W

ith the continued foreign-currency shortage, increasing divergence between the official exchange rate and the black-market rate, and a stalemate in negotiations with the International Monetary Fund (IMF), the prospects for the pound and the wider economy are looking ambiguous, with some unpleasant scenarios possibly on the horizon.

This situation entails immediate action beyond the confines of routine economic policies and concerted efforts to rescue and stabilise the country’s economy.

The reappearance of the black market for foreign-exchange transactions over the past year has further complicated matters, deepening the divide between the official and the unofficial exchange rates. This has been worsened by the country’s economic downgrade by the international rating agencies and the reluctance of partners to inject fresh funds into the economy. There has been an inability on the part of the commercial banks to meet customer demands for foreign currency at the official rates.

The authorities are grappling with conflicting pressures. On the one hand, the IMF and certain influential groups, particularly importers, are advocating a further devaluation of the pound and its being allowed to float freely at market rates. On the other hand, most people are urging restraint and a resistance to moves that could perpetuate the depreciation of the pound.

As no decision has yet been made, many commercial banks and importers have been adopting pragmatic solutions to sustain import activities without violating the rules.

One workaround involves importers acquiring dollars on the black market at the prevailing rates and then selling them to the banks at the official rates. At the same time, the banks agree to sell the same importers an equivalent amount of dollars at the official rate, ostensibly completing the transaction.

Another sees the banks selling dollars at the official rate while at the same time entering into agreements with importers on interest-free deposits. The deposit amounts are then meticulously structured to nullify the sale of dollars at the official rate, effectively masking a transaction concluded at the black-market rate.

These manoeuvres present a stark reality, however, namely, that the official figures for foreign-currency transactions by the banks do not mirror the real situation. Instead, the black market operates as a covert hub for executing substantial imports, depriving the official market of significant foreign exchange. The black-market rate becomes the de facto rate for a considerable volume of imports, relegating the declared rate to an at best de jure rate. The tacit acceptance of such practices signifies the unofficial introduction of a dual exchange-rate regime, something often adopted by countries grappling with foreign-exchange shortages or economic crises.

Such countries sometimes adopt this system as a short-term solution to deal with such shortages or economic crises. Currencies can be exchanged at both fixed and floating exchange rates, with a fixed rate being reserved for transactions such as certain imports and exports and other transactions being determined by a market-driven exchange rate.

While this system may provide a temporary boost to foreign-exchange inflows, it often comes with significant drawbacks. These include market distortions, reduced transparency, inflationary pressures, loss of central bank control, the encouragement of rent-seeking behaviour, and a growth in speculative activities. Collectively, these mean that this system is not a sustainable or long-term solution.  

One way of dismantling a dual exchange-rate system is to unify exchange rates and to peg a single rate to the black-market rate, indicating a devaluation of the currency. However, unifying rates alone does not guarantee a sustainable equilibrium price on its own. Achieving stability in the foreign-exchange market necessitates a comprehensive approach that addresses broader economic fundamentals such as the inflation rate, fiscal and monetary policies, and the trade balance.

In the absence of such measures, the re-emergence of a black market and the potential perpetuation of a dual or even a multi-exchange-rate system loom ominously.

Aware of these challenges, the IMF has been pressing hard for a permanent shift to a durable flexible exchange-rate regime in Egypt as a pre-condition for approving the disbursement of the second trench of the loan it has made to the country under its Extended Fund Facility. In a letter of intent to the IMF last November, the Central Bank of Egypt communicated its commitment to a durable shift to a flexible exchange rate. However, the aftermath of that commitment proved to be easier said than done. The hesitancy to fully embrace a freely floating rate stems from apprehensions about its potential consequences, both economically and socially.

Determining the “best” exchange-rate regime is complex and depends on various factors, including a country’s economic conditions, policy goals, and external circumstances. There are several exchange-rate regimes, among them the floating, the fixed (pegged), and the managed floating regimes. Each of them has its pros and cons, and there is no one-size-fits-all system, as the suitability of an exchange-rate regime depends on a country’s unique circumstances.

Small open economies may benefit from more flexible exchange rates to adjust to external shocks, for example, while larger economies may seek stability through fixed or managed exchange rates. The best exchange-rate regime involves a careful balance between stability, flexibility, and responsiveness to economic conditions. Moreover, the effectiveness of any regime also depends on the supporting economic policies and institutions and the overall macroeconomic environment.

In the light of the current economic conditions in Egypt, it seems most appropriate to implement a fixed exchange-rate regime in the short run as a temporary measure until conditions improve and then to transition to a managed pegged regime in the long run. This kind of approach should be part of a phased or transitional strategy to address immediate challenges, with movement then being made towards a more flexible exchange-rate arrangement over time. It is particularly relevant given the current severe shortage of foreign currency and turmoil in the region. It can provide stability to the currency and the economy.

A short-term fixed exchange rate carries several potential benefits. Firstly, it can achieve the immediate objective of stability, alleviating the rapid depreciation of the currency that contributes significantly to economic instability. Secondly, by reducing uncertainty about the future value of the currency, it can also instill confidence among businesses, investors, and the wider public. This, in turn, is conducive to economic activity and has the potential to attract foreign investment, crucial for economic revitalisation.

Because it is a temporary measure, it helps to buy time for the government to enact the necessary economic reforms. During this period, policymakers can work to address fiscal imbalances, improve the business environment, and enhance economic competitiveness.

In order to uphold a fixed exchange rate, central bank intervention is widely employed as a direct approach. A central bank wields the power to engage in the buying or selling of the national currency on the foreign-exchange markets, thus having significant influence over the exchange rate.

However, this form of intervention necessitates a reservoir of foreign-exchange reserves. Given the anticipated persistence of the current foreign-currency shortage in Egypt, it would be more prudent to resort to administrative measures that can also furnish a temporary respite. Embracing a fixed exchange-rate regime hinges upon the amalgamation of central bank intervention with complementary administrative measures.

These encompass a spectrum of approaches, including capital controls, trade restrictions, and regulations governing the foreign-exchange market. Their collective objective is to control the flow of capital across the nation’s borders, curtail the importation of non-essential goods, and assert control over the foreign-exchange market by mandating that both businesses and individuals conduct their transactions at the officially sanctioned exchange rate. This suite of measures is poised to become the prevailing norm of the times.

As progress is made in addressing structural issues and fortifying economic fundamentals, a phased transition to a managed pegged regime is a logical next step. This provides more flexibility than a strictly fixed rate and allows for some adjustment in response to changing economic conditions. Under such a regime, the central bank may periodically adjust the peg within a certain band to reflect evolving economic fundamentals. This flexibility allows for a more gradual transition to a regime that is responsive to market forces, while still providing a degree of stability.

A managed pegged regime introduces elements of market discipline, as the currency is allowed to fluctuate within a predetermined range. This can encourage a more realistic alignment of the exchange rate with economic fundamentals and reduce the risk of speculative attacks.

However, the success of this strategy hinges on the effective implementation of policies, an unwavering commitment to reforms, and the ability to manage the transition smoothly. It necessitates a holistic approach, with the fixed-rate regime serving as a precursor to a more flexible exchange-rate arrangement.

This kind of comprehensive strategy, embedded within a broader economic reform agenda, is fundamental to fostering sustainable economic growth.

The writer is a banking consultant.

* A version of this article appears in print in the 9 November, 2023 edition of Al-Ahram Weekly