It has been a long battle, but after years of defending the local currency, the Egyptian government has showed it was willing to end its grip on the pound in 2016, floating the currency after months of speculation. The effects of this decision are likely to be one of the key economic talking points of 2017. As with other significant depreciations around the world in recent decades, the development presents sizeable challenges to the government at a difficult time in Egypt’s economic history. However, if managed skilfully, there are also substantive benefits to be secured.
While Egypt has not, like many hydrocarbons producers in the MENA region, adopted a dollar peg strategy, it has operated a managed float for many years. Under this system the Central Bank of Egypt (CBE) intervenes in the currency market by deploying its foreign reserves to keep the Egyptian pound at a desired level, a technique used by many economies, such as India and the UK, as a means to protect their industries and trading volumes from currency volatility.
However, the ability of any central bank to pursue such a policy is dependent on it having access to sufficient foreign reserves. In Egypt’s case, the CBE was able to keep the dollar exchange rate at around $1:LE5.75 between 2004 and 2010, despite a growing negative trade balance, thanks to sizeable foreign currency inflows from tourism, remittances, oil exports and Suez Canal revenues. The 2011 revolution, however, depleted reserves. The traditional sources of foreign revenue were all negatively affected, with the slowdown in the once-buoyant tourism industry being particularly damaging to the nation’s external position. By June 2013, Egypt’s foreign reserves dropped from $35bn and over six months of import cover to $14.5bn, below the critical threshold of three months of import cover, according to the IMF’s Article IV consultation for 2014.
The foreign currency shortage took its toll on the domestic economy as the CBE began to ration the dollar through foreign exchange auctions held three times a week. As a result, companies faced challenges in securing hard currency needed for imports. The result was the emergence of a parallel market, the premium of which fluctuated between 2% and 7% to the US dollar, according to the IMF. Unregulated and unreported, the black market allowed individuals and businesses to find a way to meet their currency needs, which the banking system was unable to. An August 2016 report in local media said the rate in parallel markets had reached $1:LE12.20-12.70, and local media reported rates rising to $1:LE18 immediately before the flotation.
Egypt’s case for being an attractive investment location was significantly undercut by these developments. Throughout this period the country maintained its policy of a managed float, and after the change of government in 2013 it was able to secure cash grants and deposits from Gulf donors to support the ailing currency. However, by the fourth quarter of 2016, with donors such as Saudi Arabia and the UAE facing economic hardships of their own due to subdued oil prices, the policy of currency defence appeared unsustainable and a significant depreciation inevitable.
The CBE began to show it was willing to let the pound slide a little in the markets in 2015. By July 2015 the currency had fallen to a new low against the US dollar, at $1:LE7.73. However, this partial loosening did nothing to control the black market in Egyptian pounds. In March 2016 Tarek Amer, the newly appointed governor of the CBE, took a number of steps that suggested the bank would take a different approach. First came the removal of the cap on dollar deposits and withdrawals for firms, which had been put in place in a bid to curb the parallel market. Shortly afterward, the CBE lifted the cap on dollar deposits and withdrawals by individuals.
The Next Step
The March 2016 devaluation brought some relief: the black market rate converged towards the official rate immediately following the move, with parallel market transactions ceasing completely for a day, according to a March 2016 report by Blominvest Bank. However, by October 2016 the spread between the parallel market and the official rate had increased to record levels, with dollars changing hands unofficially for $1:LE15. Remarks by the CBE that efforts to defend the pound had been a costly mistake, and the IMF’s apparent insistence that a $12bn facility for Egypt would be partially dependent on the country floating its currency, led to expectations of a free float.
The final decision to float the pound came as a surprise, given that as late as October 20, 2016 Prime Minister Sherif Ismail stated at a press conference that instead of a float, the government would allow a more flexible exchange rate. Instead, on November 3, 2016 the government finally floated the Egyptian pound, resulting in the immediate depreciation from the peg of $1:LE8.80 to $1:LE13. By the end of the week the rate had fallen still further, to approximately $1:LE17. By February 2017 the currency had begun to stabilise and was trading around $1:LE18.80.
The effects of this development are likely to be widespread and long-lasting. The most obvious short-term effect has been a rise in inflation, which in August 2016 was already running at 15.5%, the highest in seven years. According to the Central Agency for Public Mobilisation and Statistics (CAPMAS), Egypt’s headline inflation rate hit 23.3% in December 2016, despite the CBE’s decision to raise key interest rates by 300 basis points in a bid to control it. This represents uncharted territory for the current government, as, according to the World Bank, the last time the inflation rate reached a similar level was in the mid-1980s.
The short-term trajectory of the Egyptian pound is of great consequence. Most outlooks for 2017 are bullish. At the time of the float, JPM organ Chase predicted volatility for the first quarter of 2017, followed by a settling of the currency at around the $1:LE15-16 level.
The ultimate goal of any meaningful depreciation is to make Egypt’s exports competitive again, close the trade deficit and to help establish the country as a desirable target for investment in manufacturing. Yet achieving these ambitions is likely to result in considerable discomfort for a population faced with increasing costs even on basic items. Concern regarding the effects of the currency float on citizens was heightened in 2016 with the revelation by CAPMAS that 27.8% of Egypt’s citizens live beneath the poverty line, defined as an income of LE482 (equivalent to $25.55 as of December 2016) per month.
According to CAPMAS, the inflation rate rose in June 2016 to 14.8%; this was primarily due to increases in the price of food and garments. The flotation also comes at a time when Egypt is attempting to reduce its subsidy bill for fuel, food and power, which puts further pressure on Egyptian households.
In The Future
While the short-term effects were being felt in the market by the outset of 2017, the potential long-term gains were of more interest to most observers. It is expected that the flotation will allow the CBE to remove the remaining currency restrictions over the coming years, as the true market value is discovered and currency movements stabilise, according to November 2016 media reports. Any rate decided by the market will almost certainly be lower than the old rate, which will boost Egypt’s external competitiveness.
With the currency controls gone and an attractive exchange rate stabilised, the country will once more begin to look like an attractive prospect to foreign investors. Should the government succeed with its economic reform agenda, the return of strong, sustainable economic growth is a real prospect.
This scenario has played out elsewhere after the catalyst of devaluation. Notable examples include Argentina, South Korea and Sweden. Yet in Egypt’s case it is certain that an export boom would follow flotation. The problem lies primarily in the fact that Egypt has defended the pound for so long, and kept the value of the dollar artificially low, that it has disincentivised investment in the manufacturing sector for years. Manufacturers have found it too easy to import inputs and intermediate products, or even place capital in other sectors such as real estate rather than their core business, and therefore Egypt’s exporters are heavily reliant on imported items.
By January 2017 Reuters was already reporting that thousands of importers were facing bankruptcy and ballooning dollar debts. The government’s strategic shift from a managed float to a more flexible monetary framework is an important development for the economy as a whole, and should help to remedy the dysfunctional exchange system that currently prevails. The long-term solution to currency challenges, however, lies in the government’s ability to successfully reduce spending and boost national production.