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Fortune, Ethiopia December 13, 2009 Tamrat G. Giorgis The administration of Prime Minister Meles Zenawi might have a reasonable record in taming inflation. Doing that has a drawback, though. Sapping excess liquidity from the system has the downside of starving investors and makes access to capital very expensive. The federal government's policy of tightening its belt and imposing caps on the lending ability of commercial banks will remain in place as long as inflation is not totally out of the system and annual money growth is put on target (at 17pc), said Prime Minister Meles Zenawi. This is despite the monthly moving average of inflation recorded over the first quarter of the current Ethiopian fiscal year reduced below zero and the yearly moving average recorded was at 10.6pc in November 2009. This had created an expectation in the private sector that the administration could ease its hold on the credit market, and let the banks lend as much as their deposit allows. "We are not at a stage where inflation is completely out of the system," said Meles during a two-hour press conference he had with reporters from the local media on Friday, December 11, 2009. "We have to continue credit tightening." Alarmed by a record high rate of inflation over the past two years (the July 2008 to June 2009 average headline inflation had reached nearly 39pc), his administration has declared "war" on fighting price escalation in the economy. Meles had told Parliament last year that "inflation is the number one enemy." Growth in the gross domestic product (GDP) has had its own drawback. Expansion in the economy over the past consecutive five years came at the price of dwindled foreign exchange reserves (eaten up by an historic global price for oil in 2008) and rapid inflation. At stake was the need to reduce the growth of money supply in the economy from an average of 25pc recorded over the past five years. The volume of money circulating in the economy had reached over 100 billion Br during the last fiscal year, growing by 22.7pc from the previous year. The administration is determined to limit the growth of money in the economy to 17pc annually. Having a ballooned federal budget of 64.5 billion Br for the current fiscal year, the federal government has chosen to limit its budget deficit to 1.5pc and impose lending limits on all commercial banks, similar to the ones which have been enforced since the late 2008. The liquidity in the system is limited, according to a macro economic analyst. This has painful consequences for the banks, according to industry analysts. Many of them reached their ceilings within a few months of last year, affecting their annual performances. The newly formed banks were the hardest hit. Zemen Bank declared a loss of 9.1 million Br, Lion Bank grossed only a little over three million Birr, and Oromia Cooperative Bank's was a little over two million Birr. Oromia International Bank is expected to declare a loss or breakeven in its operations of 2008-09, according to industry sources. Even the private commercial bank with the highest profit declared from its operation of last year (249.8 million Br), Dashen Bank, has come to exhaust its lending limit this month, according to a senior manager at the bank. "Our job now is to collect what we have been lending out," this manager told Fortune. Meles has challenged the view that banks are seriously affected by the capping, particularly when it comes to short-term and merchandise loans, which constitutes one third of the total loans and advances to the private sector. Meles also argued that his policy of limiting private borrowing does not stifle economic growth. "What it does is," said Meles, "stifle inflationary pressure." In spite of the cap imposed on the banks, each bank can still recover its loans on time and lend it again within the limits of the cap, according to Meles. "Bank managers have a misunderstanding about what the cap is all about," said the Prime Minister. "They can provide loans so long as they collect back what they have advanced. It is revolving loans." Industry leaders, however, argue that they are clear on the policy. Although there is room for them to do business with borrowers within the limits, the deposit they mobilise from their customers and interests they pay on deposits is growing at a faster rate than their ability to collect back their loans and advances. Deposit mobilisation by 13 of the banks operating in the country grew by nearly 25pc during last Ethiopian fiscal year to reach close to 100 billion Br, according to data from the Central Bank. However, total loans and advances made to the private sector during the same period have increased by a little over 16pc; they have reached close to 60 billion Br. The National Bank of Ethiopia (NBE) should consider paying interest on banks' reserves with NBE in order to address their concerns, analysts advise. But these analysts advise prudence because doing so could also spoil the banks - doing business with the Central Bank is totally risk free. Industry leaders see, however, that the manner in which authorities at the Central Bank set limits on each bank has little logic. "It is like a magic number," said a senior manager of a private bank. He would rather see the Central Bank use banks' deposit to loan ratio when setting the ceilings. This, he said, would maintain the competitive sprit among the banks, a sprit he says is fast fading from the industry. "There is no economy without a limit," Meles said. It is like choosing between two evils, according to the macroeconomics analyst. On the one hand, the administration has to fight inflation by controlling the growth of money in the economy. Conversely, it should be careful not to create an economy where the cost of capital is so expensive that it discourages investment from the private sector. However, with his policy measures in response to the ravaging inflation registering a reasonable success and the foreign exchange reserve of the national treasury beefed up to over 1.5 billion dollars, and the budget deficit remaining below the international best practice of three per cent, Meles was seen as being reluctant to commit himself to a specific time when his administration would lift the policy of imposing caps on borrowing. "Caps will always remain in place as long as macro economic stability has not been achieved," Meles said on Friday. It appears that limits on borrowing, designed to control the volume of money in the economy in a bid to keep inflation at bay, will remain a fact of economic life in Ethiopia for a few years to come. Economists are worried, however. They argue that keeping this policy for too long will be counterproductive. They caution that achieving macroeconomic stability requires the administration to strike a delicate balance. "It has chosen to deal with the worst evil," said the macroeconomic analyst. "You have to pay a short-term price in order to achieve the long-term health of the economy." The short-term price is starving investors' capital in order to deliver the economy from inflation. Investors and borrowers will be compelled to pay high interest rates for capital or seek other expensive sources of funds if the administration fails to respond quickly by increasing liquidity to the market. "It is very difficult to know how to strike that balance," said the macroeconomic analyst.