The Eritrea Monetary Divorce of 1997 and the War It Helped Cause

A border war with a monetary cause

On 6 May 1998, Eritrean mechanised units crossed into Ethiopian-administered territory near the town of Badme. On 13 May, Ethiopian Prime Minister Meles Zenawi declared a state of total war. By the time the conflict ended in June 2000, between 70,000 and 100,000 soldiers had been killed and 600,000 civilians displaced, in what observers described as the most intense fighting in Africa since the Second World War.¹ The fighting was, in the standard telling, about a border — about the small town of Badme and the precise alignment of the colonial-era boundary that had separated Italian Eritrea from imperial Ethiopia.

This article argues that the border was the occasion of the war, not its cause, and that one of the principal underlying causes was a monetary dispute — the breakdown of negotiations over how Ethiopia and the newly independent Eritrea would conduct trade and settlement after Eritrea introduced its own currency in November 1997. The claim is not that money “caused” the war in some unicausal sense; the claim is that the monetary dispute was one of the proximate drivers of the deterioration in bilateral relations through late 1997 and early 1998, and that this monetary dispute deserves to be in the explanation rather than left out of it. Most accounts of the war either omit the monetary dimension entirely or treat it as a minor detail. This article makes the case that it is closer to a load-bearing piece of the story.

The broader point for this series is the one already foreshadowed in earlier articles: monetary policy is not a technical sideshow that operates separately from the rest of national life. Monetary arrangements are political arrangements, and when they break down, the breakdown can drive consequences far beyond the realm of finance — up to and including organised violence. The Ethio-Eritrean War is the clearest case in modern African history of a monetary dispute contributing to a major interstate conflict. It belongs in a Ethiopian monetary history.

The 1993 monetary union

When Eritrea formally separated from Ethiopia in May 1993 after a referendum, the two countries agreed to maintain a transitional monetary union. The Protocol Agreement on Harmonisation of Economic Policies, signed in September 1993, committed both governments to: continued use of the Ethiopian birr in Eritrea until Eritrea introduced its own currency; harmonisation of exchange-rate policies including possible pooling of reserves; harmonisation of interest-rate structures; coordination of monetary expansion to be “consistent with the growth and inflation objectives of the two countries”; and synchronisation of policies on foreign-exchange surrender requirements, allocation, capital flows, and external debt management.²

This is a serious monetary-union document. It commits, in effect, to maintaining a single currency area between the two countries on the East African Currency Board model that had operated in colonial East Africa. The commitment is sensible from both sides’ point of view: the two economies were deeply integrated (Eritrea exported more than 65 percent of its products to Ethiopia, while only 9 percent of Ethiopian exports went the other way³), the cost of maintaining a single currency was low, and the political benefits — demonstrating that the two states could cooperate after a thirty-year independence war — were substantial.

The early years of the union worked. Trade flowed. Remittances from Eritreans in Ethiopia moved freely. Ethiopia continued to use Eritrean ports — primarily Assab — for the bulk of its imports and exports. The birr functioned as the joint currency in a way that was, by African standards, remarkably successful. Until 1997.

Why the union broke

What broke the union was a combination of underlying economic asymmetries and specific political decisions on both sides. The asymmetries were structural: Eritrea was a small economy heavily dependent on the Ethiopian market and on port revenues from Ethiopian trade; Ethiopia was a much larger economy that increasingly resented its dependence on Eritrean infrastructure for its access to the sea. The Wikipedia summary captures the imbalance: “Eritrea’s port revenues from Assab and Massawa, which had comprised 8% of GDP during 1995–1997 through Ethiopian transshipment, plummeted to 1% of GDP by 1998–2000 following Ethiopia’s redirection of trade.”⁴ Even before the war, Ethiopia was diversifying its routes through Djibouti and Mombasa.

The specific political decisions were two. First, the Eritrean government announced in 1996 that it would introduce its own currency in the foreseeable future. The decision was a normal exercise of sovereignty by an independent state, and it had been contemplated since independence. But the terms on which it would operate post-introduction were not pre-negotiated, and the failure to pre-negotiate them set up the crisis.

Second, in March 1997, the Bank of Eritrea proposed three payment options for post-currency-introduction trade between the two countries: free convertibility of nakfa and birr at par; settlement in the most-convenient available currency depending on transaction type; or harmonisation of foreign-exchange policies to make the choice between options indifferent.⁵ The proposals were, by the standards of bilateral monetary arrangements, reasonable. Ethiopia rejected all three. The Ethiopian government insisted that all post-currency trade between the two countries be settled in convertible hard currency (US dollars or major European currencies), with letters of credit required for transactions above 2,000 birr.

The asymmetry of the choice

This is the decisive moment, and it is worth examining the economics carefully, because the choice was not symmetric in its consequences.

For Ethiopia, requiring hard-currency settlement was a way of recapturing seigniorage — the implicit subsidy Eritrea had been receiving by using the birr as legal tender. Every birr note circulating in Eritrea was, in effect, an interest-free loan from Eritrea to the National Bank of Ethiopia, in exchange for which Eritrea got a usable currency it had not had to issue. The seigniorage was small relative to Ethiopia’s total monetary base but non-trivial. From the Ethiopian government’s perspective, ending the seigniorage transfer when Eritrea introduced its own currency was a reasonable economic position.

For Eritrea, requiring hard-currency settlement was a severe shock. Eritrea’s foreign-exchange reserves were limited, its hard-currency earnings small, and its trade with Ethiopia constituted the dominant share of its external trade. Switching from birr settlement (denominated in a currency Eritrea no longer issued but had been using freely) to hard-currency settlement (denominated in dollars Eritrea did not have) would have required either a substantial reduction in trade volumes, a sharp depreciation of the nakfa against the dollar to make hard currency relatively cheap, or massive additional borrowing to finance the trade. Eritrea proposed alternatives that would have avoided this shock. Ethiopia rejected them.

There are credible accounts from both sides about who escalated. The Eritrean position, articulated by the Bank of Eritrea governor in contemporaneous statements, was that Ethiopia’s insistence on hard-currency settlement was a deliberate act of economic warfare designed to weaken the Eritrean economy.⁶ The Ethiopian position, articulated by the Ministry of Foreign Affairs in late 1997, was that hard-currency settlement was the standard practice for separate sovereign currencies and that any other arrangement would have been an unusual concession.⁷ Both positions have merit. The point this article is making is not who was right but that this dispute became, in late 1997, one of the central irritants in a bilateral relationship that had been deteriorating for other reasons and was now spiralling.

The trade war

On 8 November 1997 — the Wikipedia article gives the date variously as 8 or 15 November depending on the source⁸ — Eritrea introduced the nakfa as its national currency, replacing the birr at par in Eritrea. The Ethiopian government’s response was immediate and harsh. Ethiopian customs officials at border crossings began harassing nakfa holders: confiscating notes, tearing them, in some documented cases burning them.⁹ Inbound trade from Eritrea was effectively halted. The Wikipedia summary, citing Martin Plaut and others, documents that “Ethiopian authorities responded aggressively, harassing nakfa holders at border points—confiscating, tearing, or burning notes—and halting inbound trade from Eritrea, while mandating letters of credit for transactions exceeding 2,000 birr.”¹⁰

By late December 1997, a de facto partial trade embargo was in place. The Assab refinery — jointly used by both countries for fuel processing — closed in August 1997 as Ethiopia diversified its fuel sources through Djibouti.¹¹ In late December 1997, the first armed incident occurred at an Eritrean border post in northern Dankalia.¹² Shortly afterward, several thousand Eritreans residing in western Tigray were ordered to adopt Ethiopian nationality or leave the area. The trade war had become, by early 1998, the political war that would in May erupt into shooting.

Martin Plaut, whose 2024 retrospective on the war places the monetary dimension centrally, identifies three specific consequences of the currency dispute: it forced both governments to delineate the border (because customs needed to know where to apply the new currency regime), which generated new territorial disputes; it produced bilateral acrimony that “tarnished relations between the two administrations”; and it disrupted the flow of goods, remittances, and labourers, “generating new political pressures on both governments.”¹³ His conclusion is direct: “Taken together, these economic factors appear to have rekindled old animosities between the ruling groups of both countries, eroding their willingness to compromise or negotiate over disagreements.”

The casualty count, the monetary share

The war, when it came, killed somewhere between 70,000 and 100,000 soldiers on both sides and displaced perhaps 600,000 people.¹⁴ The estimated cost to Ethiopia, in direct military expenditure alone, was several billion dollars across the two years; the indirect costs — lost growth, diverted investment, the foreign-exchange consequences of cutting off Eritrean port access — were larger still.¹⁵ Ethiopia financed substantial portions of its war expenditure through central-bank advances, contributing to the resumption of monetary disorder in the late 1990s.

How much of this is attributable to the monetary dispute is, honestly, impossible to specify precisely. The border was disputed for other reasons; Eritrean President Isaias Afwerki and Meles Zenawi had a personal and political relationship that had deteriorated for many reasons; the economic asymmetries between the two countries would have created tensions even without the currency issue. To say “the monetary dispute caused the war” is to overstate. To say “the monetary dispute had nothing to do with the war” is to flatly contradict the documentary record. The honest position is that the monetary dispute was one significant contributor to a multi-causal deterioration of relations, and that its contribution was large enough that ignoring it produces an incomplete explanation.

The deeper point for this series is that the monetary dispute is not a natural feature of post-independence relations between two countries that share a currency. Other monetary unions have been unwound peacefully — the dissolution of the Czechoslovak monetary union in 1993, for instance, was managed without armed conflict.¹⁶ The Ethio-Eritrean case ended in war because both governments treated monetary policy as an instrument of statecraft rather than as a technical question to be resolved cooperatively. The Ethiopian government’s insistence on hard-currency settlement was a deliberate use of monetary policy to extract concessions from Eritrea; the Eritrean government’s response was to escalate. The escalation went where escalations go.

The Sowellian lesson

If this article has a single takeaway, it is the one Thomas Sowell has been making for fifty years: that economic policy choices have consequences that cannot be confined to the realm of economics. The Ethiopian government’s perfectly defensible economic position — that an independent Eritrea should pay in hard currency for its imports from Ethiopia — was simultaneously an act of pressure on a small neighbour whose entire trade structure depended on continued cheap access to the Ethiopian market. The pressure was, perhaps, justified; that is not the article’s argument. The article’s argument is that the decision to apply pressure through monetary means had consequences that the Ethiopian decision-makers did not adequately weigh, and the consequences eventually included tens of thousands of war dead.

This is the cost of treating monetary policy as a discretionary instrument of state. When the central bank’s exchange rate, the central bank’s currency arrangements, and the central bank’s settlement requirements are all available to the executive as tools of policy, they will be used as tools of policy, including in disputes where the political cost of using them is far higher than any economic benefit they yield. A rules-bound monetary regime — one in which the central bank does not have the discretion to weaponise the currency in bilateral disputes — would not have produced this particular catastrophe. It might have produced others. But this one belongs on the ledger of the Ethiopian monetary architecture this series has been describing.

The next article turns to the developmental-state thinker whose intellectual project shaped the Ethiopian monetary architecture for the entire post-1991 period, and whose ideas the EPRDF coalition continued to invoke long after his death — Meles Zenawi.

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Footnotes

1. “Eritrean–Ethiopian War,” Wikipedia, https://en.wikipedia.org/wiki/Ethiopia-Eritrea_War; Martin Plaut, “The Eritrea-Ethiopia border war of 1998-2000 revisited,” https://martinplaut.com/2024/04/14/the-eritrea-ethiopia-border-war-of-1998-2000-revisited/. Estimates of total casualties range widely; the 70,000–100,000 figure is the consensus of several major sources. ↩

2. “The Cause of the Eritrean-Ethiopian Border Conflict,” http://www.dehai.org/conflict/analysis/alemsghed2.html, citing the Protocol Agreement on Harmonization of Economic Policies, September 1993. ↩

3. “Eritrean–Ethiopian War,” Wikipedia, citing the bilateral trade asymmetry. ↩

4. “Eritrean–Ethiopian War,” Grokipedia, https://grokipedia.com/page/Eritrean%E2%80%93Ethiopian_War. ↩

5. “The Cause of the Eritrean-Ethiopian Border Conflict,” documenting the March 1997 proposals. ↩

6. “The Cause of the Eritrean-Ethiopian Border Conflict,” presenting the Eritrean position. ↩

7. Ethiopian Ministry of Foreign Affairs, “Eritrea’s Currency and Trade Policy,” statement, 1998, archived in Plaut, “The Eritrea-Ethiopia border war.” ↩

8. “Eritrean nakfa,” Wikipedia, https://en.wikipedia.org/wiki/Eritrean_nakfa, gives 15 November 1997 for the formal introduction; other sources give 8 November. ↩

9. Plaut, “The Eritrea-Ethiopia border war”; “Eritrean–Ethiopian War,” Wikipedia. ↩

10. “Eritrean–Ethiopian War,” Grokipedia. ↩

11. “Eritrean–Ethiopian War,” Wikipedia, on the Assab refinery dispute. ↩

12. “Eritrean–Ethiopian War,” Wikipedia. ↩

13. Plaut, “The Eritrea-Ethiopia border war of 1998-2000 revisited.” ↩

14. “Eritrean–Ethiopian War,” Wikipedia. ↩

15. Martin Plaut and Patrick Gilkes, Conflict in the Horn: Why Eritrea and Ethiopia are at War (Royal Institute of International Affairs, 1999); Tekeste Negash and Kjetil Tronvoll, Brothers at War: Making Sense of the Eritrean–Ethiopian War (James Currey, 2000). ↩

16. Jan Fidrmuc, Július Horváth, and Jarko Fidrmuc, “Stability of Monetary Unions: Lessons from the Break-up of Czechoslovakia,” Journal of Comparative Economics 27, no. 4 (1999): 753–781. ↩