Riding the J-Curve: How Ethiopia Can Leverage Devaluation for Economic Recovery

Introduction:

Devaluation refers to a deliberate reduction in the value of a country's currency in relation to other currencies. It is often implemented by a country's central bank or government as a policy tool to address economic challenges and achieve certain objectives. The primary purpose of devaluation is to make a country's exports relatively cheaper and imports relatively more expensive, thereby boosting export competitiveness, reducing trade deficits, and promoting domestic industries. Currency devaluation plays a crucial role in managing economic challenges and promoting competitiveness. This article focuses on the case of Ethiopia, exploring the impact of devaluation in the country's current context and discussing potential strategies to address short-term challenges and unlock long-term benefits.

There are two main ways devaluation happens:

a) Official devaluation: This is when the government directly changes the exchange rate of its currency. For example, imagine 1 euro used to be equal to 2 of your country's currency. After an official devaluation, it might take 3 of your currency to buy 1 euro.

b) Competitive devaluation: This happens when several countries try to devalue their currencies at the same time, in a kind of race to the bottom. Each country hopes that by making its exports cheaper, it will gain an advantage in international trade.

The Current Context in Ethiopia:

?In the current context of Ethiopia, the country faces numerous challenges including Lack of sufficient exportable commodities, lack of export diversification, low competitiveness in the global markets, high domestic inflation, heavy reliance on imports of critical items, limited domestic production, domestic economic challenges, high international debt, and foreign currency shortages. These factors complicate the impact of devaluation and necessitate careful consideration of the strategies to be adopted.

Currency devaluation can have both short-term challenges and long-term benefits for an economy. In the short term, devaluation can lead to inflationary pressures, increased costs of external debt, capital flight, financial instability, imported inflation, debt burdens for borrowers, uncertainty, market volatility, and social impact. However, these challenges can be mitigated through proactive monetary policy, inflation management, fiscal discipline, effective debt management, foreign exchange market interventions, and social safety nets.

The J-Curve Theory

In an economy, a J-curve indicates currency devaluation and its impact on the nation’s trade balance; it falls initially and then gradually rises—resembling a J-shape. The sharp fall is caused by a trade deficit. The J-curve is a graphical representation of a phenomenon where an initial decline is followed by a dramatic rise, resembling the shape of the letter "J."

The most common use of the J-curve is in economics, where it depicts the potential impact of currency devaluation on a country's trade balance. Here's how it works:

• Initial dip: After devaluation, the trade deficit often worsens initially. This is because: Import prices rise: With a weaker currency, imports become more expensive, leading to an increase in import costs. Export volumes take time to adjust: It takes time for businesses to adapt production and marketing strategies to take advantage of the cheaper currency and boost exports.
• Gradual rise: Over time, if the devaluation strategy is successful: Export volumes increase: As exports become cheaper for foreign buyers, their demand rises, leading to increased production and employment in export-oriented sectors. Import demand falls: Consumers may substitute more expensive imports with cheaper domestic alternatives.
• Eventual surplus: The combined effect of rising exports and falling import demand can eventually lead to a trade surplus, where the country exports more than it imports.

Structural Reforms for Long-term Competitiveness:

Despite the short-term challenges, currency devaluation can bring long-term benefits. It can enhance export competitiveness, attract tourism and foreign investment, stimulate domestic industry development, facilitate current account adjustment, promote economic diversification, and generate employment opportunities. These long-term benefits contribute to sustainable economic growth, resilience, and development.

Undertaking structural reforms is crucial to enhance Ethiopia's long-term competitiveness. This includes improving the business environment, promoting innovation and technological advancements, investing in education and skills development, strengthening institutions and governance, enhancing trade facilitation, and fostering a supportive ecosystem for entrepreneurship and small and medium-sized enterprises (SMEs).

Successful Examples of Managing Devaluation

?Examining case studies from other countries provides valuable insights. Several countries have successfully managed the impact of devaluation.For instance, South Korea's experience during the Asian financial crisis in the late 1990s and Argentina's economic crisis in the early 2000s offer lessons on the challenges faced, measures implemented, and outcomes achieved. These case studies emphasize the importance of comprehensive policy frameworks that address inflation, debt management, competitiveness, and social impact.

Conclusion:

The primary purpose of devaluation is to enhance export competitiveness, attract foreign investment, promote domestic industry development, and address trade imbalances. It can be impactful when implemented strategically and accompanied by supportive policies. However, in the scenario where there is a lack of exportable commodities coupled with domestic instability, high dependency on imported commodities, high inflation rates, low domestic production of consumable goods, poor infrastructure to attract foreign direct investment (FDI), and high debt stress, devaluation alone may not be sufficient to address the challenges comprehensively. In that case a comprehensive approach is needed, including diversification of the economy, promoting domestic production, improving infrastructure, attracting foreign direct investment, addressing political instability, managing debt effectively, and implementing sound monetary and fiscal policies. These efforts should be part of a broader strategy aimed at achieving sustainable economic growth and stability. Ethiopia faces significant challenges in the current context, but strategic management of currency devaluation can help unlock its potential for economic transformation. By implementing short-term measures to address immediate challenges, actively promoting and diversifying export sectors, undertaking structural reforms for long-term competitiveness, and drawing lessons from successful case studies, Ethiopia can navigate the path to stability, growth, and prosperity.