Beware the Cost of Ethiopia's Financial Repression

Jul 17 , 2022
By Abu Girma Moges

Financial repression has a considerable economic cost to society. Careful policy consideration is needed to minimise the temptation to extract implicit tax revenue from the financial asset holdings of the public. Prudent and practical approaches coupled with effective monetary policy to stabilise the inflation pressure is required to address the challenge, writes Abu Girma Moges (PhD), a professor of economics at the University of Tsukuba in Japan.

The primary purpose of financial services is intermediation and more efficient allocation of resources across households and a broad spectrum of sectors of the economy. Households with surplus avail their financial resources in the form of savings or purchase of financial instruments. These would make possible the use of such resources by other households and business firms for objectives that generate a better rate of return for both parties.

Effective financial intermediation provides this vital service of allocating scarce economic resources to areas and agents with the highest expected return rate. This collectively improves how the national economy allocates its financial and economic resources. The financial services sector plays this critical role in mobilising resources from the surplus households. It redirects them to deficit households, business firms, and the public sector at the determined lending and borrowing rate.

The practice of financial repression, where savers earn negative real interest rates, is rationalised to provide limited and strategic protection from the vagaries of market competition. Most often, the practice lives beyond its intended purpose and rarely do beneficiaries graduate from this artificial protection.

Financial repression comes in different shades, forms, and intensities. Yet, its cumulative cost on the economy involves misallocation of economic resources, distortion of relative prices, and emergence of arbitrary and inefficient distribution of taxation burden. There will also be foregone productive investment, lost employment creation possibilities, and severe instability in the macroeconomic performance of national economies. When a repressed financial sector becomes a recurrent problem, economic agents' saving and investment behaviour also shifts. Sectors that have protection against arbitrary and disguised tax burdens become attractive. However rational it may seem for those agents involved in the process, it generates a considerable opportunity cost that is ultimately borne by the public.

One of the typical features of financial repression is official ceilings on the deposit and lending rates that hardly reflect the real cost of loanable financial resources. This gives rise to a negative real interest rate, especially when inflation is high and the cost of borrowing does not reflect the changing situation.

This discourages financial surplus from households holding their assets in such vulnerable forms. They prefer to change their portfolio in favour of assets that have better protection against inflation, such as real estate, precious metals, or even stable foreign currencies. This could lead to the weakening of loanable funds supplies in proportion to the severity of the financial repression.

On the other side of the ledger, artificially low borrowing rate encourages borrowers to take advantage of negative real interest rates. They take on loans without considering the risk-adjusted rate of return. Well-connected borrowers with access to credit can convert the borrowed funds into real assets with better protection against inflation pressure and stay in an overall surplus. When access to financial services is limited, all corrupt practices crop up to oil the looting machinery. Eventually, this gives rise to a shortage of loanable funds. Credit rationing becomes inevitable, and access to credit facilities becomes a critical lever of survival.

The loanable funds market and the trends in the interest and inflation rates in Ethiopia indicate that there is a considerable distortion created by the misallocation of financial resources in the economy. Financial resource allocation in recent years, through market intermediation and administrative allocation, exhibits how the public is deprived of the returns it should have secured from its saving efforts.

There is also severe rationing of loanable funds to a privileged few. Commercial and policy banks maintain strict control on who has access to credit and could provide sufficient collateral for borrowing, enables them to play a critical gatekeeper role in the credit market. The negative real interest rate serves as rent, which lending banks share with their credit clients. However, the broader public without access to credit services has no or insignificant economic rewards from putting its financial resources in the financial system. Those with no alternative ways of allocating their financial assets instead of deposits in saving or time deposits are losing in the range of 23.2pc to 26.8pc of their financial assets every year.

Economic agents that have access and resources to participate in the treasury bills (T-bills) market fare a bit better. Yet, it also bleeds the financial assets of banks and non-bank entities in the range of 24.5pc in real terms.

Given the relative size of the financial sector and the development of the economy, the burden of the disguised tax on financial asset holders is considerable. To compensate for some of the extra burden, those affected entities widely engage in less productive, off-priority operational domains and largely speculative asset investment outlets. The extent to which commercial banks and even insurance firms engage in the property market to compensate for lost economic resources through financial repression is a typical case in point. Such unproductive, speculative and inflation-expectation fueling diversion of financial resources has had a cumulative deleterious effect on the health of the national economy. The capacity to generate sustained and widely shared growth and employment generation have been dented.

Policymakers are confronted with a difficult choice. Artificially cheap credit distorts economic decision-making behaviour, which applies to the private and public sectors. The distortion increases steadily when inflationary pressure is persistent and becomes evident to the public. The rise in the inflation pressure and inflationary expectation necessitates action on the interest rate adjustment. Yet, such a move risks significant default by borrowers that did not efficiently use their financial resources to boost productivity and improve their investment.

Inaction on the side of policymakers will further erode the supply of loanable funds. A credit crunch will emerge sooner or later. Both options are difficult decisions and yet addressing the cumulative cost of the repressive practice demands pursuing realistic and yet gradual cost of borrowing adjustment. Entities operating under the artificial shield of the monetary authorities should learn how to survive in a more realistic and competitive economic environment.

This orientation to reality, which is costly in the short run, is necessary and imperative if economic resource allocation is to improve. Redirecting credit and investment resources to economic agents that could better use such resources to create economic growth and employment opportunities is a policy imperative.

Once the inflation expectation reaches a threshold momentum, it will be difficult to bring it back to normality. It is within such a setting that bold policy measures are needed. While recurrent and rampant inflation is largely a monetary phenomenon, this could not be sustained without the corresponding fiscal deficit, recurrent shocks and gross misallocation of critical economic resources throughout the economy. As such, inflation is not an economic mystery, and its root causes are clear to pinpoint.

The commitment to overcome the inflation momentum and to muster the collective will to bear the cost of such adjustments is different across countries or policy regimes. This indicates the need to seek the solution to the current problem in a coordinated monetary and fiscal policy spheres. The necessary adjustments and institutional reforms to improve how financial resources in the economy are allocated, how fiscal deficits are financed, and how deliberate financial repression measures are practised ought to be taken.

With such a multi-pronged approach and effectively communicating with the public, the momentum of accelerated inflationary pressure could be ameliorated. All the same, the adjustments in the loanable funds market should be robust and credible enough to show the commitment of policymakers to address inflation. It should demonstrate their will to redirect the entrepreneurial capital of the economy towards economic growth, value creation, innovation, and productivity improvement. Addressing financial repression also betters opportunities for sectors that have been starved of critical investment resources to have better access to loanable funds, further reducing the inflationary pressure on the economy.

PUBLISHED ON Jul 17,2022 [ VOL 23 , NO 1159]

Abu Girma Moges (, professor of economics at the University of Tsukuba in Japan. He can be reached at

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