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The Current State of Ethiopian Financial Sector and Its Regulation: What is
New after a Decade and Half Strategy of Gradualism in Reform, 2001-2017

Working Paper · February 2017

DOI: 10.13140/RG.2.2.13411.35369

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The Current State of Ethiopian Financial Sector and
Its Regulation: What is New after a Decade and Half
Strategy of Gradualism in Reform, 2001-2017.

Alemayehu Geda*
Tony Addison**
Getnet Alemu***

(Unprocessed, Department of Economics, Addis Ababa University)

January, 2017.

Abstract
Ethiopia is one of a number of SSA economies that adopted state-led development strategies in the 1970s
(others include Angola and Mozambique), and suffered from intense conflict (leading to the fall of the
Derg regime in 1991). The then new government was therefore faced with the twin tasks of
reconstructing the economy, and embarking on the transition to a market economy in early 1990s. As part
of this process, state banks have been reorganised, the role of the private sector in the financial system
has been expanded, interest-rate controls have been liberalized, and the central bank has been given new
powers of financial supervision. Financial reform has been gradual, but nevertheless determined despite
disagreement with the IMF over restrictions on the entry of foreign banks and the role of the largest state
bank. This paper argues that gradual financial liberalization—while simultaneously investing in
regulatory capacity—is the appropriate strategy for maintaining macro-economic stability and growth
in Ethiopia. In this regard, the Chinese transition strategy—in which significant control was
retained over the financial sector—can be a useful guide. However, since the sector cannot be protected
forever and new and complex liberalization demands are in the horizon, the study suggests a time-specific
strategy of capacity building for regulating and supervising the sector with cautious and partial opening
of the sector using different modalities such as joint-ventures and management contract with the objective
of efficiency, stability, shared growth and local ownership.

Keywords: sub-Saharan Africa, Ethiopia, conflict, economic reform, financial sector, Banks, Banking
Regulation and Supervision
JEL classification: O10, O55

* Professor, Department of Economics, Addis Ababa University, Corresponding author, E-mail:

AG112526@gmail.com or Alemayehu.Geda@aau.edu.et
** Professor, United Nations University, World Institute of Development Economics Research, UNU
WIDER, Helsinki, Finland.
*** Associate Professor, College of Development Studies, Addis Ababa University.
.
I. Introduction
In 2001, Alemayehu and Addison (2001)1 argued that gradual financial liberalization—
while simultaneously investing in regulatory capacity—is the appropriate strategy for
maintaining macro-financial stability and growth in Ethiopia. They also noted the
Chinese transition strategy—in which significant control was retained over the financial
sector—can be a useful guide to strategy design in SSA, provided that rent-seeking can be
contained. In this study, we will be asking what is new in the last decade and half in this
arena. We also examine if the argument noted is still valid. For the sake of comparability
with the previous study, we have maintained the structure and historical information of the
earlier paper, in this new version.
Successful reconstruction and development both require financial institutions capable of
mobilizing resources, in particular domestic savings, and channeling them into high- return
investments. But, as the case of Ethiopia shows, the creation of a sound financial system
together with an appropriate regulatory framework is not a straightforward task. During the
era of state socialism (1974 to 1991), Ethiopia's financial institutions were charged with
executing the national economic plan; state enterprises received bank finance in accordance
with the plan's priorities. This system, based on the template of the Soviet Union, saw
little need to develop the tools and techniques of financial regulation and supervision
found in market-based financial systems. With the overthrow of the Derg Regime in 1991,
Ethiopia began its transition to a market economy. This transition has had profound
implications for the financial system. New financial institutions have emerged, the role of
the private sector in the financial system has been expanded, and the role of the central bank
is being reformulated.
The government's strategy for financial development is characterized by gradualism— the
financial sector consisted of a mix of private and public entities—and a strong emphasis on
maintaining macro-economic stability. This is in contrast to Mozambique, where state
banks were rapidly privatized (Addison and de Sousa 1999). Private Banks and insurance
companies have been incorporated alongside restructured state banks in Ethiopia, and
interest rates have been liberalized in two stages. Simultaneously, the strategy has aimed to
strengthen domestic financial capacity as well as the central bank's capacity for prudential
regulation and supervision before further liberalization is enacted. In contrast to
Mozambique, restrictions on the entry of foreign banks have been retained. In the eyes of
the IMF this strategy is too slow. However, the unsatisfactory transitions in Eastern Europe
and the Former Soviet Union (FSU) and financial distress following liberalization
elsewhere in the world (in the late 1990s in Asia) highlight the dangers of rapid financial
liberalization when regulatory frameworks are still underdeveloped.
This paper explores the issues. It begins, in section 2, by setting out the main features of
Ethiopia's financial development prior to 1991, focusing in particular on the policies of the
Derg. This sets the scene for the summary and analysis in section 3 of the financial reforms
undertaken since the fall of the Derg and the coming of the current government in
1991/92. Section 4 considers important regulatory issues, and section 5 discusses second-
phase financial reforms and the disagreement with the IMF. In all these sections the
progress made in reform to date is also documented. Section 6 focuses on the critical issue
of reform speed and sequencing. Section 7 concludes by highlighting the relevance to

1
In 2001 Alemayehu Geda and Tony Addison, have attempted to offer the general picture of the
Ethiopian financial sector and its regulation at the onset of liberalization. That study, not only attracted a wide
reading (over 10,000 reads in one year and in one site, researchgate, in 2016), but also the authors got frequent
queries for an update of this study from all corners, including a number of private sector actors –hence, the
reason for this update.
2
Ethiopia of different types of transition strategy, including that of China.
II. Financial Development Prior to 1991
The establishment of the Abyssinian Bank in 1905 marked the start of modern banking in
Ethiopia. The financial sector was dominated by foreign ownership until the Abyssinian
Bank was nationalized in 1931 and renamed the Bank of Ethiopia, thereby becoming the
first bank to be nationally owned in Africa (Belay Gedey 1990: 83, Befekadu Degefe 1995:
234). Further financial institutions were established during the Italian five years
occupations in the late 1930s. In 1943 the State Bank of Ethiopia was founded, despite
considerable British opposition (see Befekadu Degefe 1995, for an interesting neo-colonial
story). Resistance to foreign control of the financial system has therefore been a
longstanding theme in Ethiopia's banking history, including arguments by the countries
famous economist in the last century - Gebre-Hiwot Baykedagn in 1920s - and it still i s an
influence today.
The State Bank of Ethiopia operated as both a commercial and central bank until 1963
when it was dissolved to form the central bank, the National Bank of Ethiopia (NBE), and
the Commercial Bank of Ethiopia (CBE). A number of other private financial institutions
were also established during the 1960s. The structure of Ethiopia's financial system
therefore resembled that of other African countries at this time.
All of this changed with the overthrow of the monarchy of Haile Selassie in 1974.
Under the Derg (meaning the committee [of solders] in Amharic) regime all privately
owned financial institutions including three commercial banks, thirteen insurance
companies and two non-bank financial intermediaries were nationalized on 1 January
1975 (Befekadu Degefe 1995: 273, Harvey 1996). The NBE continued its functions as a
central bank, although the directives of the planning system now circumscribed its
activities. The NBE fixed both deposit and loan rates (both of which were set at very low
levels), administered the allocation of foreign exchange (all of which had to be
surrendered to NBE), and directly financed the fiscal deficit (NBE 1996a). NBE's bank
supervision and regulation was largely restricted to off-site inspection of a few bank
branches.
By allocating credit and foreign exchange in favour of the state sector, NBE constituted a
powerful tool for imposing state-led development. Credit to the private sector fell
from nearly 100 per cent of total bank credit under the monarchy to only 40 per cent
under the Derg (Di Antonio 1988). The Agriculture and Industrial Development Bank
(known today as the Development Bank of Ethiopia) allocated 68 per cent of its
resources to State farms (Di Antonio 1988: 74). State banks undertook little in the way
of any financial or economic analysis of prospective projects. Since loan collateral was
not required from state-owned enterprises (SOEs) and the government implicitly covered
losses by fiscal subventions, state banks developed very little capacity to appraise the
riskiness of their balance sheets. Moreover, the inefficiency of the state financial system
manifested itself in excess liquidity; the ratio of liquid reserves to CBE's total net
deposits averaged 25 per cent during this time (IMF 1999b: 28).
III. Economic transition and financial reform
With the fall of the Derg in 1991, the new government (the Ethiopian Revolutionary
Democratic Front, EPRDF, which is still in power) faced the difficult tasks of organizing
the demobilization as well as starting the transition to a market economy. There is a
considerable literature on the policy changes enacted since 1991 to which the reader is
referred (see for instance Hansson 1995; Alemayehu 2005, 2008). Here, we confine
ourselves to summarising the main characteristics of the transition in order to place the
3
financial reforms in context.
Economic reform began soon after the new government took power. War and the Derg's
policies had left a crippled economy and an impoverished people. Fiscal policy aimed to
raise revenue and to reduce the fiscal deficit which became a source of inflation.
Structural reforms concentrated on lifting most domestic price controls, reducing import
tariffs, and moving to a market-based system of foreign exchange allocation. Exchange-
rate reform, which was an essential first step in achieving economic recovery, began in
October 1992 with a devaluation of 140 per cent from 2.07 Birr to the dollar (the rate at
which it was fixed for nearly two decades) to 5 Birr to the dollar. The devaluation's size
was justified by the substantial premium on the parallel market, which was 238 per cent
at one point. A foreign exchange auction system was introduced in 1993 (Aron 1998).
The auction-system initially worked alongside the official (fixed) exchange rate which
applied to critical imports and external debt-service, but the system was further
liberalized over 1993-96. Once export earnings had recovered sufficiently the negative
import list was abolished and controls requiring the surrender of foreign exchange were
liberalized. Reform of the exchange and trade system corrected major policy distortions
of the Derg era, in particular by removing the disincentive to produce exportables
inherent in the pre-1992 currency overvaluation. Today, in 2016, the government is
following a managed floating exchange rate policy. Until recently, despite a significant
gap between imports and exports, where exports financing only 20% of imports by 2016 –
the parallel market premium remained insignificant being about Birr 0.20- to 0.30 (1.5%).
This premium has dramatically increased to about 5 Birr (about 23 %) in January, 2017 –
doubling from 14% in November 2016. This has happened following the relapse to
violent conflict in the country after nearly a decade of relative peace.
Ethiopia has received large aid inflows in support of its reconstruction and transition
programmes; the country was the largest World Bank client in SSA in 1998. The early
reforms were supported by a World Bank structural adjustment credit (SAC) and an
IMF Enhanced Structural Adjustment Facility (ESAF) over 1993 to 1995. A second ESAF
was launched in 1996, but ran into trouble in 1997, before resuming in 1998 (see section
5). Still the country is in the favorite list of IFIs and the Western developed countries
getting nearly an average aid inflow of USD 3 billion per year by 2015/2016. In addition,
there is a significant inflow of capital from the emerging South - Chain, Turkey and India
being the most important ones – the combined figure that came from China alone during
2005-2011 being about 17 billion USD, which is a third to half of the GDP of the country.
The informal and formal inflow of remittance is also estimated at USD 3.8 billion in 2016 –
this is significant compared to total export of the country which is just USD 3 billion in the
same year. This is accompanied by significant capital flight, however. On the average there
is an annual capital flight of about USD 1 billion (in some years such as 2010 this has reach
as high as USD 4 billion) since the fall of the Derg – the cumulative capital flight since the
fall of the Derg being about USD 21.4 billion – nearly half the annual GDP (Alemayehu
and Addis, 2016).
The economy has responded reasonably well to reform despite the structural constraints
characteristic of a predominantly agrarian economy (large annual fluctuations in GDP
occur in response to weather variations), terms of trade shocks (the decline in the coffee
price) and the 1998-2000 war with Eritrea (see Alemayehu, 2008). Table 1a shows the
main trends following the reform in the 1990s, and Table 1b gives the recent picture. Fiscal
and monetary policies have kept inflation low, and exchange rate and trade reforms have
stimulated exports until the year 2005 (IMF 1999a; Alemayehu and Kibrom, 2011).
However, the external deficit has deteriorated with the rise in imports (related to
reconstruction), and the alarming deterioration in debt-service made Ethiopia a candidate
4
for official debt-relief under the Heavily Indebted Poor Countries (HIPC) initiative. The
indebtedness is back in the year 2016 despite a significant debt cancelation with the HIPC
initiative (Table 1b). Inflation also became a major macro challenge since the 2005 violent
election and its aftermath (see Alemayehu and Kibrom, 2011).
Following this early period of post-reform Ethiopia in the 1990s, economic growth has been
very good (extremely good if we take the official statics which shows a double digit growth
for a decade, Table 1b). However, that official figure needs to be taken cautiously (see IMF,
2012; Alemayehu and Addis, 2015). Notwithstanding this, the Ethiopian economy has been
characterized by lack of structural transformation (the share of industry being about 12 % of
the GDP for nearly four decades), chronic foreign exchange constraint, stagnant export and
growing imports, as well as an alarming level of domestic and external debt (Table 1b). On
the positive side, the government has invested heavily on developing the infrastructure of
the country and achieved significant results (see Alemayehu and Addis, 2015).
Table 1a: Ethiopia: major macroeconomic trends following the Reform in 1990s

1991/92 1992/93 1993/94 1994/95 1995/96 1996/97 1997/98

Real GDP growth rate (%) -3.6 12 1.6 5.2 12.7 5.6 0.5
Inflation Rate (%) 21 10 1.2 13.3 0.9 0.8* 2.3*
Exchange Rate, Birr/US$ 5.01 5.77 6.25 6.32 6.47 6.80
Exchange Rate, Birr/US$ 7.6 7.05 7.30 7.64 7.16 7.23
Trade Balance (M-X), % GDP -6.2 -8.6 -10.1 -9.7 -12.5 -10.8 -13.4

Debt to GNP ratio (%)** 63.9 65.7 157.6 208.5 180.3 168.9 159
** Based on World Bank (1999) including Ruble denominated debt.
Sources: Alemayehu (2011), Alemayehu Geda (1999) MEDaC (1998), and World Bank (1999).

Table 1b: Recent Major Indicators of the Macroeconomic Environment 2000-2015

Sector/Indicator 2005 2006 2007 2008 2009 2010/ 2011/1 2012/ 2013/ 2014/15
/06 /07 /08 /09 /10 11 2 13 14
Real GDP Growth Rate (%)* 11.5 11.7 11.0 9.8 10.3 11.4 8.7 9.9 10.3[7] 10.2[6]
Inflation (CPI, % Change) 10.6 15.8 25.3 36.4 2.8 18.1 34.1 13.5 8.1 7.6
Exchang rate Birr/ USD 12.9 16.1 17.3 18.2 19.1 20.1
Gross Domestic Saving (%GDP) 8.3 12.4 9.2 9.8 9.3 17.2^ 19.2^ 17.6 20.5 21.89
Gross Domestic Investment (% of GDP) 27.6 24.2 24.5 24.9 27.0 32.1 37.1 39.1 38.0 39.3
Trade deficit [M-X] GDP ratio (%) -22.9 -19.6 -19,6 -18.4 -19.5 -14.8 -17.8 -16.5 -17.5 -17.5
External Debt to GDP ratio (%)**
32.5 26.9 27.5 26.8 25.7 27.4 28.6 29.1
Source: MOFED (2012) & NBE (2012).
^= unexplained huge jump; also the saving in the banking sector as % of GDP is only 10% * IMF figures in [ ]
** Domestic debt is as big as external debt, being about 50% of the total debt in the last 5 years.

3.1 The new private banks

Financial reform began in earnest in 1994. NBE's role in overseeing the commercial banks
was codified. Sector-specific interest rates administered by NBE were also ended, and
replaced with a minimum deposit rate (10 per cent) and a maximum lending rate (15 per
cent). The domestic private sector was permitted to enter the banking and insurance business
(foreign financial institutions are not yet permitted to invest). The response to these
reforms has been promising. There were 6 private banks at the initial stage of this
reform and this has grown to 19 by 2016. There were also 8 private insurance companies at
the initial sage of the reform. This has grown to 14 by 2016.

5
The market shares of the private banks, although growing, still remain small relative to
those of the publicly owned CBE (see Tables 2 and 3). CBE dominates the deposit market
(its share was 87.6 per cent in 1995/96) a reflection of CBE's national coverage and its
role as banker for many SOEs. However, CBE's dominance in the loan market has
eroded, its share having fallen to 56.3 per cent i n 1 9 9 7 / 9 8 from 83.9 per cent
in 1995/96 (Table 2) and to 51.2 % in 2015. Another public institution, the Development
Bank of Ethiopia, has captured some of this share, but the new private banks have raised
their share to 17.3 per cent (Table 2) at this initial stage of the reform. This has reached
34.8% in 2015. Nevertheless, the market dominance of CBE has proved to be a
contentious issue, and one that we return to in section 5.
Table 2: Ethiopia: distribution of total deposits and loans in the banking system in early days o reform
(percentage shares)
1995/96 1996/97 1997/98
Deposits Loans Deposits Loans Deposits Loans
Commercial Bank of Ethiopia 93.2 83.9 91.6 73.7 87.6 56.3
Development Bank of Ethiopia 0.1 10.9 0.3 15.7 3.6 21.3
Construction and Business Bank 3.65 5.12 4 4.3 3.2 4.9
Private Banks 3 0 4.2 6.3 5.6 17.3
Source: MEDaC (1998).

Changes on the supply-side of the loan market have been paralleled by important
changes on the demand side. Lending to public enterprises has fallen absolutely and as a
share of total loans in this early phase of the reform. Public enterprises accounted for
only 3.6 per cent of total bank credit by the end of the 1990s. This reflects the
privatization of 197 mostly small- to medium- scale SOEs and 27 large state-owned
farms, from 1996 onwards (IMF 1999b). The next phase of privatization saw the
divestiture of 110 SOEs, thereby accelerating the decline in the share of bank credit taken
by the public sector. This has dramatically increased to about 30% in 2015, however –
indicating the reversal of the government policy after the end of the 1990s. Credit
demand by the private sector has grown—particularly to finance imports as well as
wholesale and retail trade (see Figures 1a and 1b)—and the private sector's share has
risen from a low of 40 per cent during the Derg to over 80 per cent by the end of the
1990s – this has declined to 56% by 2015, however (Table 3b). This reflects the
liberalization of business licensing which has encourage private-sector growth, the
reduction in import tariffs (thereby raising credit demand to finance imports), and the
general upturn in activity as the economy reconstructed between 1991 and 1998 and grew
faster since then. In terms of sector credit, as can be read from Figures 1a and 1b, at the
initial period of the reform lending to the government has fallen sharply while lending to
the import sector saw the largest growth (Figure 1a). This has changed recently. The
biggest lending growth is now for the industrial sector (followed by the international
trade). Lending to the government sector has declined to take about 10% in 2015 (Figure
1b) – which is a significant decline compared to about 22% at the end of the 1990s (see
Figure 1a).

6
 Figure 1b: Recent Trends of Outstanding Loans and Advances by Sector, Banking Sector total -2009-2014
40
% of Total davances and loans

35
30
Government Defici (%}
25
Agriculture (%)
20
Industry (%)
15
Domestic Trade
10
5 International Trade

0
2009/2010 2010/2011 2011/12 2012/13 2013/14

3.1,1 Recent Financial Sector Development

Today the major financial institutions operating in the country are banks, insurance
companies and micro-finance institutions (NBE, 2015). The number of banks operating in the
country by the end of 2015 reached a total of 19, of which 16 are private commercial banks.
The number of bank branch networks and hence physical reach of the sector is increasing
very fast. By 2015, this number reached a total of 2, 693, the public banks making about 42
per cent (the private banks share being 58 per cent). Among publicly owned banks the CBE
still takes the lion’s share of about 40.7 percent (977 its own bank branches and 120 branches
of the CBB that it recently absorbed). This is followed by private banks: Awash International
Bank (207), Dashen Bank (164), Abyssinia Bank (136 branches) and Wegagen Bank (119
branches) being the top four as of June 2015.The total capital of the banking sector has also
reached Birr 31.54 billion – the share of public and private banks being 43.5 and 56.5
percent, respectively (NBE, 2015). This latter growth in the share of the private banks is
related to the surge in the capitalization of private banks following the NBE regulation that
raised these banks’ minimum paid up and start up capital to be Birr 75 and 500 million,
respectively. Thus, in the last decade private banks have grown significantly, eroding the
dominant position of the CBE.
The total amount of resources mobilized by the banking sector through deposit, loan
collection and borrowing in 2014/15 has reached Birr 138.76 billion. This is more than

7
 double the amount mobilized in 2009/10. By 2014/15 public banks have accounted for 58
percent of the resources mobilized – aggressive branch expansion and the government policy
of providing loan for low cost housing conditional on having some minimum saving at CBE
explains this surge in deposit mobilization. Similarly, in terms of loans and advances, by
2014/15, a total amount of Birr 75.5 billion is disbursed to various economic sectors by all
banks taken altogether. The public banks, the dominant being CBE, dominate this
disbursement of loans, accounting for about 55.5 percent of the total -this averages to about
60 per cent in the last five years (NBE, 2015; Table 3a).
Table 3a Total Resource Mobilization and disbursement in millions of Birr
2009/2010 2010/11 2011/2012 2012/2013 2013/14
Total Resources Mobilized 48,146 76,488 89,193 98,074 111,425.3
Public Banks share, % 51 61 70 63 63.0
Private Banks share in, % 49 39 30 37 37.0
Loans and Advances by Lenderes 28,905 42,208 56,102 54,252 59,965.4
(by Disbursement)
Public Banks 13,939 21,956 36,949 33,250 38,937.9
[Share of total, %] 48 52 66 61 64.9
[of which CBE share, %) 37 42 57 50 53.7
Private Banks total 14,966 20,252 19,153 21,002 21,027.5
[Share of total, %] 51 48 32 39 35.1
Source: Author’s Computation based on NBE, Annual Report (2013& 2014),
The total value of outstanding loans and advances of the banking sector steadily increased
over the last five years (Table 3b).By 2013/14, a total of Birr 181.3 billion was recorded as an
outstanding claim on the various sectors of the economy. The share of the industrial sector in
this was the highest, claiming about 37 percent – perhaps reflecting the government’s recent
policy focus on the industrial sector. This is followed by the international trade and
agricultural sectors. From institutional borrowers’ perspective, the share of outstanding loans
and advances to private business and individuals was the highest and stood in the range of 55-
67 percent in the last five years. This is followed, though at distant, by the public enterprises
(14-30 percent), and the central government (5-12 percent) (Table 3b).
Table 3b Loans and advances by sector and institutional borrowers in Millions of Birr
2009/2010 2010/2011 2011/12 2012/13 2013/14

Loans and Advanced by Sector 62,292.2 77,690.5 116,346.1 151,344.3 181,327.4

Government Defici (%} 12.2 4.8 5.3 10.3 7.2
Agriculture (%) 10.9 13.6 14.8 11.0 8.7
Industry (%) 19.6 26.6 28.8 32.2 37.1
Domestic Trade 10.0 9.3 10.4 9.4 9.0
International Trade 23.2 23.2 21.5 18.2 18.0
Loans and Advances by Institutional Borrowers 62,292.2 77,690.5 116,346.1 151,344.3 181,327.4
Central government (%) 12.2 4.8 5.3 10.3 7.2
Public Enterprices (%) 13.6 17.6 23.8 27.0 29.6
Cooperatives(%) 8.2 10.8 11.8 8.1 7.0
Private & Individuals 65.7 66.8 58.9 54.5 56.2
Inter-bank Lending 0.4 0.0 0.2 0.1 0.04

Source: Authors’ Computation based on NBE, Annual Report (2013& 2014),

In sum, in the past five years the key monetary policy target of the government, inflation,
had emerged as a policy challenge. Inflation using the official data has, however, declined
from the high of 34 percent in 2011/12 to 8.5 percent in June 2015. This decline is chiefly
attributed to the tight monetary policy that the government pursued lately. Broad money
8
growth declined from the period’s high of 39 percent in 2010/11 to 26.5 percent in 2013/14.
Similarly, the base money has significantly declined in the last three years with 19 percent
growth in 2013/14, chiefly through sterilization. However, domestic credit, especially to
non-central government has grown significantly in the last five years, from a low of 11
percent in 2008/09 to 39.5 percent in 2011/12, before coming to a relatively lower growth
figure of 28.4 percent in 2013/14. This is primarily driven by government borrowing for
financing the activities of public and semi-public (or party owned) enterprises. Thus, it is
imperative to address the challenge of coordinating the link between fiscal and monetary
policy and debt management to make monetary policy effective and the financial sector and
the macroeconomy stable (see Alemayehu and Addis, 2015).
Lax monetary policy and the resultant inflation had also implications for the banking and
external sectors. A single digit and lower level of inflation is required not only to have a
competitive real exchange rate but also to reverse the current negative level of deposit and
lending rate that ranged from -31.9 to -24.2 percent (in 2008/09) to -5.0 to -3.0 percent (in
2016), respectively, in the last 5 years2. The last five years also witnessed significant
expansion of the banking sector, both public and private, as noted above. This has shown
itself in significant domestic resource mobilization and provision of loans and advances.
This development is, however, still dominated by public banks, in particular by that of the
CBE. This needs to be complemented by similar expansion of the private sector to address
the shallowness of the financial sector as can be inferred, inter alia, from the M2/GDP ratio
of just 28 percent in 2015 compared, for instance, to over 50 percent in Kenya. The role of
mobile-banking (called M-Pesa in Kenya) in this development has been significant in Kenya
and it is imperative to learn from this excellent Kenyan experience.
In sum, recent IMF (2014) study using financial soundness indicators (FSIs) revealed that
there are no indications of immediate risks to the health of the banking sector in Ethiopia.
The study noted, on average, the banks appear to be well-capitalized and profitable, their
capital adequacy ratio stood at 17.5 percent, as opposed to the 8 percent minimum required3.
Return on assets and return on equity showed comfortable performance, at 3.1 and 44.6
percent, respectively. Asset quality has also improved, the nonperforming loans being less
than 3 percent of banks’ total loan portfolio. Given, the lack of financial depth and less
sophisticated nature of the financial sector, the NBE has also no problem in managing and
regulating the sector, according to the IMF. The IMF study, however, cautions the systemic
importance of the CBE and the concentration of CBE’s operation through large exposures to
single entities - the public sector.
From a systemic risk perspective it is also worth discussing the DBE as it generally does not
obey to sound finance and regulatory practice both historically and today. This was the case
during the Derg period through its financing of loss making state enterprises, especially state
farms, and writing-off their loans - where arrears of DBE were on average 75% of total
principal outstanding before the 1992 reform (Alemayehu, 2011). During the current
government DBE was financing party-owned and politically connected firms in a significant
way – to the tune of over 60% of their project costs and writing-off some of these loans and
lending again to the same firms. In a nutshell, DBE’s activities are more political than

2
The only exception here is the year 2009/10 when both rates were positive owing to the unusual low
inflation rate of 3 percent in that year; and last year for lending rate (see Alemayehu and Addis, 2015).
3
This IMF conclusion is, however, unwarranted. In 2016 the government acknowledged a serious
problem with the CBE’s capital adequacy ratio which is about 4% and below the 8% global bench mark (where
the loan to capital ratio grew up from 400% to over 800% in five years – if other liabilities taken in the
computation this could go as high 2016%). The government, thus, decided to issue a “corporate bond” aimed at
raising the paid up capital of the CBE from the current level of 13 billion to 40 billion (The Reporter, Tire
3/2009: Jan 11/2017).
9
economic and are not amenable for evaluation from sound banking and regulatory practice
perspective – thus political analysis, than economics, gives more insight 4. This is another
systemic risk in Ethiopian banking sector. Thus, unless the government pursues impartial
and professional sound surveillance and closely monitors their lending activity to public and
semi-public entities; and, more importantly, reduces its own pressure on the public banks to
finance such unviable public and semi-public owned projects, a systemic banking sector risk
is unavoidable.
Notwithstanding the general positive outlook alluded above, the financial sector in the
country is still shallow and reserved for local investors who are thus protected from global
competition and best practice in the industry. It is also dominated by the state owned CBE.
Government policy is also biased to the public banks as the governments lending cap on
private banks, holding of its big accounts in the public banks and its policy of linking
government low income housing loan provision to having a saving account at the CBE
show. In addition to the systemic risks and connected lending noted, these are the challenges
of the financial sector that need to be addressed. Finally, although we have argued for
gradual liberalization of the sector more than a decade ago (Addison and Alemayehu, 2001),
it seems the government has stalled any form of reform in the sector. We have discussed this
issue in the next sections.
IV. Regulating the New Financial Sector

Financial markets are inherently imperfect, characterized as they are by asymmetric

information in the relationship of borrower to lender (Bascom 1994, Stiglitz 1994). In
Ethiopia this imperfection is aggravated by the institutional under-investment of the
Derg era. I t i s a f t e r t h e f a l l o f t h e D e r g , t h e p ublic and private banks b e g a n
developing the capacity to evaluate loan risks in the context of a market economy and are
yet to offer the full range of financial instruments required by potential clients (which vary
from large commercial enterprises to micro-entrepreneurs). The supporting framework of
commercial law and accounting practice—both essential to sound financial systems—are
highly underdeveloped in Ethiopia. For these reasons, investment in NBE's capacity to
regulate the financial system in the public interest must get the highest priority.
Under the Derg, regulation consisted of enforcing interest-rate controls and the allocation of
credit and foreign exchange according to the dictates of the planners. Thus, it was a must
for NBE to learn the skills of prudential regulation and supervision appropriate to a market-
based financial system5. This requires the monitoring of capital adequacy and restrictions
on bank portfolio choices (to avoid large loan exposures and 'insider lending'). It also
requires the imposition of disclosure standards (including the publication of audited
accounts), the provision of deposit insurance and lender of the last resort facilities and
intervention in distressed banks (Bascom 1994:170, Polizatto 1993: 173). This is a
challenging set of tasks, and the necessary institutions take years to build (see Sheng 1993).
In 1996, NBE established a new division to undertake regulation and supervision. Its

4
Although it is not as pervasive as in the DBE, such politically decided and invariably not rigorously
evaluated and executed loans to party-owned and party-affiliated firms (and their subsequent write-off or
transfers from CBE to DBE through the highest level political orders) could also be observed at the CBE. In
2001 CBE’s problematic loan to party-owned firms to the tune of 2.8 billion was transferred from CBE to
DBE, apparently under the pressure of the IMF to reduce the CBE’s NPL. This is at a time when DBE’s own
NPL is about 50% of its total loan (The Reporter, December 12, 2001; see also Ermias (2016) for a book length
treatment of the political-economy of such loans and the documentary evidence about it in the appendix to the
Book).
5
Polizatto (1993: 174) defines prudential regulation as the ‘... codification of public policy towards
banks, while banking supervision is the government's means of ensuring the bank's compliance with public
policy’.
10
first task was to draw up a set of guidelines (NBE 1996b). These codify what is
expected of banks and of NBE itself. Among its tasks, NBE licenses and approves external
auditors to prepare regular accounts for financial institutions; this is important since
private-sector capacity in auditing is itself a nascent and therefore inexperienced industry in
Ethiopia. NBE's supervision consists of both off-site surveillance and on-site examination.
NBE's off-site surveillance mechanisms require banks to submit key financial data— such as
the composition of lending and the scale of non-performing loans—on a regular basis in
order to identify all the risks to which each bank is exposed. Commercial banks are legally
required to make 100 per cent provision against ‘bad’ loans (those with no collateral) and 50
per cent provision for 'doubtful' loans (those for which repayment is more than one year later
and for which there is no adequate security). Close attention is paid to credit concentration—
over-exposure to a small number of borrowers has undermined many developing financial
systems—and the total liability of any one borrower must not exceed 10 per cent of the
net worth of the bank according to NBE’s earlier regulations. This also encourages banks to
seek out new customers, an incentive that is important to raising private sector investment
and thereby achieving reconstruction. This has been relaxed currently, however, as the
maximum level of credit that commercial banks can provide is set not exceed 25% of their
total capital for single borrower and 15% of their total capital for a related party6.
To maintain further the stability of the financial sector the NBE has also issued various
directives in the last decade and half. Thus, the NBE, first, stipulated the maximum
outstanding loan relative to the total capital not exceed 35 per cent of the total capital of the
commercial bank in question. In addition, it has established a unit that provides credit history
services to commercial banks on individual applicant so as to reduce ex-post risks. Second, to
reduce ex-ante risks, it has issued a loan provision directive that force banks to craft and
work out Non-Performing Loan (NPL) reduction plan. The decline in non-performing loan
from the high of 6.8 per cent in 2008 to 1.4 per cent in 2012 could also be the result of this
rule. This is excellent performance compared to the trend of NPL in SSA that ranges from
6.5 to 9.6 percent for the same period (WB, 2013). Third, the NBE has also issued various
directives with the aim of reducing other ex-ante risks. These includes: reserve requirements
(15%), liquidity requirements (25%), minimum capital adequacy ratio (of 12%), minimum
paid up capital (of 75 million Birr out of 500 million startup), among others. It has also used
these instruments to fight inflation which became a serious problem since 2005 and reversed
them once inflation is abated. For instance, following the success in getting down the
inflation in 2012/13, the NBE revised the reserve requirement downwards to 10% in 2012
and further down to 5% in 2013 and liquidity requirement to 20% in 2012. Finally, with
regard to Basel Accord, the NBE is not using Basel accords phase by phase. Instead, it
simply adopts instruments as it sees it fits the Ethiopian context (Getnet, 2014).
On the liabilities side, NBE's directives require banks to maintain liquid assets of not less
than 15 per cent of their total demand, savings and time deposits with less than one month to
maturity. This has been increased to 20 percent since 2007. Banks must also report their
weekly liquidity position to NBE as a further safeguard measure to protect depositors. The
information that NBE collects from its off-site surveillance is used to score the bank on its
6
Related party to a commercial bank means, on the one hand: ‘a shareholder (who holds 2% or more
of commercial bank’s subscribed capital), a director, a chief executive officer, or a senior officer of that
commercial bank and/or the spouse or relation in the first degree of consanguinity or affinity of such
shareholder, director, chief executive officer, or senior officer. It also means a partnership, a common
enterprise, a private limited company, a share company, a joint venture, a corporation, or any other business in
which the shareholder, director, chief executive officer, or senior officer of the commercial banks and/or the
spouse or relation in the first degree of consanguinity or affinity of such shareholder, director, chief executive
officer, or senior officer has a business interest as shareholder, director, chief executive officer, senior officer,
owner or partner. (NBE Directive No. SBB/53/2012).
11
performance ranging from 1 (unsatisfactory) to 5 (strong)—and the results are reported to
NBE's Governor and its board. Off-site surveillance is only as good as the reports that banks
submit to NBE. Therefore NBE also has comprehensive on-site examination powers under
which banks are subject to annual inspection, and banks could be visited at any time without
notice.
Finally, although many African countries have moved to an open capital account, the closed
capital account policy of the NBE has also helped to maintain the stability of the financial
sector. This is much more important in Ethiopia in view of the serious foreign exchange
shortage in the country. Although this shortage suggests the need to open the capital account
to attract capital, if such capital is not forthcoming owing to lack of fundamentals, the
exchange rate could depreciate significantly leading to significant inflation (in Ethiopia, the
elasticity of inflation with respect to depreciation is closer to 2). Both inflation and
depreciation would lead to immediate fiscal deficit owing to huge public sector with strong
demand for imports which further aggravates inflation through possible monetization (see
Alemayehu and Kibrom, 2011). This policy has also importance in helping avoid toxic
capital inflows, as the recent experience of emerging economies with capital control shows.
Emerging economies with capital control regime were successful in preventing the impact of
the recent world financial crisis as the control enabled them to prevent the entry of toxic
financing (Subbaro, 2013). In particular, the price-based instruments of capital control
(compared to the quantity based) are found to be important in these countries.
Therefore on paper, NBE has a comprehensive set of supervisory and regulatory tools at its
disposal. However, effective supervision needs considerable human capital investment;
Caprio (1996: 4) notes that '... experienced supervisors estimate that it could take many
countries 5-10 years of substantial training before their supervisory skills would be near the
capacity found in industrial countries'. Our observation also shows that even 15 years was
not enough to have such capacity in countries like Ethiopia. NBE's supervision department
is still short of the necessary human and financial resources as it was over a decade ago. The
non-existence of foreign banks may have also reduced the incentive by NBE authorities to
adopt the Basel accord and market based policy tools in full. Indeed, this sophisticated
method of supervision requires capacity which is not found in full at the NBE. Those abilities
are in demand by the private sector itself too (including the banks), and therefore ways must
be found to recruit and retain experienced staff in NBE in a continuous and sustainable
manner (donors, including the IMF, have provided assistance, mainly in the form of
training). Moreover, the valuation of bank assets has not been a straightforward process.
Nevertheless, NBE's supervision division has 'teeth'; in 1997 it pressed CBE to tighten its
loan collection procedures, and by 1998 CBE's stock of non-performing loans was down to
24 per cent of total loans compared with 35.8 per cent of total loans in 1996 (GOE-IMF
1998)7. The NPL of the CBE today is a comfortable 1.4% (in 2014) although it is vulnerable
to systemic risk related to its operation with the public (and semi-public) sector. In general,
today, thanks to an array of regulatory requirements of the NBE, the banking sector
performances are within the limits set by NBE indicators outline above (see Getnet, 2014).
This doesn’t imply, however, it is in a good shape to manage further liberalization as the
controls are many and managing them, once liberalised, is getting sophisticated by the day.

7
The scales of CBE’s non-performing loans is not unusual in transition economies—see Gros
and Steinherr (1995: 208) on Eastern Europe and the FSU—reflecting as it does the inheritance of ill-
conceived lending from the time of the Derg. Since such ill-conceived lending during the EPRDF period had
been relegated to the DBE, which, in turn, written-off such loans, this must have also helped the CBE’s good
performance with regard to NPL. Moreover, the pressure from the IMF on the government has also helped the
NBE to have such “teeth”.
12
V. The second phase of financial reform

After the 1994 financial liberalization measures, the authorities concentrated their efforts on
building regulatory capacity in the financial sector as well as on other priority areas of
economic transition, in particular further liberalization of the foreign exchange system and
trade liberalization. But financial liberalization accelerated again when loan interest rates
were decontrolled in January 1998. A minimum floor on bank deposit rates is retained so
that deposit rates remain positive in real terms. This floor ensures that the excess liquidity
of the banks does not lead them to impose low rates on depositors, thereby undermining
the recovery of the savings rate (which rose from 2.7 per cent of GDP in 1991 to a high of
8.6 per cent in 1997, before falling back again to 4.5 per cent in 1999). The floor can be
removed when excess liquidity is finally eliminated. This is not done even by 2016,
however.
With a stronger banking system and an improving macro-economic situation, further
institutional investment could take place. For example, an interbank foreign exchange
market began operation in 1998, enabling banks to manage their foreign-exchange
requirements more efficiently. At the same time, a framework was established for an
interbank money market, in which banks and non-bank financial institutions can borrow
and lend at market-determined rates. This measure should reduce the level of excess
liquidity in the banking system; in particular CBE will be able to lend overnight to other
banks thereby enabling them to meet any shortfalls in their operation. The interbank
market c o u l d a l s o facilitate indirect instruments of monetary policy (such as open
market operations using government paper) to influence liquidity and interest rates (GOE-
IMF 1998). However, by 2016 the interbank money market remained inactive since its
introduction in 1998, partly, due to the existence of excess reserves in the banking system
(NBE, 2015).
These steps are crucial to creating a modern, market-based, financial system. Nevertheless
two problems arise. First, African inter-bank markets are often dominated by a small
number of banks; this can result in oligopolistic practices that reduce market- efficiency
and disadvantage smaller, and newer, banks—thereby constraining financial development.
In Mozambique, for example, one commercial bank accounts for 70 to 80 per cent of the
inter-bank exchange market (Lum and McDonald 1994). Similarly, the Zambian current
condition shows that few banks dominate this market and such structure could easily bring
about financial sector instability (Alemayehu and Weeks, 2016). It is therefore important
for Ethiopia's regulators to closely monitor the efficiency of the interbank markets if it
develops in the near future. Second, inter-bank transactions are uninsured, thereby creating
a systemic risk (Dewatripont and Tirole 1994). Indeed, FSU interbank experiences
highlight the dangers for Ethiopia. Former state banks flush with excess liquidity but
inexperienced in lending directly to private enterprises, lent instead to new private
banks in the belief that this was less risky (Roe et al. 1998: 18). But the poor quality of the
loan portfolios of the new banks exposed the large banks to as much risk as direct lending,
and the interbank market spread financial distress throughout the system.
5.1 Disagreement with the IMF
The second phase financial reforms took place against a background of disagreement
between the IMF and the government over the financial sector. This led to the suspension
of the second ESAF in October 1997 (the World Bank and the bilateral Donors
continued to disburse). IMF criticism focused on two major issues. First, the IMF
argued that CBE's share of the deposit and loan markets (see section 3) constrained
competition; the Fund wanted CBE split up into three or four banks for privatization.
Second, the Fund pressed the government to open the market to foreign banks, citing the
13
example of Mozambique. Limitations on the operation of foreign exchange bureau were
another source of disagreement.
The dispute was finally resolved with the announcement of further reforms in September
1998. The resulting Policy Framework Paper (PFP) sets a target to reduce CBE's non-
performing loans to 15.4 per cent of total loans by the end of 1999 (GOE- IMF 1998).
This continues the progress made since NBE's 1997 examination of CBE which reduced
CBE's non-performing loans to 24 per cent of total loans (see section 4). CBE's
compliance with NBE regulations is being tightened up, and its capital and reserves are to
be increased. An external audit of CBE was also agreed, and this audit will guide further
restructuring. The IMF continues to press for CBE's break up and privatization. The
government has agreed to the privatization of the Construction and Business Bank
[CBB]—the second largest commercial bank—but remains wary of privatizing CBE. It
cites the improvement in CBE's performance since the NBE examination and the erosion
of CBE's dominance in the loan market (Tables 2 and 3 shows a fall in CBE's market
share to 56 per cent from nearly 84 per cent in 1995/96; and further to about 60 percent
today). After a decade and half, in 2016, the government not only resisted the
privatization of CBE but also decided to merge the CBB with the CBE – thus ending the
former’s existence.
Certainly experience elsewhere indicates that privatization does not automatically
improve performance; the 1998 scandal involving the Uganda Commercial Bank is a case
in point. Moreover, the World Bank's experience of financial reform in the FSU leads
Roe et al. (1998: 8) to the conclusion that early privatization does little to improve the
quality of the banking system and may be counterproductive when institutions are weak
and prudential regulation is underdeveloped. Therefore it is by no means self- evident
that Ethiopia should follow Mozambique's example of privatizing state banks early in the
transition (and we are not out there for it even today, see below).
Be that as it may, the controversial issue of opening the financial system to foreign banks
remains on the table. The benefits of opening include recapitalization of the banking
system (a strong motivation for opening to foreign banks in Angola and Mozambique)
and the transfer of modern banking technologies. However, although some (but certainly
not all) foreign banks have considerable ‘reputational capital’—and may therefore
transfer high standards to Ethiopian partners—they can introduce new risks (such as
excessive and unhedged short-term foreign borrowing) which the central bank has little
experience in containing. Moreover, NBE faces considerable pressure in effectively
supervising the financial system as it stands. At present, the procedures of the
restructured state banks and the private banks are similar to those of CBE with which
NBE supervisors are familiar. NBE also needs to build its capacity to grade the quality
of foreign banks; some poor- quality Asian banks have set up in Africa's transition
economies. Hence, the authorities are understandably cautious in opening up to foreign
banks with unfamiliar procedures and potentially doubtful reputations. The ideology of
using public banks in public and developmental interest is also at the heart of this
government policy.
Thus, the disagreement with IMF continued to date - the range of issues for disagreement
increasing over time. Currently, in addition to the restriction on the participation of non-
citizens in the financial sector, the IMF is concerned because Ethiopia is exercising control
on a number of capital transactions including capital market securities, money market
instruments, collective investment securities, derivatives and other instruments, commercial
credits, financial credits, guarantees and financial backup facilities, direct investment,
liquidation of direct investment, real estate transactions, commercial banks and other credit
institutions and institutional investors (IMF, 2012). Regarding the type of instrument used in
14
such capital control, the current practice in Ethiopia is more towards quantity based capital
account management instruments: prohibition, ceiling, or partial permit, etc. Derivative
operations are prohibited, real estate transactions abroad are prohibited, there is a ceiling on
net exposure in foreign currency, foreigners are not allowed to invest in domestic securities,
equity investment by foreign firms is strictly regulated, residents are not allowed to invest
abroad, financial institutions are not allowed to borrow from abroad, external loan and
supplier credit are allowed to exporters and FDI firms only. Thus, it is understandable if the
government worries about what will happen to the stability of the macro economy in general
and the financial sector in particular if it lifts all these controls without a well equipped
regulatory and supervision capacity.
In addition, recent trends point at an incipient foreign owned investment banking activities
that are in the course of entering the country using the “equity finance”/ ”investment
banking” and “representative office” schemes. They may also, partly, be motivated by the
desire to lay the ground for quick and effective action if the sector is opened, circumventing
the regulation that restrict foreign participation in the financial sector. Thus, many, big and
famous equity investments firms are becoming active in Ethiopia. This list includes global
firms such as KKR, Blackstone Group, Hedge-fund managers (such Paul Tudor Jones who is
planning to back a $2 billion geothermal power project financing); Bob Geldof’s UK based
firm, Miles LLP, the South African Standard bank and Germany’s 2nd largest bank
Commerzbank, among others. This development not only calls for capacity and institutional
building at the NBE to regulate and manage such financial institution at some time in the
future but also brings about the issue of the risk of liberalizing the sector and opening the
capital account to spotlight.
Given the closed nature of Ethiopia’s capital account and the huge financing requirements of
the economy, Ethiopia may not afford to restrict capital inflows in to the country by
imposing strict capital control regime forever. Thus, the current capital account management
regime should be revisited by authorities to loosen some of the restrictions. In revisiting the
capital account management regimes there is a need for capital control instruments to be
tailored to fit the country’s circumstances (see. Ostry et.al, 2011). It should also be gradual
but with time specific schedule; it should also move from the simple to the complex - for
instance, foreign companies being limited to some activities such as management contract or
in equity holding with public and domestic private sector – the former having a minority
holding to protect the indigenous ownership structure. Given capacity at NBE, another
design consideration is the administrative ease of imposing a particular capital control
instrument (see Gallagher, 2011; Getnet, 2014).
Finally, from macroeconomic perspective, financial stability is also conditional on prudent
policy to address the serious problems of capital flight (that reached over 20 billion in the
last two decades (Alemayehu and Addis, 2016), the growing level of external and domestic
debt (which is in the course of exceeding the GDP), the alarming levels of trade deficit
(which is about -17.5% of the GDP) as well as the consolidated public deficit (which is
about -17% of GDP) and its possible monetization and hence inflation and exchange rate
depreciation effect (see Alemayehu and Addis, 2015; Alemayehu and Kibrom, 2011). This is
important because next to the exposure of CBE and the DBE to unviable or poorly managed
public (and semi-public) projects and connected lending and hence a potential systemic risk,
macroeconomic instability particularly related to shortage of foreign exchange and inflation
is one of the major risk factors for the financial sector stability in Ethiopia (see Alemayehu,
2015).
VI. The speed and sequencing of financial reform

It is generally agreed that macro-economic stability is critical to financial health; cross-

15
country evidence shows that achieving macro-stabilization before or during financial
reform controls an important source of financial instability (Demirguc-Kunt and
Detragiache 1999: 327). On this score, Ethiopia has done well during the onset of the
reform. Despite the Fund's criticism of the pace of financial reform, its July 1999 Article
IV consultation with the government commends Ethiopia's ‘.... remarkable progress in
improving macro- economic stability and implementing structural reforms over the last two
years, despite the shocks created by heavy terms of trade losses, adverse weather
conditions, and the war with Eritrea’ (IMF 1999a: 2). Indeed, Ethiopia's macro-economic
policymaking is arguably stronger than that of its former cold war patron; Russia's 1998
crisis highlighted the dangerous interaction that can develop between macro-economic
instability and the loosely regulated financial system of a transition economy.
Although it is clear that macro-stability must underpin financial reform, the policy
debate is far less clear about how far liberalization should go and at what speed. For sure,
Ethiopia's policymakers are very aware of the perils of directed credit and interest-rate
ceilings; these depressed savings and reduced investment efficiency under the Derg. This
experience informed Ethiopia's termination of sector-specific lending rates in 1994 and its
decontrol of lending rates in 1998 and thereafter. But how far and how fast financial
liberalization should be taken, and what is the optimal sequence of measures (for
example early or later privatization) are still issues open to debate, even after a decade and
half on this road.
The cross-country evidence in the King and Levine (1993) study indicates that financial
liberalization, by fostering financial development, may increase long-run economic
growth; this appears to validate the McKinnon-Shaw critique of financial repression.
But it is also evident that liberalizing the financial system may increase its fragility.
Demirguc-Kunt and Detragiache (1999) and Arestis (2016) find, for example, that banking
crises are more common in countries that have liberalized and that the risk is greatest in
countries with weak institutions. As Brownbridge and Kirkpatrick (1999: 27) note, the
demands on supervisors have grown at a much faster rate than supervisory capacity in
many countries; deregulation has allowed the rapid entry of new financial institutions many
of which, being small and inexperienced, need close supervision.
It is evident that the World Bank is much more cautious in its advice regarding financial
reform than the IMF, and gives more priority to early institutional investment. The Bank's
former chief economist, Joseph Stiglitz concludes that ‘.... the key issue should not be
liberalization or deregulation but construction of the regulatory framework that ensures an
effective financial sector’ (Stiglitz, 1998: 16). Caprio (1996: 1) notes that disappointment
with financial reform in Africa and the transition economies might be due to perverse
sequencing, in particular ‘... often more visible aspects of reform, such as complete interest
rate deregulation, bank recapitalization, or more recently, the creation of stock exchanges,
have been pursued before basic infrastructure in finance—auditing, accounting, legal
systems and basic regulations— have been prepared’. Caprio (1996: 4) goes on to argue
that although regulatory investment is important, it by no means guarantees safe and sound
banking; without motivated bank owners, supervision alone is ineffective. Therefore,
reducing competition in private banking may actually improve financial stability (Caprio
1996: 4). Limiting entry raises the value of bank licenses as well as the discounted value of
bank profits. This may motivate owners to behave in a safe and sound manner, thereby
ensuring that they remain open to enjoy those profits. Hence, limiting entry into banking
can support regulatory investments in ensuring the stability of the financial system, at least
in transition's early years. In addition, following the Asian financial crisis in late 1990s and
the recent global crisis of 2008/09, financial liberalization is not generally recommended by
experts or seen cautiously at best (see Arestis, 2016).
16
In summary, differences with the IMF have arisen over the pace and sequencing of
financial reform—not over the desirability of reform per se. There are valid arguments
in favour of Ethiopia's cautious approach to financial liberalization, and there are
considerable social returns to investment in regulatory capacity. This is demanding of
scarce human resources, and this institutional capacity certainly cannot be built overnight
in Ethiopia – thus the government’s earlier cautious approach was important and the right
approach. What is more challenging today, however, is that the government has failed to
build such strong capacity over a decade and a half. Hence, the question is how long is the
long run? Should Ethiopia need to protect the sector forever? We have returned to this
issue in the next and final section.
VII. conclusion
Consideration of financial reform leads to the larger question of what Ethiopia can learn
from transition experiences elsewhere. It is now evident that there is no 'one true path' to a
market-economy. This much is clear when comparing the diversity of strategies and
outcomes among the European and Asian transition countries. Stiglitz (1999) is among
many in highlighting the dramatic difference in performance between the FSU and China
early on.
China has avoided ‘big bang’ reform—the rapid privatization and market-decontrol seen
in the early years of Russia's transition—in favour of what the Chinese call 'crossing the
river by feeling the stones underfoot' (Gros and Steinherr 1995: 109). China reformed
agriculture at an early stage and achieved a major expansion in non-traditional exports,
but has only later accelerated privatization. Financial reform has been notably cautious
and capital account transactions remained restricted. These controls have facilitated the
use of monetary policy and the central bank's performance on price stability is greatly
superior to that of Russia (Pomfret 1995: 137). Despite financial inefficiency—serious
problems in China's state banks are now apparent—growth has nevertheless averaged 9
per cent a year for twenty years and continued to date.8 China's gradual financial
reform is therefore one of the 'highly contradictory ingredients' of its economic transition,
a strategy that has nevertheless, delivered unprecedented growth (Gros and Steinherr
1995: 108).
That elements of the former command economy can exist side by side with the new
private sector is an anathema to proponents of rapid liberalization. However, this
strategy—if well implemented—is not as paradoxical as it first seems given that most
policy-makers must live with the market imperfections characteristic of a ‘second best’
world. For these reasons, Qian (1999: 6) argues that:
... the main lesson from Chinese experience is that considerable growth is
possible with sensible but not perfect institutions, and that some
'transitional institutions' can be more effective than the best practice
institutions for a period of time because of the second-best principle:
removing one distortion may be counterproductive in the presence of
another distortion.
Hence, Ethiopia's emphasis on maintaining macro-economic stability—even at the cost of
retaining inefficiency in the financial system—may be optimal in the second-best world
8
In part this is because China's private-sector has successfully relied on self-finance (including that
provided by the diasporas) rather than bank or state credit (Gros and Steinherr 1995: 111). In this regard,
Ethiopia may enjoy an advantage similar to that of China: it is favoured by a large diaspora with excellent
financial and commercial linkages. Already remittance has reached USD 3.8 billion in 2015 (larger than the
total export of USD 3 billion at the same time). In this regard, it is sad to see the recent NBE rule of excluding
the Ethiopian diasporas from the private banking sector when the latter wants to raise their capital most.
17
that characterises Africa's transition economies. This view is also validated by the official
growth rate of Ethiopia which is about 10 per cent per annum consecutively for the last
decade. However, we need not to stretch this point too far. Clearly, much depends on
how Ethiopia manages the market-controls that it does retain; in particular how the
authorities cope with the rent seeking b e h a v i o r which such controls inevitably
encourage. Rent seeking, if unchecked, can pervert otherwise well-intentioned strategies
transforming them from mechanisms to raise living standards into means for personal
gain. Such, after all, was the experience of Africa's transition economies under state
socialism and corruption is becoming an alarming trend in today’s Ethiopia. Second, as the
Chinese experience shows, a transition economy needs fast growth to tolerate the
efficiency losses associated with financial-sector controls (and market-interventions
elsewhere). For Ethiopia this means fast and shared growth in general and rural growth
in particular—where poverty is deepest— together with a major breakthrough in non-
traditional exports which it failed to invigorate thus far - as the stagnation in exports show.
This in turn implies close attention to improving micro-finance and rural savings
institutions to enable communities to participate in growth is also needed.
To conclude, financial reform raises complex technical issues over which there is at best
partial consensus (Jansen 1990, Vos 1993; Arestis, 2016). Since reform began,
Ethiopia has seen considerable reorganization of state banks as well as the entry of private
banks and insurance companies. Interest rates have been significantly decontrolled and
interbank foreign exchange and money markets have been established. Simultaneously,
regulatory capacity has been strengthened. Financial reform has been gradual, but
nevertheless determined. The government has been very aware of the structural and
institutional problems that need to be overcome for a market-based financial system to
develop. This has at times provoked disagreement with the IMF, but reform experience in
Africa and in the transition economies of Asia and Europe demonstrates that there are
many paths through transition, some successful, others not. The creation of a sound
financial system is crucial to transition and reconstruction, and to raising the living
standards of Ethiopia's people. However, after a decade and half on this path, the challenges
of further liberalisation and building the NBE’s capacity to regulate and supervise them is
becoming more complex and challenging. It is also now obvious that the sector cannot be
protected forever at the current level of protection.
In this regard, two policy direction need to be pursued in the immediate future. The first one
relates to (i) the issue of deepening the financial sector to enhance domestic resource
mobilization. Recent survey based evidence (Wolday and Tekie, 2014) and CBE’s saving
mobilization performance following its aggressive branch expansion (CBE, Annual Report,
2014) shows that banking those out of reach from banks including through mobile banking,
investment and housing loan based saving schemes as well as attractive return on saving are
important factors behind saving. Pursuing such policies and closer to a positive real interest
rate seems the policy direction to pursue. The second (ii) set of policies relate to a
cautiously opening up of the financial sector as it cannot be protected forever, create a level
playing field for the public and private financial sectors and time-specific capacity building
for supervision and regulation at NBE in a very short time. The latter is important as the
NBE’s current capacity is weak to handle further liberalization that are getting complex by
the day.
Thus, towards that end the NBE needs (a) to have time specific, say a five year, plan to
have a highly motivated (including highly paid) high caliber staff to regulate and supervise
the sector – this needs to be complemented by continuous training; (b) to work out on
partial opening up of the sector through various modalities such as joint venture with local
banks having a majority holding, management contract etc and learn from that to build
18
capacity; (c) to worry about the incipient investment banking type of liberalization that is
being in the course of developing in the country and noted in this study since it has not
developed the capacity to mange and regulated them; and finally (d) it needs to worry about
the systemic risks to the CBE and DBE from (i) connected and hence usually poor quality
lending, (ii) and form exposure to unviable or poorly managed public and semi-public
sector projects. Finally (e), the NBE needs also to worry about financial sector instability
that may come from systemic risk related to macroeconomic instability – in particular those
related to inflation, and foreign exchange shortage (and hence depreciation and/or foreign
exchange rationing). From this angle, since the picture of the Ethiopian financial sector and
its macroeconomic environment today are reminiscent of the eve of the 1997 Asian
financial crisis (Alemayehu, 2015), it is imperative to study the lessons from that
experience and work on preventive measure ahead of time.

19
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