Public Information Notice No. 09/133

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with the State of Eritrea

December 11, 2009

On December 7, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the State of Eritrea.¹

Background

Eritrea’s economic performance has weakened since the last consultation discussions held in January 2008. A series of exogenous shocks have taken a heavy toll on an already stretched economy. First, Eritrea experienced a severe drought in 2008, which resulted in a harvest that was one-fourth of that of the previous year, and necessitated emergency imports of food. Second, as a net importer of food and oil products, Eritrea was hard hit the same year by the international food and oil price crises. Finally, while the global financial crisis has so far bypassed Eritrea, the world-wide recession is likely to dampen the possible revival of remittances from the diaspora.

In spite of these adverse developments, the authorities have endeavored to protect the most vulnerable segments of the population and to implement their long-term development policies. They maintain an extensive social safety net, and are investing in three priority areas: (i) food security and agricultural production; (ii) infrastructure development; and (iii) human resources development.

As a result of the exogenous shocks, the economy sharply contracted in 2008, and inflation surged to double digits. To mitigate the impact of the shocks on the population, the authorities increased social subsidies and transfers. The ensuing fiscal deficit further burdened an already fragile domestic banking system. With the return of rains in 2009, agriculture is expected to rebound, and growth is projected to reach an estimated 3½ percent. Though the budget deficit is projected to improve in 2009, it will remain excessive, and inflation is forecast to hold in the double digits.

Monetary policy has continued to accommodate the budget deficit. The reliance on monetary financing of the budget deficit has resulted in a rapid expansion of broad money and has fueled inflation. Shortages of foreign exchange, falling remittances, and heavy government borrowing from the banking sector have hindered private sector activity. Negative real interest rates have stymied financial intermediation and weakened the stability of banks. IMF staff analysis suggests that the exchange rate is overvalued, indirectly confirmed by a growing parallel market exchange rate. Domestic and external debt levels are deemed unsustainable.

The medium-term outlook presents development challenges and may entail risks. In spite of progress toward certain Millennium Development Goals, poverty reduction has been thwarted by subdued growth and high inflation. Continued fiscal and domestic imbalances under current policies would impose an increased burden on the population. Conversely, the coming on stream of a major mine and of a cement factory in 2010 will have positive contributions to economic performance over the medium term.

Executive Board Assessment

Executive Directors noted that Eritrea’s economic performance weakened in 2008 in the wake of international food and oil price hikes, a severe drought, and the global economic crisis. They commended the authorities’ efforts to mitigate the impact on the most vulnerable segments of the population. Real growth is expected to rebound in 2009, but inflation is projected to remain high. Directors noted that low growth and high inflation have undermined poverty reduction in Eritrea—despite commendable progress toward the Millennium Development Goals in primary education and health, as well as in infrastructure development. They encouraged the authorities to take decisive and prompt actions to arrest the weak economic performance, to address large financial imbalances, and to place the economy on a path of sustained growth with poverty reduction.

Directors called on the authorities to reduce the large fiscal deficits that have been at the root of economic instability in Eritrea. They encouraged the authorities to implement comprehensive fiscal and structural reforms, and welcomed the authorities’ interest in requesting technical assistance from the IMF to improve public financial management and revenue administration, and adopt a medium-term expenditure framework. A few Directors recommended further reductions in defense spending to strengthen the fiscal position and release resources for development.

Directors expressed concern that the latest debt sustainability assessment shows Eritrea to be in external debt distress, accompanied by a very high level of domestic debt. They advised the authorities to reduce the need for further borrowing and to re-engage with the donor community, seeking grant or highly concessional external financing. Such renewed relationships will help provide the assistance—including debt relief under the enhanced Heavily Indebted Poor Countries Initiative and the Multilateral Debt Relief Initiative—necessary to help restore debt sustainability. A few Directors recommended using part of the revenue from the Bisha mine toward reducing domestic debt.

Directors regretted that the conduct of monetary policy continues to be dominated by the government’s large financing needs, fueling inflation, and curtailing credit to the private sector. Restoring the independence of monetary policy was viewed as critical, along with efforts to strengthen the banking sector and reduce distortions in financial intermediation. A few Directors encouraged the authorities to pass and implement Anti Money Laundering/Combating the Financing of Terrorism legislation.

Directors underscored the importance of liberalizing the exchange and trade systems to mitigate the foreign currency shortage, revive remittances, and reinvigorate private sector activity. They recommended reinstating the franco-valuta scheme. Directors noted the staff’s assessment that the real exchange rate is significantly overvalued, while also noting the deficiencies in data and assessment methodologies. They generally concurred that a gradual correction in the misalignment should be part of a comprehensive reform plan.

Directors encouraged the authorities to publish the budget and macroeconomic data to bolster transparency and economic accountability, utilizing technical assistance from the Fund, including from East African Regional Technical Assistance Center (AFRITAC). They also encouraged the authorities to address the serious data shortcomings that hamper Fund surveillance.