The Impact of Production Expansion of Labor Intensive Industrial Activities on the Ethiopian Economy

TABLE OF CONTENT

Contents Page

ACKNOWLEDGEMENTS LIST OF TABLES

LIST OF FIGURES

LIST OF ANNEX

LIST OF ACRONYMS ABSTRACT

CHAPTER ONE: INTRODUCTION
1.1. Background of the Study
1.2. Statement of the Problem
1.3. Objective of the Study
1.4. Scope and Limitation of the Study
1.5. Significance of the Study
1.6. Organization of the Paper

CHAPTER TWO: DESCRIPTION OF THE ETHIOPIAN ECONOMY
2.1. Economic Policy of Ethiopia
2.1.1.Imperial Regimes
2.1.2.The Dergue Regime (1974-91)
2.1.3.The EPRDF Regime (post-1991)
2.2. Characteristics of the Ethiopian Economy: SAM Based Analysis

CHAPTER THREE: LITERATURE REVIEW
3.1. Theoretical Review
3.1.1.Leontief /Input-Output Model
3.1.2.Computable General Equilibrium/CGE/
3.1.3.Armington
3.2. Empirical Literature

CHAPTER FOUR: MODELING
4.1. Stage CGE
4.1.1.Data Source
4.1.2.Activities Account
4.1.3.Commodities Account
4.1.4.Factors Account
4.1.5.Institutions Account
4.1.6.Trade/Price/ Block
4.1.7.Production and Trade Block
4.1.8.Institutional Block
4.1.9.System Constraint Block
4.2. Equivalent Variation
4.3. Model Closure and Scenarios

CHAPTER FIVE: SIMULATION RESULT
5.1. Calibration Procedures and Elasticities
5.2. The Effect of Increasing Efficiency of Labor Intensive Industrial Activities on the Macro Economy
5.3. The Effect of Increasing the Production of Labor Intensive Industrial Activities on Trade Balance of Priority Industrial Goods
5.4. The Impact of Efficiency Improvement of Labour Intensive Industrial Activities on Domestic Production of Priority Industrial Goods
5.5. Impact of Labor Intensive Industrial Activities on Factor Price and Demand
5.6. Impact of Labour Intensive Industrial Activities Efficiency Improvement on Welfare

CHAPTER SIX: CONCLUSIONS AND POLICY IMPLICATIONS
6.1. Conclusion
6.2. Policy Implications

Reference

Annex

ACKNOWLEDGEMENTS

I would like to thank the almighty God for giving me this opportunity, to explore every kind of endeavor and for opening doors when it seemed impossible.

Next I would like to extend my deepest gratitude to thank Zerayehu Sime (PhD), who has been giving me a starting point to see the way. Moreover, I would like to appreciate the

staffs at EDRI Ermias who has made significant help.

I am also very much indebted to my families, colleagues and friends for being with me through thick and thin.

This study wouldn’t have been possible hadn’t I gotten the help of my Advisor, Solomon Tsehay (PhD) so, I owe it all to him.

LIST OF TABLES

Table 1: share of Sources of Household Income

Table 2: source of rural and urban household income (in percentage)

Table 3: Share of use of income of households on different sectors

Table 4: households’ income spent on different sectors (in %)

Table 5: Computed and actual tax rates and values of import

Table 6: Effects of increasing efficiency of labor intensive industrial activities on the macro-economic indicators (in percentage)

Table 7: Impact of efficiency increment of labor intensive industrial activities on household consumption of priority industries

Table 8: Impact of efficiency increment of labor intensive industrial activities on price of factors

Table 9: Impact of efficiency increment of labor intensive industrial activities on demand of factors by priority industries

Table 10: Changes in factor income (%)

Table 11: Changes in household income (%)

Table 12: Changes in price of selected goods (%)

LIST OF FIGURES

Figure 1 : Share of inputs in the production of labor intensive industrial activities

Figure 2: Trade balance of government priority industries (percentage change)

Figure 3: Impact of efficiency increment of labor intensive industrial activities on domestic production of priority industries (percentage change)

Figure 4: equivalent variation of household income (in million birr)

LIST OF ANNEX

Annex 1: Share of Factors in the Production Process of Labor Intensive Industrial Activities

Annex 2: Name and Description of Variables of the STAGE CGE Model

Annex 3: Tax Rate Block Equation

Annex 4: Government Tax Revenue Block Equations

Annex 5: Impact of Efficiency Increment of Labor Intensive Industrial Activities on Domestic Production

LIST OF ACRONYMS

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ABSTRACT

Ethiopia ’ s industrial activity has been characterized by meager growth for the last epochs. But recently the Ethiopian government endorsed Growth and Transformation Plan (GTP) which gives prime attention to selected industries. This study examines the likely effect of productivity expansion of labor intensive industrial activities on the macro economy, government priority industries, factor and household income and welfare of households. The sectors were selected from the Ethiopian 2009/10 SAM based on their production characteristics. The selected labor intensive sectors include dairy, grain milling, milling service, sugar refining, other food process, beverage, textile, leather product and wood products. In order to investigate the impact of a 10% increase in the technical coefficients of these labor intensive industrial activities, the study used the static stage computable general equilibrium (CGE) model. The recently updated 2009/10 Ethiopian SAM was used to calibrate important parameters of the CGE models.

The 2009/10 Ethiopian SAM revealed that 45.22% and 52.13% of rural and urban households generate their income from labor. The production expansion via an increase in their technical coefficient of the sectors derived significant change on macro variables such as real GDP, government consumption demand, investment demand, household consumption, export and import of goods and services. The GDP of the economy has been increased by 3.41%. The findings also suggest that production and export increase in government prioritized industrial products largely .For instance, the production of the textile and leather sectors increased by 26.08% and 41.03%,respectively.Increasing the production of labor intensive industrial activities showed significant decline of import of priority industrial goods. It also resulted in welfare gain to all rural and urban households. The study further extends its recommendation for Ethiopia to develop a strong industrial policy aimed towards promoting labor intensive industrial activities.

CHAPTER ONE: INTRODUCTION

1.1. Background of the Study

Ethiopia is one of the least developed countries in the world. Agriculture is the mainstay of the economy. This is evidenced by the fact that the sector contributes 42.7% to GDP, creates 80% of employment and generates 70% of the export earnings of the country in 2012/13(AfDB, OECD, & UNDP, 2014 ). In addition to this, 90% of the exportable commodities of the nation are coming from agricultural sector. These mainly include coffee, oilseed, chat, hidden and skin, flower, etc. Cognizant to its immense importance, the Ethiopia government has set agricultural development led industrialization as long- term development strategy which was formulated in the early 1990s and subsequently elaborated in stages and put into serious implementation from the early 2000s.

Ethiopia generates foreign exchange from few agriculture commodities while imports capital goods. This leads to the country to entertain trade deficit across years. Accordingly, the trade deficit escalated to USD 8.4 billion in 2012/13, from USD 7.9 billion in the previous year(AfDB et al., 2014 ). The volume and values of exportable items has been increased. For instance the country export was growing at an average rate of seven percent from the year 1981 to 2011 while the average growth of the export proportion to domestic product (GDP) was growing 10 percent in the same period. In addition of that in the fiscal year of 2010/11, the ratio of exports to GDP increased to about 10 percent compared to 6.7percent a year ago. The export receipts covered about 33 percent of the import bill during the review year in contrast to 24 percent last year(National Bank, 2010/11).

Coffee is the most and has largest share compared with other exported commodities of the country. For example in the year 2012, Ethiopia exported 3.15 million bags called the country to be the most important coffee exporter in the Africa and ranked the nation the tenth largest coffee exporter in the world by getting share of 3% of the world market. Leather and its product, and “kat” took the second and third rank, respectively in 2003. But starting to trade with China since 2004 made the oil seed becoming the second exportable commodity, and leather and its product and “kat” has brought down to in the third and fourth place, respectively. However, the share of coffee in the world market is not satisfactory even compared with other coffee export countries like Brazil, Colombia and Vietnam(Worldbank database, 2010). In the reform year of 1991, the share of coffee was 55% but by the end of 2009 its share declined to less than 35% on the other hand the shares of other goods such as chat, flower, leather and leather products have increased substantially. Particularly the share of flower showed remarkable increase to 10% in 2010 while it shares was only 1% before a decade.

The aforementioned description entails that the performance of the Ethiopian economy mainly depends on the performance of agriculture. High degree of concentration both in structure and partner countries is the characteristics of the external sector of Ethiopian economy. This may lead the country to be vulnerable to external shocks. The industrial sector contributes nearly 10% of the GDP since 1960s. The industrial sector is so feeble that it cannot withstand external shocks. This is evidenced by the fact the contribution of the sector to export and GDP remains constantly very low across years. In order to change the structure of the economy, the Ethiopian government endorsed growth and transformation plan in 2010 in a bid to enabling the industrial sector contribute a higher share to GDP as well as export.

1.2. Statement of the Problem

The country’s capacity to generate foreign exchange and create job opportunities for the growing labor force is challenged by the nation’s narrow base of the industrial sector (GTP).Encouraging export based and import substituting industries has been considered as a way of giving highest emphasis of the industrial sector in the first as well as in the second five year growth and transformation plan. Small-scale manufacturing enterprises are the other focus of the plan as they are the source of employment creation, hastening urbanization, the footing step for the establishment and intensification of medium and large scale industries.

It is a daunting challenge to select the best performing sectors among industrial sectors for strategic interference. But, theories have emphasized that dwelling on labor intensive industries in developing countries would benefit the economy as well as enables to enhance the welfare of the society. In addition, at early stage of development developing countries suffer from unemployment. So the rationality that lies behind such view also takes this problem as big note to be addressed. The other argument that has been used as a salient reason to opt such policy is the fact that labor intensive industrial sectors engenders developing countries a comparative advantage in the export performance of countries. The Vernon product theory implies such justification. According to the 2010 report of WTO, the share of Ethiopian export in the world market is only 0.01% (WTO, 2011). For example in the year 2008, the country's share in world trade was merely 0.027%(Worldbank database, 2010). From the same source, these figures were 0.052% for Kenya, 0.065% for Sudan, 0.29% for Egypt, 0.050% for Cote d‘Ivoire, 0.049% for Ghana and0.51% for South Africa. On the other hand according to the World Bank (2009), the share of the manufactures export had only 9 percent from the total export of Ethiopia which is little compared with primary agricultural commodity which had 91 percent share.

But, it is a vivid fact that the prices of primary products fluctuates and are unpredictable which calls for an alternative endorsement of industrial policy. Cognizant to this fact, the Ethiopian government clearly selected some priority sectors in the GTP in 2010 and has been implementing this plan. Special effort has been being excreted on industrial sector in a bid to making this sector the mainstay and leading sector in the Ethiopian economy. This is done under the aim of industrializing the country and to increase the share of the industrial sector by giving more consideration on government prioritize activities like that of Textile and Apparel Industry, Leather and Leather Products Industry, Sugar and Sugar Related Industries, Cement Industry, etc. Theories have shown that investing on labor intensive industries in Ethiopia could benefit the overall welfare of the society (Samuelson, 1941). This research therefore searches selected only labor intensive sectors and examines the likely impact of such alternative policy on the macroeconomic and general status of both urban and rural households. There is no as such any research that shows the impact of such policy shift on the Ethiopian economy. So this study intends to examine the likely impact of increasing the production of labor intensive industrial commodities on the Ethiopian economy using STAGE CGE modeling approach.

1.3. Objective of the Study

The main objective of this study is to assess the impact on the general economy when the production of labor intensive industrial activities increased. And the specific objectives are,

- To examine the impact of the increase in the production of labor intensive industrial activities on households, income;
- To elucidate the possible welfare effect of production increment of labor intensive industrial activities on different households across different agro -ecologies;
- To understand the possible effect of such policy on priority industrial and other activities in the economy.

1.4. Scope and Limitation of the Study

The scope of the study is to see the impact on the Ethiopian economy when efficiency of government prioritized labor intensive industrial activities increased and limited to 2009/10 Ethiopian SAM.As well this research will use single country model. This research has also limitations since it does not see the dynamic effect as well as will not do micro-simulation.

1.5. Significance of the Study

Clearly identifying the impact on the Ethiopian economy when efficiency of government prioritized labor intensive industrial activities increased is necessary for a number of reasons. It is important from the point of view of having stable macroeconomic condition as well as maintaining the ongoing economic growth. More importantly the result may be used for policy implication and other researchers also used this paper for further study in this area.

1.6. Organization of the Paper

The study is organized in five chapters: The first chapter of the study includes general concepts about the topic and main objective of the assessment. Chapter Two deals about overview the description of the Ethiopian economy. Chapter three is devoted to a brief review of relevant theoretical and empirical literature followed by Chapter four, which discusses the methodology and sources of data used in the study. Chapter Five deals with the interpretation of the result. Finally, chapter six presents the conclusion and policy implication of the study.

CHAPTER TWO: DESCRIPTION OF THE ETHIOPIAN ECONOMY

2.1. Economic Policy of Ethiopia

It is in the turn of 20th century that industry in modern sense as an economic activity had been emerged in Ethiopia. The demand for imported manufacturing products increased as the result of establishment of modern central government, expansion of cities and strengthens foreign relation which leads to establish import-substituting industries domestically. Accordingly, in 1950s a number of new industries were established (Shiferaw, 1995).In this period a remarkable works also done on comprehensive plan to stimulate and guide the country’s industrial and economic development in general.

2.1.1. Imperial Regimes

It is about six decades since Ethiopia adopted a planned approach to development. During this regime, three five-year plans were prepared for the development of the economy with different targets and area of priorities and the details of the development planning experience of the imperial regime is presented as follows. In the first five year plan (1957-1962), more focus was given for import substitution, industrial promotion and construction of infrastructural facilities like road development. The other major target in the first five year plan was diversifying the export structure of Ethiopia by exploiting the large livestock population, and the products of agro-processing industries. Construction of infrastructure also got attention that would have been a positive impact on the country export growth.

The second five year plan (1962-67) was extending from the first five year plan and priority was given for structural change and export diversification to achieve high level of foreign exchange earnings. One of its objectives was increasing the export share of industrial commodities and plans to decline its dependence on agricultural product export. Thus, new export of industrial origin and mining products were supposed to play a key role.

The ultimate goal of third five year plan (1967-73) was to satisfy the economic and social development of the nation. In this period the crucial role of agriculture in the country’s economic development (TFYP)and anticipated a rapid increase in exports of manufactures through the increased manufacture of meat, meat products, leather and shoes (TFYP) got more attention.

During this period (1957-73) the government tried to attract investors by extending incentives and strengthen its involvement in economic activities through direct investment on manufacturing sector. This was done by favoring the market and the private sector by filling the gap through direct ownership on selected sectors. However, the incentive structure was biased towards import- substituting, larger, capital-intensive, and foreign-dominated industrial activities.

According to World Bank report (World Bank, 1985), the implemented incentives attract foreign investors and gave boost the manufacturing sector in Ethiopian economy. But by the end of the plan period the expected result was not achieved; the industrial sector was weak and characterized by dual structure; small scale sub-sector and modern medium large scale sub-sector in which each of them contributing half of the manufacturing value-added(Eshetu, 1995)

2.1.2. The Dergue Regime (1974-91)

The military government came to power in 1974 and nationalized most of MLSM enterprises as it follow the socialist economic policy (PMAC, 1975). Accordingly, introduced different restrictions on private sectors and on the market: restricting the private investor to have only birr half million and the entrepreneur should participate only in one venture. There were quantitative restrictions and imposed higher tariff on imported items, labor market restricted highly and the exchange rate was also fixed at about 2.07 per US$1.

Because of the revolution, the manufacturing sector experienced sharp decline in the first few years that is why the government initiated “zemencha” program to improve the productivity of this sector. Behind these protective tariff and quantitative restrictions the then government development strategy was an inward looking strategy under the ownership of the public and undertook a ten year prospective plan (1985/86-1994/95).

This was done under the objective of promoting import substituting and labor intensive industries. This plan also aimed to make the export structure high value added export oriented commodities, improving the share of manufacturing items in the export activities in terms of amount and composition, and increasing the socialization of the export sector. However, in practice only stated owned sectors were got high priority regardless of their inefficiency as the public sectors were considered the main ways towards the industrialization of the country (World Bank, 1985).

Due to restricting the private sectors from engaging in major economic activities, the government took the higher responsibility of involving and operating in MLSM activities. This was evidenced by in 1985/86,the state-owned enterprises (SOEs) managed to command 95 per cent of the value added and 93 per cent of the employment of in all MLSM enterprises. However, SOEs exhibited rely on government subsidy and weak in their financial status(UNIDO, 1991) Because of constraint in working capital, foreign exchange and raw material at the early establishment of the manufacturing sector, most of them forced to operate below their capacity and unable to meet even the local demand.The problem became serious in the period of 1987-91 when the manufacturing sector exhibited an about 40 per cent decline in value added in 1991 alone. However, in March, 1990 the government adopted mixed economic policy even if it had not been implemented since there was regime change in May, 1991.

2.1.3. The EPRDF Regime (post-1991)

After the downfall of the Dergue regime, the EPRDF regime under the support and guidance of the IMF and the World Bank has undergone liberalization and enhanced Structural Adjustment Programs (SAPs) to foster competition, opening the economy and promoting the private sector. Under the sponsorship of the IMF/WB, the government implemented three phases of economic and structural reform programs. The first phase undertook within the period between 1992/93 and 1994/95by taking measures like removal of subsidies and export tax rebate, reduction of the import tariff, liberalization of the foreign exchange market, liberalization of price, etc. The second economic reform program (1994/95-1996/97) adopted to restrict the role of government in economic activities and improves the involvement of the private sector participation. The third phase reform (1996/97-1998/99) was the time when the government committed itself to achieve broad-based economic growth with a stable macro- economic environment and strengthen the ongoing liberalization. The undertaken economic reforms coupled with stable macro-economic condition strengthened the manufacturing sector in particular and the economy in general.

Due to the lack of improvement in export diversification the Ethiopian government adopted export promotion strategy in 1988 under the objective of promoting high value agricultural exports (e.g. horticulture products and meat) and labor-intensive manufacturing products (clothing, textile, leather and leather products). However, this strategy was narrow in scope and thus, a comprehensive strategy was formulated under successive development plans, that is, Sustainable Development and Poverty Reduction Program (SDPRP) 2002/03-2004/05 by giving great emphasis for smallholder agriculture, the Plan of Action for Sustainable Development and Eradication of Poverty (PASDEP) 2005/06-2009/10, and the Growth and Transformation Plan (GTP) 2010/11-2014/15 which aimed at urban and industrial development. The main emphasis of the IDS is to actively support the export-oriented and labor-intensive sectors

Even if the implementation of these strategies and policies helped the country to grow by double digit, the structure of Ethiopian economy is remain unchanged especially the share of the industrial sector remain small while the service sector share shows improvement.

2.2. Characteristics of the Ethiopian Economy: SAM Based Analysis

SAM summarizes the transaction among economic agents in an economy. Accordingly, it serves as a basis for other modeling strategies such as computable general equilibrium modeling. Hence, understanding the nature of the SAM enables to characterize the overall economy and possible routes through which the effect of economic policies transmits to each economic agent. The 2009/10 Ethiopian SAM contains113 production activities, four factors of productions which are further disaggregated into subunits (labor, land, capital and livestock), 64commodities, transaction cost, rural and urban households, government and ROW.

Activities

There are 113 production activities and three aggregates representing agriculture, industry, and service. A detail characterization is given for labor intensive industrial activities. From these 113 production activities; there are 24 industrial activities of which nine of them are labor intensive. These industrial activities used more labor than other factor of production.

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Figure 1: Share of inputs in the production of labor intensive industrial activities

Households’ income source differs significantly among household groups. In the 2009/10 Ethiopian SAM households generate their income from different factor of production; labor (skilled, semi-skilled, unskilled and agricultural labor), non-agricultural capital, land and livestock and from transfer. Rural households derive their income mainly from non-agricultural capital (36.12%), agricultural labor (21.95%). In aggregate, 36.72% of rural household income is obtained from labor. On the other hand, urban households generate the lion share of their income from labor (83.52%), of which 42.85% is generated from skilled labor and non-agricultural capital contributes 16.48% (See table 2). Then, increasing production would exert significant effect on household welfare through factor remuneration.

Alternatively, if production expansion induces expansion of the labor intensive industrial sectors, those households engaged in the sector would benefit most.

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Table 1: share of Sources of Household Income

Source: computed from Ethiopian SAM (2009/2010)

Nearly 43.9 and 28.78 % (of which 12.66% and 16.125 on labor-intensive and other industrial products respectively) of rural households’ income is spent on the consumption of agricultural products and industrial products respectively. Conversely, urban households are allocate 48.35% of their income on consumption of industrial products (of which 17.75% on labor intensive industrial products and 30.65 on other industrial products) and 30.3% of their income on consumption of service products (see table 4).

Expansion of labor intensive industrial product impacts consumption means their demand through increment of their income from factor payment. In this analysis, as the production expands those engaged factor productions income increases and thus the owner of factor of production gain become raise leads the household demand for products will be changed positively.

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Table 3: Share of use of income of households on different sectors

Source: computed from Ethiopian SAM (2009/2010)

The following table shows how aggregated rural and urban spent their income on different sectors.

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Table 4: households’ income spent on different sectors (in %)

Source: computed from Ethiopian SAM (2009/2010)

CHAPTER THREE: LITERATURE REVIEW

3.1. Theoretical Review

3.1.1. Leontief /Input-Output Model

Partial equilibrium analysis has been the most popular method of analysis in applied economics. This model or technique is used to investigate inter-sectorial relationship in order to understand the interdependencies and complexities of the economy and thus the conditions for maintaining equilibrium between supply and demand. According to Ghatak (1995), “the technique usually describes the general equilibrium analysis and the empirical side of the economic system of production of any country. It is also known as “inter-industry analysis.”

As Jhingan (2005), there should be three main features of input -output to be considered as best in general equilibrium analysis. The first one is since input-output analysis is not applicable to partial equilibrium analysis, consider it in an economy which is in equilibrium; second, it deals exclusively with technical problems of production, thus, the demand analysis does not concern with it; and the final one is it is based on empirical investigation.

Related with the technical operations, the assumption is to produce a given level of output, there is no substitution between inputs and the input coefficient are constant-the marginal input coefficients are equal to the average in the case of linear input functions; joint products are impossible, that is, each industry produces only one commodity and each commodity is produced by only one industry; and external economies are ruled out and production is subject to the operation of constant returns to scale Ghatak (1995).

3.1.2. Computable General Equilibrium/CGE/

Because of its simplicity partial equilibrium analysis has been the most popular method of analysis in applied economics. Indeed, it can be used to analyze policy issues arising from a shock whose effects are limited to a particular industry. Nevertheless, this approach only used to show the effect of shocks in partial way, that is, it has limitations to handle issues of general shocks or policies which affect the outputs and prices of other activities at a wider scope. In actual world, the effect of policies transmits to all sectors and cannot be limited to a certain sector or institution. Their effect trespasses and influences the whole economy such that all interactions and their feedback effects ought to be captured in an economy-wide general equilibrium framework. This called for the need of economic-wide modeling and gave birth for CGE modeling.

CGE modeling is an attempt for the analysis of empirically oriented resource allocation and income distribution issues by using general equilibrium theory in market economics. It is a multi-sector model based on real world data of one or several national economies. It is recognized that the objective of households and firms are to maximize utility and profit respectively and excess demand functions are homogenous of degree zero in prices and satisfy Walras´ law. Moreover, in most CGE models product and factor markets are assumed to be competitive and relative prices are flexible enough to simultaneously clear all product and factor markets. Factor of production are paid according to their marginal revenue productivity. By making all these individual optimizations feasible and mutually consistent that is clearing all markets simultaneously the solution fixed by the model provides a set of prices.

The relevant theoretical development for the CGE literature began in the late 1930s and consists of both pure theoretical work on general equilibrium issues as well as empirical work on different model specifications and solution techniques. The first empirical model of a national economy was developed by Leontief in 1941.The structure of the American economy 1919-29 done by the Leontief signifies the classic input-output study (Leontief, 1941). This work was influenced by the recession of the 1930s and was applied to policy simulations during World War II. The development of general equilibrium theory was pushed forward by Samuelson, Arrow, Debreu, Hahn, McKenzie, and Negishi which is inspired by Hicks’s publication of Value and Capital in 1939 (HICKS, 1939).

Historically, the first CGE model was presented in Johansen (1960). Scarf´s (1967) famous algorithm for computing a Walrasian general equilibrium sparkled another epoch for the development of CGE modeling. Using Scarf´s algorithm SHOVEN & WHALLEY (1983) designed a computational procedure for finding a general equilibrium with taxes.

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