Interest rates between expectations and reality - I

Dahlia El-Hawary, Saturday 30 Nov 2019

In the first of two articles, Dahlia El-Hawary analyses the extent to which monetary easing can stimulate growth

Interest rates between expectations  and reality

The Central Bank of Egypt (CBE) initiated a series of interest-rate reductions starting in 2018, followed by a further number of cuts in 2019, the last one of which was in November.

This followed a period of what is called “contractionary” monetary policy, whereby interest rates were raised several times in order to absorb excess market liquidity to reduce inflationary pressures in the economy and to maintain them at low levels.

These tightening measures by the CBE have undoubtedly succeeded in reducing inflation to an estimated average rate of eight per cent in 2019, and it is predicted to reach an average of six per cent over the coming few years. The interest-rate reductions have been in tandem with ongoing monetary loosening undertaken by central banks worldwide in response to the global recession in an attempt to stimulate dragging growth.

However, the effectiveness of monetary policy in stimulating economic growth may be questioned, as it may prove to be limited and a more comprehensive policy response may be needed, as was recently noted by economist Mohamed Al-Erian in an interview with the US network ABC about the global recession.

In Al-Erian’s view, “central banks cannot do anything about economic imperatives such as boosting productivity, building infrastructure, and upskilling workers.” While his views pertain to the ultra-low interest rates currently adopted in the world’s major economies, and are not directly related to the Egyptian economy, implications about the promptness of monetary policy in stimulating growth may apply to the local context.

Conventional wisdom stipulates that lower interest rates trigger positive supply responses from the private sector, a long-awaited objective of the government. Theoretically speaking, there is a positive relationship between lower interest rates and activity in the real economy as private-sector credit conditions start to improve. Specifically, lower interest rates, entailing lower lending rates, should lead to lower borrowing costs and hence encourage more borrowing on the part of the private sector. This should ultimately lead to higher investment, more output, more employment opportunities, more jobs created, and ultimately higher growth rates.

Is that what we should expect? Will lower rates automatically lead to higher investment rates and higher growth? Is it that simple? Unfortunately, it is not. It could be argued that lower interest rates may be a necessary but not sufficient condition for higher private investment as they do not automatically trigger the long-awaited positive supply response from the private sector.

Yes, lower interest rates have positive effects on the economy. They are expected to yield beneficial effects on the budget by reducing domestic debt-service payments, hence lowering the fiscal deficit and placing the debt burden on a downward path, for example. This is a very welcome effect, given that budgetary pressures would be relatively eased and more fiscal resources could be used for social purposes such as improving health and education services. Another positive indirect effect of interest-rate reductions would be the redirection of liquid funds, diverted by currently unattractive lower bank deposit rates, towards investment in other sectors of the real economy.

However, the hoped-for effects of monetary easing in increasing the share of the private sector in the economy, creating more jobs and stimulating growth, would be best achieved within a comprehensive policy reform package that addresses both the stabilisation and the structural adjustment fronts.

Over the past few decades, the Egyptian economy has been suffering from structural weaknesses that the government has been working enthusiastically to rectify within the framework of its Sustainable Development Strategy: Egypt Vision 2030. The reform efforts have also been backed by the International Monetary Fund’s $12 billion Extended Fund Facility under the stand-by agreement over the 2106-2019 period.

Specifically, the government has successfully undertaken a number of important reforms aiming at fiscal consolidation and addressing structural barriers to doing business in Egypt. These include, but are not limited to, regulatory reforms such as the introduction of the new investment law in 2017, in addition to the exchange-rate reform programme that started three years ago with the devaluation of the Egyptian pound in November 2016.

The adoption of a flexible exchange rate was a policy measure that was very much needed in order to stop the drain on the international reserves that had long been used to defend the value of the pound. This has been in addition to the gradual phasing out of energy subsidies and the introduction of a new value-added tax, initially introduced at 13 per cent and then increased to 14 per cent. These reforms have been accompanied by well-targeted social safety net programmes to alleviate any harmful effects on the most vulnerable groups in Egypt.

The government has successfully maintained its reform momentum over the past few years, yet the question remains of what is needed to ensure the triggering of a positive private supply response to the CBE’s ongoing efforts to stimulate higher growth.

 Further discussion of this will follow in the next article.

*The writer has a PhD in economics and is a former advisor at the Ministry of Investment.

*A version of this article appears in print in the 28 November, 2019 edition of Al-Ahram Weekly.

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