Egypt’s economy is saddled with an array of complicated and interrelated challenges. The government is burdened with the unenviable task of addressing and overcoming these challenges in a weak global context for emerging economies. Unemployment and inflation contributed to the uprising in 2011, and the instability since then has not helped matters. Egypt’s hard currency reserves are dwindling due to collapsing inflows, inflation continues to erode consumers’ purchasing power, the pound is overvalued, levels of foreign direct investment are inadequate, and the country faces a substantial trade deficit. As the government tries to balance competing demands, the situation threatens to spin out of control.
Fighting a Trade Deficit and a Dollar Shortage
In the aftermath of the 2011 uprising, Egypt’s tourism industry declined sharply and investor confidence was low. Despite these challenges, the Central Bank of Egypt (CBE) decided to maintain a peg to the dollar and reached deep into its hard currency reserves to do so. In 2010 reserves peaked at over $35 billion; by the close of 2011, it had dropped to around $17 billion and has failed to recover since. Current reserves, though boosted by deposits from Gulf countries, are barely adequate to cover three months of imports while the government continues to take on debt—denominated in Egyptian pounds (LE), dollars, and euros—and consumer demand for imported goods rise.
Egypt’s hard currency shortage is the product of a series of problems. Aside from growing demand from imports, Egypt’s hard currency revenue has taken a number of hits in the past few years. One of Egypt’s most important sources of hard currency, the Suez Canal, has seen a drop in revenue in the past several months. This has been a result of slowdowns in global trade and the price of oil. Historically low oil prices also mean that it can be more cost effective for shipping companies to travel around the Cape of Good Hope rather than pay the expensive tolls for passing through the canal. The number of tourists continues to dwindle not only due to political instability but also because of the violence in the country. Egypt’s security forces accidentally killed a group of Mexican tourists and their Egyptian guides, while the local Islamic State affiliate claimed the crash of a Russian airliner had been their doing. The loss of tourists has reduced the supply of dollars in circulation in both the formal and informal market. In order to fight the trade deficit and dollar shortage, the government recently announced that it intends to reduce the country’s import bill by a quarter in 2016. The government has indicated new import restrictions are in place to promote consumption of domestically produced goods while curbing demand for increasingly scarce dollars.
One traditional economic response to deter the consumption of imports is allowing the currency to devalue. As the currency devalues, imports rise in price, deterring consumers from purchasing them, or reducing the amount they purchase. However, devaluing the currency will result in rising prices at a time in which Egypt suffers from double-digit inflation. The central bank reported in December 2015 that year-on-year inflation had reached 11.06%. The government understandably wants to avoid any further rises in inflation if possible.
To keep dollars in the country and slow the pace of imports, Egypt has imposed a series of strict capital controls that limit transfers of money abroad and limit the amount of dollars Egyptians can purchase at the official rate through the nation’s banking system. The government has also sought to deter purchasing dollars on the black market by limiting dollar bank deposits to $50,000 a month so that importers would have a bottleneck in financing their imports.
The government has recently raised the deposit cap for importers of essential goods to $250,000. This is to address an important challenge that has emerged as a result of the strict capital controls in place. Many local industries have struggled to import the necessary raw materials and capital goods, such as machinery, required to maintain production at capacity. These industries must have access to necessary inputs and machinery in order to meet the needs of the market, which is all the more urgent if the government seeks to reduce consumers’ dependence on imports. Moreover, if Egyptian factories with export-worthy goods can increase their production all sell their goods abroad, this increases the inflow of hard currency to Egypt and helps to reduce the country’s substantial trade deficit. Raising the deposit cap does, however, increase the demand for the dollar and can result in the price of the dollar rising in the black market as it did following the announcement before stabilizing.
The price of the dollar on the black market is also essential to the rate of inflation in Egypt, as many of Egypt’s importers purchase their dollars on the black market because the capital controls in place make it impossible for them to secure an adequate amount of dollars to finance their imports. The dollar on the black market in Egypt is currently sold at roughly a 20% premium over the official price of 7.83 LE to the dollar.
This gap has also encouraged Egyptians sending home remittances to avoid the banking system in favor of selling their dollars on the black market when possible. Former Central Bank Governor Hesham Ramez estimated that only 10% of remittances passed through the banking sector. Remittances are one of Egypt’s most significant sources of hard currency. In fiscal year 2014-15, remittances were worth $19.33 billion. A recent article from the American Chamber of Commerce in Egypt noted, “remittances from abroad provide more hard currency than tourism and foreign direct investment combined.” It will be difficult for the government to be able to redirect those funds to the banking sector without addressing the gap between the official rate and black market rate, which can’t happen without increasingly dollar supplies through official channels requiring loosening capital controls.
Non-Financial Pressures on Importers
In addition to financial measures designed to directly affect the price and availability of dollars, the government has imposed a series of regulations and tariffs to reduce Egypt’s reliance on imported goods. One of the new measures announced requires importers to register every single factory they source imports from with the Ministry of Trade and Industry. Part of the justification for this measure was to ensure the quality of the goods being imported. In principle this is not a problematic objective and quality control to protect consumers from dangerous products is a good plan. The requirement may, however, be somewhat impractical. Many international brands have extremely complex supply chains. If one were an importer of Nike products for example, that individual would be required to register countless factories across the globe, which aren’t even Nike owned factories, but rather subcontractors that produce official Nike branded apparel. In a bureaucracy not known for its efficiency the prospect of properly coordinating the registration of products from 669 factories in 43 different countries seems daunting if not borderline impossible.
New tariffs have been announced on a variety of “luxury” items. The government has said it hopes that as the price of these imported goods rise, Egyptians will turn to domestic alternatives, which will both increase demand for domestic production and decrease Egypt’s import bill at the same time. In effect this is an attempt to achieve the effect of devaluation in a targeted way without allowing basic foodstuffs to be hit by the consequences of full-scale devaluation. Through tariffs the government can increase the price of select goods, depressing demand for those items. However, not all the goods on the list have domestic alternatives and bringing new domestic production online will take time, hurting consumers and the merchants who trade the goods in question.
The theoretical underpinning for the protectionist policies being undertaken by the government is the concept of Import Substitution Industrialization. It’s a concept that became popular in development economics following the period of decolonization and was undertaken by president Gamal Abdel Nasser during his tenure. This policy is widely seen as having failed, partly due to the Nasser government’s failure to effectively identify Egypt’s comparative advantages and focus on those industries. The same can be said of the disorganized application of tariffs today. Rather than selecting goods that Egypt is in the position to produce competitively and could eventually be sold abroad, policymakers appear to be targeting any item they believe to be unnecessary or potentially replaceable. It’s not wrong for the government to select industries it believes Egypt is well suited to excel in and support or even protect those industries within reason, but it must be a studied decision. Closing the flow of an array of imports in the hope that local businesses will find a way to produce replacements efficiently is not sound economic policy.
Appreciating the Pound
In preventing the Egyptian pound from devaluing in accordance with market pressures, Egypt has actually allowed its currency to increase in value against most currencies. The CBE has focused its currency policies on the pound’s relationship to the dollar and since the U.S. Federal Reserve ended its program of quantitative easing the U.S. dollar has surged in value against much of the world’s currencies. In the last 18 months the euro has dropped from LE9.60 to LE8.65. The pound has similarly appreciated against the Australian dollar, Canadian dollar and many emerging market currencies. This both increases the attractiveness of imported goods and reduces the competitiveness of Egyptian products.
Egypt has also sought to attract foreign direct investment to bring in hard currency and help grow the economy. While FDI has increased somewhat, Egypt has failed to meet the $10 billion target set for the last fiscal year by the investment minister in 2014. The majority of that FDI that was invested came from Gulf states which are facing their own financial challenges as a result of severely depressed oil prices and a glut in the market. Saudi Arabia, one of Egypt’s most generous donors and investors, has introduced dramatic cuts in spending to reign in its budget deficit. It’s likely these pressures will reduce the Gulf’s appetite to buoy Egypt’s economy as it has in the past few years.
FDI in Egypt is hampered by the country’s capital controls and currency policy. As foreign investors look at the country’s tenuous economic position, they have delayed investments. Much of the market expects an eventual devaluation of the pound and so many investors believe buying overvalued pounds that will soon drop in value to be a poor investment decision. As Bloomberg reported, “Twelve-month non-deliverable forwards—one of the main ways traders speculate on Egypt’s currency—were at LE10.45 per dollar as of 1:04 p.m. in Cairo, a 25 percent discount to the official exchange rate. They hit LE10.5 on Nov. 10, the weakest since 2007, according to data compiled by Bloomberg.”
For perspective, if an investor believes the pound will eventually drop to 10 LE to the dollar, and purchases the pound today at less than 8 LE to the dollar then the eventual devaluation would represent a 25% loss in value in the investment just due to changes in the exchange rate.
On top of the fear of losses due to an eventual devaluation, potential investors worry that, with Egypt’s strict capital controls in place and the possibility that an increasingly desperate government could take even more radical measures, they would be unable to withdraw future profits. This is all in the context of a global slowdown in investments in emerging markets.
Conclusion and Recommendations
The challenges facing Egypt’s economy are numerous and complex. Undoubtedly, Egyptian officials are in the unenviable position of having to find a way out with all the problems they face. As one can see, for every solution there is a problem. Devalue the pound and FDI would likely increase, local production would be more competitive, and demand for imports would decrease. Unfortunately, Egypt’s high level of inflation would worsen, as well, driving up the cost of basic goods even as many Egyptians already struggle to get by. Lift capital controls and FDI will feel safer, industry will be able to access necessary inputs and the black market for dollars will dry up, but the state’s limited currency reserves would be at risk of drying up, putting the state in a financial crisis. Restrict imports through tariffs and trade restrictions and the demand for dollars in Egypt would slow as consumption of imported goods drops. However, the import sector of the economy would shrink—along with industries depending on it, such as Egypt’s sizable retail sector—with the consequent losses of jobs in a country with already high levels of unemployment.
Whatever package of measures the government settles on, there will be significant costs, both economically and politically. Economic hardship often translates into political tension. It is essential, however, that the government move away from its current practice of implementing unpredictable haphazard economic regulations and instead set out a coherent strategy for the fiscal year that begins in July so that traders, industrialists and investors can plan their operations and anticipate regulations and costs. At the moment, the business community is unable to predict what new regulations, restrictions, tariffs or capital controls the government may introduce. This lack of predictability discourages investing, which exacerbates Egypt’s economic weakness and takes away from potential growth. Once again, a lack of transparency in Egyptian governance hurts Egypt and its potential for progress.
Given the limited resources available to the government right now, it seems that its only viable option is to allow the Egyptian pound to devalue. It should try to do this in a gradual manner to avoid panic and runaway inflation. The CBE needs to implement devaluation in coordination with other ministries as part of a coherent package of policies that aim to stabilize the Egyptian economy and attract foreign direct investment. There needs to be more predictability on capital controls, which should be loosened as soon as is effectively possible. The devaluation in concert with a lifting of capital controls will start to diminish the growing premium paid for dollars in the black market.
As the currency reaches its market value, the inflationary pressure of speculation on the pound will decrease, helping to offset part of the inflation that will come from devaluation. Currently importers are pricing for both elevated costs of accessing hard currency and speculation that those costs will rise in the near future even further. Removing that speculation from their calculus could come with some benefits to consumers.
Devaluation will allow prices on imported goods to rise, depressing demand for such goods and likely reducing Egypt’s trade deficit, which has strained the country’s reserves. That said, this inflation in pricing must be met with targeted policies that soften the blow on Egypt’s most vulnerable citizens. The government may have to consider temporarily increasing subsidies on essential foods to avoid prices on such items jumping dramatically compromising the food security of millions of Egyptians living in poverty with little if any slack in their disposable income. While subsidies are notoriously inefficient mechanisms for poverty relief, the government lacks the ability to implement a more precise system of means tested cash transfers at this time. The government’s consumer protection authorities will have to also be vigilant in monitoring for vendors who exploit the devaluation to raise prices in an exaggerated fashion. At the same time, the authorities must be cognizant of the natural increase in prices that will come as a consequence of devaluation in an economy that depends so heavily on imports for vital goods.
There is no doubt that the working and middle classes of Egypt will be burdened with additional economic hardship in the near future. However, devaluation offers a sustainable formula for securing the long-term health of the Egyptian economy, whereas the current cocktail of tariffs, capital controls, and import regulations are, in effect, a series of damaging half-measures that provide little more than band aid solutions. Continuing on such a path will merely result in deferring the inevitable pain that is required for stabilizing the situation.