Financial liberalization: GO SLOW AND STEADY TO WIN THE RACE

This administration is in a tight spot. Once again it put itself there.

Its economy is at a standstill, unemployment is high, very (very) high. The Birr continues to plummet against the Dollar, contributing to high imported inflation. And now with the war in Tigray the country faces more tragedy. The current crisis in Ukraine is also one out of a handful of crises that may rival the COVID-19 pandemic in its scope and long-term impact.

Things are not going well!

In all this, we hear the intention of the Prime Minister to open the banking sector to foreign financial institutions “to keep pace with the growth of our world and to compete with the banks of other countries as well” as he puts it. He said he will not protect local banks anymore; they had the market for themselves for too long. These locally owned banks are getting nowhere – it's time to bring out the big guns! The opening-up of the banking sector to foreign participation should be a key decision within a broader reform strategy. In fact, Ethiopia's banking sector and its financial system in general remains small and under-developed; it still is relatively undercapitalized and saddled with nonperforming loans (NPLS). In terms of monetary aggregates, the ratio of M2 to GDP still remains low, implying a small banking sector even compared to many Sub-saharan countries.

Prior to the 1990s, the development of Ethiopia’s banking sector was slow, with only one dominant state owned commercial bank. Today the number of privately owned banks has grown to 29 and is still growing. The profitability in the banking sector has also been higher than other countries in Africa.

Doesn’t this imply positive signs of financial sector development? Note this happened despite few to no significant measures taken to overhaul the sector. In fact inertia had set in for a long time, except for shock responses during periods of crises.

On the other side, many people take it for granted that external financial liberalization is desirable on efficiency grounds: it is said to have positive effects on the level and allocation of investment, and these efficiency gains more than compensate for the loss of policy autonomy, i.e. reduced ability of governments to achieve national objectives by using the policy instruments at their disposal. A very questionable proposition. Impact of foreign entry on domestic banks Some of the most positive impacts include: The introduction of state of the art technology and training for domestic bankers: Foreign banks are familiar with sophisticated financial instruments and techniques, and have faster and cheaper access to international capital markets and liquid funds.

Studies suggest that foreign banks presence encourages other foreign firms to invest in the domestic economy.

Studies also indicate foreign banks (assuming the foreign banks healthier than domestic banks) improve the functioning of national banking markets, both by increasing the degree of competition and by introducing a variety of new financial products and better risk management techniques.

It’s argues that the entry of foreign banks may have positive effects on employment and wages in the sector.

The main apprehensions

First, despite the almost universal assumption, studies suggest that the positive relationship between financial liberalization and economic growth is rather weak in the case of developing countries. Second, foreign banks may not address directly issues of poverty and the access of low-income and rural-based savers and borrowers to financial services. In most cases only wealthy people gain from financial liberalization.

Third, foreign banks have historically followed their home-country customers to the emerging markets, they are often seen as specializing in servicing large corporate customers, either multinational companies or “cherry-picked” host country large corporations. This has led to concerns that some segments of the market – rural customers, small and medium-sized firms – would be left unattended.

Fourth, foreign banks appear very cautious about lending to smaller firms because of their limited knowledge of local industry. They usually attract better credits with more sophisticated products and marketing and have “deep pockets” to put domestic banks at a competitive disadvantage. Fifth, foreign banks are said to look at lending opportunities around the world and may neglect the host country economy if its prospects deteriorate or if prospects improve in other countries Domestic banks, by contrast, are more committed to the domestic economy, in the sense of having both longer-term business relationships with customers and a patriotic affinity with the national interest.

Sixth, foreign banks are also less likely than domestically owned banks to heed exhortations by the domestic authorities to maintain lending during recessions. In some cases, foreign banks have been less cooperative in rescheduling loans in times of crisis.

Seventh, there is also concern that foreign banks may dominate the inward and outward flows of capital through capital and money-market transactions; credit operations; personal capital movements; etc. This may cause foreign exchange and liquidity shortages, with potentially adverse effects on the country’s capital account. Eighth, the existing tendency to encourage residents to hold foreign exchange deposits with banks at home, can push these residents to withdraw their funds from the locally owned banks in favor of the foreign banks, increasing the accumulation of foreign currency with the foreign banks. Ninth, foreign banks will provide needed credit to borrowers if they are certain they will get back their money in foreign currency.

It is evident from the preceding discussion that there may be both economic benefits and costs to be derived from financial sector liberalization, in particular from the entry of foreign banks and the privatization of state-owned banks. So the question authorities should ask is: how to balance the market share between local and foreign banks.

One way is to make sure local Ethiopian banks retain at least half of the market. Another way is to restrict foreign banks’ activities is to require that these banks have a minimum capital double that required for domestic banks. The government may also consider to diversify the number of foreign banks to avoid domination by a single or a couple of banks, or it may restrict their activities to doing business in foreign currencies only, or to doing business in local currency in only one or two cities. More and more countries are realizing that they have long lost their financial sovereignty and fallen into the hands of institutions beyond their jurisdiction. And once it (sovereignty) is lost, it is usually lost forever and with it, those invaluable powers that enable a state to protect and govern itself as its people see fit.

Can the administration do anything about it?

There may be eagerness by the administration to open up the banking system to foreign competition quickly, but for now we can only say, start by upgrading the capacity of domestic supervisory authorities, increase the size of their staff in order to supervise the more sophisticated activities and new products that are usually introduced by foreign banks. Before supervisors gain sufficient skills, they may be exasperated by highly sophisticated foreign bank operations, not knowing what questions to ask, or not being able to convince the authorities to withdraw the licenses of institutions with suspect operations. Remember foreign banks often are at least one step ahead of the supervisors.

The administration may also choose to limit the degree of foreign ownership for a specified period of time in an effort to help domestic firms to prepare for future competition and enhance the quality of governance.

Finally financial liberalization is not a panacea for Ethiopia’s broader economic problems. It will not solve all of Ethiopia's economic problems. It may be an important component but not a sufficient condition for development. To attain sustainable growth and poverty reduction the government should at the minimum, ensure macroeconomic stability and a high investment-to-gdp ratio, put in place reliable accounting and legal systems, construct stable political conditions, as well as responsible government institutions, and sequencing of reforms in order to reap the prospective benefits of financial internationalization without falling prey to its potential costs.