Monday, March 27, 2017

Five Myths about the Dollar

After a tough struggle to get the foreign exchange market under control with its huge gap between the official rate and the black market rate for the Egyptian pound, the Central Bank of Egypt (CBE) threw in the towel late last year and resorted to the long-awaited floating of the pound.

This had been widely opposed by many due to its inflationary effects, while it was cheered on by others because of its expectedly positive effects on attracting investment. The critical decision to float the pound was made in early November to satisfy one of the key conditions of the International Monetary Fund (IMF) deal, directly after which the IMF approved a loan to Egypt.
While the economy has been on a rollercoaster of reforms, many people disconnected from economic policy and unaware of its mechanics have been lost as a result and many still are.

The dollar exchange rate officially doubled overnight as a result of the floatation and with it prices skyrocketed. Other reforms have meant ever-increasing prices. While many economists expected the dollar to settle at lower rates than those on the black market after the floatation, the official rate kept on rising, and many had no alternative but to build their own theories because of the lack of a credible explanation.

Some of these theories are far from true, and one should shed light on five key misconceptions. The first one says that dollar fluctuations are part of an overall conspiracy by some people or institutions that benefit from such moves. While this is an easy explanation that is in line with the Egyptian way of interpreting events, there is not much evidence to support it. The study of other countries that have floated their currencies shows that this is usually followed by a transitional period of high volatility as the local currency, having been fixed for years, strives to find its true value in the market.

With every move in the exchange rate, analysts try to offer an explanation, and then only a few days later, after the exchange rate has moved in the opposite direction, they try to offer another explanation, which again does not hold for more than a few days. But what people are missing here is that the last few months, and probably the next few months too, should be considered as a transitional phase in which high volatility is to be expected. Understanding the nature of this phase and embracing this volatility is better than trying to offer unreasonable explanations for erratic movements in the exchange rate.

The second theory says that the dollar exchange rate will continue to go up without hitting a ceiling. For some people, holding dollars is therefore the best investment. They assume that the high gains the dollar has made over the past year will be fully or partially repeated over the coming years amid low foreign investment and struggling tourism.

But though the dollar may further increase in value if the economy does not fundamentally recover, it should not be assumed that there will be continuous increases without a limit. In the end, foreign currency is meant to be used for international trade purposes, and having a currency that loses a quarter or half of its value every year would not allow this international trade to flow. Thus, there is a limit to how much the dollar can increase every year after the floatation of the pound because if its value passes a certain limit import prices will become prohibitive. As a result, demand for dollars will decrease and its exchange rate go down accordingly.

The third theory says that the dollar will eventually go down to LE4. This was obviously a joke made by the CBE governor on a TV show that people picked up on and expected to be true or wanted to be true. While in a free-floating system any rate is possible based on market forces, it is hard to see the dollar at LE4 in the short or even the medium term. In the same way, it is hard to see the dollar worth LE50. 

The fourth theory is that the dollar will reach a fixed price soon. While the recent period has shown us that almost anything may happen, it is hard to believe that after floating the pound the CBE will return to a fixed exchange-rate system. Fluctuations are expected to be contained over the next few months compared to the erratic movements since the floatation. The dollar is expected to reach an indicative price, which will be the average rate of the fluctuations. This figure will change from day to day, and even this indicative price could change from period to period given general macroeconomic developments.

The fifth theory is that prices will stabilise as soon as the dollar stabilises. Though the dollar is expected to stabilise soon around an indicative price with less severe fluctuations, prices are not expected to stabilise, however. Price increases have not only been driven by increases in the value of the dollar, and other key factors have played a role, such as the application of the new value-added tax (VAT), increases in customs duties, indirectly levied barriers to imports, increases in energy prices, and the lag effect of the money printing that has taken place over recent years.

The cumulative effect of all these measures has lain behind the huge spikes in prices. Some of these drivers should stabilise soon, such as the changes in the exchange rate and money printing, but others such as the VAT and energy prices will remain in motion.

As a result, prices are not expected to stabilise with inflation at low levels, though it is expected that in a few months inflation that has skyrocketed above 30 per cent lately will decrease to 20 to 25 per cent with the dollar stabilisation. An exception to this would be fully imported products such as cars or electrical appliances, which have been priced at LE20 to LE25 to the dollar. With the dollar at lower levels, we will see a relative decrease in prices.

Contrary to widespread misconceptions, the dollar will still fluctuate in value, yet these fluctuations will be within a tighter range. Probably around mid-year the dollar is expected to stabilise around an indicative price, perhaps around LE15. It could even witness a decrease in value after Ramadan thanks to the extraordinary flow of dollars from Egyptians living abroad and coming to visit Egypt for the summer.

While dollar fluctuations are expected to be tamed and the exchange rate is expected to stabilise in a few months, inflation will stay with us for a while. We have not yet seen the end of the government’s reforms, and a few more reform waves are likely to follow in the next few years. Having said this, the upcoming inflationary waves are expected to be less severe than the current ones, which were exaggerated by the application of many reforms at the same time.
Looking beyond 2017, it is hard to reach a conclusive view about where the dollar will be heading. There are many variables that will affect the dollar’s value, including security that could affect tourism, international financial market trends and their effect on investment in emerging markets, the local political and economic situation that could affect foreign direct investment, or the revival of local manufacturing to substitute imports, among many others.

From a strategic angle, many macro-economic reforms are already in place. Though they could have been debated for years, they were critical and they have now been made. Yet, even these tough reforms alone are not enough, since many micro-economic policies are even more important to improve local competitiveness, remove barriers to investment, resolve profit repatriation issues, and create a level playing field for the private sector against the government and its related entities.

Without such policies in place, the bitter medicine we have taken will not yield the expected relief, and the dollar problem could become even worse in the medium term.

Omar El-Shenety
24 March 2017
This article was published in "Al Ahram Weekly"