Sink or Swim: Egypt’s Anticipated Currency Float

10/03/2016 . By Timothy E. Kaldas

Tarek Amer, the governor of the Central Bank of Egypt (CBE), announced in July that Egypt’s longstanding policy of defending the Egyptian pound (LE) against devaluation had been a “grave error.” The strategy had slowly whittled away Egypt’s foreign reserves to no discernible benefit to the economy, causing shortages of dollars in the formal economy and a host of related problems. Some form of devaluation was among the reforms demanded in exchange for a loan from the International Monetary Fund, the preliminary agreement for which was reached in September. Given Amer’s comments, the IMF’s demands, and economic realities in Egypt, rumors of impending devaluation have been circulating for weeks. News website Mada Masr, citing a briefing from Beltone Financial, reported on October 2 that the pound’s floatation was imminent.

Whether the pound is floated this week or next month, if the official rate moves to around LE12 to the U.S. dollar, as Beltone anticipates, one can expect the black market rate to move to between 13 and 14 pounds to the dollar. Non-essential imports are currently being financed by black-market currency purchases and the price of these goods will rise moderately as prices in the market have already priced in a devaluation to a large extent. It is likely that the spread between the official exchange rate and the black market exchange rate will shrink from the current premium of nearly 50 percent. Amer’s July comments set off a round of speculation, such that approximately half of the current spread is a product of speculation anticipating this devaluation.  The execution of the devaluation, coupled with a clear plan to move toward a float, should dampen speculation in the black market and reduce the spread.

As soon as possible, the CBE will need to relax capital controls to reduce demand in the black market, which will undercut traders’ ability to compete with the banking system for dollar depositors. Dollar scarcity and the consequent capital controls in the banking system is the primary reason Egypt has a large black market for hard currency.  If the CBE can help Egypt’s banks more successfully satisfy the demand for dollars, importers and other businesses will not need to turn to the black market, resulting in a collapse of demand in that system. If demand drops and the spread between the black market and bank rate shrinks, then the high interest rates offered by Egypt’s banks on dollar-denominated financial products—such as dollar bonds and certificates of deposit—could help draw dollars back into the banking system.

One very important benefit to shrinking the spread between the black market dollar price and the bank rate will be to get remittances to be transferred again through the banking system. Former CBE Governor Hisham Ramez estimated that 90 percent of remittances were being handled by the black market. If Ramez is correct, some $17 billion of the $19 billion total remittances are being processed informally—more than the combined value of tourism and foreign direct investment. Redirecting remittances back to Egypt’s banks would significantly contribute to plugging the hole in Egypt’s hard currency shortage.

Another challenge before Egypt’s banking system that will remain is depositor confidence. Over the past few years, depositors have been hit with a series of increasingly strict restrictions on their accounts, particularly when traveling abroad. These restrictions have often been introduced with little, if any, warning. Concerns among consumers about their ability to access their deposits deters depositors from trusting Egypt’s banks with their money and encourages people to keep their money out of the banking system. The CBE will have to give clear guarantees about what capital controls and withdrawal and transfer policies will look like for the coming year to help calm those concerns and attract deposits.

Even if this plan is executed and managed properly and succeeds in stabilizing Egypt’s currency market, Egypt will experience even higher rates of inflation than are already burdening Egyptian consumers in the short to medium term. The CBE estimated headline inflation to be 15.5 percent year-on-year in August.  Inflation on fruits and vegetables exceeded 36 percent in August year-on-year. Egyptians already heavily depend on vegetarian diets due to the high cost of meat. Dramatic increases in the price of produce hits them at the least expensive food they can access aside from subsidized grains. A 40 percent drop in the value of the Egyptian pound will invariably increase inflation significantly.

If the details in Mada Masr’s report are accurate, Egyptians should prepare for rising food prices. Many large food importers currently purchase their dollars from auctions held by the CBE at the official rate as they have priority access to dollars due to the essential nature of the goods they import. Drugs will also be impacted by a sharp shift in the official exchange rate. That said, most drug prices in Egypt are strictly regulated by the government, which means that the government will have to adjust drug prices or introduce subsidies to avoid shortages in the market. The IMF statement announcing the preliminary agreement for Egypt’s $12 billion loan from the fund called for raising food and medical subsidies to help offset the inflationary impact of other measures that have to be taken to stabilize Egypt’s forex market and reduce Egypt’s budget deficit.

As the official exchange rate declines, the cost of the government’s subsidies will rise proportionally. Moreover, the government will have to raise the price of energy even further in order to execute the planned reductions in energy subsidies in real value. A devaluation would otherwise reduce, if not erase, the real value of past subsidy reductions of fuel and electricity. Rising energy prices will directly increase inflation at the point of consumption as well as have a cascading affect on other goods as the cost of transporting and refrigerating goods will rise in turn.

As this plan is rolled out, it will be important for the Egyptian government to state its intentions respecting its overall economic reform plan in detail and in a transparent fashion. The lack of predictability and transparency in Egypt’s economic planning and regulations has deterred investments, both foreign and domestic. A stable, predictable marketplace will encourage more active investment and more robust economic growth which will in turn help reduce Egypt’s debt-to-GDP ratio and increase tax revenue to fund the state’s coffers.

Undeniably, Egypt is entering into an acutely painful period, but it is possible that these difficult measures will move the country to a more sound fiscal position and help it escape the spiraling economic crisis that has plagued the country for the past few years. The extent to which Egypt’s economy recovers rests on the quality and priorities of its economic management going forward. This shock to the system could simply stabilize a weak economy that has long failed to serve its most vulnerable segments or it could be used as an opportunity to create space for more expansive development and redistributive policies that will help break the cycle of poverty that has entrapped tens of millions of Egyptians.