures exerted by friendly governments and the
IMF and the World Bank.
Ethiopia’s heavy dependence on foreign
aid coupled with its desire to join the World
Trade Organization (WTO) may prove to be
significant motivation for changes in government
policies in this regard.
Progress in this area will enhance public
trust in the banking system and may lessen the
possibility of a banking crisis.