Misidentification of the bucket holes

Gamal Wagdy
Saturday 15 Jul 2023

Central banks worldwide use all kinds of policies to boost their currencies, with the Central Bank of Egypt being no exception.


Following President Abdel-Fattah Al-Sisi’s statements hinting that a further devaluation of the local currency is not on the table, Managing Director of the International Monetary Fund (IMF) Kristalina Georgieva indicated reservations about this policy, using the metaphor of reserves leaking to support the pound like “putting water in bucket that has holes”.

“This decreases the reserves and makes the situation of the country more difficult,” she said, adding that having multiple exchange rates also creates a privileged position for those who exchange their dollars on the parallel market rather than at the official rate.

The decisions made by the Central Bank of Egypt (CBE) and the comments made by Georgieva highlight the differences between Egypt and the IMF on how each understands the present situation. Georgieva’s statement represents part of the truth, but it is not the whole truth. Her remarks fall short of identifying what the leakage is, its underlying causes, and how they should be addressed.

Supporting the currency of a country is not an uncommon or undesirable practice. On the contrary, it is one of the core functions of central banks worldwide. These are mandated to maintain the stability of their currencies, the achievement of which requires them to interfere whenever necessary.

Central banks also either directly or indirectly control the foreign-currency market. In the G7 countries, this is done indirectly by raising or reducing interest rates. A paper published by the European Central Bank (ECB) states that a central, if not the single most important, area of economic policy coordination for the G7 countries has been the management of major exchange-rate configurations.

The G7 has arguably played a central role in various episodes of this since its establishment. The ECB paper finds evidence that the G7 has in general been effective in moving the exchange rates of the US dollar, yen, and euro in the intended directions.

By contrast, China provides the most explicit example of the direct control of exchange rates, since the People’s Bank of China (the Chinese central bank) adopts a fixed exchange-rate regime by pegging the yuan to the US dollar.

Managing the foreign-exchange rate of a country is, therefore, not only acceptable but also desirable and recommended. The CBE is no exception in seeking to do so. The form of this intervention, however, varies from one country to another.

Central banks intervene in the foreign-exchange market for various reasons, and their approach can differ based on factors such as the level of economic stability, the challenges faced, and the short and medium-term targets and availability of reserves. The intervention of central banks is, therefore, a complex and dynamic process influenced by a wide range of economic and policy factors. The approach taken by each central bank is tailored to its specific context and objectives. Top of Form

In Egypt, the CBE steps in at times of excessive exchange-rate volatility, which is exactly what has happened over the past few months that have witnessed disorderly market conditions. Because the CBE does not have abundant reserves and aims to maintain them at an adequate level, it has taken measures, though inadequate, to address the demand and supply imbalance for foreign currency.

It has directed the commercial banks to sell foreign currencies to their customers according to certain priority guidelines. This is a form of managing the foreign-exchange rate that suits the country during the current crisis.   

Despite the CBE’s commitment to a flexible exchange rate, challenges persist in ensuring the optimal allocation of Egypt’s scarce foreign-exchange resources. The primary factor contributing to this is the existence of a black market for foreign exchange. In contrast to the official market, this unregulated market is prone to speculation and the spread of false information, and this distorts prices and creates volatility. All these factors render this market a “false market” or one that inaccurately represents the reality of the situation. This is exactly what has been happening in Egypt over the last year or so.

The CBE aims at preventing the excessive devaluation of the Egyptian pound and countering speculative pressures that could harm its stability. The CBE’s intervention is not motivated by a desire to keep the pound overvalued. Instead, the aim is to counter the speculative push toward devaluation.

It would be a blunder for the pound’s exchange rate to be benchmarked against the rate prevailing in the black market. Using the black-market rate as a benchmark would certainly distort the true value of the currency. Illegal transactions and speculative activities happening outside official channels disrupt the foreign-exchange market’s equilibrium and undermine the value of the currency. This is the real “hole” in the foreign-exchange “bucket”.

Georgieva also emphasised the need to reduce the state’s involvement in activities better suited to the private sector in her comments. But while it might be sensible to divest unsuccessful enterprises, the same rationale does not apply to well-run state-owned enterprises. The success of an enterprise is not determined by its ownership structure, but rather by effective management. It is crucial to recognise that numerous state-owned enterprises have thrived, while many private-sector enterprises have faced challenges. The failure of private-sector enterprises is not uncommon, and indeed it represents the main cause of non-performing-loans (NPLs) at the banks.

Having said that, it is confusing to learn that the state-owned enterprises listed for sale in Egypt are among the most successful. Selling these enterprises may provide temporary relief in the short run. But in the long run it deprives the state of the permanent stream of revenue they deliver. When sold to foreign entities, as planned, it initiates a permanent drain of foreign currency as the profits of the new owners are transferred abroad.

Instead of resorting to the outright privatisation of such enterprises, a more viable approach would be to separate ownership and management responsibilities. This approach would empower professional managers to make day-to-day decisions, while allowing the state to set the strategic direction. By promoting transparency, good governance, and professional management, this model ensures the sustainability and long-term success of enterprises. It also safeguards the country’s interests by aligning management decisions with national priorities.

Egypt’s plan to sell stakes in state-owned companies has faced hurdles, as potential buyers seem to be waiting for a further devaluation of the Egyptian pound. Another potential reason could be that they are betting on a foreign-exchange squeeze that could compel the government to sell more valuable assets.

While the expected foreign-exchange inflows from the sales of these companies are insufficient to cover the state’s funding gap, the implications extend beyond short-term financial considerations. Privatising state-owned enterprises without careful evaluation and the consideration of national interests could lead to the permanent outflow of foreign currency and the loss of a reliable revenue stream.

Egypt’s foreign-exchange challenges require comprehensive understanding and effective solutions. The CBE’s intervention in the foreign-exchange market remains crucial for maintaining stability, and its measures, though imperfect, were necessary given the prevailing market conditions.

The remarks of the IMF director, by contrast, reflect off-the-shelf solutions that do not pay enough consideration to actual conditions on the ground.


*The writer is a banking consultant.

* A version of this article appears in print in the 13 July, 2023 edition of Al-Ahram Weekly

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