Ethiopia―Africa’s sixth-largest economy and second-most populous nation, home to 90 million people―has recently attracted global attention because of its double-digit economic growth. According to the Economist, Ethiopia was one of the world’s five fastest-growing economies in 2010. Despite the country’s remarkable growth performance in recent years, however, its record in promoting socio-economic development is mixed. Ethiopia has made significant strides in reducing rural poverty, improving life expectancy, and raising education levels. But these gains have come with rising urban income inequality and surging inflation. It is also not clear whether the services sector, which has accounted for nearly half of GDP growth since 2004, can continue to serve as an economic engine.
Impressive Growth Story
Since 2004, Ethiopia’s economy has grown by an unprecedented 11 percent on average—up from less than 3 percent annual growth during the previous seven years and much faster than average annual growth in Africa as a whole (nearly 6 percent). Ethiopia’s per capita income has more than doubled over the same period, albeit from a very low base—it was still below $400 as of 2010. According to the Economist, Ethiopia is forecast to be the third-fastest growing country in the world over the next five years, after China and India.
Although the economy remains heavily reliant on agriculture, the service sector has driven recent growth, accounting for nearly half of GDP growth since 2004. The share of services in the economy has also increased by seven percentage points to nearly 50 percent over this period, buoyed by especially rapid growth in financial services, real estate, and retail trade.
Ethiopia’s remarkable growth has been associated with a number of policy successes, as well as favorable external conditions. Ethiopia has seen a significant decline in its fiscal deficit (from 4.2 percent of GDP five years ago to 1.3 percent). Better regulatory and institutional frameworks, such as improved business registration procedures and requirements, have helped strengthen investor confidence. Large investments in infrastructure relative to the economy’s size, which reached about $6 billion (20 percent of GDP), have helped fuel domestic demand and enhance the economy’s productive potential. Positive external factors include rising remittances. Moreover, rising international commodity prices and a range of special incentives have helped exports grow at an average annual rate of 10.5 percent between 2004 and 2009 and contributed to the economic boom.
Fruits of Economic Growth
Rapid economic growth has clearly been instrumental in improving livelihoods. The country’s headcount poverty ratio (the percentage of its population living on an income of under $1.25 per day at 2005 PPP) fell from 55 percent in 2000 to 39 percent in 2005 and is expected to decline further. The drop in the poverty rate has also generally outpaced that for Sub-Saharan Africa as a whole.
In 2010, the average Ethiopian could expect to live for nearly 60 years, a remarkable improvement from 52 years just ten years ago; expected years of schooling have increased by four years; and gross primary enrollment has reached 100 percent. These improvements were underpinned by pro-poor public spending in agriculture, education and health, and road development, which currently accounts for more than half of government spending.
Twin Challenges of Inequality and Inflation
The headline statistics about Ethiopia’s progress conceal many shortcomings. For example, according to the United Nations, about 90 percent of the population suffers from numerous deprivations, ranging from inadequate health care to insufficient access to education. Moreover, rising inequality in urban areas has meant slow advances in urban poverty reduction. According to the latest poverty survey data, the Gini coefficient—a measure of income distribution—for urban areas increased between 2000 and 2005 and remained as high as 0.47 percent, compared to 0.27 percent for rural areas. The worsening income distribution in urban areas may partly reflect the increasing number migrants from rural areas who tend join the lower income class. Over the same period, the share of people living below the urban poverty line remained almost unchanged. Between 1995 and 2005, every 1 percent increase in the country’s per capita income was associated with a 1.1 percent decline in poverty; but other countries, such as Cameroon and Mali, have made greater strides in reducing poverty, despite smaller per capita income growth, by significantly improving income distribution.
The challenge posed by inequality is also reflected in other indicators. For example, according to the UN, Ethiopia’s inequality-adjusted Human Development Index (HDI) was 0.216 in 2010, 34 percent lower than the unadjusted HDI reflecting the unequal distribution observed in income, health, and education.
Inequality and the failure to make a dent in urban poverty are exacerbated in Ethiopia by high inflation, which hurts the poor disproportionately. Between 2007 and 2009, annual inflation in Ethiopia averaged 26 percent, the third highest in Africa. In recent months, it has reached nearly 40 percent (year over year); food prices grew by 46 percent at an annual rate. Monetary policy is a culprit—the broad money supply (M2) grew by 21 percent on average between 2004 and 2008—as are rising prices of imported oil and other commodities. Inadequate competition in agricultural markets (for example, price fixing by wholesalers) also contributes. In a country unaccustomed to adjusting wages for the inflation rate, such high inflation has a big impact, especially on the urban poor who tend to have fixed incomes. Even in rural areas, where farmers will fetch higher prices for their crops, most poor people are net food buyers and will end up worse off.
Composition of Growth
Unlike many successful developing countries, Ethiopia has not seen a shift towards industry. While agriculture’s share in the economy declined from 49 percent in 2001 to 42 percent in 2010, services have gained and the industrial sector’s share has remained more or less constant. The industrial sector has contributed just 10 percent of GDP growth since 2004. Infrastructure bottlenecks (such as water shortages and power outages), inadequate access to finance, a shortage of foreign exchange, and a shortage of raw materials have all contributed to underperformance in industry.
Even though the service sector now represents a high share of GDP, according to the latest available data, it accounted for only about 10 percent of employment in 2005, which is in contrast to many other countries' experiences. Agriculture still accounts for more than 80 percent of the labor force. Some of the service sub-sectors that have registered the fastest growth over the past five years, such as financial services, show relatively high productivity and little potential for generating employment. In addition, service exports are concentrated in a few areas such as airlines and shipping, which have low employment growth potential. Finally, Ethiopia’s service sector lacks essential ingredients―such as a well-integrated domestic market, skilled labor force, performing institutions, and quality infrastructure―necessary to be competitive at a global level in areas such as financial services and tourism.
Policy
Ethiopia’s recent growth experience reflects its own specificities, but can provide some useful pointers of broader applicability, especially in Africa.
There are serious questions about the sustainability of Ethiopia’s services-driven growth model. Since more than 80 percent of Ethiopians rely on agriculture for their livelihoods, policies that would increase agricultural productivity should receive more attention. And so should policies that improve the competitiveness of manufacturing. In this regard, building stronger market institutions, improving access to markets and land, developing infrastructure, and promoting specific skills could play an important role. Most of these steps would also enhance prospects for growth in the service sector.
The failure to reduce urban poverty despite years of double-digit growth highlights the importance of microeconomic policies, such as conditional and well-targeted cash transfer programs to the poor. Growth in the presence of very high urban inequality and poverty may not be sustainable and can be a source of great frictions, as seen in numerous instances of protest movements across the world.
Shimelse Ali is an economist in Carnegie’s International Economics Program.
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