Sunday, November 13, 2016

The IMF deal is not enough

The bitter reality of the current status of the Egyptian economy has left no space for claims that things are going fine. The currency crisis in Egypt is hard to hide or contain when the parallel market rate for the dollar is currently double the official rate, causing a freeze in local and foreign investment inflows into the economy and a deficit in the supply of many basic goods in the local market.
The economic deterioration and surging currency crisis should not come as a surprise to anyone who has been following the development of the various economic drivers over the last few years. This disappointing course has pushed the government into seeking a loan deal with the International Monetary Fund (IMF) in order to provide enough foreign currency to save the pound as well as to gain a certificate of confidence from the IMF to help attract the foreign direct investment (FDI) needed to stir growth and contain unemployment.
Concluding a deal with the IMF is not an easy task, as it requires the borrower to undergo structural reforms aiming at financial sustainability. To that end, the government has had to do its homework by building an economic reform programme that aims at increasing revenues and decreasing costs. Four key directions have been adopted. The first is raising energy prices for petrol and diesel as well as raising the prices of public services such as water, electricity and others, in order to decrease government subsidies and bring these services closer to their market prices.
The second is the application of the new VAT (value added tax), which is intended to widen the tax base and increase government tax revenues. The third is privatising some of the profitable state-owned enterprises, whether companies or banks, through private sales or listings in the stock market. The fourth is the adoption of a flexible exchange rate system that will cut the parallel market as well as the implementation of a responsive monetary policy that will ease inflationary pressures.
These four directions should increase revenues and cut costs in order to substantially cut the budget deficit to a sustainable level.
An IMF mission visited Egypt and concluded a staff level agreement in August promising $12 billion in loans along with a further $9 billion to be raised from other financial institutions. This financing package is to be dispersed over three years and should be enough to prevent the pound’s meltdown and relieve the Central Bank of Egypt (CBE) from the excessive printing of money to finance the debt.
The agreement was supposed to be approved by the IMF board of directors in October during its annual meeting. Hence, some economists expected a devaluation to take place during the week of the IMF meeting as part of the deal. Some even went further by anticipating the details of the Central Bank’s steps.
Devaluing the pound or even floating it is imminent, and the detailed roadmap for it fired up the parallel market such that the dollar gained more than LE4 over a week or so of speculation. The IMF board did not discuss the deal in October, however, and IMF officials made it clear that Egypt should move forward with its reforms before receiving the loan.
A justified mood of suspense was created, as the history of Egypt’s relations with the IMF has not been very bright, with many promises and even agreements being made without delivery from Egypt’s side in some cases. The IMF has enough reasons to believe that the government may commit to reforms until it receives the first tranche of the loan and then back off from them. Most importantly, the reform programme has huge social costs, and it may lead to social unrest that will further hurt the IMF’s already controversial reputation.
The government’s response to the suspense was quick and decisive, as it confirmed its wish to move forward with the reforms and especially the subsidies cuts. The CBE will move forward with either floating the pound or devaluing it. It may be inadvisable to allow the pound to float freely with the country’s limited level of reserves, as the parallel market rate could reach unimaginable levels as a result. Probably the CBE will opt for a gradual devaluation that ends with a managed peg model that is flexible enough to cut the parallel market without the risk of a major decline, as has been the case in Nigeria.
With this determination to devalue the pound and cut the subsidies, one can fairly claim that securing the IMF package is now only a matter of time.
Aside from the economic reforms, there is also a political angle that makes Egypt too big to fail and highlights the strategic interest of the IMF in finalising the deal even if there are disagreements about the economic reform programme. With close to 100 million people, any major disruption in Egypt like what has happened in Syria would create a migration crisis on an unprecedented scale. In addition, the exporting of terrorism is a key concern that could make the powers controlling global financial institutions like the IMF very interested in securing a deal with Egypt to avoid its possible degradation or its becoming a failed state.
It is expected that the coming weeks will see cuts in the subsidies as well as a move from the CBE to devalue the pound. If the CBE goes for a gradual devaluation, which is highly probable, the official rate will increase significantly while the black market rate will be contained with more foreign currency from the market and more confidence in the pound. If the CBE allows the pound to float freely, which is not advisable, the exchange rate will skyrocket at first, but then should go down towards a more reasonable rate of probably less than the current black market rate.
The IMF deal will not only guarantee a short-term containment of the currency crisis but also the long-term stability of the pound. However, economic prosperity requires more than this. The government’s economic reform plan assumes that the IMF deal will encourage the flow of funds from portfolio investors, increased FDI and the return of tourism. The deal should get portfolio investors interested again, but it is hard to predict the instant return of those investors who invested more than $20 billion in government debt before 2011 but then quit the market after the revolution.
FDI is also not expected to flow quickly, as this comes from long-term investors, and their concerns are not just about the currency but also about the country’s bureaucracy and political stability. As tourism is directly tied to the security situation in the country, the IMF deal alone will not be enough to recover it.
On the other hand, the economic reforms are likely to cause a major inflationary wave that will probably be unparalleled in Egypt’s modern history. Hundreds of thousands of middle-class families may be forced under the poverty line due to the rising cost of living because of the subsidies cuts, the application of VAT, and the pound’s devaluation.
Ensuring social stability is as important as adopting a structural economic reform programme to ensure that the regime will be stable enough to reap the fruits of reform and accordingly pay back its debts. It is therefore important that the government adopt an integrated social protection programme that is broad enough to hedge against the social risks of reform and put in place a clear strategy for political and security stability that can contain any political and security risks.
The bottom line is that the IMF deal is critical to stopping the currency meltdown and achieving short-term economic stability, but it comes with huge social pressures as the resulting inflationary wave may be unbearable for many. But even with the deal in place, it is not enough alone, as the drivers of economic recovery will still require more effort. Without a comprehensive and integrated social and political framework, economic reforms alone will not yield the hoped-for fruits.
Omar El-Shenety
03 November 2016 
This article was published in "Al Ahram Weekly"