April 4, 2016
The decision came after a gap between the official and the black market rates widened substantially, where the latter has seen levels around EGP/USD 9.68 as opposed to an official rate of 7.82 right before the devaluation. The Central Bank of Egypt (CBE) defended the official exchange rate by increasing the volume of dollar auctions from February and introducing new restrictions on dollar transactions. However, these steps proved to be costly in terms of international reserve erosion, and the Central Bank gave in to the depreciation pressure arguing that a more flexible exchange rate would be beneficial for the economy. Soon after the announcement, the CBE has decided in favor a rate hike from 9.25 to 10.75% and revealed that it aims to move towards more flexible exchange rate regime, shifting its nominal anchor gradually from exchange rate towards inflation target.
The recent events are broadly in line with our forecast made in June 2015, in which we have anticipated a gradually weakening currency and in parallel, elevation of policy rates to a level around 11% by 2016. This was expected amid high fiscal and current account deficit as well as inflation around 10%, figures close to the current data.
Nonetheless, the recent announcement of the Central Bank to offer currency risk hedge on local bond risk questions whether the authorities are ready to allow full exchange rate flexibility. With this step, the CBE would take over any exchange rate risks from market participants, which would mean it would use its reserves to defend the currency in these transactions. Due to this potential pressure on reserves, we think this practice will not last in the medium term.
The root cause of Egypt’s problems are external imbalances stemming from chronically high fiscal deficit. Currently, imports are three times higher than exports, which has prompted authorities to introduce bans on imports. The administrative measures applied by authorities to curb imports led to severe dollar shortage which disrupted production in certain sectors, and some factories had to close down due to the lack of essential production inputs.
Egypt, as being a net oil exporter, is adversely affected by low oil prices. In addition, with a non-oil export sector on the verge of recession, there is little hope for improving trade balance through exports, although the recent depreciation can help to trigger import substitution as foreign goods become more expensive. In addition, tourism suffers due to political risks and is not expected to recover soon, making dollars even scarcer. Even though FDI inflows could significantly improve the external position, substantial FDIs unlikely to materialize any time soon as business climate remains uncertain.
With a deficit lingering around 10% of GDP recently, the government sought new financing sources and came to an agreement about a credit facility with African Development Bank and World Bank to close the financing gap. In parallel, the monetary stance has been very accommodative as the Central Bank has financed the fiscal spending with provision of an overdraft facility for the government. This contributed to the persistently high level of inflation and real overvalued currency, as the nominal exchange rate was broadly stable at a level 7.63 – 7.82 through last year.
The political roadmap adopted in 2013 has brought significant reforms to the agenda, but until now introduction of the bulk of them remained a promise for later. Even the fiscal consolidation envisaged in 2015 have not been wholly realized. Timely implementation of structural reforms can be significantly constrained by the delicate equilibrium as subsidies and the prevalent tax system are building blocks of the Egyptian political system.
External debt sustainability analysis of the IMF showed that a balance of current account in line with the country’s fundamentals is attainable by around 10% depreciation. Therefore with the recent shift in the exchange rate regime, the pound came broadly in line with fundamentals.
In the short run further depreciation pressure is implied by the black market rates, which have seen the pound weakening further to a range between 9.50 and 9.55 dollars as of March 20. Devaluation did not eliminate the discrepancy between the official and shadow market rates despite efforts of the CBE, who has sold 2.4 billion dollars over the past two weeks, an amount of 15% of its total reserves. Actions of the authorities to fight against black market trading by foreign reserves contradict the CBE’s plan to attain its reserves target at 25 billion USD this year from the current level of 16 billion USD.
Focusing on a medium term perspective, the high inflation differential, which has prevailed in recent years, calls for further depreciation. The ongoing practice of deficit financing has raised inflation, thus monetary policy cannot succeed to curb the inflation expectations. Needless to say, a fiscal commitment to a lower deficit is a prerequisite to revoke deficit financing, therefore a credible monetary policy shift is not expected to materialize in near future.
Further procrastination of the structural policy changes imply continuous need for depreciation for the future.
Réka Sulyok, analyst at OGResearch