Tuesday, March 29, 2016

Looking for stability

In the wake of the 25 January Revolution in 2011, the Egyptian economy witnessed significant deterioration because of the security and political turbulence that followed. This led to a reduction in various sources of foreign currency, particularly in the tourism sector and foreign investment.
Fortunately, the Central Bank of Egypt (CBE) had around $36 billion in its reserves that it used to defend the pound, pouring more than $40 billion over five years from the reserves and Gulf support into the market.
Last year, the pressure on the pound mounted with the retreat of Gulf aid. In addition, the crash of the Russian plane in Sinai in November was more than enough to kill the tourism sector. The promises of the Egypt Economic Conference held early last year in Sharm El-Sheikh did not materialize, and the result was more currency speculation
Despite several devaluation rounds last year and the CBE’s imposition of a ceiling on foreign currency deposits, as well as efforts to rationalize imports, the speculation intensified, and the gap between the official and black market rates for the dollar widened.
After a very stormy year, the leadership of the CBE changed. The first few weeks marked a shift in strategy, with the deployment of a wider set of monetary tools to defend the pound. The CBE pushed the large national banks to issue high-interest certificates of deposit (CDs) in pounds to increase demand for the pound. In coordination with the government, new rules for imports were issued, aimed at decreasing unnecessary imports and reducing pressure on the pound.
At the end of February, the CBE governor gave a televised interview highlighting his views about the pound and the economy. He made it clear that floating the pound was not on the horizon and that the CBE has solid plans to defend it. Despite the release of information that the Ministry of Finance is forecasting the exchange rate for the next fiscal year at LE 8.25 against the dollar, the CBE governor said that this is not accurate.
However, despite the reassurances the black market fired up in early March when the unofficial rate increased from around LE 8.80 to LE 9.85, with a two-pound difference between the black market and the official rate, which stood at LE 7.83. For a few days, people were running to buy dollars to protect their savings.
The CBE realized that a serious run on the currency was underway and acted quickly by removing the ceiling on foreign-currency deposits at the banks and pushing the big national banks to issue high-interest dollar certificates of deposit. The market then cooled down and the unofficial rate fell from around LE9.85 to LE 9.10 in a shock to individual speculators.
High hopes were put on Egyptians living abroad, and new dollar-denominated certificates of deposit were launched for them at rewarding rates. However, the results were disappointing, and the CBE was left in a tough situation with the retreat of its various sources of foreign currency.
It had to resort to portfolio investors. Those invested more than $10 billion in Egyptian government debt in 2010, but such investments then reduced to almost nothing. The funds of portfolio investors move very fast, which is why they are called “hot money”. Such investors require a flexible exchange-rate system that allows easy entry and exit, and they want to see the pound at its real market value. Devaluation thus became necessary to lure these investors.
In a bold move, the CBE devalued the pound by 14 per cent earlier this year as the dollar reached LE8.95. In addition, the large national banks offered options to hedge against a future devaluation and to secure foreign financial institutions investing in the country. The devaluation was a major move that most investment banks cheered on and the stock market rallied. Soon afterwards, the CBE appreciated the pound by a few cents in order to give the impression of a flexible exchange-rate system.
In parallel, the CBE tried to contain the black market by having the large national banks issue high-interest dollar CDs to push savers into putting their dollars in the banks. The banks also issued pound CDs at 15 per cent interest rates for individuals to encourage them to give away their dollars.
The CBE held exceptional auctions after the devaluation of around $2 billion, these being large enough to give the signal of dollar liquidity in the system. But the black market did not disappear as it was hoped that it might, and it even got fired up again, trading at a 10 per cent premium above the official rate at the time of writing this article.
Given that the decision to devalue went against earlier reassurances, the market has lost trust in what the CBE is saying and individual speculators see a new devaluation coming. While investment funds have welcomed the move, they expect a further devaluation and believe that 9.5 to 10 per cent would be a reasonable range.
Moreover, they want to see a more flexible exchange-rate system. Portfolio investors will probably follow a “wait and see” strategy before they come into line. They would like first to see the pound reach bottom and the CBE commit to flexibility. They also want to assess the reliability of the new hedging options.
The markets have been wondering where the CBE has been getting its dollars from in the meantime. Rumors have spread that billions of dollars have been committed by portfolio investors, but in reality the CBE has been recycling dollars within the banking system. If it had been receiving funds, it would have announced them.
Dollars are being recycled in both directions, as was implicitly announced by the CBE. The CBE holds an auction giving money to the banks, and then it borrows the dollars back from them or asks them to issue dollar-denominated CDs to collect dollars and then borrows dollars from the banks and uses them to enhance its reserves.
Recycling dollars can buy time but it creates a bigger problem later on and results in serious systemic risks in the banking system. Globally, central banks issue forward guidance to manage market expectations and remove erratic volatility, but in the Egyptian case things are in total darkness.
A case to remember is South Korea during the Asian Crisis at the end of the 1990s. Its central bank tended to overstate its reserves, and when the reality was known it caused a huge crisis. Analysts also refer to the experience of the CBE in 2003 when it devalued the pound and paved the way for large inflows of foreign investment, yet the political and security situation now is different from what it was then.
In addition, the intervening global economic slowdown has affected the flows of funds to emerging markets, which witnessed net capital outflows in 2014. These even increased in 2015, making it very hard to assume that Egypt will be an exception to other emerging markets amid such turbulence. Even if a couple of billion dollars are invested by portfolio investors, this is far too little to save the pound.
On the other hand, the cost of the devaluation will be hefty, and prices will shoot up. Despite the high unofficial rate on the black market, basic goods are handled through the banks at the official rate, while luxury goods go through the black market. Customs duties are based on the official rate, and thus will increase as well. As a result, basic goods will increase in price after the devaluation, and these are mostly bought by poor and middle-income people. The coming inflationary wave will result in the further erosion of their already limited purchasing power.
The devaluation will also cause a huge increase in the budget deficit as subsidies will increase by up to LE 30 billion. Debt servicing will also increase by the same amount due to an increase in interest rates by the CBE to curb inflation and increase demand for the pound. The result of the devaluation will thus be an increase in the budget deficit of around LE 50 billion, or equivalent to a two per cent increase in the budget deficit, killing the efforts made by the government to contain the deficit in the near future.
The bottom line is that the CBE is in a tough situation, but that it is taking a gamble by recycling dollars within the banking system to show liquidity. It has taken major measures to attract hot money, which probably will not come in quickly putting the CBE in an even tougher situation.
It has tried to gain the trust of the financial institutions, while it has lost the trust of individuals who are speculating further on the currency instead of building on the containment of the black market a few weeks ago. The results will be more pressure on the pound in the short term and probably another devaluation. In the meantime, the budget deficit and inflation will increase, exacerbating current social pressures
Omar El-Shenety
29 March 2016 
This article was published in "Al Ahram Online"

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