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It aims to reduce inflation below 20 percent by 2024 and under 10 percent by 2025

The National Bank of Ethiopia (NBE) announced stringent measures on August 11, 2023 to curb the growth of lending by commercial banks, in a bid to rein in persistently high inflation.

As per the new rule implemented with immediate effect, yearly credit expansion by banks stands restricted to 14 percent.

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The move comes in the wake of massive loan disbursements by banks in the last fiscal year. Data shows that in the 12 months ending February 2023, banks disbursed a total of 382 billion birr in loans – a substantial increase from 209.6 billion birr in the same period a year earlier.

Authorities believe excessive growth in bank lending over the past few years has contributed significantly to overall rise in cash into the economy and undermine efforts to curb inflationary pressure.

The latest figures show Ethiopia’s annual inflation eased to 29.3 percent in June – below 30 percent for the first time in two years. While an improvement on its 34 percent level a year ago and peak of 37 percent, the central bank acknowledged this reduction is not “enough.”

The NBE’s new credit limit on banks is expected to moderate the pace of money circulation.

By restricting fresh financing availability from lenders, the central bank aims to gradually ease inflation pressures over coming quarters. This monetary policy measure is part of a multifaceted approach together with supply-side interventions, structural reforms and implementation disciplined fiscal policy.

The NBE clarified the measures are not eliminating but slowing credit. “It is an important part of reducing inflation sustainably,” the central bank said.

While acknowledging impacts, bank executives broadly welcomed the NBE’s move.

“It’s a blessing in disguise – we faced choosing between inflation or credit restraint,” said a private bank senior executive.

Wegagen Bank president Aklilu Wubet shares this view.

“Low income families are hurting from high prices. As major lenders, banks must contribute to lowering inflation for the public,” he stated.

Financial analyst Abdulmenan Mohammed (PhD) said tightening credit growth is necessary to address inflation. “But reducing the growth of credit will negatively impact economic activity and potentially asset prices,” he warned.

Patrick Heinisch, an economist, also says the limit “will leave its mark on the real economy.”

“Ultimately, some economic slowdown is needed to get inflation under control,” he said.

Industrial nations are having exactly the same experience, according to Heinisch.

“Slower lending to the private sector has also been observed in the eurozone since late 2022, and this also has a significant impact on growth there,” he added.

The economist understands that credit growth must be proportionate to the overall growth of the Ethiopian economy too.

“When the money supply grows much faster than the economy, inflation occurs due to the mismatch between the money supply on one hand and goods and services on the other,” Heinisch remarked, citing Ethiopia’s economic growth of between five and six percent in recent years, while outstanding credit grew by 30 percent, fueling inflation.

Abdulmenan questioned the effectiveness of usual tools like reserve requirements that failed to restrain credit previously. “That’s likely why the NBE resorted to directly limiting growth, as implemented before but later removed,” he noted.

While praising aims to ease inflation, the expert outlined potential distortions.

“Direct curbs can cause inefficiencies in credit allocation and wider interest margins,” Abdulmenan continued.

The central bank said the credit limit is temporary, intended for use until mid-2024 when the NBE will transition to an interest rate-based policy framework.

Currently, Ethiopia uses a reserve money targeting framework like many developing nations, controlling aggregate money growth via reserves.

However, Abdulmenan says this assumes stable velocity and demand for money, untenable given Ethiopia’s rapid financial development, inclusion and innovation.

“Transitioning to an interest-based framework using the policy rate to influence money supply, as the NBE signals, is appropriate as implemented elsewhere in Africa,” he noted.

According to its outlook, the NBE aims to reduce inflation below 20 percent by June 2024 and below 10 percent by June 2025 overall – a target that Abdulmenan called unrealistic given existing economic factors.

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