Last week, the Central Bank of Egypt (CBE) unexpectedly decided to raise interest rates by two percentage points to mitigate spiraling inflation. While academic economists and observers of financial markets hold a wide range of opinions about the likely effects of the rate hike (to say nothing of its wisdom), the high inflation in Egypt—cited by the CBE as the reason for the tightening—is undisputed. The peg of Egyptian pound (LE) to the dollar gave rise to a parallel black market over the past several years, and the gap between the official bank exchange rate and the black-market rate widened throughout 2016, until the peg was removed and the pound floated in November. The CBE’s decision to float the pound was controversial, not least because of the inflation it is perceived to have caused. However, contrary to popular belief, the incredible rise of the dollar against the pound was one of the results, not the cause, of high inflation. The fundamental cause of inflation is the increase in the money supply: the amount of Egyptian pounds in circulation has increased at unprecedented rates.
Demand-side economists argue that economic activity is best boosted by boosting the purchase power of the lower and middle classes, because they are the social groups who spend much of their income on immediate consumption in the local economy, rather than saving it for later use. Thus, during times of recession or economic slowdown, a calculated increase in the money supply may be beneficial to boost economic activity even if it means a boost rise in prices as well. The distributive logic of this new money supply decides how fair and justly the new wealth is distributed. When money creation spirals out of control, it can lead to the loss of trust in the economy and have a drastic impact on the economic and social rights of the population.
Money is valuable relative to how much of it is in circulation. Very simply put, owning a million pounds in an economy that has a trillion pounds in it makes you twice as rich as owning a million pounds in an economy that has two trillion pounds in it—given that output (amount of production) and the velocity of money (how quickly it circulates among the population) remain constant. Egypt’s money supply has increased from LE 1.02 trillion pounds in August 2011 to LE 2.7 trillion in January 2017 (see Table 1). This means the amount of money in the Egyptian economy has increased about 165 percent in just over five years whereas output has grown by only about 17 percent during the same period. So of the 165 percent increase in money supply, only 17 percent has no inflationary impact, and the remaining 148 percent is causing inflation, with other things held constant namely the velocity of money.
|Year||August 2011||August 2012||August 2013||August 2014||August 2015||August 2016||January 2017||Increase (in millions of pounds)||Percentage Increase (%)|
|Money Supply (M2)||1,024,359||1,115,267||1,329,492||1,557,379||18,119,118||2,151,648||2,701,534||1,677,175||165|
|Financial year||2010-11||2011-12||2012-13||2013-14||2014-15||2015-16||2016-17||Increase (in millions of pounds)||Percentage Increase (%)|
|Public Wages||96,271||122,817||142,956||178,588||198,468||213,721||228,736 (projection)||132,465||137.6|
|Subsidies, grants and social spending||123,125||150,193||197,093||228,579||198,569||201,024||206,424 (projection)||83,299||67.6|
|Cumulative inflation rate (%)||8.5||15.4||26.68||41.24||52.37||75.23||127.1||127.1|
Source: National budgets (Ministry of Finance), Figures from the Central Bank of Egypt, and calculations done by the author.
In other words, the CBE has created more pounds in five years than all the cash that was already extant five years ago. According to official inflation rates, prices have more than doubled over the same period, which is in line with the estimate above of the amount of new money that did not correspond with an increase in GDP. This makes perfect sense: If the amount of money in circulation doubles without a corresponding increase of output, then it is only natural for prices to double as well, given no significant change in the velocity of money.
If we consider the dollar as a product that has a price against the pound, the global dollar supply over the same period of time increased by about 30 percent. Of course what decides the exchange rate is the amount of foreign currency in a certain economy (not the entire world), but this—very roughly and simply put—means that part of the massive increase in the dollar could be attributed to an increase in the pound supply and therefore demand for the dollar, and not only a decrease in the dollar supply. In other words, Egypt had too many new pounds chasing the same amount of dollars, not the same amount of pounds chasing fewer dollars.
The price of the dollar went up (in pound terms) because it is like any other product whose supply has not increased as quickly as the pound’s. Again, it is the uncalculated increase in money supply that is the primary cause that has led to the price hikes and not the shortage of the dollar. Research conducted by the Egyptian Initiative for Personal Rights challenges the idea that a decrease in dollar supply led to this astronomical increase in its exchange rate.
Why this massive increase in money supply leads to inequality and widening socioeconomic gap?
- Inflation is a tax against the poor, and a hidden one at that.
Inflation caused by money creation is generally regarded as a form of hidden taxation that primarily targets the poor. Governments often choose to create money instead of raising taxes, in order to avoid the criticism and calls for accountability that often accompany tax hikes (and to reduce their real debt burden). Creating new pounds makes the pounds in people’s possession lose value, and gives the government more purchasing power (as taxes do). This is where the idea of money as a store of value becomes very important. In times of high inflation, people try to find stores of value to prevent their wealth from being eaten away by this new money supply and the resulting inflation, and Egyptians seem to have turned to foreign currency, property, and gold as popular stores of value. The wealthy, then, are much less affected than those with cash savings in local currency and who lack access to banks and financial markets.
- The new money takes the form of credit which mostly goes to wealthy investors or the government.
Early recipients of the newly created money also tend to benefit the most from the creation of new money, which is normally injected into the economy in the form of new credit extended by commercial banks. When the CBE wants to create new money, it purchases government bonds from commercial banks, then pays the commercial bank for the bonds in the form of extra cash reserves in the commercial bank’s account at the central bank. This allows banks to create more money and lend it to their clients, lowering interest rates due to the higher supply of loans and making borrowing cheaper. This means that the first recipients of the new money are borrowers, who have access to new cheap money. The advantage an early recipient of new money has is that they have the money before prices have adjusted to the injection of the new cash.
According to CBE figures, domestic credit in local currency increased from LE 866.1 billion in July 2011 to just above LE 2.28 trillion in January 2017 with an increase of LE 1.42 trillion (or 164 percent). Of this new credit, LE 1.05 trillion (74.3 percent) has gone to the government, mostly in the form of securities. The public business sector has received LE 69.7 billion (or about 4.9 percent) of this new money, while the private business sector has received LE 165 billion (11.6 percent), and the household sector received about LE 130 billion or about the remaining 9.1 percent (see Table 2).
This period in Egypt provides a classic example of crowding out: When the government over-borrows, it absorbs the economy’s lending capacity, making it more difficult for the private sector to access finance. Looking at how domestic credit was divided among different sectors back in 2011, we find that the claims on the government amounted for only 60.5 percent of total domestic credit, which rose to 69 percent in January 2017. Claims on the business sector (public and private) declined from about 28.3 percent in 2011 to only 16.8 percent in January 2017. The share of the household sector also declined from about 11 percent to 9.9 percent.
Due to a lack of data, it is difficult to determine how much of this new money had reached low- and middle-income groups to boost economic activity and aggregate demand, and help them adjust to inflationary pressure, but we have some indicators based on previous figures that this has not been the case. Only around eight percent of new credit has been extended to households, and much of this went to high-income groups to finance home purchases. While businesses were able to borrow, cost-push inflation and modest aggregate demand so far appear to have limited the new money’s ability to stimulate the economy, and wages have stagnated in real pounds and declined in dollar terms. And though the government has raised wages for civil servants and other state employees, those too have barely kept up with inflation and devaluation, and subsidies, grants, and social spending have decreased in real terms.
|2011||% of total domestic credit||2012||2013||2014||2015||2016||2017||% of total domestic credit||Increase (in millions of pounds)||Percentage Increase|
|Net Claims on Government||524,335||60.5%||638,492||851,425||1,034,569||1,251,096||1,486,484||1,579,598||69%||1,055,263||74.3|
|Claims on Public Business Sector||24,853||2.8%||31,784||33,873||35,424||43,989||55,087||94,551||4.1%||69,698||4.9|
|Claims on Private Business Sector||220,826||25.5%||239,111||250,706||263,978||289,573||318,912||385,753||16.8%||164,927||11.6|
|Claims on Household Sector||96,112||11%||109,738||125,505||143,252||171,988||198,384||226,190||9.9%||130,078||9.1|
Source: Central Bank of Egypt’s Monthly Statistical Bulletin (December 2016)
Conclusion and recommendations:
1- Avoid excessive creation of money for the sake of social, fiscal, monetary, and political stability. The increase of the money supply should be reduced to normal rates of around five or 10 percent, depending on growth rates. This should help stabilize prices and markets without leading to contraction.
2- New money and credit should be more justly distributed to end wealthy individuals’ and companies’ preferential access to finance, which makes them early recipients of new cash. New credit should be extended to micro- and small-sized businesses, and the portion that goes to the government should be spent on low-income civil servants and pensioners to prop up economic activity, and on social support to the most vulnerable groups.
3 – Avoid excessive borrowing. The government’s share of new domestic credit has been increasing, and that affects how much the productive business sector can access finance, and therefore produce and create jobs. According to CBE figures, the government has received 69 percent of new credit in the last five years, leaving the business sector (both private and public) with about only 21 percent and the household sector with about 10 percent. In order to avoid crowding out and competing with the business sector over available funds, and also to avoid adding further to the debt burden, the government should be a more prudent borrower and allow a larger chunk of available credit to go to the private sector, especially smaller enterprises.
4- Have a better tax collection strategy. If Egypt needs to limit its money printing and borrowing, then how would it finance its quite large budget deficit? Less spending or austerity is one option, but this can kill growth and have serious social and political consequences as we have seen in Greece recently. Egypt still has massive untapped potential when it comes to tax collection. Egypt only collects about 12.4 percent of GDP in tax, whereas developed countries in Europe and North America range between 25 and 45 percent, and middle-income countries normally have around a fifth of their GDP paid in taxes. This untapped potential seems to be mostly in areas of corporate tax, property tax, and professional income tax (such as doctors’ clinics and law offices). In recent years, there has been an overreliance on consumption taxes, which is a regressive tax that mostly impacts the poor and has both an inflationary and recessionary impact because it raises prices and taxes consumption. Accordingly, Egypt should have a target for tax revenues to reach 20 to 25 percent of GDP in the coming years, primarily by better collection of property taxes and professional income taxes. Enforcing the property tax would be ideal for Egypt because it does not distort markets and will decrease the speculative nature of Egypt’s real estate market, which should stabilize the prices of property.