The pound and the dollar: The cat and mouse game returns

Ahmed El-Sayed Al-Naggar
Tuesday 10 Feb 2015

Recent changes in the exchange rate of the Egyptian pound to the US dollar point to an approaching wave of inflation, with a requisite impact on the socio-economic horizon

Over the past four decades, there has been a drawn out retreat in the value of the Egyptian pound against the US dollar, through cycles of a drop in value followed by a period of anticipation of the next drop. Over the past six months, the value of the pound suffered a significant setback against the dollar, and then a sharp drop since the start of this year on both the official market and the omnipresent black market.

Central Bank of Egypt (CBE) figures show that the official exchange rate of the pound against the dollar dropped to LE7.6 to the dollar, or a 14.5 per cent depreciation over the past six months. On the black market, it dropped by 22 per cent of its value. Any decrease in the exchange rate of the local currency impacts pricing, competitiveness of imports and exports, the trade balance, international trade, investment and tourism. Therefore, it was unusual for the CBE governor to say in a television interview that the depreciation of the pound would not impact prices, and if prices were to go up there would be intervention to block that.

This assertion contradicts the basic principles of the impact of any depreciation of the local currency on pricing. Even the IMF, which pushes for such measures, realises that depreciation results in price hikes because of increasing prices of imports denominated in local currency.

When countries choose or are forced to slash the value of their local currency against free currencies they either claim this is in response to demand and supply factors in a free market, or that it will lower the cost of local commodities and services when calculated in foreign currencies and thus increase exports, and foreign investment because of the higher purchasing power of foreign currencies. Meanwhile, depreciating the local currency will raise the cost of imported goods and services, as calculated in the local currency, and thus decrease demand on imports and contribute to redressing foreign trade imbalances. This is in theory, therefore we need a detailed reading of economic reality to find out whether it can be applied or not.

If imports are essential they cannot be reduced even if prices rise after the value of the local currency falls. As for non-essential imports, if their class of consumers continues to buy them irrespective of price they, too, will not fall. The only outcome is a rise in prices domestically and higher inflation. Exports will not increase unless commodities are of export quality and just need to increase competitiveness by depreciating the local currency. There must be an accurate reading of the economy and market before taking any rebalancing measures, because it depends on the situation and no one size fits all.

The pound: Between ideal and skewed rates

Before addressing the reasons and pressures that caused fiscal authorities to allow the Egyptian pound to depreciate against the dollar, we must underscore that the exchange rate of a currency is not sacrosanct and untouchable. Not only does it measure the exchange rate between local and foreign currencies, but it is also used to achieve a variety of economic goals as long as value changes are limited or moderate, reflecting partial stability and not turmoil.

For example, China significantly slashed the value of its local currency 35 years ago in order to reduce the price of its exports, as calculated in foreign currencies, in order to raise its competitiveness and increase demand on its goods. China had something to export when foreign demand for its goods grew, so it succeeded in quickly increasing its exports, and in three decades only was able to top world exports by a landslide compared to the US, Germany and Japan over the past four years. Then it began to gradually raise the value of its local currency against the dollar and free currencies in order to reach a fair or ideal exchange rate.

The best or fair or ideal exchange rate strikes a balance of purchasing power parity (PPP) among currencies, meaning that the ideal exchange rate between the pound and the dollar, for example, is the price that reflects the purchasing power of the pound in the Egyptian market compared to the purchasing power of the dollar in the US market. According to this outlook, the exchange rate of the Egyptian pound against the dollar is entirely skewed and nowhere near the ideal rate — even before the current depreciation of the pound against the dollar.

World Bank figures in the World Development Indicators report for 2014 (p. 13) reveal that the dollar value of Egypt’s GNP was $240.3 billion in 2012, based on an exchange rate of LE6.5 to the dollar. However, GDP according to PPP between the pound and the dollar was $520.7 billion. This means the PPP between the two currencies was 46 per cent of its true value. After the depreciation of the pound, it is estimated at less than 40 per cent of its true value against the dollar.

How to treat the causes of the pound’s retreat

The main factors influencing exchange rates of any currency are the country’s foreign balance and interest rates compared to other currencies, changes in key economic indicators, especially development rates, unemployment and inflation. The nominal interest rate of the Egyptian pound is high compared to interest rates on major free currencies; however the real interest rate — the value of interest minus inflation — is negative in Egypt, whereby the rate of inflation is higher than interest rates. Thus, the real value of interest rates on major currencies in their own countries is higher than in Egypt, which makes the interest rate in favour of these currencies against the Egyptian pound.

Lately, fiscal policies aimed to reduce interest to facilitate borrowing by capitalists to fund projects. But this does not serve the stability and strength of the pound since such reductions should be preceded by effectively addressing high prices in Egypt and revenues from widespread production and trade monopolies in Egypt.

If the foreign trade balance is even or tipped in favour of the country, this boosts the local currency; and the opposite is true. Official figures reveal that Egypt’s trade balance suffered a huge deficit of $33.7 billion in 2013/2014; 30.7 billion in 2012/2013, $34.1 billion in 2011/2012; $27.1 billion in 2010/2011; and $25.1 billion in 2009/2010. This shows that we have a huge long-standing deficit in trade, one that has been in place for more than four decades.

Any attempt to redress the foreign balance and strengthen the pound to ensure its stability must begin by redressing the trade balance, whether by boosting and diversifying exports or slashing imports, especially in times of crisis such as current conditions in the Egyptian economy. Developing exports certainly requires new and modern investment, and therefore the rate of investment is a key factor here. Official figures reveal that investment rates in Egypt were 14 per cent of GDP in 2013/2014, which is less than half the rate in poor and middle income countries, and one third of rapidly growing economies in East Asia and Pacific region, and less than 30 per cent of the rate in China.

The services trade balance had a surplus of only $979 million in 2013/2014 compared to $5 billion in 2012/2013; $5.6 billion in 2011/2012; $7.9 billion in 2010/2011; and $10.3 billion in 2009/2010. These statistics show that Egypt will soon lose its long-standing surplus in services trade. The sharp drop in tourism revenues is the main cause of losses in the services trade, and so recovering this surplus is closely linked to restoring tourism to Egypt. Egypt possesses great potential for cultural, historical, sports, safari and health tourism, has immense and superior tourism infrastructure, and is very competitive in terms of tourism costs. This drop is entirely related to security, stability and conduct, and environment regulations in tourism regions.

Official figures reveal that Egypt’s tourism revenues were $5.1 billion in 2013/2014 compared to $9.8 billion in 2012/2013; $9.4 billion in 2011/2012; $10.6 billion in 2010/2011; and $11.6 billion in 2009/2010 — a record figure for foreign tourism in Egypt. What further compounds loss of foreign tourism to Egypt are payments for Egyptian tourism abroad, which rose to $3.1 billion in 2013/2014, which means that the net revenue in this sector was only $2 billion for that year.

Continuing work on the new branch of the Suez Canal and the expected high increase in traffic there will gradually raise transit fees from the current $5.4 billion to almost double in less than five years. This may improve the services trade balance but more importantly it will use the Suez Canal region for a variety of industrial and services investments aimed for exporting.

Although remittances from expatriates pay a large part of the deficit in goods and services exports, the current balance that combines trade, services and remittances had a deficit of $2.4 billion in 2013/2014. This is a temporary small deficit because of grants Egypt received that year worth $5 billion ($4 billion in-kind grants and $1 billion monetary). The IMF estimates that Egypt’s trade deficit will sharply rise from 0.4 per cent of GDP in 2014 to four per cent in 2015, or by tenfold. This deficit had reached two per cent in 2010 and rose to 2.6 per cent in 2011 and 3.9 per cent in 2012. Then it dropped to 2.7 per cent in 2013 because of foreign assistance that year. This deficit was a key pressure point on the pound in its retreat against the dollar.

Main economic indicators of the performance of the Egyptian economy are gradually improving in relation to development rates. However, they still need a strong push in unemployment rates and effective fiscal and monetary policies to rein in rising inflation. IMF figures show that inflation rose from 6.9 per cent in 2013 to 10.1 per cent in 2014, and is projected to rise to 13.5 per cent in 2015. In 2014, the rate of inflation in developed countries was 1.6 per cent and 5.5 per cent in developing countries, expected to rise to 1.8 per cent and 5.6 per cent respectively.

Official figures reveal that foreign currency reserves can cover imports for three months forward. This is a critical coverage span that should not be shortened. However, this will happen if Egypt does not adopt effective measures such as slashing unnecessary imports, boosting exports and production of potential exports, and achieving stability necessary for tourism. Meanwhile, the monetary rule that the local currency should dominate the domestic market should be enforced diligently. This means no other currency is traded on the domestic market and thus anyone, whether foreign or Egyptian, who wants to deal in the domestic market can only do this in the local currency. In Egypt, nonetheless, this rule was mostly abandoned since the mid-1970s, and some currency exchange offices — especially those owned by the Muslim Brotherhood and Salafists — deprive the market, stockpile free currencies and conduct unofficial transactions that are a major part of the black market. These practices put pressure on the pound. Some foreign currencies on the black market are even used to fund arms and drug trading, which is a composite threat to society by depleting reserves of foreign currency and sabotaging security and well-being.

Inflation is the only certain outcome

The depreciation of the Egyptian pound against the dollar will trigger price hikes because the cost of all imported goods in the previous fiscal year, amounting to $59.8 billion or 20 per cent of GDP, will rise when calculated at the lower value of the pound. Thus, inflation may surpass IMF estimates.

Rising costs of imported goods is usually followed by a jump in the price of corresponding local goods, followed by all commodities. This incoming wave of inflation will hit the poor and middle class hard, especially wage earners because their incomes increase very slowly compared to the rapid rise in prices. Meanwhile, the wealth of property owners will grow simply because the value of their property will increase.

Businessmen who took out loans in dollars or other currencies to import equipment, machines and other needs for their businesses, will be in a bind because the value of the loans in Egyptian pounds will increase and add an unanticipated burden on them. This portends that there will be problems in paying back loans, and so banks should prepare for this. Meanwhile, currency exchange offices — mostly owned by religious radicals led by the Brotherhood (of whom some leading figures, including businessmen, were major traders on the illegal black market) — will become wealthier because of their stockpile of dollars and other currencies. The large variance between the price of buying and selling the dollar at currency exchange offices and on the black market allows these offices to make immense profits. Before floating, the difference was no more than three piastres. The majority of these exchange offices buy but refuse to sell foreign currencies, which implies that they might sell their stash on the black market to illegal traders in arms and drugs.

When justifying the need to float or depreciate the local currency, the IMF usually claims that reducing the value of local currency will increase competitiveness of exports. This is theoretical and inapplicable to Egypt, because current stagnation in production and weak growth mean there is no surplus of goods for exports in a country where the trade deficit was $33.7 billion in 2013/2014. It would be better to find a way to jumpstart growth and seek domestic alternatives to boost local and foreign investments. Also, to work diligently to achieve security and political stability necessary to attract tourism and investments, redress the foreign balance, maintain a real positive interest rate, and uphold the dominance of the Egyptian pound at home through mechanisms that guarantee a steady exchange rate and use it effectively to serve economic goals.

The writer is the chairman of the board of Al-Ahram Establishment.

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