Egypt embarked on an economic reform programme last November as part of its deal with the International Monetary Fund (IMF) to fix its chronic economic problems. With the package of reforms planned, it was expected that the country’s high inflation rate, of around 12 to 15 per cent, would get even higher, with an expectation by the government and the IMF for inflation to reach around 18 to 19 per cent in 2017-2018. To curb such high inflation, the Central Bank of Egypt (CBE) decided to raise interest rates by three per cent, a huge spike to avoid inflation getting out of control.
Despite this pre-emptive move by the CBE, inflation skyrocketed to above 30 per cent in the first quarter of 2017. And despite the huge difference between government and IMF forecasts on the one hand and the actual inflation rate recorded on the other, no one is questioning the validity of these forecasts or working to update them. Instead, the IMF is asking Egypt to raise interest rates once again to fight inflation.
Inflation is one of the key macroeconomic indicators of the economy. It is even the most critical for many people who may not understand or care about economic growth or the unemployment rate if they have a job but do care a lot about inflation. High inflation means large increases in the prices of goods and services, which indicate a decrease in people’s purchasing power. For the layman, it may not matter how much money he makes in nominal terms, but it does matter how many goods and services this amount of money will allow him to take home.
For most people in the economics and finance fields, increasing interest rates is the straightforward solution to high inflation. The assumption is simple. If inflation is high, this means the economy has been growing quickly, investment has been progressing, and demand for goods and services has been high. Thus, interest rates are a good cure as high interest rates will dampen investment, and thus decrease demand, which results in decreasing prices for goods and services, hence helping to curb inflation.
This sounds like an easy solution, but it only works if the inflation is caused by an increase in demand, as in the case above. Inflation can be caused by a growing economy and an increase in demand, what economists call demand-driven inflation, but there could also be other causes disconnected from demand and related to supply, such as an abrupt increase in the prices of goods due to the devaluation of the local currency or a spike in global oil prices or any other external shock.
In such cases, increasing interest rates will dampen demand, but inflation will not be contained because prices did not increase in the first place due to high demand but rather due to increases in the costs of supply.
The simple lesson is that demand-driven inflation is best cured with interest-rate rises, while supply-driven inflation cannot be cured with interest rates. The experience of other countries facing supply-driven inflation, especially as a result of oil shocks, shows that interest rates are an ineffective tool in such cases, and that this type of inflation should be absorbed by the economy itself. This starts to cope by changing inputs for production, such as resorting to fuel-efficient production and transportation mechanisms to decrease supply costs or local manufacturing and import substitution.
The difference between the two types of inflation was clearly shown with the huge increase in oil prices over the last decade then their severe decline over the last couple of years. The Western central banks did not change interest rate during these two episodes, simply because the inflation caused by increases in oil prices and then the deflation caused by their severe decline had nothing to do with demand and thus interest rates were not relevant to increasing and declining inflation.
EGYPT’S SITUATION: Looking at the situation in Egypt, the economy grew at around two per cent a year for four years after 2011 and then started to show signs of slow recovery when growth stood at four per cent over the last couple of years.
During the current fiscal year and most probably over the next couple of years, there have been no signs of major recovery, however. At the present low levels of growth, Egypt is officially in a state of stagnation, and it is very hard to assume that the current high level of inflation is demand-driven.
In essence, the current inflation is clearly supply-driven, being caused by a combination of factors such as last year’s floatation of the pound that more than doubled the cost of imports, the increase in customs duties that increased the cost of imports even further, the restrictions on importing activities that made the availability of imports scarcer and their prices higher, the decrease in energy subsidies that increased local production and transportation costs across the board.
These factors, as well as the expectation of their continuation in the short to medium terms, are the real reasons behind the inflation, which is clearly supply-driven. They are the direct result of the government’s economic reform programme. The government and the IMF expected a surge in inflation, and so did the CBE which pre-emptively used the typical cure of raising interest rates by three per cent. Yet, this large hike in interest rates had no visible effect on inflation, which exceeded 30 per cent in the last quarter, unprecedented in Egypt’s recent history. Such frustrating results should not have been a surprise, however, because the current high inflation rate is supply-driven, and increasing interest rates is irrelevant to curbing it.
The ineffective hike in interest rates did not go through without collateral damage, however. On the one hand, the cost of borrowing to the private sector by the financial institutions effectively reached 18 to 20 per cent. At such exorbitant interest rates, it is hard for the private sector to borrow and invest, deepening the current stagnation further. The government did not go untouched either. Being the largest borrower from the local banks, every one per cent increase in interest rates simply meant more than a LE20 billion increase in the cost of government debt, and thus the budget deficit suffered by more than LE60 billion at a conservative estimate as a result of the three per cent hike in interest rates.
So, who did benefit? The answer is portfolio investors who represent international funds focused on investing in government bonds. These saw the extremely high interest rates on Egyptian treasury bonds as a very good opportunity to make money, especially after the floating of the currency that eliminated currency risks in the short term. Inflows from portfolio investors are critical to supporting the Egyptian pound, but it is debatable whether the cost paid has been fair and if lower costs could have been paid to achieve the same result.
At this critical time, the IMF is now asking Egypt to work on curbing its inflation, which simply translates into hiking interest rates. It is hard to know whether the IMF directive is an order or a condition for the next tranches of the loan, but it would be hard to expect the CBE to decrease interest rates whatever the case may be, and most likely one or more hikes, even if small ones, will be seen in the coming quarters.
However, such hikes will be ineffective in curbing inflation because the current high rates of inflation are supply-driven, and higher interest rates will not contain them. Instead, they will have wider collateral damage on government finances and the private sector, thus decreasing the prospects of economic recovery in the medium term.
The insistence on not differentiating between demand-driven and supply-driven inflation and the determination on curing both by raising interest rates is a case in point of the adage which states that “if all you have is a hammer, everything looks like a nail.”
04 May 2017
This article was published in "Al Ahram Weekly"