It was marketed as inevitable, a necessary step to seal the deal with the International Monetary Fund. What choice did Egypt have, economists and analysts said. The nation had no choice but to hike interest rates and float its currency. Yet the country surprised the market, economists and investors with an almost 50 percent devaluation.
Egypt’s economy, one of the most critical, simmering issues in the region, is again in flux. The country’s fiscal situation, which has a direct bearing on the security and livelihood of an already endangered population, was sent into a tailspin when a new currency regime was announced this week. “There will inevitably be fresh pain for the economy in the near term,” said Jason Turvey, economist at Capital Economics in a note. The decision is already having reverberations across one of the most fragile countries in the Middle East and North Africa, with prices of staple commodities expected to balloon. Mohamed El Dahshan, non-resident fellow with Tahrir Institute for Middle East Policy told Middle East Eye:
“We are now in hell and the only way out is through.”
The IMF predictably championed the move, saying the new system better prepared people to sell dollars as well as buy them, injecting more money into the economy. The move would eliminate a thriving black market for dollars and secure, after five years of on-again off-again negotiations, that much-needed IMF loan. Without this, there was chaos and economic armageddon on the horizon.
There is a price to pay for Egypt’s complicity with the IMF at such a late stage attempt at economic recovery. Like most regimes with troubled economies, Egypt has a history of hiding the true extent of its inflationary woes. In many cases, governments fabricate inflation statistics to hide their economic problems, and Egypt is no exception. Steve Hanke, a professor of Applied Economics at Johns Hopkins and director of the Troubled Currencies Project at the Cato Institute had this to say to Rebel Economy:
“Inflation is an enormous problem and my estimate is inflation is considerably higher than official numbers and between 105 percent and 110 percent.”
The IMF, Hanke said, has provided “incredibly bad advice,” that serves predominantly to provide false hope and delay any real solution. “They [the IMF] did this just a few months ago in Nigeria, and they have not stabilized the naira [Nigeria’s local currency] and they’re not going to stabilize the pound,” Hanke said. Nigeria is experiencing an eerily similar problem to Egypt. It managed to sharply devalue its currency but only worsened the very problem that devaluation was meant to solve. Read this Quartz piece for a scary window into Nigeria’s present situation and Egypt’s future.
The underlying issue that no one wants to talk about, said Hanke, is this:
“The IMF wants a monopoly on giving advice, and the governments it advises are afraid to get a second opinion because they’re worried they won’t get money from other governments. It’s a false hope and it allows them to kick the can down a little further.”
But there is another way. Hanke suggests Egypt’s solution could be the implementation of a currency board system, which effectively combines a fixed exchange rate between a country’s currency and an “anchor currency” (which would be the U.S. dollar), automatic convertibility, and a long-term commitment to the system. “The rule is you have to back the local currency,” he said. The system has been tried and tested in several countries, including Bulgaria, where Hanke was an advisor to the government that implemented the program in 1997. The key is disciplining the fiscal authorities, says Hanke.
And guess Egypt’s primary problem is? Discipline. “In Egypt, the government can borrow from the Central Bank any time they want,” Hanke said. Bulgaria was in the midst of a banking crisis and entering a period of hyperinflation. The currency board system reduced Bulgaria’s annual inflation to 13 percent by mid-1998 and to 1 percent by the end of 1998 while rebuilding foreign exchange reserves from less than $800 million to more than $3 billion—more than six months of imports.
So why hasn’t Egypt taken this step? Why hasn’t it been put on the table? Because the military, who controls vast swathes of the economy, might find it hard to swallow.
Inflation is at the highest level in at least seven years, and the president and his team will have to satisfy the IMF through hard measures, including adequately reducing energy subsidies. And Egypt doesn’t seem too far from Bulgaria’s situation today.
Emad Mostaque, a strategist for Ecstrat, an emerging markets consultancy, says Egypt was just shy of hyperinflationary collapse before this week’s currency regime changes, with the deficit, tax base and interest payments all hovering around the 12 percent-of-GDP mark, not to mention debt-to-GDP exceeding 100 percent. (If you want to see what hyperinflationary collapse looks like, just check out Venezuela). Mostaque says:
“Nasty things happen when your entire tax base is barely enough to cover your interest costs and you have less than 3 months of import cover.”
A somewhat contrarian Reuters analysis this afternoon should calm those panicked by Egypt’s currency woes:
The key to preventing a messy devaluation of Egypt’s pound may lie with the country’s households, whose dollar holdings are being eyed by foreign investors as a critical gauge of trust in the authorities.
So in fact, it is “not the withdrawal of foreign investors from a market but the flight of local households and businesses from a currency that is instrumental in [the pound’s] collapse,” according to the article.
That means that despite what all those big foreign investors might be saying about the collapse of the pound, take no notice, because it’s ordinary Egyptians who are critical to avoiding a currency crash.
“Increased household dollarization and a run on the currency, that’s the big risk,” says Jean Michel Saliba, BofA-Merrill Middle East economist, who estimates households account for more than 70 percent of deposits in the banking system.
In contrast, foreigners hold a mere 3-4 percent of the local bond market, according to other estimates from Barclays.
This is an important indicator of how public perception is crucial and inherent to economic stability. The Morsi administration’s handling of the IMF loan negotiations – which have lasted almost 20 months, have contributed to worries over the economy.
But it was a series of bad decisions (1) pushing through an unpopular constitution, 2) issuing an “all-powerful” decree and then backtracking and 3) announcing tax hikes, and then suddenly suspending them) that have only served to undermine confidence in the economy and push panicked Egyptians to swap their pounds for dollars.
Essentially, if the government wants to stop the run on reserves and the pound, President Morsi must convince the nation he is in control. Right now, that’s exactly what the public do not see.
Egypt’s Central Bank yesterday published a strangley frank statement that sheds light on the country’s terrible spending habits and signals how the Morsi administration is losing its grip on the economy.
Just hours after the country’s president Mohammed Morsi made a speech to declare the economy was showing signs of improvement, the Central Bank said it plans to start foreign-exchange auctions in order to preserve foreign reserves after they plunged to “minimum and critical” levels.
The new mechanism, which comes into effect today, will support the dollar interbank market.
The Egyptian pound is subject to a managed float but these auctions will mean the exchange rate is determined by the market rather than the Central Bank. It is a clear response to the depreciation of the pound, which fell to 6.1858 a dollar on Friday, near the lowest level in eight years.
A wave of dollarization, where the public have swapped their pounds for dollars, has exacerbated the pressure on the currency and the ability for the Central Bank to manage the pound’s fall. If you want to read more about Egypt’s currency situation, Rebel Economy put this guide together a few days ago.
$14 billion for the import of petroleum products and foodstuffs.
$8 billion for the payment of premiums and interest on foreign debt.
$13 billion to cover the exit of foreign investors from the local debt market.
The Central Bank said the total of $35 billion was financed from reserves plus other foreign exchange inflows.
It is the clearest sign yet of how Egypt’s costly energy subsidies have eaten up some of the country’s reserves to fund petroleum imports. Just this morning the ministry of finance said it has prepared $50 million to cover “urgent” petroleum import needs.
Debt service payments in foreign debt is also significant considering the country boasts about low external debt.
Even so, the renewed transparency from the finance ministry, central bank and the presidency is a positive step toward communicating to the public the situation on the ground, something that has been missing for several months. With it, Egyptian officials have explained that the country is not in danger of going bankrupt as several media reports have signalled. This morning Mumtaz el Saeed, Egypt’s finance minister said it was all an “illusion” and a “myth”.
It is unlikely that Egypt will go bankrupt simply because it is too big to fail but also because of the large amount of domestic debt Egypt has which can be rolled over easily unlike foreign debt which carries expensive penalties if not paid on time.
However, the country could get stuck in a perpetual cycle whereby debt is always rolled-over with no fear of default, supported by a cushion from foreign donors such as Qatar, Saudi Arabia and Turkey.