Thursday, December 8, 2016

Pound stabilising on the expense of stagflation

This summer witnessed the escalation of Egypt’s economic problems, and these have now become hard to deny. The pound has kept on bleeding, and the problems have extended to the availability of the dollar and not just its high value in pound terms. This led to a surge of speculation on the pound, as many started to believe that a devaluation or floatation of the currency was imminent. By the beginning of autumn, Egypt was facing a currency meltdown in which the dollar was increasing by quarter or even half a pound daily.
After spending more than $30 billion of Gulf aid over the last couple of years, Egypt had to reach out for external help to prevent the pound’s collapse. After exhausting the Gulf aid, the country had to turn to the global lender of last resort, the International Monetary Fund (IMF). Borrowing from the IMF is not an easy task as it requires the commitment of the government to a harsh economic reform programme to get the country’s finances under control. However, this comes with a certificate of confidence that should spread global confidence in the economy.
The government properly understood the IMF requirements and put together a reform programme that fulfilled the IMF’s well-known checklist. The programme includes four main pillars. The first is the removal of subsidies by increasing energy prices as well as the cost of public services. The second is the application of the new value added tax (VAT) to replace the former sales tax to widen the tax base and increase tax receipts, as well as the new civil service law that decreases government salaries as a percentage of the country’s budget. The third is the application of a flexible exchange rate system to reflect the true value of the pound, and the fourth is the privatisation of some profitable state-owned enterprises and banks to increase government revenues.
It would have been insane to adopt such an aggressive reform programme even a few years ago, but the government has adopted it now and seems committed to it. It has moved forward with serious steps in order to introduce these four pillars, and what it has done has been more than enough for the IMF to grant Egypt a $12 billion loan facility coupled with a co-financing package of around $9 billion over a three-year period. Egypt has already received the first tranche of the IMF loan and part of the co-financing package. But while the deal with the IMF seemed inevitable to save the pound, it has had diverse effects on the economy and can be viewed from three different angles.
The first angle is concerned with the pound, which has been floated to move the official dollar exchange rate from LE8.88 to the dollar to around LE17-18 today, leaving people in shock. This has reflected positively on the availability of the dollar in the country’s banking system, and more people now realise that if there were gains to be made from speculating on the dollar these have now already been made and now is the time to sell dollars to the banks.
For the layman, the outlook for the dollar looks hazy, and many people are still afraid of new highs being reached by the dollar against the pound. It is normal to have this feeling after experiencing a currency meltdown. It is also worthy of note that after the floatation it would be wise to expect a period of three to six months of fluctuations in the exchange rate as the pound embarks on a journey of price discovery. At the end of this journey, the pound will stabilise around its equilibrium price, which is the price that creates a sustainable balance in the country’s balance of payments.
It is believed that a price level close to the initial price at floatation of LE13-14 pounds to the dollar is a good estimate of the equilibrium price, and the exchange rate should be able to reach this level within the first quarter of 2017. Such a level would be good enough to promote exports, while reasonable enough to allow people to buy the imported products that they simply cannot do without. The era of producing 100 per cent local products in Egypt is gone and is never to return.
The move to a freely floating exchange rate seems to be going reasonably well so far, and this has been reflected in the return of foreign portfolio investors to the Egyptian market by buying Egyptian government debt as well as the increase in the flows of dollars to the local banks from Egyptian traders at many levels. The IMF deal seems to have been doing reasonably well when it comes to the pound’s stability, and it would have been hard to have expected otherwise. If IMF involvement does not stabilise the pound, nothing will.
The second angle is concerned with inflation, which is now sky-rocketing and affecting people’s everyday lives. Inflation in Egypt has multiple reasons, including the devaluation of the pound, the removal of subsidies, the application of the VAT, the lack of availability of imported goods for long periods, the increase in customs duties and the excessive printing of the pound by the Central Bank of Egypt (CBE) over the past couple of years to finance the country’s budget deficit. This combination has been more than enough to push prices sky-high.
Many may hope that the latest spike in prices will be a sort of one-off, but the bad news is that it is just the first wave and more will follow over the coming couple of years as more subsidy removals take place and the lag effect of printing money comes to the surface. Official estimates by the government and the IMF expect inflation in Egypt to average 17 to 18 per cent over the next couple of years, or around seven to eight per cent more than the average of the past few years. It is worth mentioning that these are official estimates, and the real inflation that people feel when they buy goods and services will be higher due to differences in calculation methods.
The significant increase in inflation that is expected to stay with us for a while will hit the purchasing power of people whose incomes will not increase in line with the increases in prices. These people will thus find themselves less able to buy the goods and services they used to buy. The erosion of purchasing power will result in further squeezing the middle class, causing the lower part of it to move beneath the poverty line.
Finally, the third angle is concerned with growth, which was very slow for the four years following the 25 January Revolution at around two per cent, but then picked up over the last couple of years to reach around four per cent thanks to generous Gulf aid. The IMF loan is not expected to produce growth as quickly as had been hoped, since the erosion of purchasing power resulting from inflation will result in lower aggregate demand and thus stagnation in consumption in the economy. This will reduce growth in an economy in which domestic consumption contributes the most to economic activity.
Besides the hit suffered by domestic consumption, the recent significant increase in interest rates by the CBE has elevated borrowing costs to a level that is prohibitive to many companies, making effective borrowing rates as high as 20 per cent. This will decrease prospects for investment and will slow economic growth. FDIs (foreign direct investments) are expected to come after the IMF deal, but this will take time to show, and while flows from portfolio investors could be good for the currency, they have a limited effect on job creation and economic growth. The result of this could be a period of stagnation in which the economy will grow at around three to four per cent – too low to create a real increase in income per capita.
The bottom line is that the IMF deal was necessary to prevent a currency meltdown, but the pound’s newfound stability comes at the cost of stagflation (stagnation plus inflation) in the economy, which will have serious economic and social ramifications. Serious efforts by the government to speed up local and foreign investments, as well as widen social safety net programmes, are now critical if the country is to move through the transitional phase peacefully.
Omar El-Shenety
08 December 2016 
This article was published in "Al Ahram Weekly"

No comments:

Post a Comment