Ethiopia must rethink finance to achieve 2025 vision

To achieve its goal of being a middle-income climate-resilient green economy, Ethiopia needs new ways to use public funds to promote private investment, says Mulugeta Mengist Ayalew.

Guest blog by
1 October 2013

Ethiopian children play in the water of a well

In 2011 Ethiopia announced a strategy to become a middle-income country with a climate-resilient green economy by 2025. But to mobilise and manage the US$200 billion the new strategy demands, Ethiopia will need to change from the way it has funded development in the past.

The challenge will be to adopt new approaches and use public money to generate private funds. And while there are some signs that this could be possible, there is also huge inertia to resort to familiar grounds in the choice of policies and instruments.

In recent years, the finance available for development has increased. China in particular has become a major source of finance for infrastructure projects. Tax revenues have risen, thanks to the government’s reforms. And Ethiopia has received an increase in both development assistance in the form of grants and concessional loans, and in commercial loans from local sources and bilateral and multilateral institutions.

Regulations in conflict

But these are not enough to meet the government’s growing ambition and so it has recently begun to experiment with novel ways to raise finance. One example is a regulation that requires mainly private banks to buy government bonds to the value of 27 per cent of each sum they loan. These bonds mature in five years with three percent interest.

This encouraged the banks to make more longer-termed loans — which is good for development projects — for if a given sum is used for short-term loans, over a period of time, much of it will be locked into government bonds because of the 27 per cent rule. Overall though, the 27 per cent rule decreases the liquidity of a bank’s assets. Another more recent regulation compounds this.

The '40:60 rule' says that 40 per cent of each bank’s lending must be as short-terms loans of a year or less. For each one-year loan they make, they must invest in a government bond. The cumulative effect is the even more of a liquidity problem for the banks, and little incentive to lend.

New approaches

Meanwhile to achieve its climate resilient green economy strategy, Ethiopia needs investments averaging US$15 billion a year until 2025. By contrast the federal government’s budget for this financial year is about US$9 billion.

But here's a solution. If banks used the financial resources they currently spend on bonds, to provide loans instead, they could leverage significantly more private finance for development. There are several examples of how this could work.

One is a project that is due to be financed by SREP (Scaling Up Renewable Energy Program in Low Income Countries), one of the World Bank’s Climate Investment Funds. The project aims to create an investment facility to promote small and medium enterprises in the clean energy sector.

The project will cost US$12 million, with US$4 million each from SREP, the International Finance Corporation (IFC), and from other sources. It will use US$10 million to offer a risk guarantee to encourage local private banks to lend to small and medium enterprises that intend to introduce new or expand existing modern energy products and services. The investment facility would cover any defaults by borrowers. Assuming a default rate of 25 percent, it aims, by spending US$10 million, to raise US$40 million in the form of loans from the banks.

The IFC has partnered with a local private commercial bank to use a similar approach to mobilise local finance in the coffee sector. With a view to helping cooperatives produce premium coffee for the market, IFC extends risk guarantee to those cooperatives which are first strengthened through capacity building activities. IIED is currently studying this and another facility, which the Development Bank of Ethiopia and the Ministry of Water and Energy will use to finance small and medium enterprises working in off-grid electrification.

Bumpy road to 2025

The design of these initiatives looks very promising, but the first facility is now facing problems nobody could have foreseen. When the facility was being designed the local banks were flush with resources. But when the time came to implement the project, the banks faced the liquidity problems that the '27 per cent' and '40:60' rules have created. As a result, even with the risk guarantee, the banks will not lend to the enterprises the facility aims to support.

One alternative would be for the facility to lend the US$10 million to the banks, which could in turn lend it to enterprises. The problem is that banks are not allowed to borrow in foreign currency. IFC is now discussing, with the regulator, other ways to use this money.

Ethiopia's need to raise US$200 billion by 2025 will require policymakers to look beyond familiar grounds and experiment and expand the use of innovative financial instruments. In particular, they should explore, experiment and scale up ways for smaller financial resources to leverage significantly more from private and other sources. 

The good news is that leveraging is not altogether unknown territory in Ethiopia. The cases above are examples of leveraging at a smaller scale. Ethiopia must review these initiatives, identify and address bottlenecks, and expand them. The lessons learnt could feed into the design of mobilization and disbursement strategies of Ethiopia's Climate-Resilient Green Economy investment facility.

 

Mulugeta Mengist Ayalew is a freelance consultant and researcher based in Addis Ababa, Ethiopia. He can be reached at mm.ayalew@gmail.com

Photo credit: Michael Lindsey, US Navy (via Wikipedia).

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