Breakfast Wrap: The IMF on The IMF LOAN, CENTRAL BANK’S BAD DECISIONS

Yesterday Rebel Economy interviewed Ahmad Shokr, one of the founding members of the Drop Egypt’s Debt campaign, who argued that Egypt’s fiscal problems won’t be solved with a loan from the International Monetary Fund (IMF).

Today, we hear it from the horse’s mouth (so to speak).

Masood Ahmed, the Middle East and Central Asia director at the IMF, explains how the Fund can help “Cut Deficits Without Damaging Growth Too Much” in a new IMF blog in Arabic.  Here is the bulk of the blog post in English. It seems to be a strong position that the IMF is taking to tell the Middle East “We are here to help you solve your problems”.  You may also note that Mr Shokr’s argument is actually not that much different to Mr Ahmed’s:

As in other parts of the world, governments in a number of countries in the Middle East and North Africa region face a growing urgency to take politically difficult steps to bring down large fiscal deficits. Bringing down deficits is, of course, not an end in itself. But in many countries, deficits are too large and will eventually come to hurt growth and financial stability. At the same time, measures to trim the deficit can have a negative effect on economic growth in the short run. So, the question is what measures policymakers should take to reduce budget deficits while minimizing the negative impact on economic growth and the most vulnerable in society.

In response to social demands and rising food and fuel prices, governments across the region have increased spending on subsidies and wages significantly over the past two years. Public revenues, however, have been declining for a variety of reasons, including the slowdown in regional economic activity. As a result, oil-importing countries in Middle East and North Africa have seen a large increase in their chronic budget deficits, which grew to an average of more than 8½ percent of GDP in 2012 from about 5½ percent in 2010.

Such an increase in fiscal imbalances is quite difficult to sustain over a long period of time. In fact, looking ahead, there is little room for additional government spending.

Choosing the best path

Typically, deficit reduction calls for, on the one hand, measures to increase government revenue and, on the other, to cut spending. Increasing revenues can be realized either by raising tax rates or by broadening the tax base. The latter can be achieved by implementing reform measures to make the tax system more efficient and to address tax evasion and tax avoidance. Reducing government expenditure entails cuts in both current (non-interest) and capital spending.

Rebalancing the composition of revenues and expenditures may help lessen the adverse side effects of deficit cuts on growth.

1) On the revenue side, property and sales taxes are the most growth-friendly measures for raising revenues. In contrast, trade and income taxes are the least growth-friendly. Egypt is among those oil-importing economies in the region with the greatest scope to rebalance taxes toward more growth-friendly instruments.

2) On the expenditure side, social benefits and subsidies are the least growth-friendly measures, whereas capital spending tends to be the most growth-friendly instrument. Spending, especially on subsidies, is largest in Egypt, Jordan, Lebanon, Morocco, and Tunisia, suggesting that there is scope to lower such spending as a growth-friendly instrument for fiscal consolidation. In contrast, productive capital spending is smallest for Lebanon, Sudan, and Tunisia, suggesting that there is space to increase such spending.

A key fiscal priority for the MENA region is to replace generalized subsidies with more targeted social safety net instruments. Besides being very costly, generalized subsidies do not support the poor well. For example, one-third of energy subsidies in Egypt benefit the wealthiest one-fifth of the population. And, our research suggests that the situation is similar in many other countries in the region.

Quality also matters

Improving the quality of government spending more generally is critical. This would help make room to boost investment spending and reduce fiscal deficits that are increasing debt levels and crowding out lending to the private sector.

Structural reform policies that aim to enhance the overall productivity in the economy and, hence, raise growth potential could also offset the negative impact of fiscal consolidation.

Successful implementation to both enhance the quality of spending and rebalance the composition of revenue-raising and expenditure should help create more and better employment opportunities, and lead to faster economic growth in the MENA region that would benefit all.

CENTRAL BANK OF EGYPT 

This morning brokerage firm Pharos Holding emailed an interesting note analysing the Central Bank of Egypt’s monetary policy measures, and why they don’t agree with it.  Here is the note in full. It is important because it reminds readers and close watchers of Egypt that the Central Bank is an opaque institution that says one thing, and does another.  The key takeaway is that the Bank is in fact targeting a specific exchange rate, contrary to previous statements that it is not doing this and leaving the market dependant on supply and demand. That means the pound is OVERVALUED and again at a level that cannot be sustained with falling reserves: 

PHAROS: Yesterday, the CBE executed four simultaneous measures to limit further EGP depreciation:

1) reducing the cap on EGP depreciation in FC auctions from 0.5% to 1 piaster

2) reducing the number of auctions to two per week; every Monday and Wednesday

3) indirectly inducing (via moral suasion in our view) the two largest public banks and CIB to raise long-term deposit rates by 50-100 bps

4) removing the 1% commission rate on FC purchases.

The new CBE governor met with the prime minister to discuss possible means to limit further downward pressure on the EGP. The above steps suggest that the move from EGP 6.15 to 6.75 per US$ was not intended to be a move to free float as earlier announcements had suggested. Instead, it was a managed devaluation with an initial target in mind. This policy is known as a “crawling peg”, whereby a currency is pegged to an anchor currency (US$ in this case) but the peg is adjusted occasionally to reflect changes in macro dynamics.

Why We “do not Like” a Crawling Peg

1) It contradicts with initial statements made by the CBE governor and accordingly raises credibility concerns. The current governor had earlier explicitly noted that he will not target a specific exchange rate,

2) The current rate is not a rate at which supply and demand are in equilibrium. There are tight capital controls and demand is artificially capped by import rationing (primarily evident in imports of diesel),

3) If the market views the current rate as not sustainable, which is evident by an active black market, investors will actively pursue arbitrage opportunities to benefit from the black market premium (ranges between 5.0-10.0%),

4) It confuses monetary policy formulation and disrupts the carry trade because foreign investors cannot predict whether interest rates will be used to defend the currency (so go up) or to stimulate recovery (so go down),

5) Finally, if the new rate fails to present itself as a new equilibrium at which current and capital account transactions are cleared, credibility of the CBE will be significantly shaken and the whole regime will collapse. This is what exactly happened between 2000 to 2003, until the floatation decision was taken on 29 Jan 2003.

Concluding Remarks: Breather rather than a new equilibrium

The 6.75 target is only a breather rather than a new equilibrium, in our view. It cannot be sustained without a significant improvement in foreign currency inflows, which we do not see at present.




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