Ethiopia’s Recent Growth Performance: A Survey of the Literature

By

Rahel Kassahun (AFTP2 consultant)

August 2003

1. The Current Growth Strategy in Ethiopia

“For some countries, economic growth is the primary policy goal, and poverty reduction is to be achieved through measures complementary to growth. This is not the approach of the Ethiopian government. Poverty reduction is the core objective of the Ethiopian government. Economic growth is the principal, but not the only, means to this objective.” (p. I, SDPRP)

The Ethiopian government has set the alleviation of poverty as its primary goal.

Its development strategy, therefore, must be one that facilitates the reduction of poverty in the most effective way. Agricultural Development Led Industrialization (ADLI), the government’s chosen growth strategy, is expected to do just that. The objective of ADLI is to strengthen the interdependence between agriculture and industry by increasing the productivity of peasant farmers, expanding large scale private commercial farms, and by reconstructing the manufacturing sector in such a way that it can make use of the country’s natural and human resources. Ethiopia is endowed with a large number of working age population. The country is also endowed with a sizable arable land, though land is scarce in some parts of the country particularly in the northern and central highlands. The economy, however, is in acute shortage of capital. ADLI is a strategy that uses labor extensively and land intensively. By promoting the use of technologies that are labor intensive and land augmenting such as fertilizer and improved seeds, the government aims to transform Ethiopia’s agrarian economy to a modern economic system.

According to the strategy of ADLI, growth in agriculture is supposed to induce

overall economic growth by stimulating both demand and supply. On the demand side, expansion in agricultural activities is supposed to increase demand for industrial products (e.g., agricultural inputs and consumer goods) manufactured by domestic firms. On the supply side, the sector provides food (thereby reduces or even eliminates the need to import grains and other food products), raw materials for manufacturing, and export products.

Ethiopia’s ADLI program aims to enhance the productivity of the agricultural sector by

1. improving agricultural practices through increased use of fertilizers and improved seeds as well as through training programs;

2. developing agricultural infrastructure through small-scale irrigation, improved rural banking, etc; and

3. promoting large-scale (private as well as state owned) commercial farming.

The government considers the development of smallholder agriculture critical to overall economic progress since it accounts for over 90% of total agricultural output. About 96% of the cultivated land is held by smallholder farmers and on average, peasants produce 94% of food crops and 98% of coffee, the nation’s main export commodity. Moreover, agriculture is the source of livelihood for 85% of the population where the vast majority of the poor live.

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Because of the extremely low ratio of urbanization, domestic demand for

agricultural output will be inadequate, at least in the initial stage of ADLI, thus agriculture has to be made internationally competitive and part of the output has to be oriented towards exports.

In order to make agriculture the engine of growth through the domestic economy and international trade, there has to be progress in terms of commercialization, with more intensive farming, increasing the proportion of marketable output and correspondingly decreasing the ratio of production for own consumption. In addition to deepening technological progress, it means greater market interaction on the part of the farmer. To facilitate the commercialization of agriculture the government has implemented an extension program known as the Participatory, Demonstration, and Training Extension System (PADETES). The objective of the program is to help smallholder farmers increase their productivity by providing credit for inputs as well as by demonstrating and disseminating information on major food crops (such as teff, wheat, maize and sorghum) and on cash crops. Cooperatives facilitate input and output marketing and promote the provision of rural finance.

For the poverty reduction strategy program period, between 1999/95 and 2004/05, the government envisages a real GDP growth rate of at least 7% on average and aims to reduce the poverty head count ratio by 10%, from 44 percent to 40 percent. While overall economic growth is projected at 7%, agriculture is expected to grow at annual average rate of 7.5%, industry at 7.8%, distributive services at 8%, and other services at 5.4% annually.

The government has identified four priority areas in formulating its growth strategy. These are agricultural sector and rural development strategy, capacity building in both public and private sector, creation of a conducive environment for private investment and capital inflow, and prevalence of sound and competitive financial sector. The main measures taken or to be taken under each are as follows: Agricultural sector and rural development strategy

• introduce menu based extension packages; • expand borrowers’ coverage of micro-financing institutions; • establish an institute for diploma-level training of extension agents and expand

agricultural Technical Vocational Educational Training (TVET); • improve functioning of markets for agricultural inputs (fertilizer, seed) and

outputs; • organize, strengthen and diversify autonomous cooperatives to provide better

marketing services and serve as bridges between small farmers and the private sector;

• establish an agricultural products exchange market; • agricultural research, water harvesting, and small-scale irrigation; • construction of rural roads; and

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• promote commercial farming. Capacity building in public and private sector (three focus areas) a) building the necessary capacity to realize the rural-led development strategy

• targeting rural small-holder farmers and their association; • building the capacity of Woreda and regional level administration in

effectively planning, and execution of rural development programs; • building Federal Government’s capacity to build and support regional and

Woreda administrative capacity. b) building capacity for an accelerated and private sector led agro-based industrialization

through • strengthening government capacity in creating conducive policy and

institutional environment, as well as to extend capacity building support to domestic entrepreneurs;

• enhance the government’s capacity to minimize adverse impacts of market failure through such support as – information, long-term credit, technical development, etc. needed to realize the export and industrialization strategies;

• build the institutional capacity of the private sector, in coordinating their effort to improve productivity and competencies, and enhanced interface with the government on policy, implementation, and capacity building issues.

c) building the institutional capacity of public, private and civil society in • strengthening the capacity of democratic/political institutions to insure the

rule of law at all levels of the administration system; • strengthen the government’s capacity for efficient and effective service

delivery and accountability; • ensure Civil Society institutions and media play their part in the

democratization process.

Creation of a conducive environment for private investment • Make the existing policies work better by removing regulatory impediments and

improving implementation capacities of government; • encourage public-private sector partnership through establishment of platforms of

dialogue; • make the business environment and the incentive structure attractive for

manufacturing in particular; • Promote exports through production of high value agricultural products and

increased support to export oriented manufacturing sectors (e.g., high quality skins/leather and textile garment).

Prevalence of sound and competitive financial sector

• creating a favorable external environment of banking by broadening and deepening the information base for banks (e.g., enforce the foreclosure law);

• building the internal dynamics of banks by encouraging banks to raise their efficiency by adopting improved practices and building their capacities - bank supervision will be tightened while making bank management more autonomous

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and more accountable to its Board of Directors, credit rating will be introduced for individual borrowers as well as for banks;

• facilitate the transformation of micro-financing institutions into rural banks and the flow of funds from commercial banks to micro-financing institutions for purposes of on-ward lending.

Overall, the current growth strategy puts an overriding emphasis on agriculture.

Driven by productivity gains in smallholder agriculture and rural development programs (e.g., building infrastructure and expanding social services) growth in agriculture is expected to induce growth in industry and thereby bring about a structural transformation of the economy. Diffusion of technology, export promotion policies and the provision of credit are deemed to be critical components of the strategy. 2. Key Characteristics of the Ethiopian Economy The main feature of the Ethiopian economy is its dependence on rain-fed agriculture. Overall economic performance is largely determined by what happens in the agricultural sector, which in turn is extremely dependent on the amount and timing of rainfall. In “Ethiopia’s Economic Performance,” Alemayehu Geda discusses about the negative multiplier effect of a high degree of dependence on rain-fed agriculture on the level of production. He notes that a shock in one period is often carried over into the next since the drought in that period deprives the farmer not only of current income but also of assets, which may be lost (e.g., oxen dying) or are sold in the market. Geda points out that the government’s development strategy ADLI does not adequately address this central problem in agriculture, i.e., the extremely heavy reliance on rainfall.

2.1 Sources of Growth

In a paper entitled “Growth in Ethiopia: Retrospect and Prospect,” William Easterly decomposes Ethiopia’s 2.06% growth rate of output per person for the period between 1992 and 2001, into capital deepening (-0.52%) and total factor productivity (2.58%). According to Easterly, TFP growth has been the dominant influence of growth for the last half century.

By contrast, in “The Pattern of Growth, Poverty and Inequality: Which way for a Pro-poor Growth,” Geda, Shimeless, and Weeks use a model that is based on parameters derived from cross-country analysis (88 countries, of which 21 are in sub-Saharan Africa) to identify the sources of growth in Ethiopia for the period 1960-97. According to this exercise, capital explains a good part of the Ethiopian growth record.

The contribution of physical capital to output growth was the highest in the 1960s where a huge investment in infrastructure was undertaken, capital-intensive commercial farms were promoted and food-processing industries flourished. Throughout the period 1960-97, the contribution of education per worker was very weak, while total factor productivity was negative, for the most part. According to Geda et al., the factors

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contributing to the very low/negative factor productivity are backward farming technique, high reliance on weather, and inappropriate policies of the Derg regime.

In another growth accounting exercise, however, one that employed a macro-based production function, Geda et al., found that labor has strong contribution (with a growth elasticity coefficient that ranges from 0.73 to 0.91) in the short run. This result is statistically significant only in one of the two versions of the model they have shown (column 2 in table 1.3, Annex 1). Although its potency is low (with growth elasticity of 0.30), the contribution of capital to growth is statistically significant in the short run, in both versions of the model.

In the long run, however, the contribution of capital is not only insignificant but statistically is not different from zero. Labor, on the other hand, remains statistically significant and its potency is as strong as in the short run. According to Geda et. al., the major conclusion that could be made in this case is that growth in Ethiopia is predominantly explained by labor – this result is in sharp contrast to their findings in the cross-country analysis discussed above.

The use of a micro based production function (using a rural household survey)

that introduces a number of different variables, indicates that land (size of holding) is the most significant factor that determines growth. Column 1 (in table 1.4, Annex 1) which presents the estimates of the simple Cobb-Douglas production function in which only labor and capital (proxied by land under cultivation and ox/oxen used) are included shows that the contribution of capital indicators are much more important than the labor input. The result in column 2 show that controlling for fertilizer use and availability of credit reduces the potency of labor and capital, implying the importance of inputs such as fertilizer and improved seeds. Column 3 shows that the introduction of risk variables (land redistribution and availability of rainfall, prevalence of frost and flood, etc.) diminishes the importance of land. The result also suggests that positive climatic condition has a positive and significant effect on output, that expectation about future land redistribution has a negative impact on production though the size of the coefficient is not large, and that farmers who associate future risk premium tend to be reluctant on conserving and upgrading their land. If land and oxen are good proxy for capital this result is consistent with their finding in their cross-country analysis.

In a growth accounting exercise that looked at the experiences of 88 developing and developed countries for the period 1960-94, Abdelhak Senhadji examines the sources of cross-country differences in the levels as well as the growth rates of total factor productivity. Out of the six regions (sub-Saharan Africa, East Asia, South Asia, Middle East and North Africa, Latin America, and ‘industrial countries’) he found that sub-Saharan Africa had the lowest annual TFP growth rate.

The region’s low output growth, 2.83% for sub-Saharan Africa versus 3.8% for

the whole sample, is a result of lower physical and human capital accumulation and lower TFP growth. Dividing the period 1960-94 into three subperiods (1960-73, 1974-86, and 1987-94), Senhadji asserts that output growth in sub-Saharan Africa declined

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steadily over the three periods as a result of the lower TFP and lower investment growth. In “The Pattern of Growth, Poverty and Inequality in Ethiopia,” Geda, Shimeless, and Weeks confirm that from the early 1970s until the 1990s there was a downward trend of gross capital formation in Ethiopia.

Decomposition of the Growth Rate of Real GDP for sub-Saharan Africa (mean values)

α =0.2

Sub-period dTFP dk dl dh dy 60-73 0.93 1.06 1.85 0.22 4.06 74-86 -1.00 0.82 2.00 0.35 2.17 87-94 -0.97 0.47 2.04 0.36 1.91 60-94 -0.26 0.83 1.95 0.30 2.83

Note: 1) assume output follows a Cobb-Douglas production function: Yt = AtKtα(LtHt)1-α

where Yt is aggregate output, At is total factor productivity, Kt is the stock of physical capital, Lt is the active population and Ht is an index of human capital. 2) I have only shown results for α=0.2 here because it’s the closest value to that for Ethiopia, which α=0.16.

Senhadji argues that the contribution of TFP to output growth depends crucially on the share of physical capital (α) in real output. The higher α is, the lower is the contribution of TFP. The estimated share of physical capital for Ethiopia is 0.16. The average (mean) for sub-Saharan Africa, according to Senhadji’s estimation, is 0.43 while that for the world is 0.55. Thus, in the Ethiopian economy, TFP’s contribution to output growth is substantial. This is consistent with Easterly’s findings.

Senhadji also found that: • real output in developing countries is twice as volatile as in developed countries.

This is due to high volatility of TFP in developing countries. While the volatility of capital and labor in both developing and developed countries are comparable, TFP in developing countries is twice as volatile as in developed countries.

• Physical capital and skill-augmented labor account for only a modest share of the short-term variation in the growth rate of GDP per capita. Physical and human capital as well as labor are too persistent in nature to explain short term fluctuations in output. While capital and labor inputs determine the long-run level of output, capacity utilization and other factors may be the main determinants of the short-term fluctuations of output.

• Initial conditions – captured by the initial levels of TFP, physical and human capital – explain a large part of the difference in TFP across countries. The more favorable the initial conditions are, the higher the TFP performance is. In particular, the initial endowment in human capital plays a crucial role in determining the future level of TFP for a given country.

• Favorable terms of trade shocks are associated with higher TFP levels. • A good macroeconomic environment contributes significantly to the level of TFP;

lower inflation, lower real exchange rate, lower government consumption, higher

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ratio of reserves to imports, and lower external debt are associated with higher levels of TFP.

• Both current and capital account convertibility improve TFP. • Social harmony and political stability increase TFP significantly.

The following table summarizes the findings of the various authors discussed above.

Author Period covered Main determinant of growth

Type of model used for analysis

Easterly 1951-2001 TFP (0.59% of 0.68%

growth of output per person per annum)

Macro-based production function

Geda et al 1960-1997 Capital per worker (1.42% of 1.20%

growth in GDP per worker per annum)

Based on parameters derived from cross-

country analysis

Geda et al 1962-1998 Labor (growth elasticity

ranging from 0.73 to 0.91)

Macro-based production function

Geda et. al. 1999 Land (used as proxy for capital – growth elasticity ranging from 1.11 to 1.51)

Micro-based production function

Senhadji 1960-1994 Labor (1.95% of 2.83%

growth of real GDP)

Based on parameters derived from cross-

country analysis

2.2 Fundamental Determinants of Long Run Growth

As for the fundamental determinants of long run growth and the prospects for Ethiopia to move to a sustainable higher level of development, Easterly finds the quality of institutions, the literacy rate, openness to trade, and the structure of transformation (the degree to which output shifts out of subsistence production into higher productivity modern sector activities - proxied by urbanization ratio) to be important variables. Comparing the growth experience of Ethiopia with that of Korea, Easterly found that most of the large income gap between the two countries can be explained by these four variables.

Geda et al. also explore the determinants of long run growth by using an

augmented Solow model that uses coefficients derived from a cross-country regression based on data from 85 developing countries. They use the mean growth performance of

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the 85 countries as a benchmark to compute how much Ethiopia’s growth deviates from the mean growth of the countries in the sample. Their finding is that Ethiopia’s growth has been below the predicted level in all periods (see table 2.2 in Annex 2). Overall, initial income (measured by log of real GDP per capita in the initial year of the half-decade) and the replacement investment term (measured by the growth rate of population) are found to be the most important explanatory variables of Ethiopia’s slower than expected growth rate. The table below summarizes the fundamental determinants of Ethiopia’s long run growth.

Author Country/countries

compared to Most important explanatory

variables Easterly Korea The quality of institutions, the

literacy rate, openness to trade, and the structure of

transformation Geda et. al. 85 developing countries Initial income level,

investment rate, initial education attainment and the growth rate of the population

2.3 The Impact of Policy Reform on Growth Comparing the Reformist period 1992-2001 with the last decade of the previous

regime (1982-1991), Easterly illustrates that about half of the change in growth is explained by policy reforms. Using coefficients on policy changes derived from cross-country cross-decade growth regressions for the whole world sample (1960-99), he showed that 1.4 percentage points of the 2.8 percentage point growth increase in the Reformist period can be explained by policy changes. The variables that have the most important impact on growth are financial deepening, real depreciation, and the reduction of the black market premium on foreign exchange (see table 3.1 in Annex 3). Easterly argues that only half of the growth change is explained by these variables because the change in growth after the end of the civil war in 1991 contains some transitory elements; otherwise policy change would have explained a larger share of the underlying permanent change in growth.

Geda et al. also show the effect of policy reform on growth, though their story is

quite different. They assert that the contribution of policies to growth deviation is negative throughout the three regimes, including the reformist period. Judged by the average performance of the countries in the sample of 85 developing countries, policy reform in Ethiopia seem to have a negative impact on growth. They note, however, that the negative deviation of the parallel market premium shown in the table below for the period 1990-97 is exaggerated because the data includes the early years of the 1990s

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where the exchange rate policy was problematic. The parallel market premium rate has declined from its highest level of 358% in 1992 to 15.5% in 1997. Geda et al. conclude, although growth and policy performance seems to be improved in the 1990s, their sustainability is highly questionable because structural problems such as dependence on rain-fed agriculture, vulnerability to external shock and political instability, most of which are captured in the ‘base’ variable of their regression equation (refer to table 3.2 in Annex 3) have not been adequately addressed yet. The following table summarizes the findings of Easterly and Geda et al. with respect to the impact of policy reform on growth.

Author Methodology Result

Easterly Comparing reformist period (1992-2001) with the last decade of the previous regime (1982-1991)

1.4 percentage points of the 2.8 percentage point growth in GDP per capita is explained by policy changes

Geda et. al. Comparing with the average performance of 85 developing countries

Contribution of policy reform to Ethiopia’s growth deviation is negative, namely –0.85 for the period 1960 to 1997, and –1.17 for the period 1990-97

2.4 On the Structure of the Economy

It is a well known fact that the structure of the Ethiopian economy has not changed in any significant way over the last four decades. Growth performance is still very much dependent on a fragile agricultural sector. In an attempt to explain whether this pattern can be explained by the country’s initial conditions, Geda et. al provide the following table, which contains information on agriculture’s share in the labor force.

Agriculture’s share of the labor force Ratio of average labor productivity in non-agriculture to agriculture sector

Period

actual fitted residual actual fitted residual

1960-64 92.75 43.32 49.43 6.47 -1.44 7.92 1965-69 91.81 40.83 50.99 7.68 -1.40 9.09 1970-74 90.85 38.35 52.50 8.26 -1.92 10.18 1975-79 89.91 35.79 54.12 8.22 -2.40 10.62 1980-84 88.73 33.17 55.57 6.48 -2.80 9.28 1985-89 87.19 30.82 56.37 6.85 -3.82 10.67 1990-97 89.30 27.72 61.58 7.43 -4.19 11.61 Total 90.08 35.71 54.36 7.34 -2.57 9.91 The residual in agriculture’s share of the labor force indicates that the country is performing nearly half below expectation (in terms of structural transformation of the

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economy) given its initial condition and a typical developing country’s performance. The ratio of productivity between the non-agricultural and agriculture sectors is significantly above what would have been expected given the initial condition of the country and a typical developing country’s performance. The implication is that shifting to the more-productive non-agriculture sector is growth enhancing. 2.5 Decomposition of Growth by Sector

Looking at the supply-side and demand-side composition of growth, Easterly points out that on the supply-side, industrial growth has been the most volatile (it was affected severely by the civil war in the late 80s, then recovered strongly in the 1990s); whereas growth in agriculture has been more stable but lagging despite the government’s commitment to agricultural-led development. Services, on the other hand, was the main component of growth in the 1990s. Decomposition of growth in the 1990s by sector revealed that the agriculture component was only 1%, while that for industry and services were 0.9% and 3.6%, respectively; the overall average GDP growth rate for the period 1992/93-1999/2000 was 5.5%. On the demand side of growth, the export sector has performed relatively well, leading growth throughout the decade. Government spending (both in public consumption and investment) was the other leading sector.

2.6 On Sectoral Linkages

In “Agriculture and economic growth in Ethiopia: growth multipliers from a four-sector simulation model,” Steven Block develops a four-sector (agriculture, services, modern industry, and traditional industry) numerical simulation model of economic growth in Ethiopia to calculate macroeconomic growth multipliers resulting from income shocks to each of the fours sectors. He found the growth multipliers are 1.54 for agriculture, 1.80 for services, 1.34 for modern industry and 1.22 for traditional industry. These results imply that intersectoral linkages in Ethiopia operate on a highly uneven basis. That is, linkages operate robustly between the agricultural and service sectors, and to some extent from agriculture to traditional industry. The service sector provides important stimulus to modern industry. The industrial sectors, however, are relatively limited in their impact on either services or agriculture.

The stochastic equations in Block’s paper are specified in such a way that

agriculture is a function of lagged output in services – but is not directly a function of output in either of the industrial sectors, reflecting the fact that the smallholder peasant farmers who produce 95% of the nation’s agricultural output consume few if any purchased inputs. The lack of effective demand for industrially produced inputs results in a situation where industrial output is essentially unrelated to agricultural output.

Modern industrial output is a function of output in services and gross investment

in non-agriculture. Ethiopia’s modern industrial sector is essentially unrelated to the agricultural sector, which neither supplies inputs to modern industry nor provides substantial demand for its output. Inputs consists primarily of mineral resources and imported capital and outputs consists mainly of intermediate goods. Rather, the sector is

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heavily dependent on imported inputs; and therefore in an indirect way, there is an important link from agriculture to industry, since agriculture is a major source of the foreign exchange needed to import industrial inputs.

By contrast, output in traditional industries is determined by output in each of the

other sectors, agriculture and service. As for service, it has a reciprocal relationship with agriculture, and no measurable backward linkages from either industrial sector. Service, however, is the economy’s strongest link to modern industry; a $1 increase in service sector income leads to a $0.25 increase in modern industrial sector income.

As mentioned above, the most robust linkages to emerge from Block’s simulation

experiment are between the agriculture and service sectors: these two sectors have the two largest multipliers in absolute terms (agriculture 1.54 and service 1.80) and of the net impacts of income shocks, agriculture and services share the largest portions with each other. A $1 shock to agriculture income generates $0.24 of income in the service sector, 44% of agriculture shock’s net contribution. On the other hand, a $1 increase in service sector income spills over to increase agricultural sector income by $0.42, equivalent to 52% of the service sector shock’s net contribution. In contrast, the two industrial sectors have the two smallest multipliers in absolute terms (modern industry 1.34 and traditional industry 1.22) and modern industry retains within itself a much larger share of the net impact of an own-sector income shock (23%) than do any of the other sectors.

Block also found that a simulated drought costs Ethiopia 7% of the total GDP

during the drought year; yet only 5% of that loss is directly in agriculture. Over the 5-year life of the drought’s impact on the economy, 29% of the total cost lies outside the agricultural sector.

Block concludes by saying, in terms of the distributional implications of growth,

an income shock to agriculture is the most progressive choice (since poverty in Ethiopia is disproportionately rural), indicating the need to highlight agricultural development in growth strategies for the country. However, an income shock in service is more growth enhancing because a $1 service sector income shock generates $0.80 in indirect benefits, whereas a $1 agricultural income shock generates only $0.54 in indirect gains.

Using a Social Accounting Matrix (SAM) -multiplier analysis, Tadele Ferede

shows that, taking both direct as well as indirect or induced effects, the agricultural sector in general and teff, wheat, and coffee in particular have strong integration with the entire economy. When general equilibrium effects are taken into consideration, agriculture seems to stimulate economic growth more than any other sector. Within industry, food processing, metals, beverages, and textiles have substantial linkages with the rest of the economy. His findings imply that policies directed towards the expansion of the rural sector and on selected manufacturing activities would generate substantial income for rural areas as well as urban households.

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2.7 On Structural Transformation

In “Sustainable development and poverty reduction revisited: a demo-economic conceptual framework and its application to Ethiopia,” Jean-Marie Cour argues that the slowdown of the urbanization process that started in the early 1970s has retarded economic growth, and that in order to accelerate growth, the government must adopt a new development strategy, one that is less focused on the supply of goods per se (agriculture and industry) and more in favor of the development of demand, trade, the revival of cities and towns, and on urban-rural linkages. Using a rather crude conceptual framework, Cour illustrates two scenarios, based on two different assumptions regarding the rate of urbanization, to examine the future prospects for growth in Ethiopia.

He starts from the assumption that the total population will reach 110 million in

2025 (a figure that corresponds to the low variant of the population projection by the CSA). The levels of urbanization achieved in 2025 will be 25% in the low urbanization scenario, which assumes a continuation of recent trends, and 40% in the high urbanization scenario which is supposed to fill part of the gap of urbanization accumulated during the last two decades.

The idea is to progressively increase the number of consumers per producer of

food – or the number of urban dwellers per rural dwellers. Cour argues that if the urban dwellers are able to purchase their food and other rural goods at a reasonable price and if they are able to attract and accommodate a steady flow of migrants from rural areas, then conditions are in place for a progressive increase of the real income of the majority of rural dwellers, for a sustainable increase of agriculture production, for agricultural intensification and food security, regardless of the overall growth rate of the Ethiopian population.

Using a rural-urban computable general equilibrium (CGE) model, Ayele Gelan

investigates the impact of trade liberalization on structural transformation and overall growth of the economy. He applied policy shocks of a 50% nominal devaluation of the Birr, a 50% reduction of import tariffs, and a 50% reduction of export taxes; and found that the impacts of trade liberalization depend on wage-setting conditions in the urban region.

With a fixed urban real wage, trade reform adversely affects overall economic

growth mainly because of large contractions in the urban regions. According to Gelan’s estimation, urban GDP falls by as much as 14% in the long run, while the rural GDP rises by 2.3%. Due to a large adverse effect on the urban region, aggregate GDP falls by 5.6% in the long-run. When the real wage rate is fixed, the urban nominal wage rate has to change by the same proportion with the consumer price index in the region. The policy shocks cause urban consumer price indices and hence urban nominal wage rate to rise. As a result, labor demand in the urban region falls. The combined effect of no change in urban real wage but a decline in employment opportunities in urban region is a drop in the expected urban wage rate. This causes the direction of migration to be reversed with a good proportion of the urban labor force moving to the rural region. Large

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contractions in the urban region mean a proportionately large decline in domestic demand. The policy implication here is, with inflexible urban wage formation, economic reform programs are unlikely to succeed.

With a fixed urban nominal wage, the long run effect of trade reform is such that

both rural and urban sectors experience expansion by 6.5% and 3.5%, respectively. Sectoral expansion in the rural region occurs mostly as a result of increases in capital stock. The size of rural labor supply and hence rural employment (full employment is assumed in the rural sector) actually declines by 0.2%. In contrast, urban sectors expand by making use of more labor as well as capital. Employment in the urban region increases by 8.0% in the long-run. The increase in labor demand in the urban region is satisfied from the local unemployment pool and additional migrants from the rural region, which causes the urban labor supply to rise by 1.4%. Assuming that there is a huge urban-rural wage differential, the urban region gets a continuous net-inflow of labor force from rural region. The direction of migration does not change although urban wage declines in real terms (by 20%) and rural real wage rise (by 8%). The reason for this is that the decline in urban unemployment (by 25.1%) represents a significantly large increase in the probability of finding jobs in the urban region. Thus, the ‘unemployment effect’ of trade liberalization dominates ‘the wage differential’ effect and thus rural-urban migration continues to happen.

In this modeling framework, notes Gelan, there seems to be a conflict between

trade liberalization and the long-run development objective of accelerated industrial development, i.e., changes in the structure of the economy from predominantly rural-agricultural to urban industrial. As stated above, rural GDP expands by more percentage points than urban GDP. This, he points out, has an important policy implication for designing economic reform programs. It is possible to achieve the objective of employment and output expansion as well as accelerated industrialization by choosing a suitable sequencing of the applications of different policy instruments. For instance, it may prove useful to begin with devaluation and export trade liberalization and then eventually proceed to import tariff reduction.

2.8 Growth, Employment and Productivity

In “Growth, Employment, Poverty and Policies in Ethiopia: An Empirical Investigation,” Demeke, Guta, and Ferede note that while the Ethiopian economy grew on average by 2.3% and 4.6% during the 1980s and 1990s, respectively, employment expanded by 5.9% during 1984-94 (Population and Housing Census were conducted in 1984 and 1994) and it declined by 0.6% annually in 1994-99 (the National Labor Force survey was conducted in 1999). Demeke et al. assert that the employment expansion in the 1980s was at the cost of productivity whereas output growth in the 1990s was achieved through higher productivity. The following table shows employment share by major economic sector. Two points may be noted from the table; first, the agricultural sector is still the leading sector in terms of employment share and secondly, the 1999 Labor Force Survey suggests that

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the structure of sectoral employment share has changed significantly. According to the survey, employment share in agriculture declined from 89.3% in 1994 to 79.6% in 1999 while employment in wholesale, retail trade and catering increased from 4.2% to 9.6%. Moreover, employment share in manufacturing increased from 1.8% to 4.4%. On the other hand, the authors also note that according to the Annual Survey of Large and Medium Scale Manufacturing industries, employment share of the various sub-sectors of the manufacturing sector remained almost the same for seventeen years, 1983/84-1999/00.

Employment Share by Major Economic Sector

Sector 1984 1994 1999 Agriculture, hunting, forestry & fishing

88.6% 89.3% 79.6%

Mining and quarrying 0.1% 0.1% 0.1% Manufacturing 1.6% 1.8% 4.4% Construction 0.3% 0.3% 0.9% Electricity, gas & water supply 0.1% 0.1% 0.1% Wholesale, retail trade & catering

3.8% 4.2% 9.6%

Transport, storage & communication

0.4% 0.6% 0.5%

Financial Intermediation 0.1% 0.1% 0.4% Other services 5.1% 3.6% 4.4% Total 100% 100% 100%

Using the method of arc elasticities, Demeke et al. estimate sectoral employment elasticities of output. The results are shown below. For the period 1994-99, the estimated elasticities suggest that manufacturing; construction; electricity, gas & water supply and financial intermediation were the most employment intensive sectors of the economy and that investment in these sectors would create higher employment opportunities since, for example, a one percent increase in output led to about 3.9 percent increase in employment. The employment expansion exhibited in this period, however, was not accompanied by a rise in labor productivity as the estimated arc elasticities for most of the sectors are above unity. The sectors in which employment expanded along with a rise in productivity are mining and quarrying and other services.

15

Arc Elasticity of Employment by Major Economic Sectors

Sector 1984-94 1994-99 1984-99 Agriculture, hunting, forestry & fishing 2.02 -1.21 1.06 Mining & quarrying 0.54 0.07 0.35 Manufacturing 5.06 3.86 4.28 Construction -2.66 4.45 -54.56 Electricity, gas & water supply 1.60 3.83 1.91 Wholesale, retail trade & catering 16.18 2.53 4.07 Transportation, storage & communication 1.86 -0.44 0.92 Financial intermediation 1.64 5.30 3.30 Other services 0.41 0.37 0.40 Total 1.91 -0.23 0.94

Demeke et al. also estimated employment elasticities of output econometrically for fifteen sub-sectors of the manufacturing sector, and all the estimated elasticities were below 0.5 and some were even negative. The exception was the furniture manufacturing sub-sector, which stood at about unity. The estimated elasticities show that the manufacturing sector of the economy is not as labor intensive as the arc employment elasticity suggests and that employment expansion in most of the activities was accompanied by productivity growth. The average economy-wide real labor productivity growth during the post-reform period was found to be about 2.3% per annum (shown in the table below). This was accompanied by a fall in employment expansion by about 0.6% per annum, implying technological shift in the economy. The average real labor productivity of agriculture fell by about 0.4% during the post-reform period. At the same time, agricultural employment declined by about 2.9%, indicating a slowdown in agricultural activities. In terms of average real labor productivity, public administration and defense sector followed by mining and quarrying registered the highest labor productivity. Most of the economic sectors experienced a healthy expansion; and the source of output growth in the post-reform period has been mainly productivity growth rather than employment expansion.

16

Post-reform labor productivity growth by major economic sector

Sector/sub-

sector 1992/

93 1993/

94 1994/

95 1995/

96 1996/

97 1997/

98 1998/

99 1999/

00 Aver-age

Agriculture & allied activities

3.7 -5.8 1.1 12.2 1.2 -13.1 1.5 0.0 -0.4

Mining and quarrying

43.3 -22.9 6.5 10.6 10.5 7.6 7.0 7.1 5.3

Electricity & water

3.5 2.8 3.2 -9.4 3.5 1.4 -0.9 1.7 -0.2

Construction 24.1 7.0 5.1 5.0 6.3 6.2 -0.7 -6.6 3.7 Trade, hotel &

restaurant 33.8 4.2 6.3 6.2 6.0 2.2 4.0 1.6 4.5

Transport & communication

4.7 3.4 1.1 7.1 4.4 4.8 -2.7 10.3 3.8

Banking, insurance

6.7 7.9 6.0 6.2 6.1 2.8 1.9 7.0 5.0

Public admin. & defense

27.3 8.3 7.0 2.5 4.3 21.9 13.2 12.0 9.1

Education & health

-0.3 5.2 2.4 1.8 2.0 4.4 5.8 3.3 3.3

Domestic & other services

3.8 3.6 3.0 3.2 2.7 1.3 1.7 1.5 2.4

Avg. labor productivity

8.3 -1.0 2.8 8.4 2.8 -3.6 3.2 3.2 2.3

In “The urban labour market during structural adjustment: Ethiopia 1990-1997”, Pramila Kirshnan, Tesfaye Gebre Selassie, and Stefan Dercon examine the response of the labor market to structural adjustment. They found that the public sector has contracted over this period. There is evidence of a large reallocation of labor out of the public sector between 1990 and 1994, and an increase in unemployment. Between 1994 and 1997, unemployment declined slightly with limited increase in private sector and self-employment.

Pointing at the seriousness of the unemployment problem, Geda notes that, in the 1990s, the economically active population grew at an average rate of 5.2% and based on the 1984 and 1994 censuses, the unemployment rate increased from 0.4% to 0.7% in rural areas while the increase in urban areas was from 7.9% to 22%. The ratio of registered job seekers to the vacancies announced rose from 3.9 in 1989/90 to 24.7 in 1996/97. Kirshnan et al. show that manufacturing and food processing firms register a slight fall in employment over the period 1990-97, while employment in construction and in local government has increased. The public sector, which absorbs 40% of the labor force, remains the single most important sector of employment in urban Ethiopia; and there has been little structural change despite the talk of reform. Since formal sector wage employment is the most important source of income in urban Ethiopia, the

17

evolution of real wages matters both for labor market functioning and living standards. Unlike in other adjusting countries, there is little sign of large expansion of informal sector activity for men. In fact, fewer men are involved in this sector, while there has been an increase in the participation of women, mainly in household based food processing.

Real wages in the pubic sector declined between 1990 and 1994, mainly as a result of an inflationary shock in 1991/92. On average, monthly and hourly wages increased in the period 1994-1997. The increase in hourly wages is 9% for men and 12% for women. Hourly wages increased in both sectors and for both sexes, but the change in hours worked - a reduction in the private sector for both men and women and a slight increase in hours in the public sector - resulted in far larger monthly wage increases for public sector workers than for those in the private sector. The upward revision of public sector pay-scales in 1995 means that men and women in the public sector obtained 17 percent higher wages than in 1994. Men in the private sector had virtually unchanged total monthly earnings, while women gained in real terms by about 6%.

Average earnings in the public sector remain systematically higher than in the

private sector, and the gap appears to have grown; monthly earnings for men in the public sector were 8% higher in 1994, but it increased to 26% in 1997. For women, the gap is even larger. Growth in the formal sector economy in this period translated into higher earnings for some, but not into higher employment levels. Self-employment earnings appear to have fallen considerably.

With respect to education, public sector workers are generally better educated. A relatively high proportion of those with secondary and university education are employed in the public sector. The unemployed are also relatively highly educated with about half of them having completed secondary education. Those without primary education are mainly self-employed – very few in this group have secondary education. Self employment does not seem to attract the educated. Those out of the labor force have low levels of education.

While in each sector and for both males and females, there are increasing wages for higher educational levels on average, the high variance in wages for each level of education implies that only at the higher levels of education (tertiary or secondary), are the wages significantly higher. Wages for those with primary education are not significantly higher than wages for those with less than primary education, except for men in public sector and for women in the private sector. These findings suggest low or zero returns to education at lower levels of education and high returns at higher levels. Also, the wage dispersion between levels of education is far larger in the private sector than in the public sector. Krishnan et al. conclude by saying that the labor market in Ethiopia has remained rigid and unresponsive to either the pressures of reform or the growing queues of the educated unemployed.

18

3. Main Obstacles to Ethiopia’s Growth Performance

In “Growth and Poverty in Ethiopia in the 1990s” Stefan Dercon points out that in recent years, there has not been any important policy initiative towards the rural sector, beyond the input supply, extension and credit policy packages (PADETES). As a result, growth in agriculture has been limited.

Dercon identifies two key challenges for economic policies to result in growth

and poverty reduction. The first is related to urban unemployment of skilled labor and limited entrepreneurial activity. Urban Ethiopia is characterized by remarkably small informal economy based on self-employment and a remarkably high unemployment rate especially among skilled young people. Wage income constitutes the highest share in urban incomes, particularly in large towns, and despite the much improved business environment, he notes, not many are willing to consider self-employment.

The second key challenge facing Ethiopia, according to Dercon, is how to

stimulate income growth in rural areas via agriculture. He argues that in recent years, the only major policy initiative taken towards the rural sector is the input supply, extension and credit policy packages. As he put it, “rural policies seem to be reduced to policies to increase farm output via chemical fertilisers.” (p. 14) Despite the acclaimed success in terms of yield increase due to the extension program, much of the growth in cereal production in the 1990s is a result of expansion of total area under cultivation. In non-cereal producing areas yield increase was only marginal. Furthermore, although fertilizer use increased drastically between 1993 and 1995, it has remained constant since 1995. The reasons are; first, the fertilizer market structure is neither competitive nor transparent. Currently, very little competition takes place, with extensive vertical integration of fertilizer distribution and virtual local monopolies. Firms with close regional government connections control most of the fertilizer market. Secondly, the organization of fertilizer credit is such that virtually all loan administration is controlled by the local government agencies. Input supply and credit are usually dealt with in the same transaction and local governments allow only their preferred suppliers to conduct sales on credit. Land tenure insecurity is another major obstacle to Ethiopia’s growth performance. In “Tenure Security and Land-Related Investment: Evidence from Ethiopia,” Deininger et al. used a large data set that differentiates tenure security and transferability to explore determinants of different types of land-related investment and its possible impact on productivity. They found, transfer rights are unambiguously investment-enhancing. A household with fully secure and transferable land rights is 59.8% more likely to invest in terracing than one who expects a redistribution in the village within the next 5 years. Through its impact on investment in terraces alone, abolition of further redistribution is estimated to increase annual output by about 1.5% overall. Adding transferability of land rights would increase output by an additional 4.4%. Taken together, and capitalized into future land values at a standard rate of discount, the

19

security-induced increase in terrace investment alone could thus increase land values by about 50%, apart from improvements associated with higher levels of transferability.

Deininger et al. point out, all of this suggests that, in the case of Ethiopia,

improving security of land ownership and transferability of land can have a significant impact on overall output and household welfare. This is of particular interest in view of the fact that the high levels of underemployment in the sample villages would allow additional investment be undertaken at very low additional cost to the economy. They conclude, in Ethiopia, government action to increase tenure security and transferability of land rights can significantly enhance rural investment and productivity. Bill Easterly lists a number of institutional and social factors that inhibit economic growth in Ethiopia. Among the factors are less than full democracy, restriction on civil liberties, centralized authority, recurrences of civil and international wars, involvement of political parties in “private companies”, and disparity in business ownership between ethnic groups. The social crisis in Ethiopia in the form of high illiteracy rate, alarmingly high percentage of children suffering from malnutrition, adverse sanitary conditions, a severe HIV/AIDS crisis, grossly inadequate infrastructure, and widespread prevalence of poverty are also factors that retard growth. In “Exports and Economic Growth in Ethiopia,” Debel Gemechu notes that while the measures taken under the trade policy reform have helped improve the export incentive system (export volume and earnings have increased substantially), there is still an anti-export bias that should be eliminated in order to fully achieve a neutral incentive system that would be conducive for effective export promotion. The table below shows the improvement in the effective exchange rate for exports (as the rate has increased by 208%) and for the anti-export bias incentive system, which declined by 27% as compared to the last six years of the previous regime. However, the anti-export incentive structure has not been eliminated entirely, which suggests the need for additional measures in order to achieve a neutral incentive system.

Effective Exchange Rate (Birr/Dollar) and Anti-Export Bias (EERm/EERx)

Item 1985/86-1991/92 Average

1992/93-1998/99 Average

Percentage Change (%)

Effective exchange rate for exports (EERx)

1.89 5.82 208% increase

Effective exchange rate for imports (EERm)

3.74 8.39 124% increase

Bias against exports (EERm/ EERx)

1.98 1.44 27% decrease

In “Conflict, Post-Conflict and Economic Performance in Ethiopia,” Geda and Degefe assert that the two fundamental determinants of economic performance in

20

Ethiopia are drought and conflict. They point out that although GDP growth during the two years of conflict with Eritrea (1998/999 and 1999/2000) was respectable, the major source of growth was the services sector, mainly a result of inflated government expenditure to finance the war. As shown in the table below, for the two years, 52% and 78% of the overall growth rate was due to growth in services.

Sectoral Contribution to GDP Growth

1998/99 1999/2000 Agriculture 1.7 0.8 Industry 1.3 0.5 Services 3.3 4.2 Distributive 1.1 1.4 Others 2.2 2.8 GDP Growth 6.3 5.4

Geda and Degefe, note that although no sector is immune from the effect of conflict, the relatively less affected sector is agriculture by virtue of its being operated by a large number of small holders. Industry, and more particularly manufacturing, is affected most by conflict since the sector relies heavily on imported inputs, which are in short supply due to government’s increased demand for foreign exchange. The overall development cost of conflict/war can be enormous. In addition to the direct cost, which involves lives lost, people injured and/or displaced, and destroyed infrastructure, there are other major costs including reduction of spending on social and economic development during the conflict and the huge amount of resources required for rehabilitation. The following table summarizes the findings of the papers discussed in this section.

21

Main Obstacles to Ethiopia’s Growth Performance

Sector/Area Author Finding Agriculture Dercon No significant policy initiative beyond the input

supply, extension, and credit policy packages Land tenure insecurity

Deininger et al.

A household with fully secure and transfer land rights is 59.8% more likely to invest in terracing than one who expects a redistribution in the village in the next 5 years.

Limited entrepreneurial activity

Dercon Remarkably small informal economy based on self-employment, despite the much improved business environment

Underdeveloped democratic system and social crisis

Easterly Restrictions on civil liberties, recurrences of civil and international wars, involvement of political parties in “private companies”, and so on. Other factors include high illiteracy rate, high levels of malnutrition, HIV/AIDS, inadequate infrastructure, etc.

Anti-export bias Gemechu Though it is declining, there is still an anti-export bias that should be eliminated.

4. Policy and Strategy Recommendations According to a publication by the Economic Commission for Africa entitled, Economic Report on Africa 2002 Ethiopia has good medium-term prospects- prospects that will be realized if the country remains politically stable, the weather continues to be favorable, and if the government fully exploits opportunities from initiatives such as the HIPC and Africa Growth Opportunity Act (AGOA). A World Bank document entitled, “Developing Exports to Promote Growth” asserts that despite recent reforms, Ethiopia’s participation in the global economy is minimal. Per capita real exports were less than $15 in 1999 – just marginally above the value in the early 1980s – and well below that for sub Saharan Africa ($163) and low and middle-income countries ($379). Ethiopia’s exports remain dominated by coffee (which represents about 60-70 percent of merchandise exports) and a few other agricultural goods. Manufacturing exports have remained as insignificant as they were in the 1980s, less than 10 percent of merchandize exports. Product concentration increased in the 1990s, and there has been little market diversification. Though halved over the past 10 years, average tariff rates at 19.5 percent, are higher than in most developing countries. The trade to GDP ratio rose from 22 percent of GDP in the late 1980s to 46 percent of GDP in the late 1990s but is still lower than the 61 percent average for SSA. Much of this increase was due to a rise in imports, which was made possible by increased reliance

22

on official and private flows. Finally, Ethiopia has failed to attract any significant foreign direct investment flows, despite reforming its investment code twice during the 1990s. The Bank’s document argues that it is likely that market deregulation and other reforms were not deep enough to reduce supply constraints and stimulate a sustained growth in the private sector, including attracting foreign direct investment, or to stimulate foreign trade. For example, foreign investors and exporters alike complain of lack of competition, administrative weaknesses and cumbersome regulations and procedures. Trade finance is weak. Transport costs are some of the highest among developing countries. Furthermore, exporters report that customs continue to inspect 100 percent of all containers and sometimes insist on holding up export consignments for 24 hours for security reasons. Acceleration in the pace of reforms is necessary to increase export growth. Market import demand for Ethiopian products is anticipated to grow at roughly the same pace as in the 1993-2000 period, 6.6 percent a year. Oil prices are forecast to decline. Coffee prices have fallen sharply in recent years and prospects for a significant rebound are poor, though they are expected to recover in the near future. Accelerating agricultural export growth will require reforming marketing arrangements, assisting farmers to replant trees and increase yield, and implementing effective extension services to promote better production techniques, and lower transportation costs. New market opportunities could give a significant boost to the garment sector and opening up the air travel sector could significantly increase prospects for tourism and for horticultural exports. In the ‘high’ case scenario, merchandize exports could grow up to 13 percent a year (in volume terms) during 2001/02-2010/11. However, on current policies, Ethiopia will not see acceleration in exports. The recent decline in coffee prices is likely to significantly affect coffee volumes and unless strong reform measures are taken, growth in coffee volume will remain low, despite price recovery. Other sectors, including manufacturing, could also stagnate. If the current business environment is not improved, Ethiopia will miss completely the opportunities arising from global trends in trade and FDI. Improvements in the coffee sector need to be made all along the production, marketing, transport and processing chain if exports are to increase measurably. For example, the development of niche markets for coffee with special characteristics (e.g. organic) should be encouraged. Coffee buyers should be allowed to inspect and test coffee before the auction and facilities to allow testing should be developed. The Government has recently signaled its intention to move from the current auction system to a Commodity Exchange System. This represents an excellent opportunity to address the entire strategy of the sector, including marketing problems, and to review the role of Government in the coffee export market. Chat faces strong demand prospects. Export prices should be liberalized in order to obtain the maximum export revenue and taxes possible. There is potential to greatly expand production and exports of sesame seeds since the quality of production is good,

23

land is available, labor costs – which are important to the manual harvest of sesame – are low and world import demand is growing. Export prospects for pulses are also good because of the excellent quality of Ethiopian pulses. For both sesame seeds and pulses, better marketing and promotion efforts should be undertaken. Exports of hides and skins (and therefore of leather) face severe constraints because of a parasitic disease which has dramatically reduced the quality of hides and skins and the government’s policy which favors domestic processing by banning exports of raw hides and skins. Control of the disease is possible and cost effective, if farmers participate. The Government should review the overall functioning of the sector – from hides and skins to the tanneries and the leather industry, with a view to replace the export ban on raw hides and skins with an export duty to be progressively reduced to zero. The African Growth and Opportunity Act (AGOA) represents a unique opportunity to increase garment exports. AGOA allows exports of garments into the U.S., quota and duty free. Another important opportunity is represented by the Everything But Arms (EBA) initiative, under which all exports (except arms) will be able to enter the EU free of all duties and quotas. Ethiopia is well placed to benefit from the AGOA and EBA. First, its labor market is flexible; labor laws do not represent a constraint to the exit of firms and wages for unskilled workers are among the lowest in the world. Second, prices of inputs such as electricity and water are low by international standards. Finally, the recent involvement of foreign investors through non-equity collaborations is revitalizing the textile and garment sectors. The report recommends a number of immediate measures that are necessary for Ethiopia to take full advantage of the market access opportunities embodied in AGOA and EBA, as well as in promising sectors such as cut roses and tourism:

• The new Proclamation to Establish Export Trade Duty Incentives Schemes must be implemented effectively and efficiently.

• The new Export Credit Guarantee System should be implemented efficiently. The report recommends a number of changes to improve the functioning of the scheme including measures to allow exporters to access the credit facilities of foreign suppliers and to improve the system of foreign exchange retention.

• To lower the tax burden, the report recommends that the two percent service charge that commercial banks levy on Fanco-Valuta imports be reduced. In addition, the implementation of the recent withholding tax on income should be carefully monitored to make sure that the refunds due to exporters are paid quickly.

• The custom clearance system should be improved by clarifying rules and streamlining procedures.

• A number of measures to improve shipping and air transport should be given priority.

• The Investment Code needs to be brought in line with the export strategy. Measures that could be taken into consideration include: a) lifting the current minimum investment thresholds for foreign and joint venture investments for 100 percent export-oriented FDI and joint ventures; b) eliminating the reserved areas

24

for certain types of investment associated with exports; c) allowing the entry of private banks providing trade and investment finance primarily for export-oriented activities; and d) streamlining bureaucratic procedures with regards to investment permits and its renewal as well as technology agreements.

In order to improve the business environment and facilitate global integration, the

report recommends: • Improve competition in the transport sector to reduce costs by privatizing

parastatal enterprises, opening the transport market to foreign operators and completing deregulation;

• Level the playing field in terms of access to credit, information, and contracts by implementing competition laws and anti-trust legislation; and

• Increase regional cooperation/promote intra-regional trade.

According to Bill Easterly, in order for Ethiopia to grow at a higher rate, a second generation of reforms that address some of the initial conditions – such as the poor quality of institutions, the high illiteracy rate, the low level of openness to trade, and the low degree of structural transformation of the economy (measured by urbanization) – is necessary. A significant “big push” that would simultaneously improve institutions, accelerate human capital investment, open trade further, and a good business climate for diversifying the economy would accelerate growth. He also points out that the substantial rural-urban gap in literacy and other social indicators must be addressed effectively.

Dercon contends that continuing efforts to create a better investment climate to encourage more private investment is necessary. He also argues that the current land tenure policy is unsustainable because farmers’ insecurity and thus do not have incentive to invest in entrepreneurial activities in agriculture. To address the labor absorption problem, Dercon recommends that the economy needs to become human-capital friendly, i.e., increase the demand for human capital in the economy. He points out that both government and donors are pushing for higher educational attainment to increase growth in general as well as the poverty impact of growth. The situation in Ethiopia is such that a large number of educated people are unemployed. More effort is needed to raise the actual returns to education. Based on their analysis Geda et. al., conclude that growth in Ethiopia, to a large extent, depends on structural factors such as the initial condition (initial income, investment, level of education), vagaries of nature, external shocks, such as terms of trade deterioration and peace and stability both in Ethiopia and in the region. Among the policy areas that need immediate attention are the dependence on rain-fed agriculture, a short to medium term strategy to cope with periodic terms of trade shocks, harnessing the labor resource and the productivity of land, a policy of sustainable peace and stability, and a detailed analysis and policy aimed at changing the structure of the economy to high productivity sector.

25

In a separate paper, Geda underscores the need for an appropriate labor market policy with a focus on the informal sector, which employs 51% of economically active population. Policy reforms have had little effect on urban unemployment. The following table summarizes the recommendations of the various authors discussed here.

Objective Author Policy/Strategy Recommended

Increase export growth The World Bank Accelerate the pace of reforms in a number of areas including export promotion schemes, the investment code, transport, etc; improve the production, marketing and transport of coffee; liberalize the export prices of chat; undertake better marketing and promotion efforts for sesame seeds and pulses; review the overall functioning of the hides and skins sector.

Accelerate overall growth rate

Easterly A second generation of reforms that address some of the initial conditions – such as poor quality of institutions, high illiteracy rate, low level of openness to trade, and the low degree of structural transformation of the economy is necessary; a significant “big push” that would simultaneously improve institutions, accelerate human capital investment, open trade further, and promote good business climate is essential.

Promote private investment; expand employment opportunities

Dercon Continue efforts to create a better investment climate; Increase the demand for human capital in the economy

Accelerate overall growth rate

Geda et al. Address agriculture’s high dependence on rainfall, a short to medium term strategy to cope with periodic terms of trade shocks, improve the productivity of land, a policy of sustainable peace and stability, and a detailed analysis and policy aimed at changing the structure of the economy to high productivity sector.

Improve land tenure security

Deininger et al. Policy dialogue to identify and implement measures to increase producers’ tenure security

26

Annex 1

Sources of Growth Accounting

Table 1.1

Easterly – TFP as the Main Determinant of Growth

(macro-based production function)

Regime Period Capital Deepening

contribution

TFP growth Growth of output per

person Monarchy 1951-1973 0.25% 1.26% 1.51%

Derg 1974-1991 0.20% -1.22% -1.02% Reformist 1992-2001 -0.52% 2.58% 2.06%

Total 1951-2001 0.08% 0.59% 0.68%

Table 1.2

Geda et al. – Capital as the Main Determinant of Growth

(based on parameters derived from cross-country analysis)

Contribution of Period Physical capital per worker

Education per worker

Residual Growth in Real GDP per worker

1960-64 2.63 0.01 -0.28 2.36 1965-69 2.16 0.02 -0.47 1.71 1970-74 0.86 0.04 1.04 1.94 1975-79 -0.04 0.07 0.09 0.13 1980-84 1.81 0.12 -1.93 0.00 1985-89 1.69 0.14 -1.35 0.47 1990-97 0.81 0.08 0.69 1.81 1960-97 1.42 0.07 -0.29 1.20

27

Table 1.3

Geda et al. – Labor as the Main Determinant of Growth

(macro-based production function; dependent variable is change in logarithm of output, 1962-98)

Column 1

Compact ECM Column 2

Scattered ECM Regressors Coefficient t-value coefficient t-value Constant -0.005 -0.27 1.87 2.80* ∆Ln (capital) 0.30 3.44* 0.29 3.50* ∆Ln (labor) 0.73 1.23 0.91 1.67** ECM(t-1) -0.89 -2.48* Ln (capital)t-1 0.01 0.30 Ln (labor)t-1 0.29 2.58* Ln (output)t-1 -0.31 -2.87* R2 = 0.38

F = 4.8 D.W. = 1.65

R2 = 0.41 F = 4.2

D.W. = 1.69 * significant at 1% **significant at 10%

Table 1.4

Geda et al. – Land (used as proxy for capital) as the Main Determinant of Growth (micro-based production function)

Column 1 Column 2 Column 3 Coeffi-

cient t- value

slope Coeffi-cient

t- value

slope Coeffi-cient

t-value

slope

Constant 4.29 49.5 4.19 50.3 4.05 44.6 Ln (labor) 0.21 9.0 0.21 0.15 6.54 0.15 0.15 6.61 0.15 Ln (land) 1.51 17.0 1.49 1.38 16.16 1.37 1.11 11.54 1.10 Ln (oxen) 0.36 5.44 0.35 0.33 5.25 0.33 0.28 4.52 0.28 Credit 0.14 2.0 0.14 0.11 1.5* 0.11 Fertilizer use 0.63 10.9 0.63 0.58 10.1 0.57 Land quality 0.04 50 0.04 0.014 0.70* 0.01 Redistribution -0.08 1.65 -0.08 Climate 0.01 5.8 0.01 Note: all inputs used are statistically significant at 1% level.

28

Annex 2

Determinants of Long Run Growth

Table 2.1

Easterly – Development Level Accounting for Ethiopia and Korea (1999)

constant Institutions Illiteracy

Rate Trade share in GDP

Urbanization ratio

Predicted log per capita income

Actual log per capita income

Coefficients 7.34 0.65 -0.02 0.002 0.015 Ethiopia -0.12 62.6 43.12 17.16 6.48 5.95 Korea 0.48 2.4 77.36 81.16 9.01 9.26 Log income difference

0.39 1.08 0.07 0.987 2.53 3.30

Table 2.2

Geda et al., - Growth Decomposition for Ethiopia

Estimated contribution of period Actual growth (per-

capita)

Predicted

growth

Res-idual

Actual deviatio

n of growth from

sample mean

Initial income

Investment rate

Initial educa-

tion attainm

ent

Replacement

investment term

Time dummie

Res-dual

1960-64

1.13 1.54 -0.41 -0.80 1.40 0.99 0.99 0.99 0.60 -5.77

1965-69

1.02 1.45 -0.43 -0.91 0.32 -0.03 -0.01 0.97 0.63 -2.79

1970-74

1.03 1.37 -0.33 -0.90 0.32 -0.09 0.00 0.97 -0.06 -2.02

1975-79

1.05 1.40 -0.35 -0.88 0.31 -0.07 0.00 0.96 0.26 -2.35

1980-84

0.93 1.47 -0.54 -1.00 0.31 -0.01 0.00 0.96 -1.44 -0.82

1985-89

1.08 1.41 -0.33 -0.85 0.32 -0.03 0.00 0.93 0.10 -2.17

1990-97

1.10 1.60 -0.50 -0.83 0.30 0.06 0.00 0.99 0.60 -2.78

Total 1.05 1.46 -0.41 -0.88 0.47 0.12 0.14 0.97 0.10 -2.67

29

Annex 3

Effects of Policy Reform on Growth

Table 3.1

Easterly – Results form Reform in the 1990’s

Policy variable Average

1982-91 Average

1992-2001

Latest value

Growth effect of change from

1982-91 to 1992-2001

Coefficient on policy

t-statistic

Log inflation 0.068 0.041 0.038 0.03% -0.00998 -1.37 Overall budget deficit (% GDP)

-7.00 -6.23 -4.80 0.06% 0.00083 1.97

M2 to GDP 30.24 40.63 37.48 0.30% 0.00029 2.22 Real overvaluation index

98.82 52.48 35.35 0.35% -0.00007 -2.08

Log black market premium

0.890 0.311 0.011 0.69% -0.01188 -3.09

Log telephones per worker

0.762 0.931 1.109 0.11% 0.00665 2.93

Total growth change explained by policy effects

1.42%

GDP per capita growth

-0.76% 2.06% 2.82%

30

Table 3.2

Geda et al. – Ethiopia’s Growth Performance (relative to a sample of 85 developing countires)

Fits and Residuals Actual and predicted growth

deviation Breakdown of policy contr. By var.

period

Actual growth per capita

Fitted growth

Res-idual

Actual growth deviation from sample mean

Base var-iables

Political instab-ility

policy Inflat-ion (>500%)

Para-llel Mkt. Prem-ium

Govt. spend/ GDP

1960-64

1.23 5.08 -3.86 -0.97 2.42 0.13 -0.19 0.04 0.05 -0.28

1965-69

1.23 4.42 -2.37 -0.97 2.18 0.20 -0.19 0.05 0.02 -0.26

1970-74

0.50 3.60 -1.45 -1.70 1.42 -0.32 -0.30 0.05 0.03 -0.38

1975-79

-0.14 1.95 -1.33 -2.34 1.55 -1.04 -0.98 0.00 -0.43 -0.55

1980-84

1.59 1.19 0.15 -0.61 0.55 -0.13 -0.73 0.04 -0.36 -0.41

1985-89

-0.28 1.44 -1.54 -2.48 1.59 -0.19 -1.70 0.05 -1.02 -0.73

1990-97

1.86 1.26 -0.45 -0.34 0.44 0.03 -1.17 0.03 -0.92 -0.29

Total 0.79 2.31 -1.16 -1.40 1.29 -0.24 -0.85 0.04 -0.45 -0.44 Note: base variables include initial income/endowment life expectancy, age dependency ratio, terms of trade shocks, trading partner growth rate, and landlockedness. Political stability index is constructed from the average number of assassination, revolutions and strikes. Policy indicator contains high inflation rate, public spending and parallel market premium.

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