Determinants of Financing Sustainable Economic

Development in Ethiopia- Investment Needs

Prospective
1. INTRODUCTION

1.1. Back Ground and Justification

In the global negotiations on sustainable development, one of the most important issues is that
several low-income nations face shortage of funds to promote socio economic development and
meet the sustainable development goals (MDGs). The most fundamental human needs to succeed
in todays world, such as water and sanitation, food, energy, transport, health care, and
communications: These needs are only be properly addressed through greater infrastructure
investment in developing countries. The estimated annual shortfall in global infrastructure debt
and equity investment is at least USD 1 trillion, and also for ASEAN countries, around USD 8
trillion will be needed to bridge the gap in infrastructure financing by 2020 (World Economic
Forum ,2014).

In Sub-Saharan Africa, the cost of redressing the infrastructure deficit is estimated at USD 75
billion per year the equivalent of approximately 12% of Africas GDP (World Bank 2013). It is
also to be bear in mind also that the micro, small and medium-sized enterprises (MSMSEs)
participating in the formal economics of developing countries account for around 45% of
employment and a third of their GDP; yet approximately 70% of formal and informal MSMSEs
do not use external financing from financial institutions, despite being in need of it, and a further
15% are underfinanced (Stein, Goland, and Schiff, (2010).Overcoming the infrastructure
bottleneck would boost long-term economic growth. Infrastructure is an input to a wide range of
industries and, as such, an important driver of long-term growth. Delays in the realization of
infrastructure projects pose potentially large economic and social costs Torsten, (2014).

Financial development greatly influences poverty, makes available more finances, deposit
opportunities, and avoids inequality. A developed financial system increases access to capital and
subsequently enhances economic growth. The allocation of resources becomes efficient as the
information is as given to investors. An organized financial system have the ability to draw
financial resources from offshore and this should be supported by the quality of the legal and
regulatory environment, risk management initiatives and the effective regulation of firms. The
banking sector dominates the markets in Sub Saharan Africa (SSA) and the level of maturity of
financial instruments as well as activity is still low. Regional groupings assist in overcoming
these barriers imposed by the size of the countrys economy and the financial market, Standley
(2010). Developing financial markets at country is still a challenge hence the need to tackle it
from a country level is very critical issue.
Developing countries share no responsibility for the financial and economic crises since 2008,
but they suffered the consequences and affected by the lack of financial stability. This has stunted
positive developments in particular in African developing countries, especially the area of trade
and investment. Financing for development must serve to create global justice. It must help to
overcome poverty and hunger worldwide. Therefore, financial stability at the international level
must take into account the interests of developing countries (United Nations, 2014).

Ethiopian financial sectors governed by commercial banks, which have a lion share for over 90
per cent of the financial systems total assets. The sector is also characterized by high degree of
concentration (lack of competition), and relatively small by world standards. Moreover, Ajakaiye
(2005) revealed that the financial sector of Sub Saharan Africa (SSA) is at their elementary stage
comparing to the rest of the world. For instance, the ratio of M2 (Broad money supply) to GDP
ratio was 32 percent in 1990, increased slightly to 37 percent by 2003. In the same manner for
East Asia countries, the above figures are 63.1 and 158.8 percent respectively, which are more
worthy in the same year.

Financing economic development study in Ethiopia put the problem of financing in a national
accounting framework to analyze both domestic and external resource gab. The study will be
show the level of domestic resources is too low to cover domestic projects (especially mega
projects), and foreign direct investment needs. Therefore, the focus of this paper will be on what
are the major determinants of financing sustainable economic development in Ethiopia?
Moreover, how to improve these determinants and finally helps formulate sound financing
policy.

1.2 Statement of the problem

Studies such as those of King and Levine (1993), Levine and Zervos (1998) and Beck and
Loayza (2000) have been conducted to emphasize the importance of financial development to
economic growth. When an economy starts to grow it creates immediate additional demand for
financial services and helps grow a better financial system. At this stage, the positive impact of
financial system on economic growth could be modest. As development proceeds in a sustainable
way, a better and well functioning financial system be a need. Moreover, a well developed
financial system can contribute at a greater extent to income growth by reducing market frictions
(including information and transaction costs), pooling risks and easing trade (Levine 1997).
Evidence shows that the result of financial development indicates transformation of sustainable
economic growth, Hassan et al (2011). This idea of having a well developed financial market
contributing to long term economic growth has been established, (Beck et al (2000); Hassan et al
(2011); Christopoulos & Tsionas (2004); Abu-Bader and Abu-Qarn (2008)).

The was an experience of recent years shows that high growth rates in many developing
countries especially in Ethiopia have not led to a significant decrease in poverty or an increase in
wealth of broad segments of the population. To the contrary higher growth rates go hand in
hand with increasing inequality and unequal distribution of income and property, which leads
Social unrest. For effectively overcoming absolute poverty by 2030 and enforcing the universally
valid human rights, sufficient resources must be available to the public budgets in the nation to
finance the expansion of fundamental health and education systems, promote social security
systems and carry out public infrastructure measures (venro, 2015).

Corruption as well as weak institutions and administrative structures lead to the loss of more than
half of all tax revenue through tax evasion and tax flight. According to recent estimates, for each
Euro in investments and financial inflows, developing countries lose two Euros due to capital
flowing out of the country, including through illegal profit transfers of corporations as well as
other illegitimate capital outflows, Eurodad,(2014). Capital outflows due to tax avoidance and
evasion are a central obstacle to sufficient mobilization of domestic resources for fighting
poverty and inequality and for achieving a more sustainable economy. A comparison with
international development aid payments shows how high the proportion of revenue lost due to
tax flight is in particular in developing countries Venro,(2008). In addition, recent estimates show
that the African states alone lose between 50 and 60 billion US dollars in tax revenue per year
due to illegitimate financial flows. This public revenue is lacking for programmes to finance
basic social services and for implementing human rights, for overcoming poverty and for
financing sustainable climate protection programmes, High Level Panel on Illicit Financial
Flows from Africa, (2014).

In the case of Ethiopia, financing sustainable development is under question mark because of the
unstable macroeconomic environment and the underdevelopment of the financial system.
Despite the effort made to develop the country in the past, the financial system of Ethiopia is too
weak to support the private sector. This underdevelopment imposes heavy costs on potential
investors and traders. Moreover, Ethiopias financial sector is characterized by dominance of
state ownership and low level of development with the Commercial Bank of Ethiopia accounting
for 90 per cent of total deposit (Alemayehu, 2006). Ethiopias financial sector is rudimentary, is
dominate by the banking system, and has no capital market and very limited informal investment
in shares of private companies. Currently, the sector includes 18 banks of which 16 were private
and the remaining two were state-owned, 17 insurance companies, around 35 microfinance
institutions, over 700 savings and credit cooperatives and a Social Security Authority. Bank
branch to population ratio still not significantly decline i.e. 1:33,448.2 in 2014/15(NBE,
2014/15). Ethiopia remains a highly under-banked country in the world, the banking service is
growing from year to year but it has not led to an increased outreach of the banking system at
large. Unorganized active informal financial market such as idir, equb and mahber are
present. Many companies are established by issuing shares in the various sectors of the economy.
Money markets are not developed and there is only a thin primary market for treasury bills and
weak inter-bank money market. Except government issued bonds, all types of capital markets
including stock exchange and equity markets are missing. The regulatory and institutional
framework for this market is not develop yet, as stated by Haile Kibret and Kassahun, (2011).
Access to financial services to the wider public is limited.

According to the financial liberalization index, which measures banking security and
independence from government control, on a scale of 10-100(100 being most liberal), Ethiopia
stands at the 20th place which is lowest in sub-Saharan Africa (Dailami, 2000). Ethiopias
financial sector development, as measured by the financial indicators such as private credit to
GDP, the ratio of narrow to broad money and the ratio of broad money to GDP, is well below that
of other African countries, and is even more undeveloped when compared to the financial
systems of the industrial countries (Abdi, 2000).

A developed and efficient financial system is important to mobilize savings and foreign resources
and to allocate them to high return investment. In addition, if financial services are extended to
rural and poor producers, a developed financial system is a strong tool to reduce poverty and
promote growth (Abdi, 2000). The inefficiency of these financial sectors will raise the
transaction cost and channel savings of households into physical assets which in turn reduces
investment and hence, reduce growth. Due to the missing markets, the only financial assets
available to investors other than bank deposits are treasury bills of short term maturity.

There is also a huge gap between savings and investment which the Ethiopian financial sector is
unable to bridge and hence led to foreign borrowing to finance investments. These indicates that
mobilize domestic revenues reduces aid dependency and can raise country creditworthiness.
Ethiopia still struggle to increase domestic revenue mobilization in the face of high levels of
capital flight and limited capacity to collect revenues from multinationals, inefficient public
expenditures and investments further compound the problem. Although Ethiopia has enjoyed
increased access to international capital markets over the past decade, there is an increasing
mismatch between available financing and investment needs. This is partly due to fragile market
conditions in the wake of the global financial crisis, which constrain the availability of the type
of long-term finance needed to support productivity-enhancing investment, World Bank, (2015)

In general the financing development of Ethiopia needs deep understanding so as to fill the gap
between available financing and investment needs. How to finance development is one of the
most pressing questions to achieve the Sustainable Development Goals. Thus, Ethiopia can only
succeed the SDGs through a transformative, sustainable, economic, social and ecological policy
change backed by just and sound financing.

Several studies were undertaken by different scholars on financial development and economic
growth nexus. As Hailye (2014) expressed, examine empirically the nexus between banking
sector development (proxy by the margin between lending and deposit interest rates) and
economic growth (proxy by real GDP per capita) in Ethiopia over the period 1975-2011.The
Johnson approach to Co-integration employed to investigate both the long run and short run
relationships. According to Haile Kibret and Kassahun (2011), the link between financial
development and economic growth using data of Ethiopia from 1972-2010. Their study
employed liquid liability as a financial indicator and found a positive link between the two.
Abebaw (2014) expressed as determinants of financial performance, a case study on selected
Micro finance Institution in Ethiopia. Most of these studies have failed to observe and compare
in detail the determinants of financing development in the country. This thesis will try to address
this knowledge gap that realizing determinants of financing sustainable development in Ethiopia.

1.3 Research Questions

The study critically investigates the following research questions regarding the determinants of
financing sustainable economic development in Ethiopia.

1. What are the main determinant sources of financing sustainable economic development in
Ethiopia?

2. Which determinant sources of financing overcome sustainable economic growth of the

country?

3. How these determinant factors affect the long run and short run economic growth of the
nation?

5. If there is long run relationship between financing sustainable economic development and its
determinants how the deviation will adjust towards the long run equilibrium or to find out the
speed of adjustment?

1.4 Objective of the study:

The general objective of this study is to examine the major determinants of financing sustainable
economic development indicators and clearly identify the short run and long run impact of the
determinants of financing on the sustainable economic development of Ethiopia for the period
1980-2015.

Specific objectives:

To identify what are the main determinant sources of financing sustainable economic
development.
To assess how the financing development indicators contributes to sustainable
economic growth.
To analyzing the economic impact of financing sustainable development.
To forward policy prescription.

1.5 Significance of the Study

This study will be conducted to examine the determinants of financing sustainable development
in Ethiopia. One of the most important things that from the result of this particular study we will
be clearly know and understand the major determinants of financing sustainable development
indicators and give greater attentions to these determinants variables and attempt to manage
them properly in order to reduce borrowing constraints and finally to become financially self-
sufficient.

The study is believed to provide relevant information for policy makers and financial institutions
in considering areas of intervention to develop the financial sector and promote sustainable
economic growth. Knowing the determinants of financial development indicators is not sufficient
by itself, however if proper policy is to be formulated, this information is going to play a vital
role for designing proper policy and fill the knowledge gap.

The other significance of this study is, indicated in the other section, to support further
investigation on the area. Since, there are no sufficient studies conducted on this area, this
research will also help other researchers in two ways. For one thing, it will provide a good
literature for the study which may be conducted on the same area. And for the other thing, to
show directions in which other researchers should follow to make further investigation on the
sustainability of financing development indicators.

1.6 Scope and Limitation of the Study

The study will be confine only to know the key determinants of financing sustainable
development a case study of Ethiopia by measuring and analyzing the financial development
indicators from 1980 to 2015 years. The study will be limited due to the availability of data
between the given fiscal year.

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