NBE’s Dilemma: How Liquidity Injections Threaten Ethiopia’s New Monetary Strategy

A couple of weeks ago, the National Bank of Ethiopia (NBE) released a monetary policy statement, unexpectedly lifting the lending cap imposed three years ago and announcing its focus on indirect monetary policy instruments, such as its policy interest rate. The lifting of the cap was accompanied by a 1 percentage point increase in the NBE policy rate to 16 percent (with a symmetric band of ±3 percent) to maintain the tight monetary policy stance maintained over recent years.

In fact, the NBE had progressively relaxed the lending cap due to pressure from stakeholders. While lifting the cap is a vital step—as direct credit ceilings are distortionary emergency measures—it is striking that this took place as inflation began roaring back due to conflict in the Middle East. The NBE justified its move by relying on the mechanism of the policy rate.

Furthermore, the NBE has taken these steps while executing a massive gold purchase program at a premium from artisanal gold miners under its Gold Purchase and Reserve (GFR) scheme for foreign exchange reserves. Although this program has enabled the central bank to build a substantial forex reserve to stabilize the foreign exchange rate through regular auctions, it has injected a significant volume of liquidity into the banking system, particularly at the state-owned Commercial Bank of Ethiopia. Neutralizing this excess liquidity required massive open market operations (OMOs), costing the central bank Br 3.33 billion in 2024/25—a figure projected to rise substantially in 2025/26.

The implications of this liquidity accumulation, combined with the lingering effects of the former lending cap, are reflected in repeatedly oversubscribed foreign exchange auctions, OMOs, and Treasury bill auctions, as well as downward pressure on policy, Treasury bill, and money market interest rates.

With the lending cap removed, the NBE faces challenging tasks ahead. It must rely primarily on its policy rate to keep inflation at bay while simultaneously managing forex stabilization activities through the GFR scheme. The core trouble is the difficulty of simultaneously achieving monetary tightening and exchange rate stabilization when the GFR scheme continuously injects substantial liquidity into the banking system.

This accumulated and fresh liquidity enables commercial banks to lower lending rates and expand credit rapidly without restriction, creating significant inflationary risks. Under these circumstances, the NBE will need to scale up liquidity-mopping OMOs to drive interest rates up and restrain monetary expansion.

The success of these operations depends on how banks respond. Considering the lending limits imposed on commercial banks for nearly three years, extensive loan queues have built up. Following the cap’s removal, banks may prefer extending credit to private borrowers rather than actively participating in central bank OMOs, presenting a major monetary policy challenge for the NBE.

Another hurdle for the NBE is its limited experience with market-based policy tools. Relying on a policy rate requires complex macroeconomic modeling, high-quality and timely data, specialized expertise, and proactive central banking. Introducing the GFR scheme’s unpredictable liquidity injections into this framework adds another volatile variable to an already complex equation.

Drawing a historical parallel, prior to its prohibition in the recent NBE Establishment Proclamation, the monetization of budget deficits continually injected base money into the banking system. Under the monetary targeting framework used for a decade and a half, this made monetary control nearly impossible, and the NBE repeatedly failed to contain inflation.

Furthermore, exchange rate stabilization through the GFR scheme is unsustainable over the long term. Ideally, an exchange rate should evolve according to supply and demand dynamics rooted in real economic performance. Addressing exchange rate depreciation requires tackling structural challenges within Ethiopia’s export sector.

What the NBE is executing instead is an artificial intervention. First, the central bank accumulates foreign exchange while incurring substantial losses on gold purchases and exports, posing balance sheet risks to the NBE and carrying fiscal implications. Second, foreign exchange obtained through these loss-making transactions is sold at regular auctions to stabilize the Birr—effectively auctioning forex at subsidized rates, hindering natural price discovery, and distorting import and export prices.

When the NBE eventually phases out the GFR scheme, the economy will face a reality check. Rapid exchange rate depreciation could follow to correct the distortions created by subsidized auctions, unless Ethiopia’s foreign exchange earnings—particularly from the export sector—markedly increase.

The foreign exchange constraints Ethiopia faces are undeniable, and the GFR scheme can be viewed as a temporary expedient. However, the longer the NBE relies on the scheme, the greater the exchange rate distortions will become and the less effective monetary policy will be. The sustainable solution to the country’s forex challenges lies in strengthening the real economy, particularly the export sector, allowing the NBE to focus on its primary mandate: maintaining price stability.

(Abdulmenan Mohammed ( PhD ) is a seasoned financial expert based in London who keeps a close eye on Ethiopia’s financial sector.)

Contributed by Abdulmenan Mohammed ( PhD )