The Dos of Financial Sector Reform

April 6 , 2019
By Abdulmenan Mohammed ( Abdulmenan Mohammed (abham2010@yahoo.co.uk), a financial expert with 15 years of experience. )

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The National Bank of Ethiopia is on track to undertake significant financial sector reforms. Major policy changes though should not come before there is clarity on the economic direction the nation should pursue, writes Abdulmenan Mohammed (abham2010@yahoo.co.uk), a financial expert with 15 years of experience and based in the United Kingdom.

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Late last month, Yinager Dessie (PhD), governor of the National Bank of Ethiopia (NBE), presented the eight-month performance report on the Ethiopian economy to parliament. The governor’s report covered several issues such as interest rate, advances to the government, foreign reserves and import-export performance.

What is interesting was that he stated that studies are being undertaken in collaboration with experts of the World Bank to make significant reforms in the financial sector. It included opening it up to international players, the establishment of a capital market, modernising the payment system and allowing the diaspora community to invest in the financial sector. These reforms may be considered as serious as those reforms made in the early 1990s, such as financial sector liberalisation for domestic private players.

Over the past 15 years, the ruling party has tenaciously pursued the developmental state model. The state has been considered the driver of economic development. The role of the banking sector was defined within this economic paradigm. It preferred credit-based instead of market-based financial system and credits allocation have been influenced according to government priority rather than based on market principles.

This economic paradigm resulted in the heavy presence of public banks in the financial sector. The Development Bank of Ethiopia (DBE) was positioned as a policy bank for funding priority private industrial and agricultural developments and the Commercial Bank of Ethiopia (CBE) was tasked to finance mega-state projects. Private banks were forced to purchase significant amounts of NBE bills to funding the policy bank’s operations.

More than a quarter of private banks’ deposits was used for the purchase of NBE bills and interest rates have been kept low for prioritised long-term projects to foster industrial and agricultural transformation.

Consequently, out of the total deposits of 750.36 billion Br, public banks mobilised 61.3pc and disbursed 75.3 pc of the loans and advances. Over half of the loans and advances of the sector were given to state-owned enterprises (SOEs), with two taking up almost a third of the banking sector’s credit. CBE is as a result exposed to significant credit risks.

Non-prudential loans and advances to risky ventures have also exposed DBE to massive credit risks. As a result, its non-performing loans soared to the point that has shaken the financial position of the policy bank to the core. Without extensive financial restructuring, its continuity has become a going concern.

In the past year, several economic measures such as the announcement of privatisation of SOEs have been taken due to soaring state debt and worrying economic situation. The measures showed the limits of debt-fuelled state-led development.

Even if the decade-old economic philosophy seemed to run out of steam and economic reforms are underway, there is still a lack of clarity about the economic direction that the government should be pursuing. It is in this context of economic policy ambiguity that financial sector reform is being considered.

An economic philosophy that is explicitly spelt out provides a rationale for the financial sector reforms. It is essential to locating the role of the financial sector within in the overall economy, avoiding policy incompatibilities, charting the long-term course of the financial sector and making reforms go beyond addressing issues such as shortage of hard currencies. It will also identify the role the central bank and public banks should play.

If economic reforms are intended to expand the role of the private sector, reforming the financial system should be conducted with the intention of expanding the role market forces play in resource allocation, increasing autonomy for the central bank, deepening of the treasury bills market to scale down government borrowing from central bank and creating capital markets. The right set of reforms would entail enabling financial institutions to function according to market principles, limiting state intervention in their decision-making process and guaranteeing central bank independence.

The creation of a capital market is a commendable move as it will be a platform for raising long-term funds and allocating resources efficiently. Allowing foreign nationals of Ethiopian origin to invest in the financial sector is overdue. As it does not pose serious regulatory issues; speeding the process will only enable the diaspora community to engage in the financial sector.

The reform should also address quantity restrictions, including the removal of direct credit allocation mechanisms such as the NBE bonds that private banks are compelled to purchase. Relaxation of entry barriers in the financial system will foster competition. This entails reducing the capital requirement so that new players would join the banking industry and opening the sector for foreign banks. How foreign banks will be engaged in the financial sector and regulated should be thought out thoroughly.

What is fundamentally important is the redefinition of the role of public banks. There should be a roadmap that would eventually enable them to operate on market principles and foster private sector development. This will require gradual removal of special privileges afforded to public banks.

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PUBLISHED ON Apr 06,2019 [ VOL 19 , NO 988]

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