Policymakers Should Be Cautious While Banking on Franco Valuta Scheme

Sep 1 , 2024
By Tesfaye B. Lelissa (PhD)

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Forex shortage has been a persisting issue, leading the federal government to introduce the Franco Valuta (FV) scheme. While promising immediate relief, its potential long-term repercussions should raise concerns among policymakers. The scheme could inadvertently encourage market distortions and arbitrage, creating a precarious dual exchange rate system, writes Tesfaye B. Lelissa (teskgbl@gmail.com), president of Global Bank.

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The federal government’s recent introduction of the Franco Valuta (FV) scheme clearly acknowledges the country’s acute foreign currency shortage. While this measure may provide some immediate relief, it risks entrenching the market distortions it seeks to ease, raising concerns that parallel market activities will persist and evolve more sophisticatedly.

While potentially easing short-term pressures, introducing such a scheme is no substitute for comprehensive reforms to strengthen the formal foreign exchange market.

In theory, by easing demand on the official exchange rate, the scheme could reduce the gap between the official and parallel market rates, potentially diminishing the allure of illicit currency transactions. It could offer a temporary solution to the foreign currency scarcity that has impeded Ethiopia’s ability to import essential goods. However, the scheme allows importers to access foreign currency through unofficial channels, bypassing the formal banking system.

While proponents argue that the scheme could introduce more transparency by formalising these transactions, making it harder for activities in the parallel market to thrive, the reality is more tricky. The FV scheme may inadvertently encourage market distortions and arbitrage by creating a dual exchange rate system. Over time, this could weaken efforts to develop a robust formal foreign exchange market, which is critical for long-term economic stability.

Data from Global Financial Integrity (GFI), a Washington-based think tank, illustrates these risks. The organisation estimates that between 55pc and 80pc of Ethiopia’s illicit financial outflows result from trade mis-invoicing, amounting to six percent to 23pc of the country’s total trade value. The scale of the government's challenge in trying to regulate and stabilise its foreign exchange market is evident. If not carefully managed, introducing FV schemes may not address or even exacerbate these deep-rooted issues.

The primary concern with the FV scheme is that it could lead to a proliferation of parallel market activities. These could manifest in various forms, such as using digital platforms, under-invoicing, over-invoicing, informal money changers, or cross-border smuggling. The authorities would need to continuously adapt their regulatory and enforcement strategies to keep pace with this evolving practice. The persistence of a parallel market, even with the FV scheme in place, could undermine the central bank’s ability to manage monetary policy and maintain exchange rate stability effectively.

The scheme does not guarantee that the formal banking system will be able to meet the foreign currency needs of importers. If the official exchange rate remains out of sync with market realities, importers might still prefer unofficial channels, counteracting the intended benefits of the FV scheme. The misalignment could perpetuate the problems the scheme seeks to solve, with importers continuing to seek foreign currency outside formal structures.

Ethiopia’s reliance on the FV scheme would be unsustainable in the long run. To achieve a more stable and market-driven exchange rate, the country's policymakers should focus on increasing the supply of foreign currency through formal channels. This could involve boosting exports, attracting foreign direct investment, and encouraging the repatriation of diaspora remittances. Strengthening the formal market is crucial to establishing a more sustainable foreign exchange regime supporting economic stability and growth.

They should also recognise that effective policymaking in this context requires a dynamic approach. The impact of the FV scheme needs to be continuously monitored, with strategies adjusted in response to changing market conditions. This iterative process is essential for identifying and mitigating the unintended consequences often accompanying such interventions. A failure to adapt could lead to entrenched market distortions, undermining the country’s broader economic objectives.

Ultimately, the federal government faces a delicate balancing act.

Policymakers should not rely too heavily on stopgap measures like the FV scheme. Instead, they should focus on laying the groundwork for a more resilient and market-driven economy, one that can weather future challenges. The success of their efforts to stabilise their foreign exchange market will depend on their ability to implement lasting economic reforms that address the root causes of the foreign currency shortages.

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PUBLISHED ON Sep 01,2024 [ VOL 25 , NO 1270]

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