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Financial sector reform in a centrally planned economy requires systematic separation of governance of lenders, borrowers, and work-out vehicles for non-performing loans (NPLs). This is crucial in addressing problems of bad loans and zombie companies that survive only on new loans and/or government guarantees. A mechanism for resolving these problems can help drive dynamic economic growth. Doing this properly can free up substantial resources to be redirected towards public services or infrastructure investment, reduce tax burdens, or strengthen state finances. Placing real assets (factories, transport systems, farms, shops) under well-motivated management will realise quick benefits. It can also assist in developing domestic capital markets, further supporting the economy, and bringing real benefits to the population. In the medium term, the largest government-owned corporations should lose state guarantees and source some of their funding from non-bank lenders. Issuing bonds helps develop the capital market; it may require a bond rating. Obtaining private financing without a government guarantee will impose accountability on management.
An example from Ethiopia illustrates how some of these ideas might be put into practice.
The Case of Ethiopia
Ethiopian Investment Holdings (EIH), the National Wealth Fund of Ethiopia's government, owns corporate and real-estate assets and banks. The Commercial Bank of Ethiopia (CBE), the country’s dominant commercial bank, is part of the EIH portfolio. It has incurred NPLs of $24bn, or almost a quarter of GDP, by lending to the corporations owned by EIH. The bulk of these loans has been transferred to the Liabilities and Asset Management Corporation (LAMC), a separate asset management company. However, without accrual accounting at the government level and timely financial statements from the respective institutions, it is challenging to attract political will to address the underlying governance issues.
A successful financial sector reform would require the ownership of financial institutions such as the ‘good bank’ (CBE) and the non-bank funder (LAMC) to be separated from EIH and its portfolio companies that are the debtors to these financial institutions and held at arms’ length not only from EIH, but also from close government management. The future role of the CBE should be clarified either by operating it as a commercial bank or converting it into a slimmed-down and focused development bank. The dividends from EIH could support any needed re-capitalisation of the CBE (and ultimately by issuing shares to institutional investors) instead of through taxes.
Meanwhile, the LAMC should convert the troubled debt and the collateral behind the debt (the non-performing loans) into ownership of the underlying corporate and real estate assets. This would allow for comprehensive restructuring and transformation, after which many assets could be divested through private sales or Initial Public Offerings (IPOs), to wind down the LAMC within a few years. The Ethiopian authorities are reviewing options in this regard.
Furthermore, with the ultimate sale of some or all the government’s stake in the restructured ‘good bank’ together with some of LAMC’s holding and potentially some EIH assets – through a private sale or an IPO – the government should be able to restore its public net worth within a few years.
Properly managed and financed through an independent debt rating and bond issuance, the EIH could provide the government with a material annual funding source. Divesting non-core assets within each portfolio company and rationalising the entire portfolio could also result in a meaningful one-off dividend to the government. As a rule of thumb, it is not unusual that as much as one-third of the portfolio’s value is deemed non-core and could be divested through private sales or IPOs, providing the foundation for the domestic capital markets. In the case of the EIH, this could result in a one-off income of at least $15bn.
Economic recovery and growth will also depend on foreign investment flows from the private sector, which will seek evidence that the EIH portfolio operates strictly commercially and is not encumbered by any policy agenda, unfair advantage, or market distortion. Properly restructuring the management of public commercial assets is, therefore, the gateway to investment in the country as a whole and to its future development as a sustainable market economy.
However, generating these benefits will not depend solely on a radical reform of the governance and management of EIH’s portfolio of commercial assets. For companies to thrive, whether state-owned or private, they need the freedom to operate commercially and take advantage of economic opportunities. For instance, companies producing quality goods should not be required to export them (at the official, overvalued exchange rate) or sell them only at the airport but be allowed to sell them domestically, for domestic currency, where there is demand.
Robust economic development will rely on imported goods and materials – whether it is farmers needing fertiliser and spare parts for equipment, high-tech companies providing the services needed by a modern economy, or the national airline company investing in new stock. But the ability to obtain needed imports in a timely manner can only be guaranteed if the foreign exchange market is functioning properly. This requires unifying the official and parallel FX markets at a market-clearing rate and clarifying and simplifying exchange controls. This will be crucial, too, to attract foreign investors and motivate domestic investors in financial services and non-financial corporations.
