Tuesday, October 13, 2015

The pound under pressure

The foreign exchange (FX) rate is critical, and people are smart enough to realise this, even if they do not have a strong background in economics, simply because with every drop in the value of the Egyptian pound, the rate of inflation increases.

The value of the pound, like that of any commodity subject to the forces of supply and demand, is determined by the market. If demand for dollars is more than their supply, the rate against the pound increases; the reverse occurs when demand is low and there is an excess of dollars in the market.

The foreign currency market is regulated by the Central Bank of Egypt (CBE) which intervenes to balance the market by offering dollars from its reserves if demand for dollars is more than the available supply, and balancing its interventions between two outcomes.

The first of these is inflation resulting from the increase in the FX rate and, thus, increases in the prices of imported goods. The second is the competitiveness of Egyptian exports, which become more competitive and thus more in demand in international markets when the pound falls in value relative to the dollar.

Egypt has been suffering from a chronic deficit in its trade balance, with the value of exports falling below the value of imports for a long while. It is worth mentioning that this has deteriorated over the last few years: the country’s deficit was around $26 billion just before the 25 January Revolution and jumped to around $33 billion after it. This deficit put further pressure on the pound.

The CBE seems to have unlimited power in deciding the FX rate, but in reality its power and options are limited, and when the economy is suffering its power is even more constrained.

Simply put, Egypt’s chronic trade deficit used to be balanced by remittances from abroad, Suez Canal revenues, tourism and foreign direct investment (FDI). But in the last few years, tourism and FDI have fallen short, which has left the CBE with no option but to use its reserves to shore up the value of the pound.

The policy of the CBE to prop up the pound has been widely criticized by those who argue that the devaluation of the pound will help attract investment and increase the competitiveness of Egyptian exports, leading to improved economic growth.

Though theoretically this is a sound argument, practice does not support it, since exports decreased by 14 per cent in 2012 despite a devaluation of 2.9 per cent. In 2013, while exports increased by seven per cent, the pound was devalued by more than 12 per cent. The following year, 2014, saw no difference, with exports decreasing by 1.8 per cent despite a devaluation of 2.7 per cent.

Over the last three fiscal years, the pound has been devalued by 19 per cent and exports have actually decreased by 10 per cent. This experience has been more than enough to kill the competitiveness theory and caused the CBE to defend the pound whole-heartedly, spending tens of billions of dollars as it has done so, though the decrease in exports could be tied to a set of local and global economic conditions.

Over the last five years, the pound has lost one third of its value. In January 2011, the US dollar rate stood at 5.86 to the pound, and the CBE had $36 billion in official reserves, more than enough to suppress the black market.

But after the Revolution, the political turbulence and insecurity resulted in capital flight and the collapse of tourism, thus putting huge pressure on the pound and bringing the black market back to life. Over the next 18 months, the CBE defended the pound like a hero, spending $20 billion of its reserves, and the pound lost only three per cent of its value.

When the first post-Revolution president was elected in mid-2012, the pound was already under pressure, but that pressure increased over the year that followed. The pound lost 15 per cent of its value, which was a big hit, despite sizable support from Qatar, Turkey and Libya.

By mid-2013, another shift in politics was underway, but this time it was accompanied by unprecedented Gulf support. Egypt received some $12 billion in aid, helping the CBE to defend the pound, which only devalued by two per cent during that year.

With the election of the new president in mid-2014, the Gulf aid retreated, leaving the CBE exposed. Over more than a year, the pound was devalued by 10 per cent, with the Central Bank constantly spending dollars received from aid, loans and other sources.

Currently, the official US dollar rate stands at 7.83 to the pound, with the black market trading at a three to four per cent premium. In addition, the official reserves have declined for a third consecutive month, in part because of the news that Saudi Arabia is holding back on aid announced during the Egypt Economic Development Conference held earlier this year. Foreign exchange reserves now sit at $16.3 billion.

 The CBE has now run out of ammunition, and there is a strong belief that devaluation is inevitable for six main reasons. First, the economy is short of FX at a time when the deficit in the trade balance is widening, Gulf aid is retreating and FDI is growing at a slow rate.

Second, the CBE is determined to shutdown the black market, which will require further devaluation rounds to bridge the gap between the official and black market rates. Third, foreign investors are reluctant to invest in Egypt while the pound is overvalued, pushing the CBE to devalue it further.

Fourth, Europe, Egypt’s main trading partner, is facing a weakened euro, which makes devaluation inevitable in order to avoid hurting Egyptian exports to EU countries. Fifth, China has recently devalued its currency, initiating a wave of devaluations across emerging markets and putting pressure on Egypt to follow suit.

Finally, the Central Bank has expanded its printing of money in order to finance the budget deficit, thus pushing inflation higher and increasing demand on the dollar as a safe haven.

The market is speculating about a new devaluation, and most probably this will be the case. It is very hard to time this precisely, however, as the practice of the CBE shows a preference to surprise or shock the market to avoid further speculation.

Still, it is fair to believe that a further round of devaluation is due by the end of this year or early next year. Looking into history, devaluation in the next round could be in the three to five per cent range in order to send the right signals to the market without causing uncontrollable inflation, given that the pound has already been devalued twice this year.

One might think that the rush to the bottom will stop after the next round, but this is far from the case. The pressures on the pound will not fade away before a structural improvement in the economy happens.

Thus, it is reasonable to believe that future annual devaluations will take place in the range of five to seven per cent on a semiannual basis, and with a spike in a year or two, and with annual devaluation expected to stay within this average over the medium term.

Gradual devaluation seems to be the adopted strategy, and it is highly unlikely that we will see aggressive devaluation of 25 to 30 per cent in a single year because even such a big slide would not relieve the fundamental pressures on the pound and would cause huge inflation.

Given such a strategy, the CBE is expected to tighten access to foreign currency further within the banking system to contain the black market and limit speculation. Such measures may have an impact on curbing so-called unnecessary demand for foreign currencies, but they will also have a negative effect on imports of raw materials, equipment and other inputs that go into manufacturing for exports and local products, and this will reflect negatively on economic growth.

Despite the efforts of the CBE to kill the black market for foreign currency, it is hard to believe that this will vanish in the near term since the reasons behind its presence are fundamental and will take time to cure.

Most likely, the dollar will continue trading at a premium in the black market. It is wise to remember that the black market as a symptom of the FX problem rather than the cause.

Omar El-Shenety
13 October 2015 
This article was published in "Al Ahram Weekly"

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