Ethiopia Economic Update THE INESCAPABLE MANUFACTURING- SERVICES NEXUS: Exploring the potential of distribution services i Acknowledgements The report was prepared by a team consisting of Mesfin Girma Bezawagaw (Senior Economist), Nora Dihel (Senior Economist), Michael Geiger (Senior Economist) and Zerihun Getachew Kelbore (Research Analyst)) with input from Claire Honore Hollweg (Economist), Esteban Rojas, Gonzalo Varela (Senior Economist), Michael Jelenic (Consultant), Koen Maaskant (Consultant), Jamie MacLeod (Consultant). Jean-Pierre Chauffour reviewed the report. Tsebaot Bekele Habte (Team Assistant) provided assistance with formatting. Mathew Verghis (Practice Manager, Macroeconomics and Fiscal Management) and Carolyn Turk (Country Director for Ethiopia, Sudan and South Sudan) provided overall guidance. The team wishes to thank peer reviewers Bill Battaile (Lead Economist), Paul Brenton (Lead Economist) and Poonam Gupta (Lead Economist) for their constructive input. Additional comments were received from Tom Bundervoet (Senior Economist) and Richard Spencer (Program Leader). Comments from the Ministry of Finance and Economic Cooperation are gratefully acknowledged. The team would also like to express gratitude to Cybil Maradza (Consultant) for the design and layout. The World Bank team welcomes feedback on the Ethiopia Economic Update. Please send comments to Nora Dihel (ndihel@worldbank.org) and Zerihun Getachew Kelbore (zgetachewkelbore@worldbank.org). ii Table of Contents Acknowledgements .................................................................................................. i List of Figures ............................................................................................................ ii List of Boxes ............................................................................................................. iii List of Tables ............................................................................................................... iii Executive Summary ................................................................................................... iv 1 Recent Economic Developments and Outlook ............................................................ 1 1.1 Economic Developments in FY2017 ............................................................................. 2 1.2 Economic Prospects in FY2018 and Beyond ............................................................... 18 2 Services and Manufacturing Linkages: Exploring the Potential of Distribution Services ...... 24 2.1 Introduction ............................................................................................................. 25 2.2 Setting the Stage: Services in Ethiopia’s Economy ....................................................... 26 2.3 Potential of Distribution Services ................................................................................ 38 2.4 Recommendations for the Future of Distribution Services ............................................... 76 Annex A: Problem-Driven Political Economy Analysis .................................................. 82 References .................................................................................................................. 86 List of Figures Figure 1.1 Economic Activity ........................................................................................ 3 Figure 1.2 Monetary Sector ............................................................................................ 6 Figure 1.3 Fiscal Sector .................................................................................................. 9 Figure 1.4 External Sector ............................................................................................ 14 Figure 1.5 Financial Sector Indicators ........................................................................... 17 Figure 1.6 Economic Outlook: Selected Projections to 2019 .......................................... 21 Figure Sectoral Contributions to Ethiopia’s Economy ................................................ 2.1 27 Figure Employment by Sector and Labor Productivity ............................................... 2.2 28 Figure Services Value Added and Employment Shares in Ethiopia ............................ 2.3 28 Figure Shares of Services in Total Exports, 2005 and 2015 ...................................... 2.4 29 Figure Ethiopia’s Services Exports and Imports, 2013–15 2.5 27 .................................... 30 Figure Traditional and Modern Services Exports and Imports versus GDP per Capita, 2.6 2013–15 ...................................................................................................... 30 Figure 2.7 Services’ Export Share (Gross Value, Direct Value Added, and Total Value Added Considering Forward Linkages) versus Level of Development, 2011 .............. 33 Figure 2.8 Composition of Services Value Added (Forward Linkages), 2011 ................... 34 Figure 2.9 Composition of Manufacturing Value Added (Backward Linkages), 2011 ....... 34 iii Figure 2.10 Composition of Domestic Services Inputs in Manufacturing Production, by Country, 2011 .......................................................................................... 35 Figure 2.11 Composition of Domestic Services Inputs in Manufacturing Exports, by Country, 2011 .......................................................................................... 36 Figure 2.12 Composition of Services Value Added in Manufacturing, by Sector in Ethiopia, 2011 ............................................................................ 36 Figure 2.13 Composition of Services Value Added in Manufacturing Exports, by Sector in Ethiopia, 2011 ............................................................................. 37 Figure 2.14 Inputs into and from Productive Sectors in Ethiopia, Based on the World Bank Export of Value Added Database for 2011 ........................................................ 38 Figure 2.15 Figure 2. 15 Inputs into and from Productive Sectors in Ethiopia, Recalculated Based on the Input-Output Table for Ethiopia for 2011 ................................. 38 Figure 2.16 Role of Distribution in Value Chains ............................................................. 49 Figure 2.17 Dairy Value Chain ......................................................................................... 56 Figure 2.18 Supply Chain of Teff in Ethiopia ................................................................... 63 Figure 2.19 Teff Price Structure, by Quality, October to November 2012 ........................... 66 Figure 2.20 Supply Chain of Sesame in Ethiopia ............................................................. 68 Figure 2.21 Yield of Sesame in Major Sesame-Growing Countries, 2007–13 ................... 70 Figure 2.22 Supply Chain of Textiles in Ethiopia .............................................................. 73 List of Boxes Box 1.1 The Promise of Devaluation and Relaxation of Foreign Exchange Controls .... 12 Box 1.2 Take-Off in Electricity Exports ...................................................................... 19 Box 1.3 Ethiopia and the East Asian Model: Similarities and Differences ..................... 22 Box 2.1 Measuring Services Linkages ........................................................................ 32 Box 2.2 Players in Ethiopia’s Retail Grocery Business ................................................. 39 Box 2.3 ALLE Struggles for Relevance ....................................................................... 40 Box 2.4 The Bottom of the Pyramid Penalty ............................................................... 42 Box 2.5 Typical Explicit Trade Barriers and Regulatory Obstacles Affecting .................. 43 Box 2.6 Benefits of Contractual Arrangements .......................................................... 53 Box 2.7 Dairy and the Fasting and Rainy Seasons in Ethiopia .................................... 59 Box 2.8 Ethiopian Sesame Competitiveness through the Eyes of an Exporter ............... 71 Box 2.9 Strategies for Reforming Distribution Services ............................................... 79 Box A.1 Distribution Services Political Economy Conceptual Framework ...................... 83 List of Tables Table 1.1 Summary: Ethiopia Compared with Selected Indicators in East Asia ............... 23 iv Executive Summary v ¹ World Bank estimated growth at 8.4 percent, while the IMF estimated growth at 9 percent in 2016/17. ² In the WTO Services Sectoral Classification List 1. Ethiopia’s gross domestic product (GDP) (MTN.GNS/W/120), largely based on the United growth is estimated to have rebounded to Nations Provisional Central Product Classification, the distribution sector is defined to include four 10.9 percent in FY2017¹. According to official major services: commission agents’ services, statistics, Ethiopia’s annual rate of economic wholesale trade services, retailing services, and growth, which averaged 10.3 percent over franchising. Commission agents are distinguished 2005/06–2015/16 (compared with the regional from the other categories in that they trade on behalf of others, that is, they sell products that are average of 5.4 percent), slowed to 8 percent in supplied and usually owned by others to retailers, FY2016 due to drought-related lower agricultural wholesalers, or other individuals. Wholesale production. With agricultural recovery, gross trade services consist in selling merchandise to domestic product (GDP) growth rebounded in retailers; industrial, commercial, institutional, or other professional business users; or other FY2017. The pursuit of prudent fiscal policy – with wholesalers. Retailers sell goods for personal or a fiscal deficit at 3.4 percent of GDP - should help household consumption. Franchisers sell specific keep inflation under control, providing monetary rights and privileges, for instance, the right to use conditions remain tight in the aftermath of the a particular retail format or trademark, defined as retail sales of motor vehicles and fuel (ISIC rev 3.1 devaluation of the Birr in October 2017. Key G50), retail trade in all other goods, and repair of challenges relate to poor export performance personal and household goods (ISIC rev 3.1 G52) (Ethiopia’s growth has been driven by investment through specialized and nonspecialized outlets followed by private consumption) and weak of all dimensions (traditional stores, department stores, supermarkets, and hypermarkets). Hotels trade balance, which reflect the lack of external and restaurants are excluded. competitiveness and the vulnerability to terms- 3 Traditional definitions of structural transformation of-trade shocks. The rising risk of external debt emphasize the reallocation of production factors distress may affect Ethiopia’s access to external or resources between sectors. The traditional view considers structural change to be fundamentally finance. These developments require continued dependent on modifications in the relative policy adjustment to crowd-in the private sector importance of different sectors over time, as and strengthen Ethiopia’s competitiveness. measured by their share of output or employment. More recent literature on structural transformation stresses the positive role of productivity growth 2. How sustainable is Ethiopia’s growth within sectors through the reallocation of factors of model? To answer this question, part 1 of production between firms within sectors. Structural this Economic Update, on recent economic transformation defined as movements of factors developments and outlook, discusses Ethiopia’s of production between firms and reallocation of resources from lower to higher productivity activities growth strategy, emphasizing the sustainability of within the same sector, means that improvements the country’s investment-focused and export-led and shifts in production within each sector are growth model. Part 2 looks at the interlinkages an important element of development, and that between manufacturing and services, with a transitioning from an agricultural to manufacturing is not the only avenue as traditional development special focus on the role of distribution services² views suggest. It means instead increasingly in promoting Ethiopia’s export competitiveness embracing higher value-added production or and eventually its structural transformation.³ more productive activities in the same sector or type of commodity or transitioning from the informal production to formal activities with the assistance of more technology, services, and know-how as well as better linkages to input and output markets. vi Part 1: Recent Economic Developments & Outcome vii Economic Developments in FY2017 3. Real GDP growth is estimated to have allegedly consumer protection measures. Annual picked up to 10.9 percent in FY2017 (July inflation as measured by the Consumer Price index 2016 to June 2017), mainly due to a recovery (CPI) increased by 13.4 percent in January 2018 in agricultural production after last year’s (as compared to January 2017). The monthly CPI drought. The crop harvest is estimated to have decreased by 0.4 percent between December increased by 7.9 percent during the FY2017 2017 and January 2018. agricultural season (compared with a 2.4 percent increase during FY2016) and to have generated 5. The federal government’s fiscal policy positive spillover effects on the industrial and embarked on a moderately expansionary services sectors, which continue to account for stance in FY2017. The increase in fiscal most of the growth from the supply side. On the revenue, mainly from nontax sources, is unlikely to demand side, growth has remained driven by compensate for the increase in total expenditure. government consumption and investment. The 15 The federal government’s fiscal deficit is estimated percent devaluation of the Birr in October 2017 to have increased to 2.9 percent of GDP in is expected to sustain exports in the medium term FY2017. and improve the external balance, providing the exchange rate correction pass-through on inflation 6. Ethiopia’s export sector remains is contained and structural bottlenecks to trade particularly small. Total goods and services are addressed. exports do not exceed 10 percent of GDP , significantly below the 24 percent expected 4. Inflation in FY2017 remained in single from a country the size of Ethiopia at its level digits, although end of year inflation of development. The improvement in the trade increased by 1.3 percentage points as balance was driven by a slowdown in imports compared to FY2016. The relaxation of rather than an acceleration in exports. This export monetary policy, measured by the growth of underperformance is mainly due to structural and reserve money prior to the devaluation of the competitiveness issues, including an overvalued Birr in October 2017, has triggered inflationary exchange rate. pressures that have been repressed under Providing macroeconomic policies remain appropriately tight and efforts are made to strengthen external competitiveness, the economy is expected to move toward a more sustainable path. viii 7. Given increased vulnerabilities due The deterioration in debt indicators was mainly to export weaknesses and faster-than due to poor export performance, but there was a anticipated disbursements of non- significant improvement in debt policy over the year. concessional loans, Ethiopia’s external In July 2017, Bank Sr. Management approved the debt situation will become difficult in the decision of the NCBP committee to discontinue the medium term. Ethiopia’s risk of debt distress remedies applied to Ethiopia’s IDA17 allocations, was downgraded from “moderate” to “high” in the while retaining a $400 million ceiling on such 2017 DSA following the significant and protracted borrowing in FY18. Performance under the NCBP breach of two external debt burden thresholds. ceiling will be reviewed in April 2018. Economic Prospects for FY2018 and beyond 8. The economic prospects for FY2018 the country’s export capacity. On the downside, and the medium term should remain the economy will remain vulnerable to the risk stable, although less spectacular than of an overvalued exchange rate and limited during 2005/06–2015/16. Annual real GDP progress with structural adjust ments. The main growth is projected to hover around 8 percent in challenges to the economy are related to the FY2018 and the medium term. The government’s weak performance of the tradable sector, which macroeconomic policies are expected to remain reflect the lack of external competitiveness and the sound, with moderate fiscal deficits and prudent country’s vulnerability to terms-of-trade shocks. monetary policy. Although the rate of inflation A larger and stronger private sector would seem should remain in the single digits, the inflation to be the main response to strengthen Ethiopia’s differential with competitors may widen and need trade competitiveness and resilience to shocks. to be corrected appropriately to preserve Ethiopia’s The authorities are counting on the expansion external competitiveness. On the upside, foreign of the private sector, especially through foreign direct investment inflows supported by incentives investments in the industrial parks, to make and ongoing development of industrial parks are Ethiopia’s strong growth momentum more expected to boost the manufacturing sector and sustainable. ix Part 2: Manufacturing -Services Nexus: Exploring the Potential of Distribution Services x 9. The focus section of this edition of This is in contrast with most examined countries the Economic Update deals with the including most restrictive countries such as India interconnection between services and and Indonesia, which despite harsh foreign equity manufacturing performance. The report aims to restrictions4 permit some foreign participation in invigorate and deepen the discussion about the role the sector. of services in Ethiopia’s exports, as directly tradable activities and intermediate inputs to manufacturing 11. With a contribution of around 14 exports. At the government’s request, the focus is percent to GDP5 in 2015/16, distribution placed on the analysis of one category of services— services are an important driver of growth distribution services—and in particular the role of in Ethiopia. Distribution services also represent a these services in the dairy, teff, sesame, and textiles crucial link between suppliers and producers. With value chains. The broader context for this analysis is improved efficiency and higher productivity due the debate on growth and structural transformation to the emergence of larger supermarket chains and ways to advance the government’s export and a possible internationalization of distribution development agenda. in Ethiopia, the sector has great potential to benefit producers and consumers and contribute 10. As in other countries, services matter to increased food security and alleviation of for Ethiopia’s economic growth and rural poverty. Modern distribution channels and development. The performance of the services procurement systems that reduce transaction costs sector is an important indicator of the performance and facilitate market exchanges can increase the of the economy as a whole and the export sector access of small farmers to high-value markets and in particular. Yet, many modern services remain accelerate their transition from subsistence farming underdeveloped in Ethiopia. Services that are to market participation. For consumers, organized considered strategic by nature are allowed to markets can provide substantial benefits, including operate only as strict public monopolies (for better quality products at affordable prices. So example, the telecom, utility, and air and sea far, however, modern distribution channels have transport sectors) or through limited domestic failed to capture a large portion of the retail private ownership (for example, the financial sector). market in Ethiopia. Across the country, informality Other services sectors, such as professional services still prevails; small-scale farmers have found or health services, are not valued to the extent of themselves marginalized by the distribution sector their potential contributions to competitiveness and and its new practices; and very poor households value addition. They have not been considered a often pay more per unit for basic products than strategic priority and have seen limited reform. wealthier households. Traditional services, such as distribution services, tend to operate in a heavily regulated environment 12. Despite the growth of distribution that prevents competition and innovation, including services over the past decade, several by prohibiting the presence of foreign services factors jeopardize its potential to contribute suppliers and investment. According to the World more directly or indirectly to Ethiopia’s Bank Services Trade Restrictiveness Database, export performance. Yet, many factors tend Ethiopia is completely (100 percent) closed in retail. to impede the positive contribution of distribution 4 India imposes a FDI cap of 51 percent on multi brand retail trading while 100 percent FDI is allowed for single brand product retail trading. Indonesia requires 100 percent local capital for small scale retailers. 5 This share compares favorably with neighbors in East Africa, where distribution services accounted for between 8 and 18 percent of GDP over the past decade. xi services, including, among others, a high degree critical in the performance of each value of informality across the sector, poor access to chain, they are only one part of the story. finance, explicit trade barriers that fragment Eliminating the obstacles to distribution services markets and supply chains, nontariff barriers could help link rural producers to markets for related to standards and rules of origin, domestic inputs, facilitate the sale of raw milk, or reduce regulatory measures governing market access post-harvest and storage losses. But other binding and producer conduct, talent shortages, poor constraints, such as limited access to finance or lack infrastructure, and limited market data. of skills, would need to be addressed in parallel for distribution services reforms to benefit consumers 13. The case studies on the role of and facilitate value chains climbing into higher distribution services in the dairy, teff, value-added activities (such as cheese or sesame sesame, and textiles value chains show oil) and increase exports. that although distribution services are 14. The case studies draw conclusions on the critical role of services in manufacturing value-addition of broader relevance and implications. First, the services sectors suffer from being treated in isolation and not as part of an interconnected chain of value addition, from production to final consumption. Yet, the case studies presented in this report show that since supply chains are a series of linked international markets for goods and services, with policies in one market having spillover effects in other markets along the whole value chain, services should be considered at par with manufacturing, to achieve the desired export performance. Policy formulation needs to deal with the goods and services markets together, as there are significant links between the two sectors. Moreover, such links call for modal neutrality—trade and regulatory policies that enable services firms to provide services through all modes of supply without impeding a switch from one mode of supply to another. Second, that many services are now tradable and can be a source of export-led growth and export diversification has not sufficiently captured the attention of Ethiopian policy makers. This may reflect that the development of modern services is a relatively recent phenomenon, and also the assumption that the comparative advantage of a low-income country like Ethiopia lies in agriculture and labor-intensive manufacturing. Although Ethiopia’s services exports are currently dominated by traditional services such as transport or tourism, exports of modern services, such as communication or business services, are beginning to emerge and their role in export diversification and export earnings should not be neglected. Third, there is a genuine concern among policy makers that the state of regulation and the regulatory capacity of the administration are too weak to allow for the further liberalization of services. And finally, there is a worry that opening services sectors that operate under a monopoly would lead to declines in government revenue and potentially more outflow of foreign exchange in the form profit repatriation. xii 15. Although a wholesale services policy moving toward integrating their services markets. reform in Ethiopia’s current environment There may be long-term costs to Ethiopia if it is would be neither feasible nor desirable, left behind in services, but also manufacturing there are several steps that could usefully and processed agricultural products. Starting by be taken to increase economic efficiency reforming nonstrategic sectors, such as distribution and support the country’s development services, could be a good entry point into the world objectives. Countries throughout the region are of services reforms. 16. The case of distribution services is illustrative of the opportunities for exports, benefits from greater services openness, and policy reforms and approaches that will be required for these to be realized. This sector can provide the basis for a broader discussion of services trade policy reforms. Although the following list is not exhaustive, it provides some initial guidance for reform in this important sector. Raising awareness about the importance of distribution services for the formal and informal sectors in Ethiopia is an important first step in designing a comprehensive reform strategy that is linked with national development plans. Taking steps to relax explicit trade barriers, eliminate regulatory obstacles, and address informality issues. With distribution services closed to foreign participation, Ethiopia remains behind all East African countries and other comparators in removing explicit trade barriers. Opening up the sector to foreign competition, would benefit consumers and provide incentives for the development of more competitive local suppliers, and would clearly raise welfare in the country if liberalization was accompanied by strategies for easing adjustment of local stores that might be undermined by the entry of modern retailers. Reforms should also focus on developing the necessary regulatory frameworks, including rules and regulations affecting the business environment, eliminating disproportionate entry requirements such as lengthy registration procedures, multiple licenses, or inadequate zoning regulations. Price controls represent a serious impediment to competition and quality and should be removed. Addressing the concerns of the poorest households and facilitating the inclusion of smallholders in modern distribution chains should be a priority in Ethiopia. Measures could include the creation of organized market outlets for small-scale operators to encourage their graduation from the informal sector, better access to financial services in the informal sector, and support to traditional and informal operators to acquire market-relevant skills. xiii Addressing skills issues in the distribution sector. A strong distribution sector will require local know-how and talent. Developing local training programs and putting in place apprenticeship opportunities will be critical to achieving long-term success. Addressing infrastructure constraints (such as roads, ports, and so forth). Steps must be taken to address the infrastructure and insecurity concerns raised by the business community. 17. Guidance on the implementation of local stakeholders and global operators, to reforms could be provided by an in-depth help identify the feasible measures with the political economy analysis that looks at the greatest benefits. Services matter greatly for Ethiopia’s industrial ambition 1 1 Recent Economic Developments & Outlook 2 1.1 Economic Developments in FY2017 With agricultural recovery, gross domestic product (GDP) growth is expected to have reached 10.9 percent in FY2017. Inflation should remain in single digits, providing that monetary policy remains tight in the aftermath of the recent devaluation. The fiscal deficit is projected to increase, but remain below 3 percent of GDP. Although the general government accounts are in balance, the federal government’s fiscal policy has embarked on a moderately expansionary stance. Following an improved trade balance, driven by imports rather than exports, the current account deficit declined to 8.2 percent of GDP in F20Y17. Ethiopia’s export sector is particularly small, mainly due to structural and competitiveness issues, including an overvalued exchange rate. The unchanged financial landscape of Ethiopia is characterized by lending dominated by state-owned enterprises (SOEs); undercapitalization of the Commercial Bank of Ethiopia, the largest SOE bank; low insurance penetration; limited development in the capital market; and an increased number of bank branches in urban areas. Given increased vulnerabilities due to export weaknesses and faster-than-anticipated disbursements of nonconcessional loans, Ethiopia’s external debt risk situation will become difficult in the medium term. Real Sector 1. Real GDP growth was estimated at 10.9 5.5 percent to 8.3 percent in the production of teff, percent in FY20176 (July/June), mainly due wheat, maize, and sorghum (figure 1.1, panel d). to a recovery in agricultural production The belg season harvest dropped by 4.5 percent; after last year’s drought (figure 1.1, panel however, belg season crop harvests constitute only a). Increases in crop production and agricultural 6 percent of total harvest. Crop harvests from recovery are expected to generate positive spillover commercial agriculture increased by 7.5 percent. effects on the industrial and services sectors, which The negative impact of the current drought, which continue to account for most of the growth from has been affecting about 8.5 million people in the the supply side. Growth has been driven by the southeastern part of the country, appears to be industrial sector with a 4.4 percent contribution to minimal on overall GDP growth. growth, followed by the services sector contributing 4 percent, and agriculture contributing 2.5 percent. 3. Several leading economic activity Construction contributed 3.5 percent to the overall indicators point to strong growth in the GDP growth. On the demand side, growth remains industry and services sectors in FY2017. driven by government consumption and private During FY2017, electricity generation increased investment (figure 1.1, panel b). by 19 percent (year over year), and electricity sales to industries grew by 21 percent, suggesting solid 2. The crop harvest was estimated to manufacturing industry activity (figure 1.1, panel increase by 7.9 percent during FY2017. e). On the services sector side, during the same The harvest during the main agricultural period, Ethiopian Airlines’ passenger traffic and season in FY2017 increased by 8.8 percent cargo services continued to grow, by 15.4 and (compared with a 1.3 percent drop during 27.2 percent, respectively, following an expansion the same season last year) (figure 1.1, panel c), of the network and improved capacity (figure 1.1, mainly due to productivity increases ranging from panel f). 6 World Bank estimated growth at 8.4 percent, while the IMF estimated growth at 9 percent in 2016/17. 3 Figure 1.1 Economic Activity A Real GDP growth: Supply side (%) B Real GDP growth: Demand side (%) 10.9 11.0 9.9 10.3 10.4 20 8.7 2.0 1.1 1.5 1.1 9.0 0.6 8.0 0.6 15 0.6 1.7 0.7 1.3 7.0 0.5 3.4 1.1 10 2.2 0.7 2.2 0.2 3.8 3.5 5.0 0.3 2.2 5 1.9 0.0 2.2 1.5 0.1 3.0 1.3 0.7 0.8 2.1 1.1 0 0.5 0.7 1.0 2.2 3.1 2.3 2.6 0.9 2.5 -5 0.9 -0.3 0.0 -1.0 -10 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17F 2011/12 2012/13 2013/14 2014/15 2015/16 Agriculture Manufacturing Private Cons Private Inv Public Cons Other industry Trade & hotel Construction Net export Public Inv GDP Transport & Communication Other services GDP C Crop production growth (%) D Main season crop productivity growth (%) Cereal Pulses Oilseeds Grains Teff Wheat Maize Sorghum 19 8 14 6 9 4 4 2 1 0 -6 -2 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2014/15 2015/16 2016/17 E Electricity production and sales growth (%) F Ethiopian Airlines activity growth (%) 50 50 35 40 40 25 30 30 20 15 20 10 5 0 10 -10 0 -5 -20 2 13 14 15 /16 /17 -10 /10 11 2 13 14 15 /16 016/ 17 11/1 2/ 3/ 4/ 5 16 9 10/ 11/1 2/ 13/ 4/ 5 20 201 201 201 2 01 20 00 20 20 1 20 20 20 1 20 1 2 2 Household Sales Industrial Sales Cargo Passengers Commercial & street light Production (RHA) Sources Panel a and b: National Planning Commission (NPC); panels c and d: Central Statistical Agency (CSA); panel e: Ethiopian Electric Power(EEP)/Ethiopian Electric Utility (EEU); panel f: Ethiopian Airlines. 4 Monetary Sector 4. Inflation in FY2017 remained in single international prices since mid-2014 and tighter digits, with annual average inflation monetary conditions over the past year. However, at 7.1 percent, but with an uptick over nonfood inflation gradually increased since May recent months. Inflation rose to 13.6 percent in 2017 and reached 8.6 percent in November 2017. November 2017, the highest since January 2016, mainly because of food inflation. Food prices, 6. The relaxation of monetary policy, which constitute about 53 percent of the average measured by the fast growth of reserve household consumption basket, are a major money, may have triggered inflationary driver of inflation. Food inflation has increased by pressures in the first quarter of FY18. The 18.1 percent, the highest since September 2012 National Bank of Ethiopia (NBE) targets reserve (figure 1.2, panel a). Following the post-drought money7 as the nominal anchor for monetary grain harvest of the main growing season, food policy; broad money8 is used as an intermediate prices were initially stabilized, but picked up instrument. Reserve money growth decreased since April 2017, driven by high demand for slightly to 22.7 percent in June 2017 after an cereals, fats and oils, and meat during the Easter increase of 30.2 percent in May 2017 (compared holiday celebration. In addition, the government with 16.3 and 19.9 percent growth, respectively, purchased large quantities of food items from the during the same months of last year). The growth domestic market to supply the drought-affected in reserve money was mainly driven by increases areas. The recent devaluation of the Birr could in NBE’s net foreign assets (128 percent) and net trigger further inflationary pressures in the coming credit to the government (27.2 percent) (figure 1.2, months. However, so far, the month on month food panel c). The lagged effect of expansive monetary inflation has shown a modest decline (0.4 percent policy has certainly contributed to the inflationary in November) after the devaluation. situation of nonfood items over the first quarter of FY18. The real deposit rate remained in negative 5. Food prices are a major driver of inflation, territory and the real lending rate tends toward but nonfood prices, which have declined zero, following the rising overall inflation trend. moderately in FY2017 have started to With strong demand for bank credit, the maximum increase starting August 2017. Commodities lending rate started to move upward, increasing with inflationary tendencies, such as meat, bread the spread from the minimum deposit rate since and cereals, fruits, dairy products, nonalcoholic last year’s third quarter (figure 1.2, panel d). In beverages, and other food items, have recorded October 2017, NBE increased interest rates on an inflation rate of 10 percent or higher since July deposits from 5 to 7 percent; however, real deposit 2017 (figure 1.2, panel b). By contrast, nonfood rates will remain negative. inflation recorded the lowest increases in more than a decade, reaching 4.6 percent in April. The 7. Driven by increases in domestic credit, relative slowdown in nonfood inflation in FY2017 broad money growth remains in line with is likely due to the lagged effects of declining reserve money growth. Broad money grew by 7 Reserve money is defined as the sum of currency issued by the NBE (including the vault cash of commercial banks and currency outside banking system) and balances of commercial banks on accounts with the NBE. 8 Central banks track the growth of “broad money” to help forecast inflation. The exact definition varies between countries, but broad money usually includes short-duration deposits and short-term securities other than shares. These are less liquid than currency or demand deposits (which make up “narrow money”) but can be encashed fairly quickly. 5 29 percent in June 2017(year-on-year), up from finance the budget deficit (see figure 1.3, panel 20 percent in June 2016, about 10 percentage b, in the next subsection). points faster than the growth of nominal GDP . Net domestic credit growth played a leading 8. The NBE appropriately tightened its role in broad money growth, while net claims monetary policy in the immediate aftermath on government growth remained the main source of the devaluation. The NBE raised the floor of credit increase (increasing by 79 percent in on time and savings deposits from 5 to 7 percent June 2017). Credit to the private sector increased and reduced the 2017/18 target growth of base by 48 percent in June 2017. Domestic credit money. The NBE`s operational target for monetary to SOEs moderated, increasing by 10 percent policy (growth of base money) was reduced from (year-over-year) following a constraining 22 percent to 16 percent to contain the pass- environment for external non-concessional through from the exchange rate into domestic loans for public infrastructure investment (figure prices. Furthermore, the NBE introduced a limit of 1.2, panel e). The share of public enterprises 16.5 percent on the FY18 outstanding credit growth in total outstanding domestic credit declined to of commercial banks. The credit cap is applied to 52 percent from 60 percent in FY2016, while firms in the non-export, non-manufacturing sectors. the share of private sector credit increased by Given the lagged effect of monetary policy, the 5 percentage points to 35 percent at the end NBE would need to be particularly vigilant as the of June 2017 (compared with June 2016). The relaxation of monetary policy in the first part of the share of the net central government credit stock year – that is before the October devaluation – may in total domestic credit picked up to 14 percent have created inflationary pressures that would need (figure 1.2, panel f) despite printing money to to be reduced in the coming months. 6 Figure 1.2 Monetary Sector A Inflation (y/y, %) B Major food items inflation (y/y, %) 20 40 80 30 60 15 40 20 20 10 10 0 5 0 -20 0 -10 -40 Jan-13 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 Jul-14 Oct-14 Jan-15 Apr-15 Jul-15 Oct-15 Jan-16 Apr-16 Jul-16 Oct-16 Jan-17 Apr-17 Jul-17 Oct-17 Jun-13 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-17 General Food Non-Food Bread & Cereals Meat Milk, cheese & eggs Fruit Vegetables Other foods (RHA) C Broad money, reserve money, D Interest rate premium and inflation (%, y/y) (max – min interest rate) (%) 43 11.0 38 10.5 33 28 10.0 23 9.5 13 8 9.0 3 8.5 -2 -7 8.0 -12 7.5 Sep-10 Dec-10 Mar-11 Sep-11 Dec-11 Mar-12 Sep-12 Dec-12 Mar-13 Sep-13 Dec-13 Mar-14 Sep-14 Dec-14 Mar-15 Sep-15 Dec-15 Mar-16 Sep-16 Dec-16 Mar-17 Jun-17 Sep-13 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Reserve money Inflation (y/y) Broad money (M2) Jun-17 2013/14 2014/15 2015/16 2016/17 E Broad money growth (M2, y/y, %) F Composition of domestic credit stock (%) 85.0 100 80 40 37 37 33 30 28 30 35 35.0 9 9 8 10 60 11 14 32 21 64 -15.0 40 62 60 58 20 42 52 52 29 -65.0 0 Sep-11 Mar-12 Jun-12 Sep-12 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 Dec-11 Dec-12 Mar-13 Jun-13 Sep-13 2016/17 Dec-13 Mar-14 Jun-14 Sep-14 Dec-14 Mar-15 Jun-15 Sep-15 Dec-15 Mar-16 Jun-16 Sep-16 Dec-16 Mar-17 Jun-17 2009/10 Net Foreign assets Net Domestic credit Other items (net) Broad money (M2) SOEs CG credit Private credit Sources Panels a and b: CSA; panels c and d: CSA and National Bank of Ethiopia; panels e and f: National Bank of Ethiopia. Note In panel f, monetary survey data are used, which exclude Development Bank of Ethiopia (DBE) in private credits. CG = Central Government; SOEs = state-owned enterprises; y/y = year over year. 7 Fiscal Sector 9. The general government9 fiscal policy taxes in percent of GDP dropped by 0.15 and 0.16 stance remained cautious in FY2017. The percentage point, respectively, compared with the general government fiscal deficit (excluding SOEs) same period last year. reached 3.4 percent in 2016/17, showing one percentage point increase compared to 2015/16. 11. Despite the salary increase initiated This may be due to an increase in additional spending in the previous year and the support to to finance drought affected areas. Although domestic drought-affected areas in FY2017 general revenue (tax and non-tax) increased by 11 percent, government spending remained stable. Total the increase was not sufficient to compensate for expenditures in percent of GDP in FY2017 stood at higher total expenditure, which increased by 17 18.4, unchanged as compared to FY2016. However, percent mainly driven by recurrent expenditure recurrent expenditure in percent of GDP rose to up by 29 percent compared to the 2015/16 level. 9.9 (showing a 1 percentage point increase from The growth in capital expenditure moderated to 6 FY2016) following the salary increases for public percent from 23 percent in FY2016, mainly due servants and drought-related spending. On the other to a decline in external assistance and slowdown hand, capital expenditure slowed down to 8.6 in in additional external loan in capital expenditure. percent of GDP , from 9.4 in FY2016. Keeping the External loans for capital expenditure increased balance between recurrent and capital budget is by 14 percent in FY2017, which is far below the important to meet the running cost of additional 47 percent growth registered in FY2016. On the capital expenditure of public sector projects, to fund financing side, the deficit was covered by domestic the operations of existing productive assets and to and external borrowing (2.5 and 1.6 percent of ensure effective service delivery in general. Evidence GDP , respectively), and through the repayment of seems to point to underfunding of recurrent costs, cash balances and residuals (totaling 1.0 percent of raising concerns of the sustainability of public sector GDP). A large portion of domestic financing relied services (Public Expenditure Review 2015). on borrowing from non-bank sources through the sale of T-bills. Direct advances issued by the NBE to 12. The federal government’s fiscal policy has the central treasury reached 1.5 percent of GDP in embarked on a moderately expansionary 2016/17 up from 1.1 percent of GDP in 2015/16 stance. During FY2017, the fiscal deficit increased (Figure 1.3.2). by 0.7 percentage point of GDP , mainly due to lower revenues in percent of GDP and increased 10. Revenue growth slowed in FY2017. Except recurrent spending (figure 1.3, panel e). Total for domestic indirect taxes, growth in all revenue federal government expenditures decreased by 0.2 components slowed down. Revenues and grants percentage point of GDP . Capital expenditure in increased by 10 percent in FY2017, mainly due to percent of GDP decreased by 0.4, while recurrent an increase in tax and nontax revenues from SOE spending and regional transfers also increased by 0.2 state dividends and domestic indirect taxes. However, and 0.3 percentage points respectively. The federal collection from foreign trade taxes declined by 0.4 government fiscal deficit that accumulated during percentage point of GDP , potentially due to the FY2017 (about 1.5 percent of GDP) was financed decline in imports of transport and industrial capital through external—mainly concessional—financing goods. Similarly, direct taxes and domestic indirect (1.6 percent of GDP) and domestic financing (2.3 9 The general government includes the fiscal operation of federal and regional governments excluding SOEs. 8 percent of GDP) with large repayments of cash taxes. Similarly, the spending budget falls from 14.9 balances and residuals (1.2 percent of GDP). to 14.1 percent of GDP , as a result of lower allocation to the capital budget and decreased allocation to 13. The government approved a Sustainable Development Goals support programs supplementary budget equivalent to 1.1 at the local level. It is important to note that the percent of GDP in mid-FY2017. Half of the federal government’s budget excludes regional supplementary budget was intended to finance the budgets from own sources and may therefore not salary increment for civil servants that would be give a full picture of the general government’s fiscal effective during the second half of the fiscal year. The activity. remaining part of the additional budget was intended to finance the youth revolving fund and drought relief, 15. SOEs play an important role in the and provide additional financing to the urban safety government’s public investment program net program. About 56 percent of this additional and need to be considered in the fiscal budget was planned to be financed by surpluses analysis. Although SOEs play a key role in from the Oil Stabilization Fund (determined by the infrastructure development, the financing of public domestic and international fuel price differential). projects by SOEs through domestic and external Revenue mobilization from privatization receipts and loans has meant a buildup of external debt and additional proceeds from SOEs were also assumed associated vulnerabilities. Among other indicators, to contribute to the supplementary budget. the public debt-to-GDP ratio increased from 36.3 percent in 2011/12 to 54.9 percent in 2016/17. 14. The federal government approved the This is somewhat in line with the trend observed for FY2018 budget with a deficit set at 3.5 percent many commodity-exporting countries in Africa in of GDP . This compares with a 3.3 percent deficit in recent years following the global commodity price FY2017. Spending and revenues are expected to depression. Most recently, the debt service-to-export decline as a share of nominal GDP , with a steeper ratio, which indicates liquidity issues in the debt decline in revenues compared with spending, leading profile, has increased rapidly, from 10.3 percent in to a widening of the deficit. Federal revenues are 2013/14 to 19.6 percent at the end of June 2017; expected to decline from 11.6 to 10.6 percent of it essentially doubled in two and a half years (figure GDP , due to lower tax revenues driven mainly by 1.3, panel f). drops in direct tax revenues and domestic indirect Ethiopia’s macroeconomic policy stance has generated persistent Birr overvaluation, large external imbalances, foreign exchange shortages, and a higher risk of debt distress 9 Figure 1.3 Fiscal Sector A General government fiscal deficit B Direct advance from NBE (% of GDP) (% of GDP) Revenue & grants Total Expenditure Fiscal balance incl. grants (RHA) Primary deficit (RHA) 20.0 1.6 18.0 16.0 -0.9 -1.2 -1.2 1.2 1.5 14.0 -1.6 12.0 -1.2 -2.0 -1.9 1.1 1.1 10.0 -2.2 0.8 1.0 -1.6 -1.6 8.0 -1.9 -2.9 0.8 6.0 -2.4 -2.4 -2.6 0.4 0.6 4.0 2.0 -3.4 0.3 - 0.0 2011/12 2012/13 2013/14 2014/15 2015/16 2010/11 2016/17 2009/10 2011/12 2012/13 2013/14 2014/15 2015/16 2009/10 2010/11 C General Government revenue (% of GDP) D General government spending (% of GDP) 15.2 14.2 15 13.4 13.8 14.3 13.8 14.4 20 18.8 18.2 16.6 17.8 17.5 17.8 18.4 18.3 2.0 1.2 1.6 2.7 2.6 12 2.0 2.3 16 8.5 4.4 4.3 4.1 4.1 3.7 9 4.6 4.5 12 10.4 10.3 9.8 10.5 10.1 9.0 9.4 6 3.7 3.8 4.0 3.7 3.5 8 3.0 3.1 3 4 9.8 8.4 7.9 6.9 7.2 7.4 8.7 8.9 3.8 3.9 4.2 4.4 4.6 4.7 4.5 0 0 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 Direct tax Domestic indirect tax Foreign trade tax Recurrent Capital Total Expenditure Non tax revenue Domestic Revenue E Federal government fiscal operations F Debt stock-to-GDP and debt (% of GDP) service ratio 2014/15 2015/16 2016/17 Public debt External debt 20 60.0 25.0 Ext. Debt service to export ratio (FHA) 50.0 15 15 15 20.0 14 12 40.0 11 11 15.0 10 30.0 10.0 20.0 5 10.0 5.0 -3.0-3.4 0 0.0 0.0 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 -5 Revenue & grant Expenditure Budget deficit Source Ministry of Finance and Economic Cooperation (MOFEC). Note GDP = gross domestic product; NBE = National Bank of Ethiopia. 10 External Sector 16. Following an improved trade balance, US$3.2 billion at the end of June 2017 (which driven by reduced imports rather than is 2.0 months of the following year’s imports) increasing exports, the current account (figure 1.4, panel b). The external sector continues deficit declined to 8.2 percent of GDP to be vulnerable to terms-of-trade shocks and in FY2017. The current account deficit gap weakened external competitiveness, which need (including official transfers) narrowed by 2.2 to be carefully managed. percentage points of GDP during FY2017, due to a large drop in private transfers by about 17. Private transfers, one of major sources 41 percent compared with the same period in of forex earnings, underperformed in the previous year. Following the improvement FY2017. Private transfers 10 declined by 8.6 in the goods and services trade balance, the percent, resulting in a loss of 1.4 percentage trade deficit narrowed by 3.6 percent of GDP points of GDP . The decline is related to the compared with FY2016, due to lower imports reduction in nongovernmental organization (rather than higher export earnings) (figure (NGO) relief transfers after the 2016 drought and 1.4, panel a). The current account deficit was lower transfers due to the public unrest during the financed largely by foreign direct investment first quarter of the fiscal year. Private individual (FDI) inflows, which increased by 38 percent; transfers dropped by 14.7 percent compared with external borrowing; as well as drawdown of the FY2016. Private transfers were a good financing foreign exchange reserve accumulations. Foreign source for the current account deficit in the past, exchange reserves declined by about 6 percent but their contribution during the first nine months against the same period last year and reached of the fiscal year was lower than expected. The trade deficit narrowed by 3.6% of GDP 10 Private transfers include private individual transfers, NGO transfers, and estimated unofficial remittances. 11 18. Goods exports underperformed in This export underperformance is mainly due to FY2017. Exports of goods modestly increased structural and competitiveness issues, such as by 1.4 percent during FY2017, driven by a rigid labor and product markets including an 7.2 percent increase in the export volume overvalued exchange rate. Challenges range from index that was espoused by a price index supply issues and quality of products, to marketing increase of 2.2 percent (figure 1.4, panel c). channels, branding, and so forth. The whole supply Among the major export products, the value of chain of the major export products, from production coffee exports increased by 22 percent, due to to final destination, needs to be examined. the price increase in arabica coffee, as well as a rise in the volume of exports. At the same time, 20. Moreover, the contribution of services pulse exports increased by 20.5 percent, due to must be investigated thoroughly. Ethiopia is better prices and volumes compared with last year. working on developing the manufacturing sector as Flowers, oilseeds, live animals, and leather declined a major source of export earnings. To realize this by 3, 26.4, 54.2, and 1.1 percent, respectively, vision, it is important to look at the link between due to declines in prices and volumes. Overall, the manufacturing and services sectors, to enhance since 2010/11, Ethiopian exports as a percentage and increase the leverage in both sectors. (Part 2 of GDP have been on a declining path (figure of the report provides more details on this topic.) 1.4, panel d). During FY2017, services exports increased by 4 percent, primarily due to the better 21. Ethiopia’s overvalued currency has performance of government services.11 Exports of manifested in persistent, large external transportation services declined by 2.0 percent. imbalances, foreign exchange shortages, and overall slow pace of structural 19. Ethiopia’s export sector is particularly transformation. To support exports and small. Total goods and services exports do encourage the private sector, on October 10, not exceed 10 percent of GDP , significantly 2017, NBE devalued the Birr by 15 percent and has below the 24 percent expected from relaxed foreign exchange controls (see box 1.1). countries at this level of development.12 At less than 10% of GDP, Ethiopia’s export sector is particularly small for a country at this level of development 11 Government services is a residual category covering all transactions by embassies, consulates, military units, and defense agencies with residents of economies in which the embassies, etc. are located and all transactions with other economies. Transactions in this category comprise those for goods and services (such as office supplies, furnishings, utilities, official vehicles and the operation and maintenance thereof, and official entertainment) and personal expenditures incurred by diplomats and consular staff and their dependents in the economies in which they are located. Also recorded in this category are transactions by other official entities (such as aid missions and government tourist, information, and promotion offices) located in economies abroad. 12 World Bank (2014b). 12 Box 1.1 The Promise of Devaluation and Relaxation of Foreign Exchange Controls To support exports and encourage the private growth by more than 2 percentage points. sector, on October 10, 2017, the National However, the devaluation would also raise Bank of Ethiopia (NBE) devalued the Birr by the cost of debt servicing and public foreign 15 percent. Furthermore, foreign exchange currency debt stock denominated in local controls have been relaxed with the issuance currency. Moreover, the devaluation could in October of two NBE directives on (i) external lead to inflation, as imports would become loans and suppliers’ credit, and (ii) retention more expensive, with possible adverse impacts and utilization of export earnings and inward on the poor. remittances. Under the first directive, any domestic investor can now access an external To limit the pass-through to inflation, any loan, if the investor generates foreign currency. devaluation needs to be accompanied by The debt-equity ratio to access a loan from appropriately tight monetary and fiscal foreign sources has been revised to 60-40, policies. In that context, the decision to replacing the hitherto 50-50 ratio. Under increase interest rates is appropriate and the second directive, exporters of goods and timely. Looking forward, it is important services are authorized to retain 30 percent to continue to adjust the macroeconomic of the proceeds of their exports indefinitely in stance, including foreign exchange, monetary, their forex account (replacing the previous 10 and fiscal policy, for Ethiopia’s economic percent threshold). conditions and ambitions. A one-off exchange rate correction is unlikely to be sufficient to Recent empirical analysis conducted by the redress the structural bottlenecks that hinder World Bank provides strong evidence that exports. A comprehensive policy package a more competitive real exchange rate would help find the right balance between would provide an environment that is more the implementation of productivity-enhancing conducive to manufacturing-led structural structural reforms, including measures to transformation, sustained growth acceleration, strengthen the business environment (for and improved external balance. For instance, example, trade logistics, access to finance a 10 percent depreciation of the real effective and land, burdensome customs regulations, exchange rate would reduce the current skills gaps, and so forth) and the flexibility account deficit by about 2 percentage points of the exchange regime. A measure of this of gross domestic product (GDP) (through a balance would be the capacity to build the 5 percent increase in exports and a 6 percent stock of foreign exchange reserves over the decrease in imports) and increase real GDP medium term. 13 22. The exchange rate played an important during FY2017. Imports of goods declined by role in explaining the low export earnings. A 5.5 percent during FY2017, mainly driven by competitive exchange rate encourages the supply a 15.5 percent decline in raw material imports of goods for export and at the same time provides and a 12 percent reduction in imports of capital better prices for international buyers of Ethiopian goods. Consumer goods imports also declined, products. NBE discontinued reporting on the by 7 percent. This could be the result of low parallel market rate, but anecdotal evidence foreign exchange reserves and a constraining suggests that the parallel market premium environment for accessing non-concessional ranged from 10 to 17 percent in FY2017. This borrowing. Capital goods imports. which are provides an indication of the appreciation of associated with large public sector investment the real effective exchange rate and shows that activities and largely financed through external domestic inflation is still higher than foreign loans, declined with low external disbursement inflation and the rate of nominal depreciation. during the fiscal year. Fuel imports increased by 36 percent during this period (figure 1.4, panel 23. Declines in goods imports—mainly e). It is obvious that the total exports of goods driven by a slowdown in capital and and services cannot cover the cost of consumer intermediate goods imports—contributed goods and fuel imports. Services imports also to the improvement in the trade deficit declined, by 1.4 percent, in FY2017. Declines in goods imports contributed to the improvement in the trade deficit during FY2017 14 Figure 1.4 External Sector A External current account balance B Gross official foreign exchange reserves (% of GDP) (US$ millions) 30 4,500 3.5 1.3 4,000 20 3.4 4.0 2.3 3.2 3.9 8.2 4.4 3.3 3,500 3.0 2.4 4.2 4.8 6.4 5.8 2.5 2.6 2.6 3.4 4.2 5.2 10 4.1 3.2 2.6 2.3 1.4 3,000 1.8 2.5 9.0 8.6 7.5 7.5 7.3 7.6 8.3 6.9 2,500 0 -4.3 -1.0 -0.2 -0.1 -1.2 -0.7 2,000 2.0 -0.7 1,500 -10 -4.0 -6.5 -5.3 -7.9 -8.2 -11.5 -10.4 1,000 1.5 -20 -14.9 -19.2 -17.9 -16.4 -17.6 -19.8 -16.2 500 -21.0 -30 0 1.0 2011/12 2012/13 2013/14 2014/15 2015/16 Mar-11 Jul-11 Nov-11 Mar-12 Jul-12 Nov-12 Mar-13 Jul-13 Nov-13 Mar-14 Jul-14 Nov-14 Mar-15 Jul-15 Nov-15 Mar-16 Jul-16 Nov-16 Mar-17 2009/10 2010/11 2016/17 Mar-10 Jul-10 Nov-10 Private transfers Official transfers FDI Loans Foreign Reserve (mill $) Change in reserves CAB/GDP Reserve in months of import (right axis) C Growth in exports of goods (%) D Exports of goods and services (% of GDP) Value growth Price growth Volume growth Service export Goods export 50 18.0 40.4 38.4 37.1 16.0 40 14.0 30 23.1 12.0 8.6 18.7 18.7 20 14.8 10.0 6.7 7.3 4.5 6.5 5.9 10 5.6 8.0 4.6 0 6.0 4.0 3.6 -10 -1.0 4.0 6.0 6.8 8.1 6.5 6.0 5.7 -2.3 -8.6 -4.7 -9.3 2.0 4.8 4.1 4.1 -20 0.0 2004/05 2005/06 2007/08 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2006/07 2016/17 2008/09 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 E Imports of goods and services (% of GDP) 40.0 5.1 6.1 5.7 4.8 4.4 4.8 30.0 0.4 4.7 4.8 0.4 0.7 0.8 0.4 0.4 4.2 4.4 5.0 4.3 4.3 0.3 0.4 20.0 4.4 5.2 4.0 3.2 4.2 4.9 4.5 4.6 1.9 3.4 8.4 7.2 7.0 7.3 2.3 10.0 8.2 7.2 6.7 6.1 9.6 8.6 8.7 10.7 9.4 7.5 6.8 7.5 0.0 2009/10 2010/11 2011/12 2012/13 2013/14 2014/15 2015/16 2016/17 Capital goods Consumer goods Fuel Immediate goods Others Service imports Sources National Bank of Ethiopia and Ministry of Finance and Economic Cooperation (MOFEC) 15 Financial Sector 24. The structure of the financial sector has one of the lowest ranks in the world and two ranks barely changed over more than a decade down from Ethiopia’s position in 2016. Enterprise and is dominated by state-owned financial Survey 2015 also reveals that the proportion of institutions. The financial sector in Ethiopia enterprise investment in Ethiopia financed by banks currently consists of 18 banks, 17 insurance is only 7.8 percent, while a large proportion (83.3 companies, 35 microfinance institutions, and five percent) of investment is self-financed—an indication capital goods finance companies. Banking is the of financial disintermediation. dominant subsector, accounting for 78 percent of total financial sector assets, followed by insurance 26. Although the aggregate capital adequacy companies, representing 15 percent (figure 1.5, ratio of the banking sector is good, the panel a). The two state-owned banks (Commercial Commercial Bank of Ethiopia (state-owned Bank of Ethiopia and Development Bank of Ethiopia) and the largest bank in Ethiopia) seems account for 65.7 percent of total deposits, 62.4 highly undercapitalized. The Commercial Bank percent of outstanding credit, 35.9 percent of total of Ethiopia’s capital-to-assets ratio is about 3.5 branch networks, 64 percent of total banking sector percent, which is less than one-third of the private assets, and 48.9 percent of total banking sector banking sector average capital-to-assets ratio of capital as of December 2016; the remaining 16 12 percent. In recognition of this, the government private banks cover the balance. The state-owned has decided to raise the Commercial Bank of insurance company accounts for 23 percent of the Ethiopia’s capital by threefold to US$1.7 billion. total capital of the industry. Micro finance institutions, The fund will be financed by interest-free and tax- which mainly serve the rural population, represent free government bonds. The Ministry of Finance only about 6 percent of the financial sector capital. and Economic Cooperation will issue the bonds on New additions to the financial sector are five capital behalf of the government. The bonds will mature in finance companies that started operation in the 10 years after a five-year grace period. However, past few years. There is no foreign bank or foreign the banking system’s ratio of capital-to-risk-weighted financial institution in Ethiopia. Currently, there are assets stood at 17 percent (double the minimum 35 micro finance institutions, with total capital of requirement). The ratio of nonperforming loans to US$419 million, a total network of 1,647 branches, total gross loans stands at 3 percent, which is well and total outstanding credit of US$1.2 billion as of below the 5 percent limit. The banking sector’s return December 2016. on equity (ROE) and return on assets (ROA) were 25. The domestic credit market is dominated 39.7 and 3.0 percent, respectively, in 2015, which by lending to SOEs—mainly to finance is much higher than Sub-Saharan Africa’s average infrastructure investment—contributing to ROE of 14.9 percent and ROA of 1.7 percent. The weak financial intermediation. Domestic credit high profitability of Ethiopian banks vis-à-vis their as a percentage of GDP increased from 28.3 percent regional peers can be mainly attributed to low in 2014 to 32.1 in 2016, while private credit increased overhead costs of 2.2 percent in 2014, less than from 8.7 to 11.7 percent. A large part of domestic half compared with the Sub-Saharan Africa average credit was credit for SOEs—17 percent between of 4.7 percent (figure 1.5, panel b). 2014 and 2016. However, with a policy preference for financing SOEs at low cost, the credit market 27. Insurance penetration in Ethiopia is tended to crowd out the private sector. The 2017 very low and products are concentrated in Doing Business report ranks Ethiopia at the 170th general insurance lines of business. In 2015, place of 190 economies in ease of getting credit— the ratio of total insurance premiums to GDP was 1 16 percent, which is much lower than the Sub-Saharan Corporation (8.7 percent). The Commercial Bank of Africa average of 3.5 percent (figure 1.5.4). Most of Ethiopia is the sole purchaser of these bonds, making the insurance business in Ethiopia is targeted at the the bank susceptible to the financial performance of corporate market and focused on general insurance. SOEs and single-borrower risk. Ethiopia has yet to The corporate focus implies that, to date, insurers develop a secondary capital market. have had little experience in intermediating products to individuals, and cost margins have not yet been 29. Despite significant improvements in tested against the more cost-sensitive retail business. outreach led by the expansion of bank Premiums from the retail sector are almost entirely branches, penetration of formal financial derived from motor insurance. As of December institutions remains very limited in rural 2016, there were 17 insurance companies in areas. The number of bank branches in Ethiopia Ethiopia with 465 branches. About 54.4 percent of has more than tripled in the past five years, from the insurance branches were in Addis Ababa and 85 970 branches in 2011 to 3,187 branches in 2016 percent of the total branches were private. (figure 1.5, panel e). Access to banks remain concentrated in the capital city and other urban 28. Capital markets in Ethiopia mainly centers. Of the total nationwide, 34.4 percent of comprise Treasury bills (T-bills) and branches and more than 50 percent of ATMs are in government bonds. T-bills are transacted Addis Ababa. However, there is a large untapped on a weekly basis and government bonds are market of borrowers and savers who are not using occasionally issued. The maturities of T-bills are 28, formal financial services. According to Findex 2014, 91, 182, and 364 days; 91 and 364 days are the 48 percent of Ethiopian adults reported saving or most demanded terms (figure 1.5, panel d). The setting money aside, yet only 14 percent saved total outstanding T-bills as of December 2016, was formally at financial institutions. During the same US$2.9 billion. The Public Servants Social Security period, 44 percent of Ethiopian adults reported that Agency, Development Bank of Ethiopia, and Private they borrowed money, but only 7 percent borrowed Organization Employees Social Security Agency from financial institutions. The Government of are the three major buyers of T-bills in Ethiopia. Ethiopia has recognized financial inclusion as a Outstanding corporate bond holdings reached priority area in its Growth and Transformation Plan US$9 billion as of December 2016, of which about (GTP II), and has approved the National Financial 94 percent was held by two state-owned institutions: Inclusion Strategy. Ethiopia Electric Power (85.4 percent) and Railways Financial repression may help contain inflation, but at a potential growing economic cost in terms of market distortion and resource misallocation 17 Figure 1.5 Financial Sector Indicators A Capital share of the financial sector, 2015/16 (Birr, millions) 13,558 8,876 CBE MFIs 22,003 2,754 Private Banks 7,501 Private insurance DBE Public Insurance 837 B ROE and ROA (%) C Insurance premiums to GDP, 2015 (%) ROE Ethiopia 60 ROE SSA 5.0 4.0 3.5 ROA (RHS) Ethiopia 4.5 3.5 3.0 3.0 50 4.0 ROA (RHS) SSA 3.0 40 3.5 3.0 2.5 2.0 2.0 30 2.5 1.5 2.0 1.5 1.0 1.0 1.1 20 1.5 1.0 0.8 0.8 0.9 10 1.0 0.5 0.5 0.3 0 0.0 0.0 2010 2011 2012 2013 2014 2015 NIG UGD ANG TAN ETH GHA ZAM MAL MZQ KEN BOT SSA D Composition of the capital market, E Development of bank branches by instrument 29% 3,500 3% Direct advance Government bonds 3,000 2,500 52% 16% 2,000 Corporate bonds T-bills 1,500 1,000 13% 91 days 500 0% 0 0% 28 days 2010 2011 2012 2013 2014 2015 2016 182 days 3% 364 days Sources Panels a, e, and f: National Bank of Ethiopia; panels b, c, and d: National Bank of Ethiopia and African Insurance Barometer. Note ANG = Angola; BOT = Botswana; ETH = Ethiopia; GDP = gross domestic product; GHA = Ghana; KEN = Kenya; MAL = Malawi; MZO = Mozambique; NIG = Niger; ROA = return on assets; ROE = return on equity; SSA = Sub-Saharan Africa; TAN = Tanzania; UGD = Uganda; ZAM = Zambia. 18 1.2 Economic Prospects in FY2018 and Beyond Post-drought real GDP growth is expected to recover moderately in FY2018 and an average growth of 8 percent is expected in the medium term. The general government’s fiscal policy is expected to continue with a moderate fiscal deficit that is consistent with macroeconomic stability. The government would pursue robust monetary policy to maintain inflation in single digits in the aftermath of the recent devaluation. On the upside, FDI inflows, supported by incentives and ongoing industrial parks development, are expected to boost the manufacturing sector. On the downside, the economy will remain vulnerable to the weak economic performance of key trading partners and rationing of foreign exchange. On balance, with potential improvements in manufacturing and exports, GDP growth is projected to remain robust in the medium term and stay around 8 percent annually. Poverty should decrease accordingly, although persistent drought could result in poverty rates declining less than projected. The challenges to the economy are related to exports performance, rising oil prices, overvalued exchange rate, and vulnerability to debt risks. Positive economic growth is expected to continue to lower the poverty rate. 30. In FY2018, real GDP is expected to recover 32. Exports could recover in the medium as agricultural performance improves. term, as large investment projects, such Following normal rainfall during the main growing as the railway to the Port of Djibouti, large season, agricultural production continued to grow power dams (with potential for electricity in FY2017, recovering from a lower growth in exports), or industrial parks, are completed. FY2016. The negative impact of the current drought The Addis Ababa–Djibouti Railway will improve in pastoralist areas, although adversely affecting trade logistics and reduce the transportation cost livelihoods and livestock production, is expected to be of moving goods in and out of the country. It will minimal, but could have significant poverty impacts. take only 10 hours for the new railway to take On the upside, FDI inflows supported by incentives goods between Ethiopia and Djibouti, a significant and ongoing development of industrial parks, are improvement over the three to four days by truck expected to boost the manufacturing sector. On the currently. Further, the Hawassa Industrial Park downside, the economy will remain vulnerable to the and the second phase of the Bole-Lemi Industrial weak economic performance of key trading partners Park have started operations and are set to and rationing of foreign exchange. On balance, increase manufacturing exports and contribute with potential improvements in manufacturing and to the diversification of exports. Investments in exports, GDP growth is projected to remain robust hydropower, industrial parks, export processing in the medium term and continue to hover around zones, and public policies to encourage FDI 8 percent annually (figure 1.6). and private investment in light manufacturing industries are expected to support export growth 31. To contain debt sustainability risks, and diversification. The completion of power external non-concessional borrowings transmission lines to neighboring countries (Kenya and their related public investments are and Sudan) and expansion in power generation expected to slow in the coming years. Exports capacity are expected to increase electricity are not projected to pick up in FY2018; however, exports, further boosting the diversification efforts an improvement as compared to the last five year`s (box 1.2). A recent United Nations Conference trend could be expected. Notwithstanding the recent on Trade and Development (UNCTAD) report 15 percent nominal devaluation, the level of the real shows that Ethiopia has recently enjoyed large exchange rate and pressure on foreign exchange FDI inflows, ranking first in Sub-Saharan Africa, may continue to contain exports. with US$3.2 billion inflows in 2016. 19 Box 1.2 Take-Off in Electricity Exports Ethiopia’s cost of supplying electricity is 2023. Currently, Ethiopia’s power exports are among the lowest in Sub-Saharan Africa, limited to Sudan and Djibouti (figure B1.2.1). presenting unique export opportunities. However, power transmission interconnection According to World Bank estimates, Ethiopia to Kenya (financed by the World Bank and other will have more than 9,000 megawatts (MW) partners) is scheduled to be commissioned in of installed capacity by 2020 (estimated to be the first half of calendar year 2019 (tower and the second highest installed capacity available stringing work is substantially advanced, and in the region). This would provide more than the converter station is under construction). 25,000 gigawatt hours (GWh) of renewable With this interconnection to Kenya, capable electricity that would be able to meet domestic of more than 2,000 MW of transfer capacity, and export demand. Therefore, over the next exports will be expanded to Tanzania and few years, Ethiopia is expected to become a possibly other countries in the EAPP . Over regional energy superpower and develop into the medium term, additional connections to the cornerstone of the regional power market Sudan and the Arab Republic of Egypt are and East African Power Pool (EAPP). also planned. In addition, envisaged EAPP interconnection to the Southern African Power Electricity exports are set to double in 2019, Pool could further open the market for Ethiopian to US$250 million, and reach US$1 billion by exports to Southern African countries. Figure B1.2.1 Ethiopia: Destination of Electricity Exports 20,000 15,000 GWh 10,000 5,000 0 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Djibouti Sudan Egypt/Sudan Kenya Tanzania The acceleration in export revenues is due to a is expected to rise 10-fold, from 1,443 GWh in combination of the significant growth in export 2016 to 14,657 GWh in 2023. Thus far, the volumes and a relatively high export price. negotiated average price under the PPAs has Based on signed Power Purchase Agreements been US$0.07/kilowatt hour. Based on this, the (PPAs) between Ethiopia and Kenya, and value of exports is expected to increase from Ethiopia and Tanzania (others are being US$250 million in 2019 to US$1 billion in 2023 planned and negotiated), the growth in exports and US$1.2 billion in 2025 (table B1.2.1). 20 Table B1.2.1 Ethiopia: Projections of Electricity Exports, 2016–25 Electricity Exports 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 Value of exports (US$ millions) 101 101 101 250 523 811 872 1,026 1,118 1,210 Price (U.S dollar, kWh)¹ 0.07 0.07 0.07 0.07 0.07 0.07 0.07 0.07 0.07 0.07 Volume (GWh) 1,443 1,443 1,443 3.571 7,471 11,586 12,457 14,657 15,971 17,286 Sources Ethiopian authorities and World Bank staff estimates. ¹ As per the Framework Agreement. Projections are on a calendar year basis 33. Pressures on the financing of public health care, and safety nets, and infrastructure investment projects may lead the government development. With the recently approved new to relax its fiscal stance. Given the slow pace of country partnership framework, the World Bank is tax reforms, domestic revenue may be insufficient to planning to frontload about two-thirds of the IDA finance the infrastructure investments contemplated resources in FY2018, to maintain the continuity of in the national development plan, potentially past investment programs, contribute to closing resulting in larger fiscal deficits. Crowding-in the the financing gap, and help address the foreign private sector to finance infrastructure (“the cascade” exchange shortage. IDA resources are expected to or “maximizing finance for development”) could generate improvements in total factor productivity usefully be explored to address the growing public and generate economic growth in the medium term. financial constraint. With limited improvements in external competitiveness and the recent recovery in 35. The relatively low inflation environment oil prices, the current account balance is projected experienced in the past two years may to remain weak in the medium term. Furthermore, not last in the aftermath of the recent monetary discipline will be required to preserve the devaluation if monetary conditions are low-inflation environment experienced over the past not tightened. Inflation can remain in single two years. digits, providing monetary policy remains tight. However, the fast growth of reserve money 34. Ethiopia has received a large allocation of and recent devaluation of the Birr could trigger International Development Association (IDA) inflationary pressures in the coming months. The resources to enhance productivity in various recent increase in deposit interest rates was a social and economic sectors. With the record welcome step in attempting to contain inflation. high IDA 18 replenishment (for FY2018–FY2020), The expected recovery in global commodity prices Ethiopia’s IDA allocation increased by about 50 is a further potential source of inflation of tradable percent to reach US$4.8 billion. In addition, Ethiopia goods prices under loose monetary conditions. has the potential to access more resources from different IDA resource windows. These resources 36. Rising external imbalances and the are intended for investment in agriculture, urban worsening of the debt situation constitute development, roads, energy, service delivery, and major challenges to the economy. The lack human resource development such as education, of external openness, rising international oil prices, 21 and an overvalued exchange rate (after the recent of major trading partners (such as China) could devaluation) will continue to have adverse effects affect short- to medium-term growth. Finally, on the competitiveness of the economy. The rising although the state of emergency was lifted in August risk of external debt sustainability may potentially 2017, political disruption associated with social impact Ethiopia’s access to external finance. The unrest could negatively affect growth through lower reserve position is low and declining. Weak growth FDI, tourism, and exports. Figure 1.6 Economic Outlook: Selected Projections to 2019 A GDP growth: Supply side, 2009–19 (%) B Determinants of potential output, 2001–19 (%) 11.4 12.0 30 10.0 10.6 10.3 10.4 9.9 10.0 8.7 25 Capital stock 8.0 8.3 8.0 5.7 7.9 8.0 4.1 5.8 5.1 20 5.9 7.0 4.4 3.4 3.2 3.1 6.0 4.0 15 Potential GDP 1.5 2.8 4.0 1.0 2.7 10 2.1 2.2 2.7 2.8 2.9 1.1 3.1 2.0 4.1 5 Working age population 3.2 2.5 3.1 2.3 2.6 2.2 2.2 2.0 1.9 TFP 0.0 0.9 0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Agriculture Industry Services GDP af factor cost C GDP growth: (Demand side, 2012–19 (%) D Fiscal and external balances, 2001–19 (%) 22 2009 2006 2008 2005 2002 2003 2004 2007 2001 2010 2019 2016 2018 2015 2012 2013 2014 2017 2011 18 14 -1 10 -3 6 -5 2 -2 -7 -6 -9 -10 2012 2013 2014 2015 2016 2017 2018 2019 -11 -13 Private consumption Public consumption GFCF Exports, GNFS Imports, GNFS Real GDP Current Account deficit General Gov’t fiscal balance Source World Bank staff compilation, based on data from the Macro-Fiscal Forecasting Model. Note GFCF = gross fixed capital formation; GDP = gross domestic product; GNFS = goods and non-factor services. 22 Box 1.3 Ethiopia and the East Asian Model: Similarities and Differences A key component of the East Asian model Although Ethiopia shows a certain similarity with is the high level of investment coupled the East Asian model, important differences with high domestic savings rates. Further, (summarized in table B1.3) raise questions sound macroeconomic management was about the replicability of the East Asian model instrumental in East Asia, contributing to in Ethiopia. stable savings rates. This was supported by liberalization and structural reform of the Similarities financial sector, which allowed private firms to access credit markets. Private investment High savings and investment rates are similar to far outpaced public investment in Korea. the levels observed in East Asia, but, given very China’s model involved very high public high investment rates, the savings-investment investment rates; yet, private investment also gap is particularly pronounced in Ethiopia. increased rapidly in China as the economy developed. But even where the public sector Strong agricultural production growth preceded played a large role, such as in China or the economic take-off. Vietnam, a much more pronounced role of competition and market forces paved the The role of SOEs in the economy in Ethiopia is way for efficiency gains in the economy. High somewhat similar to their role in China (and savings rates allowed investment rates to rise Vietnam), but lacks the notion of competition and remain at high levels. In addition, FDI to enhance SOE performance. Likewise, played a key role in the success of the East SOE investment in the East Asian model saw Asian model, with the exception of Korea, declining importance over time. which had its development episode in the pre-globalized world. Differences Another crucial element of the East Asian In Ethiopia, manufacturing exports are very model is export-led growth, especially through low compared with any of the comparator active industrial policies for manufacturing countries considered. development. The ability of governments to pursue strategies and plans based on an At the same time, Ethiopia’s real exchange rate identification of their countries’ comparative is overvalued, and this is markedly different advantages was instrumental. To foster and from the East Asian model. support their export promotion activities, many East Asian economies implemented additional Ethiopia lags in providing credit to the private competitive exchange rate policies. Emphasis sector, especially compared with China or on human capital was another characteristic Singapore. of the East Asian model, especially in the cases of China and Korea. Investment in Although Ethiopia’s public investment push has research and development (R&D) also played precedent in China’s experience, Ethiopia has an important role, especially after the initial not seen private investment picking up to the phase of development. extent seen in China. 23 Table 1.1: Summary: Ethiopia Compared with Selected Indicators in East Asia Savings Investment Exports (% of GDP) (% of GDP) Country GDP per capita Credit to private growth sector (annual %) (% of GDP) Gross Gross (% of exports) domestic national Gross capital formation FDI rate* Manufacturing Real exchange Korea, Rep. (1960–70) 7.99 9.13 N/A 19.39 N/A 58.09 + 16.46 Hong Kong SAR, China 3.47 22.96 N/A 25.59 N/A 93.54 - N/A (1960–70) Thailand (1960–70) 6.87 18.06 N/A 20.18 N/A 2.83 + 13.82 Indonesia (1966–76) 4.19 16.09 N/A 16.60 N/A 1.45 - N/A Malaysia (1967–77) 8.65 26.80 25.83 22.64 3.20 10.12 - 25.23 Singapore (1967–77) 4.50 24.74 28.63 35.56 5.65 35.14 - 49.13 China (1982–92) 8.62 35.63 37.63 36.33 0.89 57.79 - 73.78 Vietnam (1991–2001) 3.36 18.93 25.18 25.36 6.62 44.29 - 22.73 Cambodia (1995–2005) 5.70 5.00 11.18 16.57 4.96 96.88 + 6.33 Ethiopia (2004–15) 7.96 19.27 32.11 36.11 2.18 8.06 + 20.38 Note A growth period is identified with a landmark political event and/or the liberalization and opening of the economy if this coincides with accelerated growth. The periods identified do not imply that countries were not able to grow during more than 10 years. GDP per capita: Korea only available from 1961; Hong Kong SAR, China, only available from 1966; Thailand only available from 1961. Gross domestic savings: data on Ethiopia only available from 2011. Gross capital formation: Ethiopian savings are based on the 2011 National Accounts revision, which increased savings rates due to methodological changes. Data are only available for 2011–14. FDI: for the Republic of Korea; Hong Kong SAR, China; and Thailand, data are not available in the growth periods. Data for Malaysia are only available from 1970. Data for Singapore are only available from 1970. Manufacturing exports data: for China, only available from 1984; for Vietnam, from 1997; for Cambodia, from 2000; for Ethiopia, until 2014. Real exchange rate data: data for Ethiopia are only available until 2011. Credit data: for Vietnam, not available in 1994; for Ethiopia, only avaialble for 2014. GDP = gross domestic product; N/A = not available. 24 Services & Manufacturing Linkages: Exploring the Potential of Distribution Services 2 25 2.1. Introduction 37. This Ethiopia Economic Update focuses services sectors. At this stage, however, Ethiopia on the connection between services and seems to lack adequate access to necessary services manufacturing, to help advance the inputs, such as finance, electricity, and water, as government’s export development agenda. evidenced by several studies.13 Although the importance of services for development is widely recognized, the role of services, tradable 39. The objective of this Economic Update is to and non-tradable, in growth and structural invigorate and deepen the discussion about transformation is generally less understood. the role of services as tradable activities, Services not only offer promising opportunities and as intermediate inputs in Ethiopia. The for export diversification, but also are key inputs analysis is conducted in the context of the debate in the production of most goods, for export and on growth and structural transformation in Ethiopia. domestic consumption. Services imports are equally World Bank (2015) shows that Ethiopia did not follow important, as they can improve the availability and the conventional path of economic development quality of services through increased competition, through export-oriented industrialization, with better technologies, and access to foreign capital. workers moving from agriculture to high- This, in turn, can have a strong impact on the productivity manufacturing. The analysis contrasted domestic business environment and lead to this “premature deindustrialization,”14 characterized productivity increases through broader access to by a shift of labor from agriculture to services, with essential services inputs. the potential of services becoming the new growth escalator15 for Ethiopia. The report concluded that 38. A dynamic services sector is a rather than following one approach or another, necessary condition for manufacturing and Ethiopia would need to move forward across agroprocessing to thrive. Access to quality all sectors, focusing on agricultural productivity services as inputs to production is important for improvements, manufacturing growth to support manufacturing performance. Lack of quality services the strategy of industrialization, and development of as inputs can impede the emergence of a competitive services. At the government’s request, emphasis will manufacturing sector, which matters for the quality be placed on distribution services,16 with individual and value addition of goods. Manufacturing and case studies on the role of distribution services as agroprocessing cannot be competitive without inputs in the dairy, teff, sesame, and textiles value accessing good quality and varied inputs from the chains complementing the analysis. 13 World Bank (2014a). 14 Rodrik (2015). 15 Ghani and O’Connel (2014). 16 In the WTO Services Sectoral Classification List (MTN.GNS/W/120), largely based on the United Nations Provisional Central Product Classification, the distribution sector is defined to include four major services: commission agents’ services, wholesale trade services, retailing services, and franchising. Commission agents are distinguished from the other categories in that they trade on behalf of others, that is, they sell products that are supplied and usually owned by others to retailers, wholesalers, or other individuals. Wholesale trade services consist in selling merchandise to retailers; industrial, commercial, institutional, or other professional business users; or other wholesalers. Retailers sell goods for personal or household consumption. Franchisers sell specific rights and privileges, for instance, the right to use a particular retail format or trademark, defined as retail sales of motor vehicles and fuel (ISIC rev 3.1 G50), retail trade in all other goods, and repair of personal and household goods (ISIC rev 3.1 G52) through specialized and nonspecialized outlets of all dimensions (traditional stores, department stores, supermarkets, and hypermarkets). Hotels and restaurants are excluded. 26 40. What is the role of services in Ethiopia’s distribution services is highlighted in the analysis. structural transformation? How do The following section presents a diagnostic of distribution services contribute to Ethiopia’s distribution services markets in Ethiopia. In doing growth and structural transformation? so, the section pays special attention to their What are feasible reforms to accelerate poverty-reducing potential and the challenges their positive impact on the economy? To that impede the growth of the sector. Next, the answer these questions, the next section discusses report highlights the role of distribution services the importance of services for the country’s growth in value chains, with an emphasis on their role and development, looking at the services content as intermediate inputs and tasks in dairy, teff, of economic activity, services employment, services sesame, and textiles. The last section discusses trade and value added in exports, and the role options for policy reforms. of services as intermediate inputs. The role of 2.2. Setting the Stage: Services in Ethiopia’s Economy 41. Services are a large and dynamic sector, growth over the past decade (figure 2.1). Over but manufacturing remains a relatively the past years, Ethiopia’s output more than tripled small and stagnant part of Ethiopia’s in real terms, taking over agriculture as the sector economy.17 As shown in World Bank (2015), contributing the most to GDP .18 Since 2005, the “Ethiopia’s Great Run,” the services sector was one sectoral drivers of growth have shifted further of the driving forces behind the country’s growth toward services, and more recently, industry. acceleration. Recent data confirm that services However, as noted in World Bank (2015), the continue to contribute considerably to economic recent rise of industry is due to a construction growth and structural change. Services remain boom rather than being driven by a rise in the not only the largest sector in economic output, manufacturing sector, which has been largely accounting for 41 percent of GDP in 2016, they stagnant at about 4 percent of GDP . also accounted for about 50 percent of economic Services offer promising direct and indirect opportunities for Ethiopia’s manufacturing development 17 The analysis is based on latest available data: World Development Indicators and Balance of Payments Statistics published in 2017, World Bank Value Added Database - latest version for 2011, Input-Output Table for Ethiopia - latest available data for 2011. 18 Martins (2014). 27 Figure 2.1 Sectoral Contributions to Ethiopia’s Economy A Sectoral share in GDP, 2005–16 B Sectoral GDP growth contributions, 2005–16 (%) 60 14 GDP growth contribution by sector 50 12 10 5 5 Share of GDP, % 40 6 8 7 7 6 4 30 8 6 5 4 1 4 6 1 20 1 2 3 4 1 4 6 5 1 2 2 4 10 4 4 1 2 3 4 2 2 3 2 3 0 0 1 2008 2010 2011 2012 2013 2014 2015 2016 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2005 2006 2007 2009 Agriculture Industry Services Agriculture Industry Services GDP Growth Sources World Development Indicators 2017, Macro Poverty Outlook, 2017. 42. Although the structure of output and in 2013 it was estimated to employ about 20 shifted from agriculture toward services, percent of the workforce (figure 2.2, panel a). the corresponding employment shift This share lies significantly below the average for was modest. Despite the shift of output from countries at similar levels of development with a agriculture to services, agriculture continued to similar share of services in GDP , and is lower than dominate employment, although its employment all comparators. share declined from 80.2 to 77.3 percent between 2005 and 2013. Although workers moved mainly 43. Fast labor productivity growth in into services (1.8 percentage points), Ethiopia’s services may explain the gap between services sector still absorbs only a small share of the composition of employment and the population (World Bank 2015). In high-income output changes. Labor productivity in most countries, where services tend to explain the services grew much faster than in agriculture and largest share of GDP , compared with agriculture manufacturing (figure 2.2, panel b), pointing and manufacturing, services employ 74 percent once again to the dynamism of services. Labor of the workforce on average (40 percent in upper- productivity levels are the highest in sectors such as middle-income countries and 33 percent in lower- distribution (commerce), finance, utilities, mining, middle-income countries) (Hollweg et al. 2005). and transport, and lowest in agriculture and By contrast, in Ethiopia, in 2005 the services sector manufacturing. For instance, labor productivity in employed only 14.7 percent of the workforce even distribution was twice as high as in manufacturing if it accounted for about 40 percent of value added, and construction. 28 Figure 2.2 Employment by Sector and Labor Productivity A Employment, by sector (%) B Labor productivity growth, 1999–2013 (%) 100 Other services 3.8 20 26 21 Public services 2.6 80 42 33 7 7 Finance -2.0 % of total employment 6 Transport 2.6 70 60 Commerce 9.1 23 29 Construction 4.3 40 73 68 72 Utilities -0.7 44 Manufacturing 4.4 20 25 28 Mining -6.6 5 Agriculture 3.0 0 CHN ETH TZA UGA VNM KOR -10 -5 0 5 10 Agriculture Industry Services Note CHN for 2015, ETH for 2013, TZA for 2014, Source World Bank (2015). UGA for 2013, KOR for 2016 and VNM for 2015 44. Distribution (or commerce), other The remaining services sectors are transport services, and the public sector are the most (10 percent of services output and 6 percent of important services subsectors for services services jobs) and finance (5 percent of services output and employment in Ethiopia. These output and 2 percent of services jobs) (World three sectors account jointly for 85 percent of Bank 2015). Output shares have hardly changed sector value added and 92 percent of services over time, although the employment shares have jobs. Specifically, each sector accounts for increased in “other services” and public services roughly a half, a quarter, and a fifth, respectively, and declined in commerce (figure 2.3). of value added and jobs in the services sector. Figure 2.3 Services Value Added and Employment Shares in Ethiopia A Value-added shares (%) B Employment shares (%) 100% 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 0% 1999 2005 2013 1999 2005 2013 Commerce Transport Finance Commerce Transport Finance Public services Other services Public services Other services 29 45. A striking feature of the Ethiopian Taffesse and Ferede (2004) reveal that in 2000 services sector is its significant role as an the “other services” sector’s exports-to-output ratio exporting branch of the economy. Not only was marginally higher than that of the “traditional did services exports account for more than 50 agricultural exportables” sector, which includes percent of Ethiopia’s total exports between 2005 tea, flowers, fruits, and vegetables. Furthermore, and 2015 (figure 2.4), but the share of services despite relatively underdeveloped infrastructure, exports in the sector’s output (fluctuating between Ethiopia’s services trade has registered dynamic 17 and 26 percent over the past decade) was growth rates over the past 10 years. Recent data comparable to the export-to- output ratio of reveal a compound annual growth rate for services Ethiopia’s traditional export products. For example, exports of 16 percent over 2011–13. Figure 2.4 Shares of Services in Total Exports, 2005 and 2015 A 2005 B 2015 100 100 80 80 Share of Exports 2005 Share of Exports 2015 60 60 40 40 20 20 0 0 ETH KEN KOR RWA UGA TZA ZMB ETH KEN KOR RWA UGA TZA ZMB Services Goods Services Goods Source IMf BOP 2017. 46. Services exports and imports are higher the efficient functioning of an economy, services than expected from an average country at imports are equally important. Imported services, Ethiopia’s level of development. A cross- especially from developed countries, often country regression based on the International enhance the total factor productivity of domestic Monetary Fund Balance of Payments Statistics firms. Ethiopia seems to be taking advantage of shows a positive picture, indicating that Ethiopia’s cheaper and higher quality services from abroad. services exports were slightly higher than expected Ethiopia’s services imports are again higher than for an average country at its level of development what would be expected for a country at its level (figure 2.5, panel a). It is important to point out of development (figure 2.5, panel b). that although exports of services are critical to 30 Figure 2.5 Ethiopia’s Services Exports and Imports, 2013–15 A Services exports B Services imports 60 100 Exports of services as % of GDP 2013-2015 Imports of services % of GDP 2013-2015 50 80 40 60 30 40 20 20 10 0 0 6 8 10 12 6 8 10 12 Log GDP per capita (Current US$) 2013-2015 Log GDP per capita (Current US$) 2013-2015 47. Ethiopia’s exports and imports are higher productivity and generate high-skilled and concentrated heavily in traditional services better-paid jobs. However, many modern services activities; the country’s modern services sectors have relatively low employment intensity exports remain among the lowest of its and require higher educational levels. Ethiopia’s comparators (figure 2.6). “Modern services” exports and imports of traditional services as a include communication, banking, insurance, share of GDP reached 7 percent in 2010–12, business, and remote access services; transcription significantly overperforming comparator countries of medical records; call centers; and education. (except Tanzania and Kenya) and other countries These services differ from “traditional services,” at a similar level of development. Instead, Ethiopia such as transport or travel, which demand face- significantly underperforms in modern services to-face interaction. In addition to being important exports and imports, which measured close to 2 inputs into production, modern services exhibit percent of GDP in 2010–12. Figure 2.6 Traditional and Modern Services Exports and Imports versus GDP per Capita, 2013–15 A Exports of traditional services B Exports of modern services 30 40 Exports of traditional services % of GDP Exports of modern services % of GDP 30 20 2013-2015 2013-2015 20 10 10 0 0 6 8 10 12 6 8 10 12 Log GDP per capita (Current US$) 2013-2015 Log GDP per capita (Current US$) 2013-2015 31 C Imports of Traditional Services D Imports of Modern Services 25 40 Imports of traditional services % of GDP Imports of modern services % of GDP 20 30 2013-2015 2013-2015 15 20 10 10 5 0 0 6 8 10 12 6 8 10 12 Log GDP per capita (Current US$) 2013-2015 Log GDP per capita (Current US$) 2013-2015 Source WDI, 2017. 48. The expansion of Ethiopia’s services been growing slower and inconsistently for some exports was mainly driven by transport and sectors, including financial and other business travel. Jointly, they accounted for 90 percent of services.19 China and Korea, as well as Tanzania total services exports in 2012, up from 75 percent and Uganda, have been successful in exporting in 2002. This is attributed to Ethiopian Airlines, other business services. which is Ethiopia’s largest export earner (three times as big as coffee) and accounts for 60 percent 49. Although important, the contributions of Ethiopia’s services sector (World Bank 2014). of services to GDP and gross trade data Ethiopia’s services export structure is very similar ignore the links that services have with to that of Zambia or Kenya, with high shares of other sectors of the economy. Indicators transport and travel. It contrasts with that of Korea, such as forward and backward linkages, gross a substantially more developed economy, where, exports, direct value-added exports, and total even if transport is one of the largest subsectors, value-added exports can be used to assess the modern services such as insurance play an role of services in the domestic economy and in important role. Modern services exports have relation to international trade (box 2.1). 19 The category “other business services” includes merchanting and other trade-related services; operational leasing services; and miscellaneous business, professional, and technical services (legal, advertising, consulting, accounting, R&D, and so forth). 32 Box 2.1 Measuring Services Linkages In addition to value added as a percentage of payments, usually at the transaction value, of GDP and employment per sector, more that is, the price paid or payable for the goods sophisticated indicators, such as forward and and services. Transaction values measure the backward linkages, can be used to assess gross value of goods and services. interlinkages in an economy. The value added of production for domestic and export markets Direct value added of exports. This is a sector’s can be used to estimate how much value added domestic value added embodied in its own a country carries over from other sectors and exports, measured as gross exports less how much value added it brings forward into domestic and foreign inputs. The measure other sectors. captures the true sector-specific value added of exports. It is increasingly important in Forward linkages indicate how much value an environment where global production is carried by other sectors, that is, how is fragmented across production-sharing important each sector is as an intermediate networks. For example, a business process input for other sectors. This indicator treats the outsourcing (BPO) service from India contains sector as an upstream activity. Some studies telecommunication services, from local consider forward linkages as a measure of the providers and from foreign owners of satellites. “upstreamness” of the industry (for example, The delivery price of the BPO service accounts Antras et al. 2012). for the cost of such inputs. The direct value of exports nets out domestic and foreign inputs Backward linkages show how much value and captures the true value added generated added a sector carries from other sectors, in the BPO sector in India. that is, how much the sector embodies inputs that it will further process. This indicator treats Total value added of exports. This measure the sector as a downstream activity. Some adds to the direct value added of exports the researchers contend that backward linkages portion of the value added of the inputs that measure the “length of global value chains” are produced domestically. To continue with (for example, Fally 2011). the BPO example, the measure captures the value added of the BPO service plus the value Other measures that quantify the degree to which of the domestic satellites used as inputs in the the value added of services goes into downstream underlying telecommunication service (but exported sectors include the following: not the value of the foreign-owned satellite input). The measure captures the full domestic Gross exports. Gross or total exports capture component of an exported service. This in turn the value added embodied in the production of can be expressed in terms of forward and the exports as well as all domestic and imported backward linkages. Figure B2.1.1 explains intermediate inputs. Gross measures of trade these concepts. statistics are registered in customs or balance 33 Figure B2.1.1 Total Value Added of Exports Upstream costs Foreign value Intermediate of intermediate added of imported Inputs inputs intermediate inputs Domestic value GROSS Value added added of EXPORTS of intermediate intermediate inputs inputs (IDVA) Direct value added of exports Total value added of exports = (DVAE) DVAE + IDVA 50. Ethiopia continues to outperform of development in all three measures of services comparators when measuring services export shares (the share of services in total exports exports on a value-added basis (figure 2.7). measured as gross, direct, or total value added). Ethiopia’s gross services exports as a share of The direct value added of Ethiopia’s services total exports are the highest when benchmarked exports continues to be one of the highest among against peer countries (except Zambia). Ethiopia comparators (with the exception of Kenya). also outperforms other countries at a similar level Figure 2.7 Services’ Export Share (Gross Value, Direct Value Added, and Total Value Added Considering Forward Linkages), 2011 80 Gross Direct Total 60 40 20 0 Ethiopia China Vietnam Korea Kenya Uganda Tanzania Rwanda Zambia Source World Bank Value Added Database. 34 51. In contrast with other comparators in Korea, and 78 percent in Vietnam. This suggests that have successfully generated a strong that services in Ethiopia tend to be used more as manufacturing export base, the structure inputs than final consumption. The opposite is true of the services contribution to domestic for exports, where services are exported directly production and exports is strikingly similar or by other services sectors. Services inputs into in Ethiopia. In general, the direct contribution of manufacturing exported value added are much services is more important for other comparator more important in China, Korea, and Vietnam countries’ GDP than for Ethiopia’s. In Ethiopia, than in Ethiopia (figure 2.8), while manufacturing the direct contribution of services represents 48 production and exports rely more heavily on percent of services’ total contribution to GDP , services in Ethiopia than in the other countries compared with 59 percent in China, 68 percent (figure 2.9). Figure 2.8 Composition of Services Value Added (Forward Linkages), 2011 A Percentage of GDP B Percentage of exported value added 100% Inputs into ervices Inputs into Manufacturing 100% Inputs into Services Inputs into Manufacturing Inputs into primary Direct value added Inputs into Primary Direct value added 80% production 80% production 60% 60% 40% 40% 20% 20% 0% 0% ETH CHN KEN KOR RWA TZA UGA VNM ZMB ETH CHN KEN KOR RWA TZA UGA VNM ZMB Source World Bank Export of Value Added Database. Figure 2.9 Composition of Manufacturing Value Added (Backward Linkages), 2011 A Percentage of GDP B Percentage of exported value added Inputs from Services Inputs from Manufacturing Inputs from Services Inputs from Manufacturing Inputs from Primary Direct value added Inputs from Primary Direct value added 100% production 100% production 80% 60% 50% 40% 20% 0% 0% ETH CHN KEN KOR RWA TZA UGA VNM ZMB ETH CHN KEN KOR RWA TZA UGA VNM ZMB Source World Bank Export of Value Added Database. 35 52. Linkages exist primarily with traditional rather than modern services, with distribution services, such as wholesale and retail activities, seemingly the most important services inputs for manufacturing production in Ethiopia. The structure of services-manufacturing linkages in Ethiopia’s domestic economy is very similar to that observed in its exports (figures 2.10 and 2.11). The following key findings emerge from the linkages analysis: The most important services inputs for manufacturing production in 2011 were distribution and trade, transport, and business and information and communications technology (ICT). These three sectors combined accounted for more than 90 percent of all intermediate services inputs for manufacturing production; 60 percent is from distribution and trade services alone. Although, in general, manufacturing in Ethiopia uses few modern services as inputs, business and ICT services are an exception. Business and ICT services represent about 20 percent of total services inputs in manufacturing in Ethiopia. Exporting firms appear to be far ahead of non-exporting firms in adopting modern business processes (World Bank 2014). The linkages between financial services and manufacturing are particularly weak. Access to finance has been flagged as a serious constraint in Ethiopia (World Bank 2014). In 2011, financial services represented only about 3 percent of total services inputs in manufacturing. The percentage of investment that is financed through firms’ own funds, or the ratio of collateral to the total loan, is very high in Ethiopia, suggesting difficulties in access to finance. This is not an issue of demand, but one of supply; the Government of Ethiopia operates a rationing scheme whereby credit is allocated to the highest need (public investment, export priority sector, critical imports, and others). The negative real interest rate leads to excess demand and quantity rationing, such that many firms are completely excluded from access to finance. Figure 2.10 Composition of Domestic Services Inputs in Manufacturing Production, by Country, 2011 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Ethiopia China Kenya Korea Rwanda Tanzania Uganda Vietnam Zambia Water Construction Distribution Transport Communication Finance Insurance Business services & ICT Other consumer services Other services Source World Bank Export of Value Added Database. 36 Figure 2.11 Composition of Domestic Services Inputs in Manufacturing Exports, by Country, 2011 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Ethiopia China Kenya Korea Rwanda Tanzania Uganda Vietnam Zambia Water Construction Distribution Transport Communication Finance Insurance Business services & ICT Other consumer services Other services Source World Bank Export of Value Added Database. 53. Distribution services are the most (except paper and publishing and beverages important input for 11 of 14 manufacturing and tobacco). When considering all inputs (not sectors (figures 2.12 and 2.13). Key findings based just services), distribution services are the most on a disaggregated analysis by manufacturing important input for 11 of 14 manufacturing sector reveal that distribution services continue sectors, and in nine manufacturing sectors to be the most important services input for distribution services contribute more value added nearly all of Ethiopia’s manufacturing activities than the manufacturing sector directly contributes. Figure 2.12 Composition of Services Value Added in Manufacturing Production, by Sector in Ethiopia, 2011 Other manufacturing Machinery Transport equipment Metal products Metals Non-metallic minerals Chemicals & plastics Paper & publishing Wood products Leather Clothing Textiles Beverage & tobacco Processed foods 0% 20% 40% 60% 80% 100% Water Construction Distribution Transport Communication Finance Insurance Business services & ICT Other consumer services Other services Source World Bank Export of Value Added Database. 37 Figure 2.13 Composition of Services Value Added in Manufacturing Exports, by Sector in Ethiopia, 2011 Other manufacturing Machinery Transport equipment Metal products Metals Non-metallic minerals Chemicals & plastics Paper & publishing Wood products Leather Clothing Textiles Beverage & tobacco Processed foods 0% 20% 40% 60% 80% 100% Water Construction Distribution Transport Communication Finance Insurance Business services & ICT Other consumer services Other services Source World Bank Export of Value Added Database. 54. Although they are useful in providing output table for Ethiopia with the World Bank Value the big picture on the role of services, Added Database (figures 2.14 and 2.15). Moreover, results based on global databases need the sectoral classification in the input-output table to be assessed with care. In addition to giving is different from the one in the World Bank Value an overall picture about services linkages with the Added Database, making comparisons difficult.21 economy, global databases, such as the World Bank Value Added Database or UNCTAD EORA Global 55. Statistical discrepancies call for a cautious Multi-Region Input-Output Database, are valuable interpretation of the results. Nevertheless, for making comparative assessments among evidence from a variety of sources seems to suggest countries. However, often such databases are that, for manufacturing to succeed, a different constructed with many assumptions to generate the approach toward services is needed. In part, the missing information (for instance, extrapolating or structure of manufacturing may be one that does interpolating values for missing observations through not demand substantial modern services. Little value cross-entropy methods) and then employ balancing added is taking place, suggesting that Ethiopia may be conditions for the entire data set.20 This means that in assembly activities that demand primarily traditional the data can be far removed from what is happening services. But even in sectors where more domestic on the ground. This is a particularly important point value added is generated, such as food processing, for African countries, including Ethiopia. Indeed, we there seems to be insufficient use of essential services find substantive differences in the contributions of all such as financial, utility, and water supply services. economic sectors as input providers or demanders Insufficient services may be inhibiting manufacturing of inputs if we compare the latest national input- from moving into domestic value-added activities. 20 Lenzen et al. (2013, 2012). 21 For example, distribution services do not feature in Ethiopia’s input-output table. It remains unclear how the shares in the World Bank database were computed. To enable comparative assessments, the team has opted to use the World Bank database for the analysis. 38 Firm-level diagnostics can shed further light on and the economy, analyses based on more recent important questions behind this result. For a better input-output tables as well as firm-level data would understanding of the relationship between services be needed to complement the current examination. Figure 2.14 Inputs into and from Productive Sectors in Ethiopia, Based on the World Bank Export of Value Added Database for 2011 ALL INTERMEDIATE INPUTS ALL INTERMEDIATE INPUTS 22% 4% 74% 7% 56% 37% from from from to to to agriculture, manufacturers services agriculture, manufacturers services energy & energy & minerals minerals Figure 2.15 Inputs into and from Productive Sectors in Ethiopia, Recalculated Based on the Input-Output Table for Ethiopia for 2011 ALL INTERMEDIATE INPUTS ALL INTERMEDIATE INPUTS 47.57% 14.07% 38.35% 11.38% 34.99% 53.61% from from from to to to agriculture, manufacturers services agriculture, manufacturers services energy & energy & minerals minerals 2.3. Potential of Distribution Services 56. Distribution services have become a Force Survey). The recent growth of distribution significant driver of growth in Ethiopia over services has been propelled by strong economic the past decade. Distribution services contribute growth over the past decade, increasing population, about 15 percent of GDP and employ an important continued urbanization, higher incomes, and part of the population (over 42 percent of the active political stability, leading to the emergence of population in 2013, including a high proportion of supermarkets and larger retail stores mainly in the informal, unskilled, female, and part-time workers) capital, Addis Ababa (USDA 2016). (World Development Indicators, National Labor 39 57. Distribution services have experienced consumer packaged products and dry emerging recognition in Ethiopia. For goods. Ethiopia’s retail market has limited market example, GTP II covering 2016–20 states that saturation, but also low maturity. Supermarkets retail and wholesale are expected to be important sell few fresh products; rather, fresh products are drivers for services sector growth during the plan grown at home or acquired in informal markets. period. In addition, improvements in wholesale Consumer spending is generally much lower and retail trade-related activities are expected to than in more mature, neighboring markets. For boost the transport and storage sectors. buyers in these markets, price is the key factor (A. T. Kearney 2014, 2015). Formal distributors in 58. Indeed, as a crucial link between suppliers Ethiopia tend to be supermarkets and small and and producers, distribution services have medium-size retailers. Modern retail stores have great economic potential. With improved efficiency direct procurement systems and buying centers. and higher productivity, due to the emergence of Retail outlets, including supermarkets, tend to grow supermarket chains, the sector has great potential by first focusing on urban areas and large cities, to benefit producers and consumers and contribute mainly the capital city (box 2.2). to increased food security and the alleviation of rural poverty. From the perspective of producers, modern 60. For consumers, the emergence of distribution channels, procurement systems, and supermarket chains in Ethiopia is starting buying centers can reduce transaction costs and to transform the retail environment in the facilitate market exchanges, which increase the country. Many middle-class consumers already access of small farmers to high-value markets and benefit from a greater variety of goods at accelerate the transition from subsistence farming to affordable prices in modern retail outlets. The rise market participation. of supermarkets and their operational efficiencies is expected to lower prices further throughout Retail the food system, to the benefit of consumers. This is especially likely for processed and semi- 59. At this stage, Ethiopia’s retail sector processed goods, such as maize meals, wheat is characterized by little to no formal flour, bread, oils, meat, fish, and dairy, which shopping culture, with existing formal typically make up more than 50 percent of these markets relying almost exclusively on basic stores’ sales (Minten and Reardon 2008). Box 2.2 Players in Ethiopia’s Retail Grocery Business Eight major supermarket chains, with a total of are among the top suppliers of food and 21 stores, are open across Addis Ababa. The beverage products sold through Ethiopia’s retail major food retail stores—Shoa, Fantu, Safeway, grocery sector. Most retailers tend to import from Friendship, Bambis, All-Mart, Novis, and Loyal— a single country/region, mainly due to historical supply a wide array of products, most of which reasons or personal connections. For example, are imported foods and beverages. In addition Novis and Bambis prefer to import most of their to these major players, there are many mid-size food products from Europe. Shoa generally and smaller stores that supply the market. sources from the United Arab Emirates. Fantu imports a large portion of its food products from The United States, Europe, Turkey, the Arab the United States. Republic of Egypt, and the United Arab Emirates 40 In addition to direct imports, most retailers foods from local trading companies, which can purchase certain imported items from one bring in a large single-product shipment (for another or from one of the large importers/ example, breakfast cereal) in multiple containers distributors, such as Teji International Trading. The with more competitive pricing. In addition, some main reasons for this sourcing practice are price, retailers, which are large enough to import, have capacity, and distribution rights. For example, exclusive contracts with foreign suppliers and act depending on the type of product, some retailers as the de facto distributor in the country, selling may prefer to purchase some of their imported certain products to other retailers and businesses. Source USDA (2016). Wholesale 61. In the wholesale segment, we observe a Furthermore, state-owned enterprises are present high degree of duality between traditional in Ethiopia’s wholesale market. However, Alle, and specialized wholesalers.22 Traditional the state-owned and privately managed cash- chains are still widely prevalent in Ethiopia. Farmers and-carry wholesaler, which the government set and traders supply traditional wholesalers, who up to create a competitive and market-oriented then sell to individual retailers and processors. business environment in the sector before But most modern retail stores have their own allowing competition from international players, direct procurement systems and buying centers. is struggling for relevance (box 2.3). Box 2.3 ALLE Struggles for Relevance The state-owned and privately managed With its expansion plans being impeded by business enterprise Alle Bejimla was set up with various challenges, including the provision of the primary objective to supply wholesale food land by government offices, Alle has managed and other consumer goods and stabilize prices. to open only six units across the country, of which The government also expected that Alle would three are in the capital. Its plan was to have 36 inject a market-oriented and competitive business outlets in three years, a minimum of 12 units environment into the wholesale consumer goods annually. Consumers are also yet to witness Alle’s supply, which is dominated by a few companies. contribution to stabilizing food prices. Source The Reporter, Ethiopia. 22 Tschirley et al. (2014) anticipate that this duality between traditional and modern distributors will be preserved over the next 30 years in East Africa. Although they expect profound changes in the composition of what is consumed and at least a tripling of the share of the modern sector, a large share will remain in the hands of the traditional sector. 41 Franchising and basic retail household appliances, and are single-shop sole proprietorships. An estimated 62. The franchising segment is small and 70-80 percent of sales in Ethiopia still go through mostly limited to foreign firms. In July 2016, informal enterprises, with only about 20 percent the Ethiopian Parliament approved a Commercial of sales going through formal outlets. Although Registration and Business License Proclamation informal enterprises handle the large majority of that allowed registration of franchises. Difficulties sales, turnover is low for most individual informal in enforcing intellectual property rights, product enterprises and businesses tend to be very small. quality control issues, cumbersome banking Enterprises in the informal sector are more limited regulations, and limited access to foreign in their operational capacities than businesses in exchange make franchising difficult. Despite these the formal sector. Lack of access to finance, uneven challenges, several branded U.S. companies, such cash flows, absence of management knowledge, as Pepsi-Cola, Sheraton, Hilton, Marriott, Radisson and highly fragmented and inefficient supply Blu, and Ramada, have franchise operations chains are key constraints faced by enterprises in Ethiopia. In May 2017, Pizza Hut signed a in the informal sector. Informal retailers are also franchise agreement with the Ethiopian Belayab suboptimal from a governance perspective, since Food and Franchise Plc to open the first Pizza it is difficult or impossible to collect taxes (value- Hut stores in Ethiopia. The first Pizza Hut store added tax, excise tax, import duties, and so forth) is expected to start operation in the coming six from unregistered businesses without licenses. months. Electronic commerce is still in its infancy in Ethiopia and is rarely used. The Government 64. Despite positive developments and of Ethiopia is preparing a draft national law to optimistic expectations for the sector, govern e-commerce. modern distribution channels still fail to capture a large portion of the retail Informality market in Ethiopia. The distribution sector in Ethiopia has undergone several transformations 63. Informality prevails despite the in the past decade, but the impact on poverty emerging diffusion of modern retail stores. reduction remains uncertain. Many middle- Despite the growth of the higher-end supermarket class consumers benefit from a greater variety segment, the number of traditional small stores of goods at affordable prices in modern retail that sell local produce remains high in Ethiopia’s outlets. The modern procurement systems and retail market. In general, the distribution sector buying centers established by supermarkets have includes a few large supermarkets, slightly more also improved the lives of participating farmers. large to medium-size wholesalers and retailers, However, very poor urban households at the and a much greater number of independent bottom of the income pyramid pay higher prices and often informal small retail shops and street for basic goods and services than do wealthier vendors. Such informal retailers can be found in consumers—in cash or in the effort they must urban and rural areas, and are often the primary spend to obtain them—and they often receive enterprises engaging in distribution services lower quality as well. Box 2.4 illustrates the outside larger cities. Most businesses in the price penalty for sugar and teff affecting poor informal sector are engaged in the retail of food consumers in Addis Ababa. 42 Box 2.4 The Bottom of the Pyramid Penalty In informal settlements, retailers buy normal Although the smaller quantities are more goods from wholesalers or retail outlets and affordable to poor consumers, they are paying a break them down into smaller affordable considerably higher unit price for these products. quantities. For instance, poorer consumers Table B2.4.1 illustrates this point, where a 250- cannot afford to buy the 2-kilogram packet of gram pack of sugar retails at a 43 percent sugar that retails at about Birr 56 (or US$2.4) in premium, and a 250-gram pack of teff at a 25 most shops; however, they can afford to buy a percent premium. The poorest members of the pack of 250 grams at Birr 10 (or US$0.4). This society pay more for their essential goods than makes goods affordable for poor households. ordinary Ethiopians. Figure B2.4.1 Price Comparison of Selected Products in Informal Settlements Commodity Kiosk price for units less Supermarket price Price differential for units than 250 grams (Birr/kg) (Birr /kg) less than 250 grams (%) Sugar 40 28 43 Teff 30 24 25 Some retailers in informal settlements have the packs found in these retail kiosks weigh weight scales. But by and large, the portions sometimes more, sometimes less. are meted out without weighing them. Thus, Source Interviews in Addis Ababa, June 2017. 65. Moreover, given that the majority of and continue to supply traditional wholesalers, the population depends on agriculture, who then sell to individual retailers and processors. small-scale farmers have sometimes found As the supermarkets in the highest tier tighten their themselves marginalized by the distribution demands for consistency in volume and quality, sector and its new practices. Given the high small producers and undercapitalized brokers face fixed costs associated with participation in modern tougher competition from larger producers and chains, many small farmers and traders are not risk being squeezed out of the system altogether. able to participate in modern procurement systems 43 Constraints to Distribution Services 66. In the formal sector, explicit trade and address the skills shortages and skills barriers and regulatory measures obstruct mismatches that prevent farmers and small and the entry and limit the operations of medium-size enterprises (SMEs) from accessing/ distributors. Typical barriers and regulations benefiting from modern distribution channels. In affecting distribution services are listed in box addition to the explicit trade barriers that limit 2.5. Formal trade barriers stop countries from the distributors’ ability to establish themselves in importing the necessary services to respond to other countries, several other regulatory issues demands for affordable and quality services may explain the negative outcomes in the sector. Box 2.5 Typical Explicit Trade Barriers and Regulatory Obstacles Affecting Distribution Services Formal Trade Barriers Typical restrictions that affect trade in distribution services differ by mode of supply,a but typically include the following for the relevant modes of supply (modes 1,3 and 4) for distribution services: Mode 1 Restrictions on cross-border trade can have negative effects on distribution services, especially those where supply chains cross from the territory of one country to that of another. Such restrictions that could be particularly relevant to distribution services include (i) restrictions on electronic sales, (ii) quotas or economic needs tests that restrict the number of suppliers, or (iii) restrictions on payments and transfer of funds abroad. Mode 3 Restrictions on commercial presence can have negative effects on distribution services, especially where foreign chains are prevalent in domestic markets. Such restrictions that could be particularly relevant to distribution services include (i) limitations on the numbers of permitted suppliers, legal form (including joint venture requirements), foreign equity capital limits, and discriminatory tax/fiscal measures; (ii) restrictions on the legal form of distribution outlets; (iii) nationality requirements on staff, or restrictions on the recruitment of foreign personnel; or (iv) different regulatory frameworks for foreign establishments than those that apply to private outlets. Mode 4 Restrictions on the presence of foreign persons can have negative effects on distribution services. Such restrictions that could be particularly relevant to distribution services include (i) burdensome immigration requirements, (ii) quotas on the number of service suppliers, (iii) nationality or residence requirements, or (iv) labor market tests (for example, horizontal 44 measures or restrictions specific to the distribution sector that apply to staff traveling across national borders to set up establishments to negotiate arrangements, or provide instruction/training). Domestic Regulatory Barriers The typical regulatory measures in the distribution sector generally relate to market access and conduct regulation: Market access. Typical regulations on market access include requirements for setting up and opening a business, such as registration with the trade/regulatory bodies; regulations on the establishment, extension, and location of commercial presence; regulations on specific operations and products; the existence of local monopolies for some products; and impediments to the establishment of large outlets. Conduct regulation. In the distribution sector, the regulations on business practices may have considerable effects on competition between services providers. The main sector- specific measures captured under this category include regulations on prices, shop opening hours, zoning regulations, seasonal sales periods, and the range of products retailers or wholesalers may carry, as well as limitations on advertising and contracts with suppliers. In addition, specific taxes may be applied only to large formal retailers, or small retailers are exempted from certain taxes to protect small local incumbents. a. Trade in services can take place through four modes: (i) cross-border trade (from the territory of one Member into the territory of any other Member); (ii) consumption abroad (in the territory of one Member to the service consumer of any other Member); (iii) commercial presence (by a service supplier of one Member, through commercial presence, in the territory of any other Member); or (iv) presence of natural persons (by a service supplier of one Member, through the presence of natural persons of a Member in the territory of any other Member). See http:// www.wto.org/english/tratop_e/serv_e/gsintr_e.pdf. 67. Ethiopia’s Investment Code prohibits offer consumers new products, improved product foreign investment in distribution. Several standards and provide a market opportunity for international players, such as Walmart or local suppliers of consumer goods, particularly Nakumatt, the Kenyan supermarket chain, have fresh food. OECD (2017) finds that hosting an expressed interest in entering Ethiopia’s retail international retailer increases exports to the home market, but FDI restrictions as well as barriers country of the retailer. The empirical findings are affecting all modes of supply will continue to backed by case studies documenting how retailers keep foreign retailers away. Foreign retailers in engage with local suppliers of specific products, low-income and emerging economies typically providing incentives to comply with product and 45 process standards in export markets. In addition, in commercial activity. Fees depend on the modern supermarket procurement systems, type of business permit required. Multiple often championed by foreign retailers, promote licenses are a significant challenge in distribution healthier and safer production and processing services. The revised Commercial Registration and systems also locally. In many cases suppliers to Business Licensing Proclamation eliminates some the local affiliate of the retailer over time become cumbersome and duplicative requirements, such regional and sometimes even global suppliers as the yearly renewal of business registrations to the retailer. Even when becoming a supplier and the minimum capital requirements to set up to a foreign-owned retailer does not lead to limited liability companies. The law removes the exports, it may still open the entire domestic requirement to obtain a “competency certificate” market to the local farmer or food processing except in technical sectors such as health and plant, providing sufficient scale to invest in product environment. The Proclamation now allows quality and modern technology. At this stage, registration of franchises and holding companies. there are limited opportunities for foreign firms in Ethiopia’s distribution sector: FDI restrictions 69. The main restrictions affecting do not include fast-moving consumer goods, operations in the distribution sector are and foreign companies can distribute and export related to price regulation. Price controls their specific products if they are manufactured (maximum prices) exist in Ethiopia for essential within the country. But foreign companies are goods such as sugar, palm oil, bread wheat not allowed to engage in the distribution of any flour, petroleum, and petroleum products. imported goods. For example, the Heineken Compounding this issue are the cartels that control brewery can distribute beer produced locally, the prices and flow of certain goods, such as seeds such as Heineken or Walia, but is not allowed to and fertilizers. distribute imported whisky. 70. In addition to explicit trade barriers 68. In Ethiopia, new businesses, including and regulatory obstacles, nontariff barriers all distributors, must register with the hamper imports by modern retail chains in commercial registry, notify the authorities, Ethiopia. Nearly all the processed and packaged and obtain licenses and permits to engage foods sold at major retail outlets are imported. These products include breakfast cereals, candy, cooking oils (such as soy, corn, sunflower, and olive), rice, powdered milk, condiments (such as mustard, ketchup, and salad dressing), pastas, cookies and crackers, jams and jellies, and fruit juices. The combination of import duties and taxes on processed grocery food items is quite high, with a cumulative tax burden of almost 65 percent. 46 Specific duties and taxes on processed food items relies on appropriate human resource capacity are as follows: import duty (30 percent); value- and skills at all stages of the value chain, as well added tax (15 percent), surtax (10 percent), and as the proper flow of information between actors. withholding tax (3 percent). Furthermore, delays due to bureaucracy and congestion at the ports 72. Poor infrastructure affects distribution have a negative impact on the cost of importation services. Due to poor road network conditions, and stocking of appropriate inventory levels. especially in rural areas, and traffic congestion Measures concerning regulatory transparency in the main cities, distributors are forced to make and administrative procedures are also a form early deliveries to avoid traffic jams and reduce of nontariff barrier. These regulations involve transportation costs. Cumbersome importation publication and communication of the regulatory processes due to bureaucracy and congestion at and licensing regimes, as well as administrative the ports increase the price of imported goods procedures for allocating and renewing licenses. and complicate stocking and inventory planning. Lengthy customs clearance affects cross-border Moreover, limited ICT infrastructure limits the sourcing of retailers. Finally, excessive visa potential of e-transactions and e-government processing time represents an additional cost, procedures, particularly in customs clearance. especially when workers or managers need to travel to provide their services, for training 73. Limited human resources restrict the purposes and so forth. expansion of the distribution sector. The distribution services supply chain may also be 71. A poor business environment constrains affected by constraints on human resources, the development of distribution services. which can be particularly acute with respect to Underpinning the smooth functioning of the the availability of market-relevant skills such as distribution sector are many enabling factors that merchandising, category management, and just- support the business environment for trade in in-time inventory management. In addition to distribution services. These include the appropriate the absence of formal training, a limited influx framework conditions for doing business, which of knowledge about best or good practice in the imply, inter alia, rule of law, proper protection sector can limit the growth of SMEs in the sector. of property rights and enforcement of contracts, Talent shortages and limited training opportunities and a necessary degree of political and macroeconomic stability. This also implies a stable and secure environment in which to conduct business and trade. In addition, the distribution service supply chain relies on access to finance as well as adequate physical and ICT infrastructure to facilitate transactions at all stages in the supply chain. Finally, smooth trade in distribution services 47 impede the development of the distribution sector, on transformational productivity growth within and the availability of market-relevant skills existing sectors. This more recent literature remains an issue across the distribution sectors in considers structural change generated by the East Africa. Consequently, most formal distribution movement of factors of production between businesses rely on training on the job. Further, firms and reallocation of resources from lower there is limited influx of knowledge on best or to higher productivity activities within the same good practice in the sector. Lack of access to sector (see, for example, Hsieh and Klenow specialized training has led to slow growth and (2009, 2012) and Page and Shimeles (2014)). late adoption of modern retailing techniques. Indeed, in a world dominated by complex and For example, many large supermarkets are fragmented production processes, development only beginning to understand the value of and can be achieved by (i) functional upgrading, that adopt modern retailing techniques such as is, by moving to higher value-added tasks, and (ii) merchandising, category management, and just- process upgrading, that is, by specializing in the in-time inventory management. tasks and activities of comparative advantage and putting more technology, know-how, and auxiliary Distribution Services in Value Chains services into such tasks that ultimately translate into value addition and higher productivity. 74. To illustrate more broadly the opportunities and challenges for producers 76. This means that improvements and and consumers in Ethiopia, the case studies shifts in production within each sector are explore the role of distribution services in an important element of development, the dairy, teff, sesame, and textiles value and transitioning from an agriculture to chains. These case studies (i) explore the role manufacturing is not the only avenue, as of distribution services as intermediate inputs traditional development views suggest. It and tasks in value chains in these sectors, and means instead increasingly embracing higher (ii) show how distribution services affect structural value-added production or more productive transformation defined from a new angle. activities in the same sector or type of commodity, or transitioning from informal production to 75. Although most definitions of structural formal activities with the assistance of more transformation focus on sectoral changes,23 technology, services, and know-how as well as more recent literature broadens this view. better links to input and output markets. For the It is in this context that the proposed analysis case studies, this means looking at how services aims to contribute to the debate, by focusing (specifically distribution services) can facilitate the 23 Traditional definitions of structural change (or structural transformation) emphasize the “reallocation of production factors/ resources/economic activity across sectors,” and more specifically from low-productivity to high-productivity ones. For example, Rodrik and McMillan (2011) explain that the countries that manage to pull out of poverty and get richer are those that can diversify away from agriculture and other traditional products. As labor and other resources move from agriculture into modern economic activities, overall productivity rises and incomes expand. More specifically, they describe the two key dynamics in the process of structural transformation: the rise of new industries (that is, economic diversification) and the movement of resources from traditional industries to these newer ones. As such, structural transformation entails the rise of new, more productive activities and the movement of resources from less productive activities to these newer ones, raising overall productivity. Similar views on structural transformation defined as “the shift of resources from low- productivity to high-productivity uses” and “the reallocation of production factors (resources) across the broad agriculture, manufacturing, and services sectors” are found in the early literature. See, for example, Lewis (1951), Kuznets (1955), Chenery (1986), Kuznets (1966), Kongsamut et al. (2001), and Ngai and Pissarides (2007). 48 movement into higher value-added activities, such the role of services as tasks in value chains, and as production and export of processed milk (ultra- their impact on upgrading and moving up the heat treated (UHT) processed milk), cheese, or value chain.25 Therefore, this analysis attempts to sesame oil. clarify the role of distribution services (as inputs and tasks) in the dairy, sesame, teff, and textiles 77. Initial attempts to explore the role of value chains. services in changing the features of Global Value Chains (GVCs) evaluated the role of 78. To illustrate the role of distribution services as intermediate inputs. Over the past services in value chains and structural decade, an extensive literature has documented transformation, we depict a value chain the cost and quality impacts of services inputs in key food staples such as grains, such on the competitiveness and growth performance as teff, wheat, barley, corn, sorghum, and of the economy (see Francois and Hoekman millet. The value chain shown in figure 2.16 is (2010) for a summary of key findings). The based on fieldwork and interviews conducted in Swedish National Board of Trade (2013, 2010) Ethiopia in 2016–17. The results of the analysis considers the role of services in enabling GVCs: provide a snapshot of the steps through which the “servicification”24 of manufacturing, defined food staples move from producer to consumer, as the increased use of services in manufacturing as well as the key actors and institutions involved in production processes and sales. It looks at along the way. services as intermediate inputs, but also discusses 24 This is a term coined by the Swedish National Board of Trade. Earlier attempts to define the evolving role of services were undertaken by Reisken et al. (2000), who introduced the “servicizing” concept; Bryson and Daniels (2010), who refer to the “manuservice economy”; and Vandermerwe and Rada (1988), who introduced the “servitization” concept. 25 First, many examples illustrate how services act as “connectors,” play an important intermediation role, and generate strong complementarities across all types of markets. For instance, Low (2013) describes how modern communication and transport technologies have enhanced the tradability of services, leading to their incorporation into supply chains as traded inputs and bundling into composite products, such as “business functions.” Kommerkollegium (2013), based on evidence from the Organisation for Economic Co-operation and Development, identifies the business services sector as a good example of the fragmentation of production, with an important role for enabling GVCs in goods and services. Second, services tasks are important for upgrading and moving up the value chain. Saez et al. (2014) and Taglioni and Winkler (2014) show that the complexity and transaction intensity of GVCs require high-quality intermediate inputs, including services inputs, for effective coordination. Maglio et al. (2010), Demirkan et al. (2011), Allee (2008), and Low (2013) complement this approach by considering the role of networks; technology; entrepreneurship; and intangible assets, such as human knowledge, more efficient internal structures and processes, business relationships, trust, or reputation in generating innovation and creating GVCs. 49 Figure 2.16 Role of Distribution in Value Chains PRODUCERS Domestic Without contract: With Contract: Foreign Producers (Small Greater Greater VC Producers & Commercial Informality Integration (Farmers) Farmers) AGGREGATORS Domestic Food Supply Programs Farmer Cooperatives Informal Assemblers, Formal Local Importers Collectors & Brokers Suppliers VALUE Processors Local Distributor/ ADDERS Wholesalers (Millers & Brewers) Franchiser RETAILERS Informal Local Large Super - Franchised Vendors Markets Markets Retailer Small & Local Medium Shops Exporter CONSUMERS International Formal Foreign Informal Foreign Domestic Food Supply Consumers/ Consumers Consumers Programs Importers 50 Key Actors and Activities 79. Although the distribution services value bulkers, and accumulators, value adders, retailers chain may differ slightly with respect to the and franchisers, and consumers. Drawing on the particular food staple in question, there are WTO’s definition26 of distribution services, and enough similarities between these products based on interviews conducted in the region, that a “consolidated” value chain can be anecdotal evidence suggests that the actors and presented, as the one in figure 2.16. Actors and institutions involved at each stage of the distribution institutions involved at each stage of the distribution process include, inter alia, the following: process include, inter alia, producers, aggregators, Producers 80. Producers tend to be households or SMEs. Most producers choose to farm as a business; however, some households farm for subsistence and sell surplus crops if and when they are available. Producers sell their crops to: (i) consumers directly at local markets; (ii) informal assemblers or collectors, who on-sell crops to more formal aggregators, wholesalers, or processors; or (iii) cooperatives, community-based organizations, or domestic food supply programs. Producers also sell to processors such as millers or brewers, wholesale buyers, or other more formal suppliers for domestic and internal consumption. In these cases, producers often operate under the auspices of prearranged contractual arrangements (described in box 2.6), which are formal or informal in nature, and specify the terms and conditions on which crops will be bought. By eliminating information asymmetries, especially with respect to pricing, as well as other market failures, the contractual arrangements can ensure more efficient market allocation with less waste and better prices for consumers and producers. Importantly, those engaged in contractual arrangements with farmers provide valuable inputs that producers use to plant, grow, and harvest their crops. These include seeds, which can be procured locally or imported from abroad, as well as the fertilizers and pesticides, which are used to grow the crops to maturity. A final input that is often provided in the production of these food staples is the 26 Providers of distribution services generally fall into four categories: retailers, wholesalers, franchisers, and commission agents. Retailers in the formal and informal sectors sell goods for personal or household consumption. Wholesalers sell merchandise to retailers or other businesses. Franchisers sell specific rights and privileges related to operating a branded business, for example, the right to use a particular retail format or trademark. Finally, commission agents trade on behalf of others in that they sell products that are supplied and usually owned by others to retailers and wholesalers. 51 availability of farm equipment, including basic tools such as hoes, slashers, and axes, as well as more complex machines such as trucks, tractors, and water pumps. These inputs can come from a variety of providers, including outgrower companies, farmer cooperatives, community- based organizations, agro-dealers, NGOs, government, seed companies, or processors/buyers with a contractual link to the producers. Aggregators, Bulkers, and Accumulators 81. Once crops are grown and harvested, producers. Such arrangements occur with or without they are sold to consumers, informal previously arranged contracting arrangements, vendors, local markets, middlepersons, or and provide an important intermediating role in informal brokers, assemblers, or collectors. distributing crops domestically and internationally The latter are small- or large-scale entities that can (photo 2.2). Typically, cooperatives are formed collect and store crops for a period of time, and by a group of members, usually producers, who who help to market and on-sell crops to larger subsequently store, market, and distribute crops aggregators and wholesalers (photo 2.1). These to wholesalers, millers, processors, and retailers. “middlepersons” and other traders and brokers can Farmer cooperatives also provide credit to small play an important intermediating role by helping to and mid-size farmers, as well as critical inputs such bridge the gap between small farmers in rural and as seeds, fertilizers, and harvesting equipment, disconnected markets with buyers in other parts of which many small members may not have. the country and abroad. However, the profit-driven nature of these transactions necessarily drives up 83. Finally, the public sector may intervene the price of the staple crops and increases the gap through domestic food supply programs, between producer and consumer prices. such as the Ethiopian Grain Trade Enterprise or Ethiopia Commodity Exchange, or 82. Although most small farmers— international programs such as the World particularly those who do not have Food Program. These NGOs help buy, market, prearranged contracts—sell their products and manage strategic reserves, which can ensure directly to consumers at local markets, it is food security so that emergency needs are met and also common for them to sell items to more the focus is on economic and social development formal third-party suppliers, such as traders objectives. As necessary, such programs may supply or brokers, on a contractual basis. Likewise, food staples for domestic markets, or look to sell farmers’ cooperative unions may buy directly from these crops abroad if demand and prices warrant. The public sector may intervene through domestic food supply programs 52 Value Adders 84. Processors and distributors, as well 85. Likewise, wholesale companies may as wholesalers, often buy crops from add value through processing, packaging, middlepersons and aggregators, or and selling products in bulk, rather than directly from farmers with whom they have directly to consumers. Wholesalers, processors, contractual arrangements (photo 2.3). These and distributors often work together as channel entities vary in size, from local village hammermills, partners who sell to large and small retailers to large-scale millers, food processors, breweries, and, subsequently, to consumers. Contractual and animal feed manufacturers. Processors play arrangements with producers can help these an integral role in transforming raw ingredients processors and wholesalers to guarantee consistent into food or other useful products, which can be flow of supplies, proper economies of scale, marketed and sold to consumers. Key activities reduced transactions costs, and standardization involve grinding, mincing, milling, macerating, of products. Although processors and wholesalers liquefaction, emulsification, cooking, brewing, may supply food staples for domestic markets, pickling, pasteurizing, preserving, and canning they also sell to regional or international markets and packing food products. through international exporters and distributors. Retailers and Franchisers 86. Retailers include vendors, local markets, There is significant variability across countries small shops, and kiosks, which operate on in East Africa. For instance, Ethiopia relies on a largely informal basis (photo 2.4). Likewise, traditional central markets and small retailers retailors often include more formally organized to provide these products. In other countries, operations, such as medium-size, privately owned such as Kenya, there is the presence of foreign retail shops and large supermarket chains, which supermarkets and large franchised retailers from may be franchises linked to larger wholesalers. other countries in Africa, Europe, or South Asia. 53 Consumers 87. At the end of the supply chain are foreign markets, as well as more formal foreign the individual consumers of these food consumers and importers. Finally, international products (photo 2.5). Poor households spend a food supply programs, such as the World Food larger proportion of their food budgets on staples Program can be important international consumers in comparison with total food expenditures. End of domestic crops, for onward distribution to consumers can also include informal foreign institutions such as hospitals, schools, and other consumers, who cross borders to buy crops at public agencies, which provide food to their clients. Box 2.6 Benefits of Contractual Arrangements A recent pilot study was conducted by the World stipulate various terms of engagement between Bank’s Trade and Competitiveness Global the producer and buyer, including the following: Practice on international value chains related to • Specific types and quantities of crops to grow food staples (maize, sorghum, and cassava) in • Guidelines on quality standards that the Ghana, Kenya, and Zambia (World Bank 2016). crops must meet to be purchased A key finding was that farmers in these countries • Price guarantees with respect to various crop often participate in contract schemes managed categories by agroprocessors, buyers, cooperatives, or • Inputs that producers should use, including community-based organizations, as well as seeds and fertilizers directly with processors and wholesalers. These • Extension and post-harvest services, as well contracts can be formal or informal, and can as training provided by buyers. As a result of these contractual arrangements, • Larger output volume, higher yields, larger whereby producers have a prearranged plots, fewer crops lost, and fewer crops market for their crops, perception surveys have consumed highlighted several benefits for producers, • More transparent and guaranteed pricing in including the following: line with current market prices • Greater access to technology and inputs, • Increased sales and greater revenues from including seeds, fertilizers, irrigation, and crop sales. harvesting 54 Relational Dynamics 88. From the supply chain analysis, several relational dynamics emerge on the roles played by key actors and institutions. A first key observation is that supply chains for such staple crops are often nonlinear, and instead involve a complex web of vertical and horizontal connections. For instance, farmers may sell products to market vendors (retailers), which are then bought by brokers and resold to processors. Subsequently, suppliers may buy back processed products and resell them to small shop owners, and onward to consumers. The backward and forward linkages mean that there is not one standard path through which staple crops are distributed, and suggest that there are many opportunities for value addition, depending on the end use of the product. Second, and relatedly, the supply chain presented above suggests that actors often take on multiple roles and value-adding activities may take place across the value chain. For instance, all actors may play a role, however big or small, in storing, processing, packaging, marketing, wholesaling, and retailing products. As such, aggregators are not bound to merely transporting crops, as they may also bundle them and market them to particular buyers and markets. Likewise, brokers and suppliers may also separate, sterilize, sort, and package crops, above and beyond the intermediating function they provide between producers and wholesalers. A final observation that emerges from the supply chain analysis is that farmers “on contract” with cooperatives, formal suppliers, wholesalers, processors, and large retailers have a greater opportunity for their products to enter formal value chains, whereas those without contracts are less likely to have entry points into national and international value chains. The intuition behind this is that the actors who add the most value to staple crops are formal suppliers, millers, and wholesalers. These actors are often responsible for transforming staple crops into higher value-added goods, such as flour, cornflakes, and snack foods in the case of maize, or porridge and beer in the case of sorghum. To create such higher value-added products, processors and wholesalers often need crops of a certain quality standard at certain moments in time and, as a result, engage in contractual relationships with producers or other suppliers. By guaranteeing their sourcing via contracts, it is more likely that these higher value-added products can enter regional and international export markets. Conversely, as suggested by the value chain diagram in figure 2.16, it is more likely that producers without contracts will see their crops bought by food supply programs or informal brokers, or sold directly at local markets—making it much less likely that they will join regional and international value chains. 55 Case Studies: Dairy, Teff, Sesame, and Textiles DAIRY 89. Ethiopia’s dairy production can be broken down into four main systems: (i) commercial farms, (ii) peri-urban and urban, (iii) rural dairy smallholders, and (iv) pastoral and agro-pastoral. Commercial farms, which are usually government farms or privatized government farms, and peri-urban and urban producers are located close to population centers. Commercial and peri- urban/urban dairy farmers are the most important for the processing component of the sector, but also sell directly to consumers. Both use more advanced and commercial feed inputs. Commercial farms are also more likely to use more advanced cattle breeds through artificial insemination and employ better animal health practices. Rural dairy smallholders dominate milk production in Ethiopia, accounting for at least 95 percent of milk production. The greatest portion of rural dairy smallholders are in the Ethiopian highlands, and produce almost exclusively for domestic milk consumption and sale to immediate neighbors. Rural smallholders tend to own between one and five cows. Rural dairy smallholders are too remote and do not have access to cold chain logistics to connect to processors, which tend to locate near population centers. However, excess milk is used for household processing into ghee, butter, and cheese. Pastoral and agro-pastoral producers are found in most other rural areas, such as the Southern Nations, Nationalities, and Peoples' Region. They depend on moving seasonally to follow natural pasture, and produce for subsistence consumption or sale to immediate neighbors. 90. Household processors dominate the Etete Milk Processing Company, and Lame/Shola dairy market. There are around 32 processors Dairy, which was until recently government owned. in Ethiopia, which can be grouped into large Operations tend to be quite vertically integrated, processors and household processors. Large with large processors having their own dairy processors are very few in number, and include farms, collection centers, transport, and retail Sebeta Agro-Industry (Mama Dairy), Family Milk, shops, but also combining this with outsourcing 56 through specialized firms. The sector appears to Integrated Milk Industrial Company, which operates be of interest to international investors, with Etete similarly, but with smaller operations and tending to Milk recently enjoying a large investment by private be less vertically integrated. Household processing equity firm 54 Capital, and Velocity Dairy, a very concerns the production of ghee, butter, and cheese, large proposed Dutch investment almost coming mostly for subsistence purposes, with excesses sold to fruition. There are also several slightly smaller to immediate neighbors. The Ethiopian dairy value “medium-size” processors, such as the Elemtu chain map is depicted in figure 2.17. Figure 2.17 Dairy Value Chain INPUTS AND Artificial Govt extension services: Feed: SERVICE insemination veterinary & artificial PROVIDERS private private insemination (NAIC) PRODUCERS Pastoral, agro-pastoral & Commercial farms Peri-urban & urban rural smallholders (95%) (1%) farmers (4%) (Sell excess produce) TRADERS, Milk Collection MIDDLEMEN & Cooperatives transporters centers COOPERATIVES PROCESSORS & Large scale processors MANUFACTURERS (10% of milk production) Household processing (Pasteurizing and packaging milk, (Raw milk --> Ghee butter, & cheese) butter, cheese, cream & yoghurt) DISTRIBUTORS/ Supermarkets Retail shops RETAILERS Direct sales Direct sales (15%) (71%) CONSUMERS Household processed Consumers - towns/ Raw milk to immediate goods to immediate urban centres/cities neighbourhood neighbourhood Note Orange squares denote the informal sector, which comprises over 95 percent of the dairy value chain in Ethiopia. 57 Producer Challenges in the Dairy Sector 91. Access to quality feed is a major challenge affecting producers. The challenges affect rural and pastoral/agro-pastoral, and urban/peri-urban producers differentially. Pastoral and agro-pastoral smallholders are usually far from main cities and towns. As such, they lack access to commercially marketed feed and rely instead on opportunistic types of self- produced feed. There is a lack of awareness of, and seeds for, high-value fodder crops, such as elephant grass and alfalfa, which are widely used in the East African Community. These rural producers also have limited access to concentrates for feed, due to logistical and price reasons, and lack trust in commercial suppliers. Urban and peri-urban producers use concentrates and agroindustrial byproduce, such as sugarcane and oilcake, but without sufficient roughage, as they have very limited land resources from which to draw. Without land resources, they cannot sufficiently produce their own feed. Commercial feed is also expensive, and a lack of regulation erodes trust in its quality. Value-added tax is charged on feed, which exacerbates its affordability. Furthermore, there are currently few incentives behind the production of commercial feed, due to the small and disperse geography of dairy producers. Overall, it is estimated that at most 5 percent of dairy producers might use improved feed and concentrates, with at least 90 percent relying on their own self-produced feed. 92. There is very limited provision of breeds. This contrasts with Kenyan dairy production, veterinary health services available to rural which has incorporated higher-yielding animals as producers. Slightly better provision is available to somewhat of a colonial legacy. In Ethiopia, about urban and peri-urban producers. In each case, the 3-5 percent of livestock are crossbreeds, and six quality of drugs and services is poorly regulated. million of 13 million are in Kenya. However, the Commercial farms employ better private sector Ethiopian varieties tend to produce naturally higher- veterinary services. Rural and urban smallholders fat milk, facilitating a stronger household processing tend to rely on government veterinary extension industry for butter, ghee, and cheese. services. Artificial insemination (AI) services are of very limited availability and, where they are available, 94. The demand-side pull for dairy producers tend to be of poor quality and high cost. AI provision has considerably differential impacts, interacts with market failures in the provision of depending on producer location. This is a animal health and feed, as farmers will not invest in result of very limited cold chain logistical services expensive AI breeds if veterinary services and quality for rural producers, and causes two very opposite, feed are unavailable for livestock. Smallholder farms but negative, impacts on the sector. Urban and peri- usually rely on the public provision of AI (National urban producers face excess demand, enabling Artificial Insemination Center); medium and larger producers to supply poor quality and adulterated farmers use private AI providers. There is a risk that milk, with little incentive for quality upgrading. By the public sector crowds out the development of contrast, rural smallholder and pastoral producers better private sector AI providers. have very limited access to markets, and as such lack a “pull” market to incentivize production 93. The overwhelming majority of milk production relies on low-capacity indigenous 58 beyond subsistence consumption and the sale of When asked how they ensure that they always have excess produce to immediate neighbors. Several the quantities and qualities of required raw milk, interviewees highlighted these demand issues, one processor tellingly answered “impossible.” emphasizing that any measures to boost milk Processors in Addis Ababa highlight this issue, with production in rural areas must be accompanied by quality being among the top challenges. Lamenting facilitating access to markets for a complementary this, one processor stated that they had “tried to “pull” incentive. Important here is the lack of cold introduce a premium for quality milk by rejecting chain logistics and chilled collection centers. In substandard milk, but farmers know that if I don’t addition to feed, animal health, and AI interventions, buy their milk another processor will, so there farmers need a market for milk offtake. is little incentive for farmers to improve quality.” Furthermore, traditional household milk consumption 95. The cross-cutting challenge for milk tends to be less concerned by adulterated milk, and producers is access to affordable inputs, consumers just boil whatever milk they receive, and including access to quality feed, veterinary as such compound the adverse quality incentives. services, and AI services. To address such This traditional sector of the market accounts for 95 challenges, one expert proposed an electronic percent of the raw milk market. “voucher” system for buyers and sellers of inputs and outputs to interact. The voucher system has 97. Quality issues very much interact with, two benefits: (i) it can be used to help connect and are explained by, the other processor distributors with buyers, and (ii) it can operate like challenges, such as farm size, variable demand a savings and credit service, enabling access to and supply, adulteration of raw milk, underutilization products when buyers and sellers are out of cash. of dairy inputs, and lack of contractual arrangements Such a system is reportedly being developed by between processors and producers and the value of the Agricultural Transformation Agency in Ethiopia cooperatives. for fertilizer, improved seed distribution, and grain output marketing. 98. Farm size is a key constraint in Ethiopia’s dairy sector. Larger farms are better placed to Processor Challenges in the Dairy Sector provide higher quality milk supplies to processors, owing to greater use of quality private sector 96. The key processor challenges relate to veterinary services, improved feed, and superior the sufficient sourcing of quality raw milk. cattle breeds. However, the larger farms in Ethiopia Eliminating obstacles to distribution services can link rural producers to markets for inputs, increase sales, and reduce post-harvest and storage losses 59 are very limited, accounting for an estimated only is greatest during the rainy seasons, and becomes 1 percent of total milk production. As a result, relatively scarce during the dry seasons. Raw milk processors must augment their sources with milk prices reportedly rise as much 30 percent during from medium- and small-scale producers. the dry seasons. 99. Ethiopia’s fasting culture presents an 100. The compounding seasonality of unusual dairy challenge. During fasting days, production and demand presents a challenge Orthodox Christians, representing around 45 along the value chain (box 2.7). Processors percent of the Ethiopian population, practice fasting recognize that producing powdered milk or ultra- and in doing so avoid the consumption of dairy and high temperature (UHT) processed milk could help meat products. As such, consumer demand for milk to smooth sourcing and demand variability, but first oscillates considerably between the fasting and non- requires higher quality milk supplies as well as new fasting seasons. This causes a real challenge for machinery. The quality requirements are deemed processors, who must modulate their production “very demanding” and importing the requisite and sourcing accordingly. In the words of one machinery would be prohibitively expensive for most processor, “I can buy very good quality milk during established processors. One processor suggested fasting, but not at all after fasting.” Moreover, raw that less than 10 percent of raw milk meets UHT milk production has its own seasonality. Production quality requirements. Box 2.7 Dairy Fasting and Rainy Seasons in Ethiopia The main rainy season is from July to September, from November 25 to January 6, Johan’s Fast with a short rainy season in March and April. from February 6 to 9, Apostles Fast from June 5 The main fasts are the Great Lent fast from to July 12, and Assumption of the Virgin Mariam February 20 to April 15, Fast of the Prophets fast from August 7 to 12. Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Rain Fasting 101. In urban areas, demand for raw milk and wheat powder. This filters down the value reportedly exceeds supply in most seasons. chain, making it more difficult for processors to Producers and vendors can sell poor quality meet milk quality standards. milk to processors who have limited alternative supplies. Resultantly, there is reportedly a high 102. Better contractual arrangements level of adulteration in raw milk supplies, as between farmers and processors, including suppliers seek to bulk up their milk with water support for input services, was identified 60 as a means for improving quality. Most dairy farmers underutilize input services and products such as feed, AI, and veterinary services for animal health. This cascades down the value chain to affect the quality of the milk obtained Access to foreign by processors. Usually large processors are not involved in the provision of services. Their currency arrangement is just to buy milk and they prefer to specialize only in their own area of processing. Useful lessons can be learned from the Kenyan franchising arrangements in which improvements for imports to different parts of the value chain, such as input suppliers, can be achieved through the franchising remains a of successful businesses. Franchising has enabled successful business models, including those of top concern input suppliers, to expand their good business methods and practices across Kenya. Although this could be encouraged in Ethiopia, it would depend on successful businesses desiring to imports remains a top concern—processors operate a franchising model. sometimes have to wait six months for dollars. 103. Cooperatives were identified as being 105. Beyond this, there also appears to much better in supplying services, such as be a challenge with policy coordination. feed and veterinary drugs, to farmers. A The government maintains a large footprint in processor who highlighted that cooperatives are different parts of the industry, although it has better at supplying services indicated that he did been privatizing operations in the past decade, not fully understand why cooperatives were not including Mama Dairy, the largest milk processor, utilized more broadly in Ethiopia, but indicated and several commercial farms. There is a need that he prefers, where possible, to work through for more coordination between the government cooperatives to ensure that his farmers have and processors during the formation of dairy access to feed and veterinary drugs, as this helps sector policy. him achieve higher quality milk inputs. 106. Any interventions that aim to improve 104. Processors additionally face dairy production in rural areas must be more general, cross-cutting business accompanied by strategies to link rural environment challenges. These include producers to markets for inputs and the sale electrical supply variability, in which fluctuating of raw milk. This would also support processors in voltage and cutoffs can damage equipment, lose accessing better quality raw milk supplies. Assisting time, and add to generator expenses. Water supply processors to make UHT and powdered milk could intermittency is another source of frustration. High help smooth the demand and supply fluctuations import duties add expenses for inputs that cannot associated with the rainy seasons and fasting be sourced locally, including packaging, yogurt periods. However, this is unlikely to happen until machines, specialized packaging ink, flavorings, quality issues can be resolved. UHT and powdered and spare parts. Access to foreign currency for milk also have greater potential for regional exports in the Horn of Africa. 61 Dairy: Conclusion and Recommendations but privatization of processing and farming operations has occurred in the past decade. 107. The single greatest challenge for dairy The government remains involved in the inputs in Ethiopia is channeling milk production section of the value chain. into commercial markets. Rural and pastoral milk production, which accounts for over 95 109. International investors in the dairy percent of total milk production, is delinked from sector seem, ostensibly, cognizant of the markets for selling produce and purchasing inputs. upstream challenges and the benefits As such, there is little market “pull” for producers of addressing the market failures. One to increase the quantity and quality of production. international investor is setting up contractual This is compounded by the absence of cold chain arrangements for cooperatives to access quality logistical services and transport infrastructure. feed and veterinary services, to be paid back There is limited access to dairy production inputs, upon delivery of milk. Within this program, the such as feed, artificial insemination services, investor also aims to purchase a chilled tanker for and veterinary services. This is somewhat of a collecting milk and provide educational services. collective action failure, as farmers will not invest in expensive artificial insemination cattle breeds 110. Several processors recognized the without the market to export their produce or potential for dairy exports within the Horn inputs to support these breeds. of Africa, and in particular Somalia, South Sudan, and Djibouti. This would only be 108. The principal challenge faced by possible with the production of UHT or powdered processors is reportedly in sourcing quality milk in Ethiopia, and remains a way off. Kenya milk supplies. Large commercial farms produce is also a highly competitive regional competitor. milk of good quality; however, processors must UHT requires higher quality milk supplies, which also rely on urban and peri-urban producers who are largely unavailable in Ethiopia due to the poor are less able to meet quality requirements. Since provision of upstream dairy inputs, including feed there is reportedly excess demand for raw milk quality, veterinary services, and animal health, near population centers, such producers have little alongside midstream transportation issues and incentive to improve quality. Milk tends to become the prevalence of milk adulteration risks before adulterated up the value chain, as the household supplies reach processors. The current value chain market for raw milk is less averse to poorer quality, lacks incentives for the improvement of quality: and urban producers have little incentive to improve there are no premiums between different qualities quality. Issues with quality are compounded by of milk and no milk quality checks. This derives from the seasonality of milk production and demand: limited supplies in urban areas, where processors production increases in the rainy seasons and are located, making processors “quality takers.” demand fluctuates with fasting periods. Finally, As such, dairy demand in Somalia is met with processors also face general business environment exports in dairy livestock directly. This contrasts challenges, including access to foreign currency, with the successful development of a regional high import tariffs, electricity and water supply dairy market in the East African Community. variability, and lack of consultations during policy Here, dairy products are traded between Kenya, formation. Nevertheless, the sector appears to be Uganda, Rwanda, Tanzania, and Burundi. Within attracting international investors, who seem more this context, Uganda, for example, has increased interested in expanding their own extension services its East African Community dairy exports from to producers. The sector has been characterized negligible amounts in 2006 to more than US$15 by excessive government ownership in the past, million in 2014. 62 111. The Ethiopian government favors a policy collaboration between the public and private private sector–led transformation of the sectors for better dissemination of the Ethiopian dairy sector, by introducing international Livestock Master Plan, which determines a clear investments and opening up investment direction for collaboration between the public and opportunities. It would be useful to engage in private sectors and discusses investment plans. TEFF 112. Teff, the main ingredient for injera, traders, many processors, and a large, mostly the daily staple food for more 50 million urban population as the consumer market. Ethiopians, is of vast importance for the consumption as well as production sides. Teff 113. An important feature of teff is the is important for food security across the country, different quality types that are produced: as well as for the livelihoods of many smallholder traditionally, the distinction has been made farmers. In Ethiopia, 6.3 million smallholder between red, mixed, and white. Red is of farmers use 20 percent of the cultivated area the lowest quality, and white teff is of the highest (2.7 million hectares in the country) to produce quality. More recently, an additional distinction teff (Minten et al. 2013a). These farmers can has been introduced: magna teff (“super white”), be found across the country, in all its ecological which is of even higher quality than white teff zones. The market is highly fragmented, with (Minten et al. 2013a). The supply chain for teff in many smallholder farmers, several layers of Ethiopia is depicted in figure 2.18. 63 Figure 2.18 Supply Chain of Teff in Ethiopia INPUTS AND SERVICE Extension services Seed enterprises Own seeds PROVIDERS PRODUCERS Smallholder farmers Commercial farmers TRADERS, Collectors Cooperatives Teff exporters MIDDLEMEN & COOPERATIVES Local market Traders Traders (redistributing Market in Addis Ababa (Mesalemia) towards other regions) PROCESSORS & Mills MANUFACTURERS DISTRIBUTORS & Restaurants Retail shops Injera exporters RETAILERS DISTRIBUTORS & Domestic consumers Foreign consumers RETAILERS Domestic, formal and informal sector Domestic, formal sector Foreign-oriented sector 64 Inputs The smallholders who produce teff Although some farmers use the best have access to several inputs, most seeds from their previous harvest, some importantly seeds and fertilizer. of the interviewed farmers indicated In addition, several extension services that they buy seeds from commercial are available. As reported by Minten et seed companies. If a farmer decides al. (2013a), the use of modern inputs to get seeds from a commercial seed (improved seeds, chemical fertilizer, company, the farmer is obliged to sell all herbicides, and pesticides) has increased the harvested teff back to the company. significantly over the past decade. Producers Teff is predominantly produced consumption of teff is in the range of by smallholder farmers (6.3 10 to 30 percent).27 million throughout the country; Minten et al. 2013a). Many of these In addition, the Agricultural farmers own some land and often rent Transformation Agency has granted 48 additional land. They use injera as commercial farmers licenses to grow their main dish (for breakfast, lunch, teff, with a goal to export it (Secorun and dinner) and therefore a significant 2016). However, this project is still in a part of the harvest is not sold (for pilot phase and therefore not expected to most of the interviewed farmers, self- affect the teff market in the near future. Trade Before teff reaches its destination their teff directly from the local market. at processing mills, several However, some traders buy from the layers of traders, middlepersons, local market (or from farmers directly) and cooperatives form a key to transport it to a larger urban center, component of the teff supply in particular Mesalemia market in chain. Farmers have essentially three Addis Ababa. This is the key distribution channels through which they can sell center for teff in the capital city. Every their teff: directly at a local market, day, trucks full of teff arrive and the to collectors/traders, or through a teff is sold to traders at Mesalemia. cooperative.28 In many cases, there is Over the past year in particular, some a collector who buys teff directly from a redistribution toward other regions has farmer at the farm. This collector sells occurred: in that case, private agents to a larger aggregator, who in turn sells or government agencies buy full trucks to another aggregator. This process of teff that can be brought to other might be repeated several times before regions. Government agencies use this it reaches the local market. Many strategy to address the emergency in consumers or processors (mills) buy several regions. 27 Minten et al. (2013b) find that for a sample of 1,200 farmers the average self-consumption of teff is 64 percent, possibly indicating that the farmers we spoke with sell relatively a lot of their production. 28 This excludes a possible fourth channel: selling back to commercial seed enterprises in case they bought seeds from such a company. 65 Processing To process teff for injera is required for the machinery,29 lack of production, it needs to be grinded a steady supply of electricity, and high at a mill. Many small mills exist, mostly cost of electricity. However, although in urban areas. These mills provide a such concerns might lower competition service and grind the teff bought by over time, from observation and other consumers or buy teff directly and sell research (Minten et al., 2013), we the grinded teff. The major challenge can conclude that there has been an for mills concerns electricity: the high increase in the number of mills and cost for the electricity input “socket” that competition is therefore growing. Distributors Many consumers buy their teff cereal shops. In addition, major clients directly from mills and bake are restaurants that buy teff from mills injera at home. However, there is or injera from cereal shops. Finally, a an increasing demand for ready-made handful of injera exporters sell to several injera. This injera is sold in certain European and American markets. Consumers Nearly all injera in Ethiopia is legal exports to Israel (for its Ethiopian consumed domestically. Since Jewish population), there are also some the government banned teff exports informal exports, especially to Eritrea, a few years ago, there are almost Sudan, and the Republic of Yemen. no exports. Although there are some Key Challenges in the Supply Chain for Teff clear demand among farmers for improved seeds is present: only three years after the introduction 114. The key challenge in the teff supply of the new quncho seed, almost a third of their chain is increasing the usage of modern sample was already using this type of teff seeds. inputs, especially improved seeds. Although Although there seems to be a clear demand, important progress has been achieved in there has been little investment in improved seed increasing the usage of fertilizer, herbicides, varieties: only around 20 varieties have been pesticides, and improved seeds, a lot remains to introduced since the 1950s (Fufa et al. 2011). In be done. Interviews with farmers indicate clearly addition, consumers’ increased demand for higher that the quality of seeds is key for a farmer’s quality teff further underscores the importance of market power, in qualitative and quantitative enabling farmers to satisfy this demand. terms. As described by Minten et al. (2013c), a 29 Some of the mill owners whom we interviewed indicated that such an input socket can cost in the range of Br 200,000 to Br 250,000 (±US$8,500 to ±US$11,000). In addition, it can take several years before the socket is installed. 66 Beyond this key challenge, several issues are specific to the distribution services: 115. High fragmentation and many layers small compared with the farmgate price, as can be of collectors and traders. Is there a potential seen in figure 2.19. Across the different qualities of role for cooperatives? Many layers are present teff, the markup range is roughly 16 to 24 percent between the smallholder farmers who produce and of the final price. This seems to be confirmed by the mills that process teff. Although intermediary our interviews: many of the farmers do not feel agents play a key role in distribution, they also that there are too many layers between them and take a markup. Many argue that cooperatives the market.30 Although our evidence is anecdotal, could play a key role in reducing the number of the farmers and mill owners indicated a similar layers in distribution, but this needs to be carefully price structure.31 In addition, the number of layers considered with the evidence at hand. Some argue has been decreasing over time, which shows that that the number of layers is not so high (Minten et cooperatives are not necessarily needed to reduce al. 2013b). In addition, the markup is relatively the number of layers. Figure 2.19 Teff Price Structure, by Quality, October to November 2012 1800.0 1600.0 1400.0 Milling and clearing 1200.0 Urban retail Birr/quintal 1000.0 Urban wholsesale 800.0 600.0 Rural market/town 400.0 Farmgate 200.0 0.0 Magna White Mix Red Source Minten et al. 2013b. 116. Cooperatives can help farmers smooth as possible. Most teff is harvested in December, across time. Many farmers indicated that the key and prices are high between June and September, difficulty for them is to sell their harvest as late especially toward September when seeds are in 30 Of course, many indicated that they would like to a larger share of the market price, but a feeling of unfairness does not exist among the interviewed farmers. 31 The price range for farmers depends significantly on the time sold and the quality of the teff. The interviewed farmers around Debre Zeit, who generally sell high-quality teff, indicated a price in the range of Br 1,670 to Br 2,330 per quintile. The price at mills at the time of the interviews was around Br 2,200 per quintile. The price range of farmers might be slightly exaggerated upward. Taking Br 1,670 as the lowest price for farmers, this still gives a price markup of 24 percent, which is in line with the findings of Minten et al. (2013b). 67 high demand due to the seeding season. Price in qualitative and quantitative terms. As described differences between December and the period by Minten et al. (2013c), a clear demand among from June to September can be substantial (prices farmers for improved seeds is present; however, can increase in one year from Br 14 to Br 20 there has been little investment in improving seed per kilogram). Cooperatives can buy teff from varieties: only around 20 varieties have been farmers in December for a low price and sell introduced since the 1950s (Fufa et al. 2011). the teff in the summer for a high price, giving In addition, consumers’ increased demand for farmers an initial advance in December and the higher quality teff. Two factors are driving a additional profit from the summer later. However, higher demand for better quality. First, part of implementation of cooperatives is very important. the population is becoming more prosperous and On the one hand, one of the interviewed farmers therefore demanding higher quality teff. Second, who was a member of the cooperative was very this trend is expected to continue, as urbanization happy with it. He emphasized the additional will continue and more people will be able to profit, as well as the possibility to acquire seeds afford higher quality teff. This further underlines through the cooperative. On the other hand, the importance of investing in availability and other farmers were unaware of cooperatives or access to improved seed varieties. did not trust the people who made up the board of the cooperative. Building trust and reputation 118. In terms of distribution services in teff by having an inclusive approach is therefore very value chains, the challenges are twofold: important and is one of the key determinants of (i) the many layers of traders point to the potential whether a cooperative will be successful. for cooperatives to integrate vertically the supply chain for the benefit of smallholder farmers, and Teff: Conclusions and Recommendations (ii) cooperatives could also play a role in helping farmers reduce early sales and allow them to 117. The key challenge in the teff supply get the full price for their produce. However, chain is increasing the usage of modern implementation needs to be very carefully inputs, especially improved seeds. Although considered: currently many farmers seem to be important progress has been achieved in unaware of the existence of cooperatives. If they are increasing the usage of fertilizer, herbicides, aware of the cooperatives, the farmers sometimes pesticides, and improved seeds, a lot remains to decide not to join, because they do not trust be done. Interviews with farmers indicate that the cooperatives based on previous bad experience. quality of seeds is key for a farmer’s market power, SESAME 119. Sesame is a cash crop that serves as an important source of income for many farmers throughout the country and enables the country to receive foreign exchange. Sesame has been the second source of foreign exchange after coffee. More than 576,000 hectares are used to grow sesame, with most of the production in 68 Tigray (41 percent) and Amhara (40 percent), after the region in which it is produced. and to a lesser extent in Oromia (10 percent) The best quality is from Humera, characterized and Beningshangul-Gumuz (9 percent). More by its good aroma, taste, and high oil content. recently, production has started in the Southern The other common types are the Wollega (which Nations, Nationalities, and Peoples' Region and also has a high oil content and is used mainly for Afar (Ministry of Agriculture et al. 2015). crushing) and Gondar types (Ayana 2015).32 The supply chain for sesame in Ethiopia is depicted 120. Different types and qualities of sesame in figure 2.20. are produced in Ethiopia, each named Figure 2.20 Supply Chain of Sesame in Ethiopia INPUTS AND Extension services Seeds SERVICE PROVIDERS PRODUCERS Smallholder farmers (50%) Investors (50%) Cooperatives Collectors TRADERS, MIDDLEMEN & COOPERATIVES Suppliers Ethiopian Commodity Exchange (95%) PROCESSORS & MANUFACTURERS Processors DISTRIBUTORS & Exporters RETAILERS CONSUMERS Foreign consumers Domestic consumers (<10%) 32 Exporters indicated that these standards are known among importers in the specific markets for Ethiopian sesame. Following a literature review and interviews, it seems that there are no formal international standards concerning sesame: every market demands particular characteristics for optimal processing. For example, since Japanese processors produce high-quality sesame oil, they require high-quality sesame: among other things, they demand a particular color, moisture percentage, and acid value (USAID 2010). 69 Inputs Sesame farmers have access terms of modern inputs, the Centre to several inputs, in particular, for Development Innovation (2013) seeds and extension services. notes that there is still a low adoption Most seeds are taken from the previous of fertilizer. harvest or imported from Sudan. In Producers There is roughly a 50-50 split in that smallholders face is finding skilled production between smallholder labor for a reasonable price. During the farmers and investor farmers. short harvest period, they often have to Since harvesting sesame is a labor- pay a high premium for labor to be intensive activity and the production able to harvest all the sesame (Ministry occurs in areas that are not densely of Agriculture et al. 2015). populated, one of the key challenges Trade Some farmers are organized in supply to ECX or bypass ECX and sell cooperatives, but the majority directly to exporters. Although some sells their sesame to collectors. bypassing occurs, ±95 percent of all Collectors aggregate several times and sesame is traded through ECX. sell it to a supplier. To be able to sell sesame at the Ethiopian Commodity ECX is trying to achieve further vertical Exchange (ECX), suppliers need to be a integration of the supply chain by member of ECX. These suppliers often organizing farmers into farmer have warehouses and bring sesame cooperatives, but currently only a small in bulk to ECX warehouses. At the group of the farmers are members of warehouses, the sesame is cleaned and a cooperative. graded. Most of the investment farmers Processing Very little processing is done by processing. For a more elaborate firms in the Ethiopian sesame discussion on this, see the subsection sector. There are a few, mostly foreign- on Developments in the Supply Chain. owned firms that have recently started Exporters Most exporters buy their sesame process the sesame as well to have the from ECX and need to be a produce qualified for exports. This mostly member of ECX to do so. Before concerns cleaning and packaging. exporting sesame, these exporters Consumers Nearly all the Ethiopian sesame market, but most of the refined oil is exported (estimates are at least consumed in Ethiopia is imported, mostly 90 percent). There is a small domestic from Southeast Asia (Ayana 2015). 70 Key Challenges in the Sesame Supply Chain Ethiopia’s yield has been decreasing over the past years, while other (African) competitors have Although there is a wide range of challenges in increased their yield and are overtaking or have the sesame sector,33 two stand out: overtaken Ethiopia (figure 2.21). The challenges underlying the low yield include the lack of skilled 121. Relatively low and decreasing sesame labor and the resulting use of unskilled seasonal yield. Although sesame yield in Ethiopia is labor, lack of adoption of seed varieties, as well roughly at the global average, two trends stand as soil degradation and increase in diseases and out. First, China’s yield is currently double the insect pests because of monocropping (Ministry yield registered in Ethiopia, indicating that major of Agriculture et al. 2015). improvement in yield might be possible. Second, Figure 2.21 Yield of Sesame in Major Sesame-Growing Countries, 2007–13 15 World 14 13 China 12 11 India 10 9 Myanmar Yield (q/ha) 8 7 Sudan (former) 6 5 Ethiopia 4 Uganda 3 2 Tanzania 1 0 Mozambique 2007 2008 2009 2010 2011 2012 2013 Sources Ministry of Agriculture et al. 2015; FAOSTAT 2015. 122. Recent global sesame price volatility and mostly to obtain access to foreign exchange to the inability of the Ethiopian sesame sector finance their importing business. Exporters argue to adjust compound the sector’s challenges. that farmers have become used to historically high Throughout conversations with sesame exporters, prices and are not willing to adjust prices down. the most common issue that was raised was the A failure to do so will eventually lead to exporters decrease in international sesame prices over the quitting the sesame business, further weakening past years and its volatility (box 2.8.). Sesame Ethiopia’s international trading position in sesame. exporters are currently selling sesame at a loss, 33 For an overview of all the challenges across the supply chain in sesame, see the chapters on “Systemic Bottleneck” chapters in Ministry of Agriculture et al. (2015). 71 Box 2.8 Ethiopian Sesame Competitiveness through the Eyes of an Exporter One of the interviewed exporters explained processing costs at ECX, leading to a total price the international sesame pricing issue in the of Br 30,000/metric ton. Thus, the total cost is following way: “For one metric ton of sesame, approximately US$1,300/metric ton. Since the we are currently paying Br 25,000 at ECX. In international sesame price is US$1,050/metric addition, we pay Br 5,000 for cleaning and ton, we lose US$250 on each metric ton.” Challenges in the Distribution of Sesame Ethiopian sesame when their shipment arrives and might default on the shipment if the price is much 123. High post-harvest and storage higher than the most recent price. Since shipment losses. Post-harvest, over 30 percent of the takes significant time, this price difference can be sesame is lost throughout the marketing substantial. Although the improvement in price process (Centre for Development Innovation information is a major achievement of ECX, it is 2013). This loss happens during the stacking important that export firms receive legal support and threshing, transportation (from and to from the government to enforce contracts with different warehouses), and storage (due to foreign buyers to counter such problems. increases in pest damages). In addition, quality is often affected by handling and storage Sesame: Conclusions and methods (Ministry of Agriculture et al. 2015). Recommendations For illustration purposes, in the example in figure B.5, the total loss is approximately 20 125. Some firms, mostly foreign, have percent. With an estimated loss of over 30 started to experiment with processing percent due to marketing problems, this means sesame in Ethiopia. However, there is much that the Ethiopian sesame exporting business more potential for this and it is key for the would become a profitable business again if sesame sector in Ethiopia to increase value the sector could eliminate all the post-harvest addition domestically and make the industry and storage losses. internationally competitive. Adding significant value is also a major opportunity to obtain more 124. Lack of support for exporters in case foreign currency. A wide range of processing of default of foreign buyers. In an effort possibilities are available for sesame: (i) edible to improve price information availability in the oil, (ii) confectionary biscuit and bakery, (iii) sesame supply chain in Ethiopia, ECX publishes tahini, (iv) halva, (v) sesame flour and seed the prices of sesame online every day, on 108 sprouts, and (vi) pharmaceutical ingredients physical price screens throughout the country, and (Ayana 2015). Although some of this processing through a phone number. Thus, farmers have more will lead to only little value addition, some has accurate knowledge about the price and therefore the potential to double the value of sesame get more value for their produce. However, (Ministry of Agriculture et al. 2015). However, some foreign buyers use this improvement in it is important that clear quality standards information negatively: they will check the price of need to be developed, since certain types of 72 processing require different types of quality. In threaten the position of Ethiopian exporters. To addition, many firms lack access to finance to regain competitiveness, several issues need to be start processing activities, which require highly addressed: (i) a wide range of options need to be capital-intensive machinery. considered to improve the yield of sesame, which has been decreasing over the past years; (ii) post- 126. Sesame is a key export product for harvest and storage losses need to be reduced (if all Ethiopia, with over 90 percent exported these losses could be eliminated, sesame exporting to countries such as China, Jordan, and would turn into a profitable business again); and (iii) Israel. However, Ethiopian sesame is currently further vertical integration, through cooperatives, uncompetitive and a rather unprofitable export has the potential to improve the competitiveness of business. Although Ethiopia has been one of sesame in the international market. Finally, more the leading sesame producers and exporters, in recently, some foreign firms have started sesame recent years, competition has increased, especially processing. Retaining value within Ethiopia could be from other African countries. Countries like Niger an important venue through which export earnings and Togo have gained a significant part of the could be increased significantly. Chinese sesame market, which might further TEXTILES 127. Textile production is an upcoming and increasing the availability of foreign exchange m a r ke t i n E t h i o p i a w i t h m a j o r (figure 2.22.). However, many domestic firms face developments underway. The construction stiff competition when entering the international of large industrial parks has the potential to market. They also face significant competition transform this industry, providing jobs to many domestically from cheap imported clothing. 73 Figure 2.22 Supply Chain of Textiles in Ethiopia INPUTS Domestic inputs Foreign inputs PRODUCERS Small scale home production Major factories TRADERS, Wholesalers in Wholsalers to Foreign MIDDLEMEN & Addis Ababa other regions wholesalers COOPERATIVES DISTRIBUTORS & Retail Factory-owned Foreign RETAILERS shops retail shops retail shops CONSUMERS Domestic Corporate domestic Foreign consumers consumers consumers Inputs Although some textile factories use and Pakistan. A major problem is domestic inputs, the vast majority the delay in shipment and the quality of inputs come from abroad, in of these inputs. particular, from China, India, Producers In addition to some small- differ significantly in the destination of scale home production (mostly their products: many of the Ethiopian- by women), most of the formal owned factories focus on the domestic production is dominated by tens market, and some of the foreign-owned of textile factories. These factories are more focused on exports. Traders Factories generally have shops. Many firms also supply directly wholesalers in Addis Ababa or to larger corporate firms (for example, abroad. Most of these factories do other factories that need clothing for not own their own retail shop: only the their workers). Some of the smaller biggest, established firms own retail firms supply directly to retail shops. 74 Wholesalers in Addis redistribute some via other wholesalers. This redistribution of their clothing toward other regions mostly happens in Merkato. Distributors Most retail shops are small and the city center of Addis have a prime can be found anywhere and in location; others in Merkato are small any form. Some of the retail shops in and approach informality. Consumers Beyond the domestic and foreign customers. The extent to which a consumer markets, factories also factory can export depends strongly on produce directly for corporate the quality produced. Key Challenges in the Supply Chain become internationally competitive. Reducing or completely removing these import taxes could 128. International competitiveness is strengthen the Ethiopian textile industry, by highly affected by the low quality of increasing exports and enabling textiles to be a inputs, the time it takes for inputs to potential source of additional foreign exchange. arrive, and the high cost of inputs due to the import tax. Firms obtain most of their inputs 130. Challenges related to finance, from abroad (China, India, and Pakistan). The infrastructure, and technical knowledge key problem is that these inputs are often of low are particularly pronounced in the textile quality, making it difficult for Ethiopian clothing to sector. Although these issues affect many compete on the international stage. In addition, industries, it is important to highlight them, since it often takes several months for these inputs to these are some of the key binding constraints arrive, due to transport and customs. Although in the textile sector. In terms of finance, many there is little to gain in reducing sea transport time, firms fail to obtain loans from private banks or it is expected that the revived Djibouti Railway the Development Bank of Ethiopia. If they can will improve land transportation time. However, obtain such loans, they are at extremely high to make full use of the advantage of the railway rates. Although progress has been made in improvement, the delays in customs clearance improving technical knowledge, most notably need to be addressed. Since it takes three to four through the expansion of textile technical and months for inputs to arrive after ordering, firms vocational education and training and related often have little negotiating power in case the special degrees at Bahir Dar University, firms quality is low: they simply have to produce the still have difficulty finding qualified people at all clothing with the given inputs. levels. Infrastructure issues, especially related to electricity, severely affect the ability of factories 129. To a certain extent, the high price to produce and deliver orders on time: a failure of inputs is due to the high import tax. to do so leads to bad relations with wholesalers, High import taxes reduce the potential for major something that could have severe consequences, exports, as Ethiopian textiles will not be able to especially for foreign wholesalers. 75 Challenges in the Distribution of Textiles Textile and Garments and Manufacturing Association has organized knowledge- and 131. Lack of quality and a perception about experience-sharing events, there has been little low quality lead to distribution issues. Many cooperation between firms from industrial parks firms fail to export because of the failure to adhere and domestic firms. to international standards. In addition, some firms might be able to produce high-quality clothing but 135. Textiles production is expanding lack awareness about the international standards rapidly in Ethiopia, mostly due to the for exports. active government policy on the opening of several industrial parks. In domestic 132. A missing link is that many firms would production, however, a major quality problem like to export but fail to establish contacts prevents the industry from expanding domestically with foreign buyers. Beyond quality, some firms and abroad. Nearly all inputs are imported, which that believe the quality of their clothing meets are often expensive (partially because of a high international standards fail to find international import tax), of low quality, and arrive after a long markets. There needs to be more interaction period. Since firms have no other options, these between textile producers and potential foreign expensive, low quality inputs must be used, which buyers. However, to a certain extent, the failure drives the firms out of the international market. The to find international markets might be intertwined resulting low quality of Ethiopian textile products with the quality problem. makes it difficult for Ethiopian firms to find a foreign market: the “missing link.” Domestically, Textiles: Conclusions and this problem perpetuates a low-quality perception, Recommendations also hampering domestic growth. Although industrial parks, such as Hawassa Industrial Park, 133. The key development within the are not perceived as a threat to the domestic textile sector is the development of industry, due to its export-oriented approach, they major industrial parks, such as Hawassa could provide an opportunity for knowledge and Industrial Park, where major international experience sharing. brands have started or will start operation. Although many of these industrial parks are Summary government-owned, some have been developed by the private sector. As indicated by Weldesilassie 136. These case studies show that although et al. (2017, 123), three industrial parks are distribution services have an important currently fully operational, two have finalized role to play in each value chain, they construction and are ready for operations, are only one part of the story. Although five are under construction, and 11 more are eliminating obstacles to distribution services can planned. In addition, since the publication of this help link rural producers to markets for inputs report, several parks have started operation or and the sale of raw milk, or reduce post-harvest are (almost) ready for operation. Firms in these and storage losses, binding constraints such as industrial parks have a mandate to produce only limited access to finance or lack of skills would for export. need to complement reforms in the distribution sector to reduce the prices paid by consumers for 134. However, the industrial parks are not these products, facilitate the movement into higher perceived as an opportunity to support value-added activities (such as cheese or sesame knowledge transfer. Although the Ethiopian oil), and increase exports. 76 2.4. Recommendations for the Future of Distribution Services 137. The analysis reveals that services and air transport—or through limited domestic matter for Ethiopia’s economic growth private ownership—for example, the financial and development, but performance needs sector), other so-believed wasteful services, such to improve for the sector to become truly as professional services or health services, are transformational. Many modern services remain neglected, resulting in almost no policy discourse underdeveloped in Ethiopia. Although the strategic on the role of the services sector in determining services are excessively controlled (for example, the national competitiveness and limited reform. services that are considered to be of strategic Traditional services such as distribution services also importance are allowed to operate only as strict witness high regulations and prohibit the presence public monopolies—for example, telecom, power, of foreign services suppliers and investment. 138. The disconnect between the reality on the ground and the ambivalent policy stance arises from various sources. First, “services” are treated in isolation and not as part of an interconnected chain of value addition from production to final consumption. Yet, the case studies presented in this report show that since supply chains are a series of linked international markets for goods and services, with policies in one market provoking ripple effects in the markets along the whole value chain (Low 2013), participation in international value chains has important implications for policy interventions. Policy formulation needs to treat goods and services together, as there are significant links between the two sectors. Moreover, such links call for modal neutrality—trade and regulatory policies that enable services firms to provide services through all modes of supply without impeding a switch from one mode of supply to another. Furthermore, regulatory coherence, simplicity, and efficiency need to be maximized to enable countries and firms to become competitive at the task level. Finally, since there has been a recent increase in the importance of value chains organized at the regional, rather than global, level in driving GVC participation and upgrading in a handful of industries (Staritz, Gereffi, and Cattaneo 2011), addressing integration at the regional level is critical. Second, that many services are now tradable and can be a source of export-led growth and export diversification has not yet been part of the policy discourse—because it is a recent phenomenon and because of the assumption that the comparative advantage of a low-income country like Ethiopia lies in agriculture and labor-intensive manufacturing. Although Ethiopia’s services exports are currently dominated by traditional services, exports of modern services such as communication or business services are beginning to emerge, and their role in export diversification and earnings should not be neglected. 77 Third, there is a genuine concern among policy makers that the state of regulation and the regulatory capacity of the government are relatively weak to support further liberalization of services. And finally, there is a worry that opening services sectors that operate under a monopoly would lead to declines in revenue and more outflow of foreign exchange in the form of profit repatriation—putting further pressure on the beleaguered exchange rate. 139. Although wholesale policy reform in good entry point into the world of services reforms. services is not feasible, several steps can The case of distribution services can be illustrative be taken to increase efficiency and attune of the opportunities for exports and the benefits services policy to be more supportive of from greater services openness and the policy development. Countries throughout the region reforms and approaches that will be required for are moving toward integrating their services these to be realized. This sector can provide the markets, and there may be long-term costs to base for a broader discussion of services trade Ethiopia if left behind in services, with negative policy reforms. The following list is not exhaustive, consequences for manufacturing and processed but it provides some initial reform guidance for agricultural products. Starting with nonstrategic this important sector. sectors, such as distribution services, could be a Raising awareness about the importance of distribution services for the formal and informal sectors in Ethiopia is an important first step in designing a comprehensive reform strategy that is linked with national development plans. The sector urgently requires a broad development strategy and recognition as a key economic driver to facilitate its growth to the next level. The importance of a formal distribution sector that contributes heavily to economic growth and is currently the second leading (formal) employer has been acknowledged in Ethiopia. Steps must be taken to raise awareness about the importance of the sector in a consistent way on the basis of detailed economic performance analyses and benchmarking exercises, while incorporating the informal sector into the landscape of distribution services. The large size of the informal sector underscores the importance of distribution strategies that can efficiently reach households at the bottom of the income pyramid and integrate small-scale farmers into the distribution system. Economic policies should address the root causes of informality, which can be a significant barrier for foreign operators to enter the distribution market in Ethiopia. Taking steps to relax explicit trade barriers, eliminate regulatory obstacles, and address informality issues. With distribution services closed to foreign participation, Ethiopia remains behind all East African countries and other comparators in removing explicit trade barriers. Box 2.7 provides a summary of experiences with the liberalization of distribution services, which may provide some guidance for possible reform in Ethiopia. Furthermore, the lack of regulation, onerous regulation, and unequal enforcement of regulation pose serious problems to competition and affect formal firms, including foreign operators, in the distribution sector. Reforms should focus on developing the necessary regulatory frameworks for distribution services, including rules and regulations affecting the business environment, eliminating disproportionate entry requirements such as 78 lengthy registration procedures, multiple licenses, or inadequate zoning regulations. Price controls represent a serious impediment to competition and should be removed. Addressing the concerns of the poorest households and facilitating the inclusion of smallholders in modern distribution chains should be a priority in Ethiopia. The majority of the population and a significant percentage of the income remain at the base of the pyramid. Possible policy actions to meet the needs of the poorest households and expand their access to basic products at affordable prices include the following: Facilitate the creation of organized market outlets for small-scale operators, to encourage their graduation from the informal sector. Facilitate access to financial services in the informal sector. Several case studies in Africa show that increased access to credit by micro and small enterprises has contributed to the growth in the distribution sector, particularly in the informal segment. Provide support to traditional and informal operators to acquire market-relevant skills. For example, training courses focusing on basic hygiene standards, merchandising, sampling, or promotion techniques offered in the slums could improve the skills of retailers in wet markets, kiosk sellers, or hawkers. There are several examples of innovative solutions to localized conditions, relying on consumer behavior and private-public partnerships with commercial potential (see box 2.9 for an example). Encourage horizontal coordination—such as farmer associations and cooperatives—to increase the bargaining power of small farmers, allow for economies of scale, and lower marketing and negotiation costs. Given the mixed experience with such associations, a case-by-case approach is warranted that emphasizes soft skills and contextualized management structures. Increase the participation of small farmers in modern chains by exploiting the widespread duality between traditional distribution chains and modern procurement systems. Rather than bypassing traditional wholesale systems and increasing the gap between traditional domestic markets and the formal processing sector, encourage the upgrading of traditional wholesale systems to support the interaction between the modern and traditional systems. The focus should be on improving basic safety standards, increasing the traceability of products, and reducing spoilage rates in the traditional markets. This can improve the structure of wholesale markets and enable upstream linkages with producers and downstream linkages with retailers and processors. Distribution services can be a good entry point into the world of services reforms 79 Addressing skills issues in the distribution sector. A strong distribution sector will require local know-how and talent. At first, companies will need to bridge the gap by using a mix of local and international employees. In parallel, investments in developing and retaining local talent are required. Developing local training programs and putting in place apprenticeship opportunities will be critical for achieving long-term success. Addressing infrastructure constraints (for example, roads, ports, and so forth). Steps must be taken to address the infrastructure and insecurity concerns raised by the business community. The removal of nontariff barriers that hamper the imports of distributors should be on the policy agenda of all East African governments. Box 2.9 Strategies for Reforming Distribution Services Strategies for reforming distribution services among distribution firms in domestic and range from full liberalization to a more gradual international markets. Hence, reform measures approach. In many developing countries, should mainly concentrate on reducing the reform strategies started by gradually constraints on the establishment of domestic expanding market access to foreign firms. As and international firms and their operations a first step, foreign distributors are allowed to (Baily 1993). accommodate customers at the higher end of the market. The second step entails allowing Liberalization also means promoting trade in foreign firms to enter the wholesale market. In services in line with General Agreement on other countries, domestic retailers dominate Trade in Services (GATS) rules and making the market and foreign suppliers cater to the commitments for more reforms. Several needs of the high-income percentiles of the developing countries promote liberalization population (UNCTAD 2005b). of trade in distribution services as part of their GATS commitments. Moreover, they commit Countries also attempt to relax restrictions and to fulfilling their commitments gradually over regulations governing distribution services and a specified period. Under GATS, World Trade foreign direct investment (FDI) to benefit from Organization members identified their policies technological diffusion and raise the efficiency that have a negative impact on distribution of these services. Developing and developed services and made specific commitments country experiences show that reforming to eliminate or at least relax some of them, distribution services concentrates mainly on as part of their efforts to promote trade increasing competition in local markets through liberalization. Several other restrictions the elimination of anti-competitive barriers imposed on these services, for specific social that affect the performance of distributors in objectives, remain outside the scope of GATS. local markets and hinder their expansion. FDI These restrictions include zoning restrictions, is a major tool that can promote competition licensing requirements, limits on store size and 80 opening hours, and investment hurdles and enterprises. Reform measures also concentrate other requirements on foreigners wanting to on improving supply chains and logistics that trade in the domestic distribution sector. Ideally, are closely related to distribution services. these restrictions would be removed through Moreover, improving logistics, especially those unilateral reform or tackled as part of regional related to agriculture and food products, is regulatory cooperation. one of the priorities of the reform agenda of distribution services in many countries. These Countries usually complement reform efforts reform measures allow consumers to have with improvements in the business climate a wider range of choices of better quality and support of small and medium-size products at much more affordable prices. 140. Guidance on the implementation of distribution service supply chain. For instance, small reforms can be provided by an in-depth producers who do not operate on contracts often political economy analysis that looks have limited information on weather, crop pricing, at structural, institutional, stakeholder, or other relevant information. Likewise, distributors sectoral, and global drivers.34 For instance, are often unable to gather information on their in the case of distribution services, key institutional market share and performance, which creates drivers relate to the role of informality in the market challenges for developing marketing strategies as well as more formal institutions/regulations. and new products, as well as forecasting and Endemic informality may dis-incentivize SMEs strategic planning. Rent seeking and elite capture from formalizing, and hence participating in may lead to the perpetuation of uncompetitive value chains, as they would face high regulatory practices (for example, price controls, domestic compliance costs and lose competitive advantage ownership requirements, and so forth) that seek to informal producers. to limit foreign firms entering the market, and hence the potential to participate in value chains. 141. Stakeholder drivers would encompass the full array of actors and regulators 142. In terms of sectoral drivers, various across the value chain, including farmers/ issues will likely arise across the retail producers, wholesalers, retailers, agents, versus wholesale sectors. Modes of trade and so forth. It will be necessary to examine can have a large impact on political economy the preferences and interests of various economic problems that emerge and the types of reforms that actors—such as distribution outlets, farmers, are pursued. Moreover, additional sectoral issues consumers, regulators, and policy makers—and may emerge as “countries’ willingness to make their key role in pushing or shaping the reform commitments in services are often inhibited by the process, by shedding some light on the economic horizontal fragmentation of power either between opportunities generated by reform and regional branches of government (executive vs. legislative) integration and the cost of maintaining the status or within them (trade ministries vs. other ministries quo. A key stakeholder issue is the limited and or agencies), and in some countries the problem is asymmetrical information at every stage in the further exacerbated by the vertical fragmentation 34 See Annex A for details on the political economy analysis. 81 of power (national governments vs. subnational sectors are subject to greater conduct regulations, units of government)” (OECD 2012). Given this such as pharmaceuticals and alcohol producers. dynamic, a critical issue is the difference in the Although quality, labeling, packaging, and levels of regulations between product categories advertising restrictions may serve a public interest, and sectors. Divergent sectoral regulations (for they may also result in an unfair advantage to example, market access, conduct regulations, these producers in comparison with other products standards, and so forth) may result in barriers for and sectors of the economy. certain types of products to enter value chains. For instance, food staples (including maize, sugar, 143. Several global/international drivers and cooking oil) and petroleum products can be can have a particular impact on the subject to price controls at the discretion of the domestic political economy of distribution government, whereas the prices of other classes services, including (i) foreign investment, which of products are unregulated. Although price can provide evidence on the intentions and interests controls are designed to prevent wide fluctuations, of external investors and firms—especially those they can give rise to a variety of problems and facing external competition—which affect how perverse consequences. For instance, powerful they lobby governments; (ii) international legal producers or trade associations may lobby for measures and sanctions, which can impact trade, a certain price control to remain in place, long financial, and travel restrictions; (iii) reputational after its usefulness as a social protection has pressures on stakeholders, which can relate to ended, which may increase producer rents but the influence that international organizations, hurt consumers, particularly the poor, who are Regional Economic Communities, or international highly dependent on food staples. Likewise, some business groups have on trade in distribution services; and (iv) external skills and ideas, which relate to international practices and ideologies on doing business. 144. Taken together, these drivers can provide a useful framework to conceptualize the political economy of distribution services reform and help identify feasible measures with the greatest benefits. 82 Problem-Driven Political Economy Analysis A Annex 83 Building on the regulatory analysis on underlying political economy determinants distribution services, this annex addresses and constraints to the distribution services the larger political economy of reform in sector. Given the nature of the sector and the the sector. Although there are many political potential transformative effects it can have on economy methodologies available, a particularly the regional and national economies of the useful framework is offered by using a “problem- member states, it is essential to tease out the driven” governance and political economy key drivers that contribute to the development, approach, developed by the World Bank (Fritz et regulation, and future prospects of distribution al. 2009) (box C.1). At the core of this approach services. Accordingly, this analysis is not about is a focus on a particular problem, opportunity, identifying one major bottleneck, but rather or vulnerability that needs to be addressed. Such understanding the political economy decisions of a methodology allows for a better understanding a myriad of challenges and frictions, and perhaps of specific issues and challenges, rather than suggesting which dimensions could be addressed. developing broad overviews, to generate useful Such an approach will provide insight not only findings and implications (Fritz et al. 2009). into challenges that result in necessary reforms not gaining traction, but also into potential A problem-driven approach can be opportunities that may unlock key road blocks in especially useful in understanding the the reform process. Box A.1 Distribution Services Political Economy Conceptual Framework35 • Structural drivers. Structural drivers are actors’ incentives. In many cases, these factors that are beyond the control of the issues cannot be changed in the short- government and reflect deeper features of to-medium run, and define a country’s the respective countries, such as resource status quo situation. At the same time, endowments, geographic position, levels structural issues can have a large impact of development, or population dynamics, on the opportunities that a country has which may affect a country’s institutional with respect to its bargaining position, setup. Such issues may additionally as well as with respect to the exogenous stem from the types of colonialization risk that it faces in a global system. For and decolonialization that a country example, structural issues may make an experienced, as well as other historical economy more exposed to commodity processes that have shaped the political, price shocks, currency fluctuations, or social, and cultural institutions that affect other macroeconomic fragilities. 35 This political economy framework for conceptualizing trade in distribution services is based on governance, regional integration, trade, and political economy literature: • Problem-Driven Governance and Political Economy Analysis (Fritz, Kaiser, & Levy, 2009); • Arguing a Political Economy Approach to Regional Integration (Byiers, Vanheukelom, & de Roquefeuil (2013); International Drivers of Corruption: A Tool for Analysis (OECD 2012) 84 • Institutional drivers. Institutional drivers, structural political economy factors. which can be seen as the “rules of the Such an exercise includes analysis of game,” are a combination of the formal informal institutions, such as kinship laws and regulations, as well as less structures, traditions, and social norms, formalized customs and institutions. as well as formally codified institutions, Understanding the formal and informal such as laws, regulations, and agencies. institutions is essential, as they provide Importantly, as noted by Fritz et al. a clearer picture about the context in (2009), it is necessary to understand the which actors operate, but also identify relationship between formal and informal “levers of change” in existing systems. institutions and ascertain whether they At the institutional level, mapping can be have complementary, accommodating, a valuable instrument in understanding substituting, or competing relationships. • Stakeholder drivers. Actor/stakeholder are individuals or specific groups. such drivers involve analyzing the divergent as government officials of a ministry, interests of government agencies, agency, civil society organization, business political parties, nongovernmental association, or political party. Once key organizations, business associations, stakeholders are identified, the problem- traditional associations, and producers driven literature suggests that they can be and traders of certain products, as well categorized in several ways to understand as external actors such as donors, foreign their interests as demand-side versus investors, and international organizations. supply-side actors, reform champions At the stakeholder level, mapping can versus reform opponents, or winners provide vital information on the various versus losers from certain reforms. types of parties involved—whether they • Sectoral drivers. As noted by Byiers et al. attribute credit or blame. Third, the balance (2013), a sectoral approach is necessary of power between policy makers and other for several reasons. First, different sectors actors is important, as monopoly services have differing levels of political salience can reduce state incentives for oversight and visibility at the national level and, and improved performance. Last, sector accordingly, will incentivize politicians or services that are frequent, predictable, or service providers in different ways. Second, area-based may make it easier for citizens depending on information asymmetries, or other groups to mobilize collectively more visible policies make it easier to (Byiers et al. 2013, 12). 85 • Global drivers. Certain global dynamics or and constraints to conceal and move processes may shape domestic institutional illicit assets, (iii) foreign investment, (iv) and political incentives, which may have global and regional security threats and positive or negative impacts on domestic responses, (v) international legal measures institutions and governance arrangements and sanctions against domestic elites, (vi) (Byiers et al. 2013, 12). In particular, the reputation pressures on political elites from Organisation for Economic Co-operation regional and international actors, and (vii) and Development approaches these drivers external ideas and skills (OECD 2012). based on the effects they have on corruption Importantly, these issues should take into and governance at the state level. These account not only current exigencies, but effects could include (i) sources of rents also their potential to affect governance and unearned incomes, (ii) opportunities in the future. 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