The trilemma facing the pound

Gamal Wagdy
Tuesday 5 Sep 2023

The Central Bank of Egypt should focus on maintaining a stable exchange rate and an independent monetary policy when managing the fortunes of the Egyptian pound.


The decline in the exchange rate of the Egyptian pound since the 1970s raises crucial questions about the factors behind its inability to retain its value. The trajectory of the pound’s decline, plummeting from its 1970s high of LE0.7 per dollar to the current rate of LE31 per dollar, alongside the lower black-market rate, invites inquiry into root causes.

Despite a 50 per cent devaluation in 2016 and a subsequent 50 per cent decline since the March 2022 devaluation, a series of currency devaluations have failed to catalyse tangible economic progress or sustainable growth. The recurrence of further losses raises questions about the shortcomings of the foreign-exchange policies pursued over the last four decades.

As the steward of the country’s monetary policy, the Central Bank of Egypt (CBE) has pursued three primary objectives: a stable foreign-exchange rate, free capital movement in and out of the country, and an independent monetary policy. It has designed its policies in such a way as to achieve the three goals simultaneously, and that is where the problem — or the trilemma — lies.

This trilemma, also known as the impossible trinity or trilemma of international finance, is a concept within international economics and finance that provides a framework for understanding the constraints and trade-offs that countries face in managing their exchange rates, capital flows, and monetary policy. It underscores the complex interplay between the three.

Proposed by the Canadian economist Robert Mundell and the British economist Marcus Fleming in the 1960s, the concept provides a perspective through which we can understand the difficulties that countries face when handling their economic difficulties. It can help us to understand the trade-offs and challenges that policymakers in Egypt face in managing the exchange rate, capital flows, and monetary policy.

According to the trilemma, any country can pursue only two out of the three objectives simultaneously, thereby necessitating the relinquishment of the third. This arises from the fact that a fixed exchange rate implies pegging the country’s currency to another currency. By doing so, a country aims to provide stability for international trade, investment, and capital flows.

However, maintaining a fixed exchange rate requires significant intervention by the central bank, which can limit its ability to conduct an independent monetary policy. The central bank needs to constantly buy or sell foreign currencies in order to defend the fixed rate, potentially depleting its foreign reserves and restricting control over the domestic money supply.

Free capital movement allows funds to flow in and out of the country without significant restrictions. This objective promotes foreign investment, capital mobility, and financial integration. However, when a country experiences economic shocks or financial instability, the free movement of capital can exacerbate the situation. Sudden capital outflows can lead to currency depreciation, a loss of foreign reserves, and financial instability. In such cases, countries might resort to implementing capital controls to mitigate the risks associated with capital flight.  

An independent monetary policy enables the country to control its domestic interest rates, manage inflation, and respond to domestic economic conditions. Central banks can adjust interest rates, implement quantitative easing or tightening measures, and regulate the money supply to stimulate or restrain the economy.

However, pursuing an independent economic policy becomes challenging when a country has a fixed interest rate or free capital movement. In these situations, changes in economic conditions might necessitate an adjustment in interest rates or the money supply, and both such actions can conflict with the goals of exchange-rate stability or capital mobility.

Historically, Egypt has faced difficulties in simultaneously achieving all three goals, resulting in the faltering preservation of the currency’s value. The country has chosen to fix the pound’s exchange rate through a managed floating exchange-rate regime with the CBE intervening in the foreign-exchange market to influence the value of the pound.

At the same time, it has allowed the free flow of capital where there have been no significant restrictions on the flow of capital across national borders. Individuals and businesses have been able freely to invest and divest foreign assets without facing significant barriers.

It has also chosen to adopt an independent monetary policy, in which it has conducted its monetary policy autonomously, adjusting interest rates and the money supply to achieve its domestic economic goals.

Historical patterns reveal that these policies were imposed without consideration of the limitations imposed by the trilemma, revealing aspirations that surpassed practical conditions. The eventual outcome was that these policies demonstrated their inability to maintain their effectiveness, remaining confined to theoretical issues rather than practical implementation. This situation could have been avoided by adopting only two of the three goals and letting go of the third.

Considering these goals against an economic and societal backdrop, it is apparent that relinquishing free capital movement would be a prudent choice for Egypt. The two alternative options carry greater adverse repercussions for the economy. Opting for a flexible exchange rate without satisfying the necessary prerequisites could engender sizable and frequent exchange-rate fluctuations, yielding unforeseen and potentially disruptive effects throughout the economy, mainly inflationary pressures.

Moreover, giving up the goal of an independent monetary policy typically means relinquishing control over domestic interest rates and monetary measures. Such a move restricts a country’s ability to adjust interest rates, regulate the money supply, and implement other monetary measures to manage domestic economic conditions. It would also reduce that country’s flexibility in responding to economic conditions.

Imposing restrictions on capital mobility thus remains a strategic choice that would bear fewer impediments compared to the alternatives, although it entails the risk of diminished global financial integration. Although capital controls may discourage some foreign investors, a well-structured framework could mitigate and alleviate such uncertainties.

It is also important to note that the effectiveness and impact of capital controls will vary depending on the specific design, duration, and enforcement of such measures. This can take diverse forms, encompassing caps on capital transfers, limits on currency conversions, and prerequisites for specific capital transactions. The rationale behind these measures is to manage capital flows and mitigate risks stemming from abrupt outflows or speculative actions.

The decision to give up one goal by a country is considered a strategic change as well as a policy change, as it involves a significant shift in that country’s economic framework and policy approach. It would represent a strategic change because it involves re-evaluating long-term economic objectives and the means to achieve them. The country would recognise that pursuing all three goals simultaneously is unsustainable, and therefore strategically would decide to prioritise certain objectives over others.

It involves a fundamental reorientation of that country’s economic strategy in order to create a more feasible and balanced framework that aligns with its priorities and economic realities. It also signifies a policy change because it requires adjusting the specific economic policies and measures employed by the country. It must modify its policy toolkit and adopt new approaches to manage its economic environment effectively. This involves implementing a new exchange-rate regime, adopting alternative monetary policy frameworks, and introducing capital controls.

The policy change is driven by the strategic decision to shift priorities and find a more sustainable path forward. The current circumstances in Egypt strongly indicate that this is an opportune moment for such a strategic and policy change.  


The writer is a banking consultant.

* A version of this article appears in print in the 31 August, 2023 edition of Al-Ahram Weekly

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