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Proposal for Inflation Control: Ethiopian Way

January 21, 2008

  • Fist, rise of crude oil price which is directly affecting price of imported goods as well as local products. Since import of petrol consumes up to 80 % Ethiopia’s export earning, impact of petrol on price of goods and services is significant. To combat inflation caused by petrol price, Mulu mentioned government’s plan to produce bio-fuel.
  • Second, Mulu argues by saying “the seven million or so grain aid per year the country had secured in earlier years is no more in place. Instead the government is getting it in a form of money”. It is obvious that even though Ethiopia had good consecutive rainy seasons and better production, buying grains in the local market to distribute it where there is shortage is going to contribute to inflation.
  • Third, recognising the excess money in the market, Mulu directed me to the government recent decision to increase saving interest rate and directive put in place to increase mandatory reserve of privet banks from 5 to 10%.

Overall, I am pleased by Mulu’s reply and measures being taken to reduce inflationary pressure. Having digested all the comments, I decided to write this follow up to stimulate discussion and find better ways of combating inflation without adversely affecting investments, growth and infrastructural development.

Though I fully support the measures being taken, I have some doubt about the effectiveness of some of the measures. In my view, Ethiopia’s economy is unique in many ways and it needs unique solutions to control inflation without slowing down investment and growth.

With this in mind, I would like to highlight some of the short-comings of the current measures to propose additional solutions.

First, bio-diesel is good but it is a long shot in the Ethiopian reality. Bio-diesel is nothing but cooking oil with lower viscosity to make injection and combustion easier. For example most diesel Engine cars can run with up to 80% of cooking oil blended with diesel fuel to assist ignition. Use of cooking oil to drive cars in UK is technically possible but illegal. It is illegal not because it is dangerous but it is considered as tax evasion since no fuel tax levy is paid on cooking oil. At a current petrol price, one can buy 2 or 3 litres of cooking oil for the price of one litre of diesel. As a result some diesel engine cars and trucks drivers get caught driving with cooking oil to face penalty.

When we come to Ethiopia, driving with cooking oil would be expensive since cooking oil is more expensive than diesel fuel. Cooking oil is above 15 birr compared to diesel price which is under 5 birr. So to make bio-diesel/ cooking oil/ competitive, Ethiopia need to produce surplus agricultural products at much cheaper cost.

Bio-diesel could have environmental benefit and can reduce dependence on import but its contribution in controlling inflation will be a long shot unless it is backed by surplus agricultural products. In the short term investing in blending system of sugar-cane based ethanol with petrol may help the transition to alternative fuel.

As it stands now the most effective way of controlling inflation is to increase productivity and efficiency than hoping to control inflation through bio-diesel production.

Second, controlling the money supply. Economic text books prescribe to control inflation by cutting public spending to slow down investment and raising interest rate to encourage saving. This process is effective in the developed world but in Ethiopia it may not work for the following reasons.

  • In the developed world, people are paid through bank transactions and they do not carry cash. Low interest rate encourages consumers to use their credit card and spend more while higher interest rate reduces borrowing and spending. But in Ethiopia this is a new concept that needs to be introduced first before it can be used to control inflation. To make this incentive work, the government needs to modernise the banking system to make salary payment through banking rather than cash. A person who has no bank account would not bother to know whether the interest rate is up or down.
  • In current Ethiopian reality, raising interest rate would only affect investors who want to set-up businesses and struggle to make profits. This would have adverse effect on business by weakening expansion of supply to exacerbate inflation. But this is not to say measures should not be taken to reduce excessive borrowing without viable business plan or exaggerated project cost to transfer away money to other account and declare bankruptcy later on. In fact the private and national banks need to set up a central database to prevent such fraudulent use of loan.
  • Third, as I showed in the last article, the money is mainly coming from abroad and unless it is spent on infrastructure, it will either get wasted or donors will not see the need for giving it away. Unless projects are implemented, money stops coming to cause a bigger problem of no growth. Though I sound contradicting my own statement, threat of inflation to a country that has no basic infrastructure and economy that is predominantly dependent on subsistence farming wouldn’t be affected significantly if the control measures were targeting fixed income earners in the urban center. Inflation is a totally different issue when it comes to developed nations, who are dependent on competitive global market and domestic consumers spending.For example the US economy was supported by consumer spending based on appreciating housing prices in the last 7 years. Simply as the price of their house goes up, consumers felt prosperous to borrow and spend money on consumer goods. To curb this inflation the U.S. Federal Reserve raised interest rate about 18 times between 2004 and 2007 taking interest rate from 1% to 5.25%. This in effect increased mortgage repayment and reduced purchasing power of consumers to cause a drop in house price and spending on consumer goods.The negative effect is that as the housing price dropped, the banks began to tighten their lending criteria to lead to what is now called the “credit crunch”. These led to slowdown consumers’ spending to leave the global economy off its guards to push many companies into bankruptcy. So inflation in the West means, low consumer spending, which means loss of job, increment of dependency on government handout, reduction of government tax collected from businesses leading to higher income tax to support a large number of unemployed work forceWhen we come to Ethiopia, most of the concepts discussed above are non- existent. To start with the government does not take any responsibility for those who are unemployed or those who have no means to survive. Furthermore, very few have mortgage or access to bank credit facility. Hence, the developed world prescription of controlling inflation through public spending, interest rate or tax-setting may not be effective in Ethiopia

As shown above inflation is very much a dreaded thing in the West. To put things in perspective, inflationary target in EU and US is less than 3%. For example when inflation goes above 2% in the UK, the danger alarm goes on until measures are taken to curb inflation. But in our case, inflation is a different beast. Even after 19% inflation (according to Central Statistics Office) life appears to go on. But inflation of 19% in Europe or US would have caused a major crisis in the economy as well as welfare of citizens. Though the inflation in Ethiopia is too high, the silver lining is that the impact is not felt on the national level because wage earners are very minority in the country and more than 80% the population are still dependent on subsistence farming.

That is why Mulu and I are concerned by the impact of inflation on urban areas. Hence the measure needed is to focus on alleviating problems of fixed income earners in urban areas. So of all measures, increasing supplies of food items at lower price in urban centres coupled with improving productivity would be the most effective way of controlling inflation. Now the biggest question would be how that can be achieved?

Before that I would like to add other causes of inflation which Mulu missed.

The fourth source of inflation in Ethiopia is the recently introduced VAT. Value Added Tax had never been in the equation when merchants buy and sell goods. Now they have to mark up their profit first and add another 15% VAT to pass it to the government. So, technically, a product price could grow by 15% every time it passes hand from the whole seller to distributors or consumers. The question we need to ask now is that is it excessive tax? Can inflation drop by 5% if the government drops, say VAT by 5%.

The fifth and the biggest source of inflation in Ethiopia is inefficiency or waste. In simple manufacturing terms, price of a product is determined by cost involved in making it plus the waste (Price = Cost + waste). Everything, time, material, energy, labour, or other resources used to make a product plus the waste during making the product have to be recovered at the selling price. Hence, in Ethiopian situation, as inefficiency grows, the price also goes up.

While working in Ethiopia and still when I was on holiday weeks ago, the TV airtime was dominated by the news of increased production of cement, leather products, beer, wheat, grains, or animal products. The news come from the government owned farms, factories and the private sectors. But what does it mean in economic terms?

Increase in production means nothing unless the cost of making a product is reduced. It is this hidden inefficiency that has to be added to the cost of a product and service and make the customer pay for it. Of course, cost could be reduced by increasing production per hour to keep a unit price down, similar to Ford’s mass production model but that doesn’t mean a lot unless cost of making it is reduced. On the contrary, Toyota’s Total Production system is about eliminating waste to reduce cost of a product. Cost down can be achieved by elimination of waste of time, waste of unnecessary transportation, waste of processing, cost of holding stock, waste of movement, waste of overproduction, and waste of making defective products.

During my short stay in Addis Ababa and going to few offices, I was observing waste everywhere; waste of time and waste of resource. The system is not designed to make a smooth workflow even with all good intentions. It needs re-design to get better workflow.

For example, a government agency may have 8 storey building but arrangement of offices that are doing the work is random. You may go to 2nd floor to submit your application, then you will be told to go to 1st floor to buy a stamp, then you would be advised to take it to the 8th floor to get it signed. Then you would be told to go to the basement to photocopy and take the copy back to 2nd floor to get it officially stamped. And if you are lucky you may go one more round chasing paper until you are told to hand your file at the 4th floor, where your file will be stored. As a result, hundreds of customers and employees walk miles engaged in non value adding activity costing themselves and the country billions of birr.

Efficiency is not about shouting and making employees work until they sweat, it is about reducing the time and the distance between consecutive value adding activities (work). It is about making a workflow effortlessly from input to output at shortest possible time and resource.

As we know, the government is the biggest employer in the country and also the biggest waster of the national wealth. To recoup for this wastage, price of service always goes up year by year rather than going down. Despite expansion of electricity, telephone and other services, the unit price has been increasing to make the customer pay not only for the service they get but also for resources that the system wasted.

Rather than reducing cost through efficiency improvement, the government contributes the lion’s share of inflationary pressure by passing the cost of the waste to customers. It is through efficiency improvement that inflation could be brought down while accelerating development and competitiveness on global market.

Productivity and efficiency of the private sector is not different. Though I do not have the data, I was told huge investors like Midroc are not making profits. Hence, by definition they are not contributing to cut down the cost of products and services. They have to recoup their inefficiency by passing the cost to customers.

Just to add one more point, the other day I saw Ato Meles’ discussion with garment factory owners posted over the internet. One of the problems mentioned in the discussion was the difference between efficiency of Chinese workers and Ethiopians in the textile industry. It was reported that it will take 3 Ethiopian workers to make the same product that a single Chinese would produce in an hour. If 3 to 1 assessment is true, Ethiopia is not far behind from China and we should cheer up as an achievement. In my view, the difference could be in order of two digits, if one counts the non-value adding activities and the waste in the system. When Japan starts making cars, the efficiency gap between American carmakers and Japanese carmakers was up to 9 to 1. It is through elimination of waste Japan closed the gap, and defeated huge industries like Ford and General Motors.

By eliminating waste alone, Ethiopia can achieve double digit economic development while controlling inflation. That can be done not by shouting on workers but by improving the efficiency of the people at the top. It is by restructuring the top echelon of managers that the economy would be structured to make work flow effortlessly.

The first step is to make the top decision making position open for merit and competition. From a day I was born until today I have not seen a job advert asking for a position of CEO of telecommunication, Bank, factories or a plantation. Management is a science but in Ethiopia it is regarded as a reward for one’s loyalty and past service. Business is about cutting cost and delivering better product and service in competitive market. A business must not be an extension of control or reward for loyalty. It has to either swim or sink by its own performance.

Profit making national institutions must be run by people who come from open and competitive market. The role of the government should be to hire the most competent person and give him/her a target to meet or fire him/her when he/she fails to deliver. This undoubtedly would bring a cultural change of work and efficiency. It breaks the barrier between work and authority. What matters most will be the delivery of result than who has got the biggest and coolest office at the 8th floor!

In conclusion, the best way to control inflation without slowing down investment is to improve efficiency – to get more out of existing system and tackle the supply side of inflation.

The last source of inflation in Ethiopia is what the economist call: built-in inflation, induced by adaptive expectation. Due to shortage of goods and services in the last 40 years, price has been going up and people have never seen price going down. So people expect price to go up tomorrow and buy things today at full market price. For example people buy car because they know that they will sell it at profit in five year time. This adaptive expectation is difficult to control unless Ethiopia begins to produce surplus product to drive price of goods and services down. People expect price to go up to pay higher and higher prices. It also attracts speculative investors to fuel inflation. The housing sector is a good example.

In conclusion, every point we raised above contribute to inflation. Rather than trying to control inflation through monetary policy, which would slowdown investment, it would be better to upgrade the system to make it more efficient and get more out of existing manpower and resources. At the same time the government needs to increase supply of lower cost goods and services to the urban population who are going to be affected during this economic transition.

Hence,

  1. The government needs to increase supply of goods and services to urban centres at lower cost. Though the text book does not recommend recent pay rise for low wage earners, it is the right decision.
  2. Cap increase of price on utilities such as electricity, telephone and other services that are monopoly and not open to market competition.
  3. Government must force government institutions to increase profit through efficiency improvement and cost cutting than price increase.
  4. Re-examine whether VAT is put too high and too early.
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