Financial Sector Liberalization in Ethiopia: How to Cope with the Upcoming Changes?

Ethiopia's government is undergoing the long-awaited liberalization of the country's financial sector. The Ethiopian Economics Association has published a study that investigates the effects of foreign investment on the financial sector, including the preparedness of financial institutions, the steps that could be taken to maintain competitiveness, and the potential negative outcomes.

Financial sector liberalization, which is opening the financial sector to foreign investment, has been shown to have multiple benefits for developing countries. It promotes financial inclusion, competitiveness, and innovation. However, it can also lead to instability and financial crisis if not aligned with existing market structures and if proper supervision is not implemented.

The Ethiopian government is currently working towards opening its financial sector to foreign investors. The Ethiopian Economics Association has published a book titled “The State of The Ethiopian Economy 2022/2023,” in which researchers analyze the challenges, outcomes, and policy concerns of financial sector liberalization.

Assessment of financial development indicators in Ethiopia and two other countries from Africa, Asia,and Latin America showed that the overall performance of Ethiopia’s financial sector was not satisfactory compared to other economies in the Sub-Saharan Africa Region (SSA) during the 2005-2020 period.

The research evidences the low branch-to-population ratio in Ethiopia. From 2005 to 2020, there were 1.46 bank branches per 100,000 adults, whereas, in the same period in SSA, there were 6.41 bank branches per 100,000 adults on average. The result was also meager compared to Kenya (4.58 branches per 100,000 adults).

Still, Ethiopia’s banking sector is more competitive than the SSA countries on average. Upon further assessment, the market of financial institutions (banking, insurance, and microfinance sectors) in Ethiopia was neither found to be a perfect competition nor a monopoly. Hence, it can be described as monopolistic competition.

However, the banking and insurance industry is expected to have fierce competition after liberalization. Even the country’s microfinance industry, which is already more competitive than the banking sector, could be hit hard by new entrants if the market is liberalized. The paper recommends MFIs should be working on enhancing operational efficiency.

The study went on to analyze the readiness of financial institutions and regulatory bodies, summarized below.

A survey of 51 firms (16 banks, 16 insurance companies, and 19 microfinance institutions) in the Ethiopian financial industry implies that domestic firms are not ready to welcome the liberalization policy. Further, it has indicated the National Bank of Ethiopia (NBE) lacks independence in supervising and guiding the sector. Around 39% of the survey respondents disagreed that the National Bank of Ethiopia has the necessary capabilities to oversee the financial system, while about 37% agreed and 24% were indifferent. 

Financial operators have suggested domestic financial institutions take the following steps to cope with the financial sector opening up to foreign markets:

  • Take advantage of the digital economy.
  • Build up global capabilities in technologies, knowledge, and skills.
  • Enhance operational efficiency, maintain adequate capital, and increase foreign currency access and reserve.
  • Increase their research and development budget, focus on continuous improvement, and develop their learning capability.
  • Facilitate offshore borrowing.
  • Be innovative and customer-focused.
  • Adopt merger and acquisition strategies to build up their competitiveness.
  • Enhance their cyber security systems.

In addition to the readiness of domestic firms, successful liberalization will require maintaining macroeconomic stability and following the appropriate sequence.

Members of NBE’s management have said that, excluding the present political and global pandemic shocks, the country is progressing well and is ready to open its banking industry. They anticipate the following subsequent benefits from allowing foreign investment in the financial sector:

– Increase the public benefit from the financial industry.

– Technology and knowledge transfer.

– Enhance competition and improve efficiency.

Financial liberalization has both benefits and costs for the Ethiopian economy. Other potential costs include increased operating costs, a sudden capital outflow (capital flight), and biased credit provision to big firms.  

Liberalization has resulted in varied economic outcomes throughout the world. The publication points out the experience of Pakistan.

“Studies in Pakistan showed that the financial liberalization index and economic growth are positively linked in the short run, whereas it is statistically insignificant in the long run (Hye & Wizarat, 2013). In underdeveloped economies like Africa, foreign banks’ entry creates financial integration, which increases the finance supply, improves its allocation, and spurs economic growth”

Read the full research here

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