Public Finance and Economic Growth in Developing Countries

Lessons from Ethiopia's Reforms

Stephen Peterson

• Publisher: Routledge
• Year: 2015
• Print ISBN: 9780367872311
• eBook ISBN: 9781317532736
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

Public finance is crucial to a country's economic growth, yet successful reform of public finances has been rare. Ethiopia is an example of a country that undertook comprehensive reform of its core financial systems, independent of the IMF and the World Bank, and successfully transformed itself into one of the fastest-growing economies in Africa.

With Ethiopia's twelve-year reform as its guiding case study, this book presents new analytical frameworks to help governments develop better financial reforms. It shows in detail how four core financial systems—budgeting, accounting, planning, and financial information systems—can be reformed. One of the principal findings presented is that governments must establish basic public financial administration before moving to more sophisticated public financial management. Other key findings include the identification of four strategies of reform (recognize, improve, change, and sustain), the centrality of ongoing learning to the process of reform, and the importance of government ownership of reform.

This book will be of interest to researchers and policymakers concerned with public finance, developmental economics, and African studies.

Part I

Understanding public financial management reform

1 The Ethiopian public finance reform—a case study for Yichalal!

Efficiency is doing things right, and effectiveness is doing the right thing.

Peter Drucker

The financial reform in Ethiopia that took place between 1998 and 2008 is considered one of the best on the continent of Africa since 2000.¹ It succeeded because the right thing was done right. As a success in a field littered with failures, it is worthy of study, for it demonstrates what it means to do the right thing in a developing country. As a success on a continent where failure is all too common, Ethiopia’s financial reform demonstrates that African governments can take the lead in designing and implementing financial reforms—a departure from the foreign aid model so prevalent in Africa. The Ethiopian case provides practical frameworks based on a long-term reform which can untangle the morass of current views on public financial management (PFM). It provides an empirical demonstration of how to carry out a financial reform because it provides insight into something that is usually ignored in the PFM literature: learning and how that is achieved through the effective engagement of technical assistance and the alignment of the roles of officials and advisor.

Although the term of choice in the field is PFM, in fact Ethiopia implemented a reform of public financial administration: PFA, not PFM. The failure to make the distinction between the two is a principal source of confusion about PFM and its reform in developing countries. Many financial reforms have failed because they parachuted techniques in that do not fit with how a government is organized: Is it a bureaucracy with weak administration that must strengthen its PFA? Or a strong bureaucracy that has a sound PFA in place, encourages management, and can thus adopt PFM techniques? Regardless of how the bureaucracy is organized, governments must first have financial administration before attempting financial management. Financial administration is compliance, external control, and ensuring the stewardship of public money. Financial management is about establishing internal control, and promoting discretion to achieve policy. Both PFA and PFM are means, not ends. History shows that development does not require PFM—robust PFA is good enough. Developing countries by definition are countries that lack the preconditions for financial management. For such countries, the objective should be to build a robust PFA. The Ethiopian reform provides insights into the principles and nuances of doing this in four key areas: budgeting, accounting, automating (the establishment of financial information systems), and planning. I discuss this issue in greater detail in chapters 9 and 10.

A case study

Public sector financial reforms typically take at least twelve to fifteen years to implement.² For twelve years I was the manager of the technical assistance project that supported Ethiopia’s public finance reform. Thus I was not only a firsthand observer, but experienced the reform from the inside. This puts me in an excellent—and unusual—position to present a case study of a reform that I observed over a long period of time.

Several years after the departure of the technical assistance to the reform and the end of the project that I headed, I was able to gain an additional perspective as an external observer when I was asked to return and review the reform’s performance. The different ways I experienced Ethiopia’s reform over a span of sixteen years—as a consultant, implementer, participant, and ultimately, evaluator of its successes and failures—make this case study a first.

In this book I tell the story of what I learned about implementing PFA and, in that process, about the necessary conditions of successful reform.

Ethiopia’s PFA reform was crucial in the government’s drive to decentralize service delivery to its weredas (the lowest level of government administration responsible for a budget) and confront the country’s abject poverty at its roots. Making decentralization work meant that foreign aid could be significantly ramped up by orders of magnitude to support the government’s efforts in poverty alleviation. The reform enabled the country, the largest recipient of World Bank concessionary assistance on the continent, to handle these financial inflows. Better financial administration at the wereda grassroots ensured the success of the government’s social protection program, the largest in the world, which was scaled up until it provided assistance to up to 9 million people.

The Ethiopian Public Financial Administration reform provides valuable lessons for other developing countries and also strengthens our ability to generalize appropriately from the reform of their public finance systems. The Ethiopian reform is especially striking because it had to overcome the challengingly low level of the country’s development. It also illustrates what “local ownership” really means, and what it can accomplish.

Achievements of Ethiopia’s reform

The Ethiopian government accomplished significant achievements in four areas that virtually all developing governments grapple with:

1 Budgeting. Two reforms were done. First, the capital and recurrent budgets were linked (“crosswalked,” in financial management parlance) with a budget classification and chart of accounts that created cost centers. Second, a system of performance budgeting adapted to context was introduced based on cost drivers and contracts that complemented a toned-up traditional budget.

2 Accounting. Single-entry bookkeeping was replaced with double-entry. Cash-basis accounting was replaced with modified cash-basis accounting. Self-accounting that could generate data for a range of annual reports was introduced. Manuals and training materials were created to explain procedures.

3 Expenditure planning. A population-based system for intraregional transfer was replaced with a needs-based unit-cost fiscal transfer system. A performance agreement with costing and multiyear planning was installed, establishing accountability by district for the fiscal transfer. Multiyear fiscal planning was established. Multiyear expenditure planning was introduced.

4 Automation. A custom-designed integrated financial management information system (IFMIS) was developed that far exceeded international standards yet could run on extremely limited bandwidth. At a cost of less than $1 million, it was far cheaper than the systems said to conform to international standards. It was delivered on time, was beyond scope, and under budget—virtually unheard of for a computer system.

At nearly every turn in this reform there were surprises that defied the predictions of financial specialists. The biggest was the government’s successful adoption of an accounting system of international standards, with double-entry bookkeeping and a modified cash basis of accounting, which was done with a mere handful of qualified accountants in the civil service and with finance staff possessing, on average, a twelfth-grade education.

Not one reform but many

Ethiopia comprises nine regions and two administrative areas, vastly different in size, geography, ethnic makeup, political profile, and even history (see the frontispiece). Thus, reform of such a heterogeneous group of states provides examples for other country contexts. Fragile state: Somali. Urban center: Addis Ababa. Extreme remoteness: Gambella. Polyglot: Southern Region. Pastoralist: Afar. State in conflict: Somali. Country within a country: Oromia. (With a population of 18.7 million in 1996, if Oromia state were a separate country, it would be the fifth most populous country in Africa.)

A remarkable feature of Ethiopia’s financial reform is that it was delivered in the context of a massive transformation in the organization of government, Ethiopia’s second-stage decentralization to its weredas. Thus, it provides a myriad of lessons on how to build financial administration at the grassroots, as well as insights into financial reform in a decentralizing and decentralized government (an issue of great significance to many developing countries, one that is little discussed in the PFM field). PFA reform supported the wave of decentralization and did not delay it.

Scale and location do matter in public sector reform. Quite possibly one reason that New Zealand was in the vanguard of applying the most sophisticated management techniques to the public sector is its demographic context. In 1984, when New Zealand started its financial reform, just 13.4 million humans populated its splendidly isolated 104,000 square miles. Ethiopia, in contrast, is 426,000 square miles (twice the size of Texas), and when the reform started in 1996 it was the second most populous country in Africa, with 59 million people. Furthermore, it is located in one of the most dangerous neighborhoods on earth.

Against the odds

One would be hard put to find a more challenging environment to reform public finance than Ethiopia in 1996. The Four Horsemen of the Apocalypse—war, famine, pestilence, and death—seemed to be permanently stabled in-country. Ethiopia had been devastated by a long civil war, and the revolutionary party that assumed power in May 1991 represented an ethnic minority with tenuous control over a vast country. The bureaucracy was demoralized and many skilled professionals had fled the country. Foreign aid agencies rushed in to support the new regime, producing an inchoate and crowded aid agenda that further burdened a weak administrative system barely coping with daily operations. The government’s strategy of ethnic-based decentralization to Ethiopia’s eleven regions, implemented shortly after the change of power, further stretched an already strained administration. Less than two years into the start of the reform, the Horsemen rode in with even greater force as a two-year war with Eritrea was followed by the most serious famine in a century. Two years after the cessation of hostilities, Ethiopia embarked on a second stage of decentralization to its weredas, which increased the number of organizations administering finance by a factor of 15. Many of them were in some of the earth’s most inaccessible locations. In one of the early training programs in the Southern Region, in the south of the country, some participants required five days to reach the venue, two of them spent on horseback on roads made impassable to vehicular traffic by the weather. The odds of success seemed slim.

Why the reform succeeded

The reform succeeded for three reasons, two of them based in Ethiopia’s culture, and one based in the character of the reform itself. Most important was Ethiopia’s vigilant protection of its sovereignty. Unique to the continent, the government was absolutely clear that it would own this reform and that it would limit and closely monitor foreign aid. As a newly formed government emerging from seventeen years of civil war, the government was acutely aware of the importance of its need for legitimacy and a free hand to execute its policies and those of the foreigner. Sovereignty was sacred and not to be infringed upon.

Second was discipline, a trait that is deeply ingrained in Ethiopian culture (discussed in more detail in the next section). The foundation of any public finance system is discipline. There is little point in reforming budgeting procedures if the budget is a leaky sieve—if you can’t track where money comes from and where it goes. There must be a hard budget constraint—governments must live within their means—and there must be good transaction control—the pennies must be counted if the pounds of the hard budget constraint are to be controlled. Ethiopia was able to maintain this requisite fiscal discipline. In fact, it is the only African country that had a single-digit inflation rate for decades before 2000. The United States went off the gold standard in 1971, but Ethiopia continued to use the standard to anchor its currency—further evidence of uncommon monetary discipline.

The third reason that Ethiopia’s financial reform succeeded was that it was well managed. The government undertook a comprehensive needs assessment of its civil service and then realistically prioritized what most needed doing. It determined the scope of the reform and then budgeted for the funds and time required to make it happen, thus ensuring coherence among scope, budget, and time.

The cultural context

Those familiar with Ethiopia will not find it surprising that the financial reformers overcame incredible odds and adversity to achieve each success. Ethiopia has many ethnic groups, so cultural generalizations are suspect, yet the cultural marker of discipline, mentioned earlier, is discernible across all ethnic groups. Ethiopians’ discipline is shown in myriad ways. The virtues were many: seriousness of purpose; prudent, indeed tightfisted use of public money; and the low incidence of corruption. Yet there is a downside to discipline: a certain rigidity.

Don Levine’s Wax and Gold: Tradition and Innovation in Ethiopian Culture is one of the most respected sociological studies of the culture of the Amhara ethnic group, which dominated the politics and the bureaucracy for hundreds of years. The expression “wax and gold” (sam-enna wark) comes from an ancient form of verse that is very popular with Amharas. The wax is the obvious meaning, the gold the hidden meaning. For Levine, the “wax and gold” ambiguity is reflected throughout Ethiopian culture and helps explain its complexities: “The ambiguity symbolized by the formula sam-enna warq colors the entire fabric of traditional Amhara life. … Wax and gold is … a way of life [embodying] a fundamental indirection in speech by means of the studied use of ambiguity.” Levine goes on to explain four creative uses of sam-enna warq in Ethiopian society as

the medium for an inexhaustible supply of humor, a means for insulting one’s fellows in a socially app...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright Page
• Dedication
• Table of Contents
• List of illustrations
• List of tables
• Foreword
• Preface
• List of acronyms
• PART I Understanding public financial management reform
• PART II The Ethiopian reform
• PART III Lessons for the developing and the already developed
• References
• Index