Ethiopia Needs Long-Term National Development Plan (Part Twenty-Five, Funding Sources and Impacts)

Tsegaye Tegenu, PhD
2024-08-11

Funding long-term national development plans refers to the process of securing and managing financial resources to support strategic initiatives aimed at fostering the six goals of “Creating a Post-Scarcity Economy, Thriving Middle Class, and Self-Reliant Society” (see Part Sixteen). There are diverse sources that can be discussed in terms of the roles and responsibilities of different actors in funding long-term national development plans: government, international and private sector sources.

Government Sources

The government is usually the primary source of funding for national development plans. It finances infrastructure projects, social programs, and public services through its budget, which is funded by tax revenues, domestic borrowing, and sometimes through the issuance of government bonds.

Tax Revenues:These are the most significant source of government funding, collected from various forms of taxation (income tax, corporate tax, VAT, etc.). There are also non-tax revenues (Fees, fines, royalties, revenues from state-owned enterprises) and natural resource revenues (from the extraction and sale of natural resources like oil, gas, and minerals). Developing countries often face challenges in tax collection due to a large informal economy, but improving tax administration is a critical component of national development.

Domestic Borrowing:Governments may borrow from domestic markets by issuing bonds to domestic investors and/or taking loans from domestic banks and financial institutions to finance large projects. This can be sustainable if the debt is managed prudently.

Public Investment:Governments often invest directly in critical sectors like education, healthcare, infrastructure, and agriculture to stimulate economic growth and development.

Grants and Aid:Governments may also allocate funds received as grants or aid from other countries or international organizations toward development projects.

Sovereign Wealth Funds (investment funds): Utilizing surplus revenues saved in sovereign wealth funds for long-term projects. Countries like Norway use revenues from oil to fund national projects through sovereign wealth funds

International Source

International organizations provide crucial financial support to developing countries, particularly for large-scale projects that require significant investment, technical expertise, and policy advice. These organizations can offer both grants and loans, often with favorable terms.

Foreign Borrowing: this includes loans from international financial institutions (loans from the World Bank, IMF, regional development banks, etc.). The World Bank provides long-term loans and grants for infrastructure, education, healthcare, and other development projects. The IMF offers short-term financial support and policy guidance, especially during economic crises. Organizations like the African Development Bank (AfDB) provides regional funding and expertise for development projects.

Foreign borrowing includes also bilateral loans (loans from other countries through bilateral agreements) and international bonds (Issuing bonds in international financial markets).

Countries may also receive funding directly from other nations through bilateral agreements (Official Development Assistance), often focused on specific development goals such as infrastructure development, healthcare improvement, or education enhancement. Various UN agencies, such as UNDP (United Nations Development Programme) and UNICEF, fund and implement projects focused on sustainable development, poverty reduction, education, and health.

International sources include also Remittances (diaspora contributions): Financial contributions from citizens working abroad, structured through programs or diaspora bonds. There is also Innovative financing mechanisms, such as climate finance (funds from climate change programs like the Green Climate Fund).

Private Sector Sources

The private sector is increasingly recognized as a vital source of funding for national development, especially through investments, public-private partnerships (PPPs), and corporate social responsibility (CSR) initiatives. The private sector can bring in not just capital but also innovation, efficiency, and expertise. The key contributions include

Foreign Direct Investment (FDI):Multinational corporations and foreign investors can invest in sectors like manufacturing, mining, technology, and energy. FDI brings in not only capital but also technology transfer and job creation.

Public-Private Partnerships (PPPs):PPPs allow governments to collaborate with private companies to finance, build, and operate different projects such as infrastructure projects. This can reduce the financial burden on the government and improve project efficiency and innovation.

Domestic Private Investment:Local businesses and entrepreneurs contribute to economic growth and development by investing in various sectors, creating jobs, and generating tax revenue. Encouraging the growth of small and medium-sized enterprises (SMEs) is particularly important in developing economies.

Corporate Social Responsibility (CSR):Companies often invest in community development projects, education, healthcare, and environmental sustainability as part of their CSR efforts. While not as large-scale as government or international funding, CSR can make a significant impact at the local level.

In summary, the government, international organizations, and the private sectoreach play critical roles in funding long-term national development plans in developing countries. The government provides the foundational funding and policy direction, international organizations offer financial support and expertise, and the private sector contributes through investment and innovation. It is very important to know the roles and responsibilities of different actors in funding long-term national development plans.

Challenges of Balancing and Coordination of Diverse Sources of Funding

As you can see, there are diverse approaches to mobilize resources effectively. A successful national development plan typically relies on a balanced and coordinated approach that leverages these diverse sources of funding. Each funding source has unique strengths and limitations. A balanced approach ensures that the strengths of one source can compensate for the limitations of another. For example, government funding can provide stability, while private sector funding can drive efficiency and innovation.

In Ethiopia there are fundamental challenges in balancing and coordinating the different sources of funding long-term national development plan. Government revenues are historically limited due to a narrow tax base related to the nature of the economy and age structure of the population. In economies where a large proportion of economic activity occurs in the subsistence and informal sectors, much of the economic activity is not captured in official records. Subsistence farmers, small-scale traders, and informal workers typically operate outside of the formal economy, making it difficult for the government to tax these activities.

The age structure of the population is dominated by children and young adults. In such society all the goods produced and value added generated are used for immediate consumption straining the capacity to save. The high dependency burden in the society has affected the domestic saving rate which in turn affect the level of investment in the country. For detail on saving and investment ratio, see Socio-economic and Environmental Effects of Age Transition in Ethiopia: 1950-2000. High unemployment and underemployment in the country mean that fewer people are earning taxable incomes. Even those who are employed may earn low wages, contributing little to income tax revenues.

The second source of funding of long-term plan, namely, the private sector in the country is underdeveloped, with small-scale enterprises dominating and a lack of large-scale industrial or financial activity. The capacity of the private sector to contribute to national development funding is limited, reducing the potential for private investment in large-scale projects.

Study on the private sector’s contribution to the national economy (share of GDP, share of aggregate employment and share in gross capital formation) shows the low level of private sector development in Ethiopia. The private sector’s share of GDP on the average is estimated at 17% for the last 25 years. In developed countries, the market based private sector generates on the average 80% of aggregate gross value added in the national economy. For details see 3-D System Approach to Private Sector Development in Ethiopia.

Since the country’s tax base is low and its private sector is underdeveloped, the balance and coordination among different sources of funding for a national development plan are significantly disrupted. Because the government lacked sufficient resources, it often prioritized short-term needs over long-term investments, leading to a misalignment of development priorities. Coordination between different sources of funding becomes also more difficult when the government is financially constrained and the private sector is weak.

Above all, the imbalance has several adverse effects: it has increased dependence on international sources of funding (such as the World Bank, IMF, or bilateral aid) and accumulation of unsustainable levels of debt. This has led to a debt trap, where a significant portion of government revenues is used to service debt rather than continue to fund development projects.

History of public debt led investment in Ethiopia

When Ethiopia was ruled by the Derg, a Marxist-Leninist military junta that came to power in 1974 after overthrowing Emperor Haile Selassie, the government implemented socialist economic policies, including land nationalization and the establishment of state-controlled enterprises.

The 1980s were marked by severe droughts and famines, most notably the 1983-1985 famine, which devastated the country and led to significant loss of life. o The Ethiopian Civil War, particularly the conflict with the Eritrean People’s Liberation Front (EPLF) and the Tigray People’s Liberation Front (TPLF), drained the country’s resources. The government’s focus on military spending left limited funds for development projects.

The 1980s were a period of economic decline and debt accumulation for Ethiopia, driven by the Derg regime’s focus on military spending, socialist economic policies, and responses to humanitarian crises. Excluding military related Russian debt (estimated at US$ 5 billion), the external debt of Ethiopia in 1987/88 was Birr 6,2 billion or 41% of GDP. By 1996/97 it has risen to Birr 27 billion or 65% of GDP (see Annual Report on the Ethiopian Economy, Vol. I. 1999/2000).

Since the early 1990s, the country has pursued a public sector-led investment model to drive economic growth and development. This approach, particularly under the government of Prime Minister Meles Zenawi (1995–2012) and his successors, emphasized large-scale public investment in infrastructure, industrial parks, and social services as key drivers of economic transformation.

The government initiated several industrial parks across the country, aiming to attract foreign direct investment (FDI) and promote manufacturing, particularly in textiles, leather, and agribusiness. Investments in education, health, and housing were also prioritized to improve human capital and living standards. Significant investments were made in road networks, railways (like the Addis Ababa-Djibouti Railway), and airport expansions to improve connectivity and support trade. Ethiopia invested heavily in hydroelectric power projects, such as the Grand Ethiopian Renaissance Dam (GERD) and the Gilgel Gibe dams. These projects aimed to provide a sustainable energy supply for domestic use and export.

Impacts of Public Debt led Investment Model

The Ethiopian government borrowed heavily from domestic sources, including the National Bank of Ethiopia, and international organizations to finance its projects. Overborrowing has the following impacts:

1. Rising Public Debt and Debt Service Burden:

Ethiopia’s public debt levels rose sharply, reaching over 50% of GDP. Public debt in Ethiopia averaged 51.6% of GDP in the decade to 2021, above the Sub-Saharan Africa region average of 42.2%. The high levels of debt raised concerns about debt sustainability, particularly given the country’s relatively low export earnings and trade imbalances.

As a result of high levels of borrowing, a significant portion of the government’s budget was allocated to debt servicing, which limited fiscal space for other crucial investments. This in turn has limited the government’s ability to engage in counter-cyclical spending, which is crucial for stabilizing the economy and funding development during downturns

2. Inflationary Pressures:

The increase in domestic borrowing contributed to inflation, which eroded the purchasing power of Ethiopians and led to higher costs of living. Overborrowing reduced the real value of Birr, affecting both public and private sector spending. High inflation has created economic uncertainty, deterring investment. It has also increased borrowing costs for both the government and private sector. Persistent inflation eroded consumer and business confidence, leading to reduced investment and economic instability. It also led to higher interest rates as central banks attempt to control inflation.

3. Currency Depreciation

Due to rising public debt, political instability, high inflation and loss of investor confidence there is an ongoing currency depreciation. The value of Birr has decreased relative to other currencies overtime. The depreciation of Birr made imports more expensive, contributing further to inflation. It has also increased the cost of servicing foreign-denominated debt, exacerbating public debt problems.

4. Trade Imbalance

A trade imbalance occurs when a country imports more goods and services than it exports, leading to a trade deficit. Ethiopia’s reliance on imported goods and lack of a strong currency making exports has caused the trade deficit. Persistent trade deficit depleted foreign exchange reserves and has increased foreign debt and put downward pressure on Birr, potentially causing further depreciation.

5. High Corruption

Overborrowing not only contributed to macroeconomic imbalances, such as trade deficits and currency depreciation, but also misallocation of resources. Funds intended for development projects were siphoned off through corrupt practices, reducing the effectiveness and reach of development programs. Corruption has inflated the costs of projects and lowered the quality of public services and infrastructure.

Mismanagement of public funds included poor budgeting, lack of transparency, embezzlement, and ineffective use of funds allocated for public services or development projects. Mismanagement has resulted in lost opportunities for economic growth and public welfare.

What is in the name of economic reforms

The impacts of public debt led investment model are interconnected and have contributed to a cycle of economic challenges. Ethiopia has recently secured an agreement with the International Monetary Fund (IMF) for a new financing program valued around $3.4 billion. As a result, the national currency dropped 30 per cent against the dollar and inflation has jumped into higher level. There is now a debate on how to drag out Ethiopia from debt to development. While there is often consensus on the need for economic reforms, differences arise in how various stakeholders conceptualize and approach the issues.

As we have discussed above there is a relationship between the various factors of rising public debt, inflationary pressures, currency depreciation, and trade imbalance. For instance, overborrowing increases the money supply, leading to higher inflation. This is because more money chases the same amount of goods and services, driving up prices.

High inflation often leads to currency depreciation because the value of the currency falls as its purchasing power decreases. Foreign investors might lose confidence in the currency, leading to capital outflows and further depreciation. A depreciated currency makes imports more expensive, and worsen a trade deficit because the country relies heavily on imported goods.

In short, there is a feedback loop. These factors are interrelated and can exacerbate each other in a cyclical manner, creating a difficult economic environment that is hard to break out of.

Breaking this cycle requires addressing the underlying causes, such as improving fiscal management, enhancing governance and accountability, promoting economic diversification, promoting private sector development, boosting exports, enhancing economic competitiveness, among others. In other words, the country needs long-term national development plan more than ever to break the negative feedback loop of macroeconomic imbalances.