Beyond raising the interest rate

Khaled Sakr
Tuesday 12 Mar 2024

It is time to break from Joseph’s prophecy.


During my 28 years at the IMF, I closely followed the public communication of many central banks. The press conference recently held by the Central Bank of Egypt was, by all standards, well-crafted. Most importantly, the governor and his deputies proactively delivered clear messages that addressed key questions circulating among the population, both laymen and experts, as well as international partners and markets.

They explained in detail the motivations of the bank’s promising monetary policy actions after a too-long period of a deteriorating economic situation and rising uncertainty that was naturally leading to a sense of desperation among the population.

As is often the case, it is expected that markets will test in the days ahead the resolve of the bank to stick to its newly announced policy commitments and the determination of the government to implement its promise to reign in expenditure on mega-projects and to deliver on enhancing social protection and structural reforms to bring about sustainable income growth. 

Not too long ago, the country had great hopes for an economic take-off and bright future as it witnessed massive infrastructure developments. The speed of implementation was unprecedented.

However, the aspiration for rapid development meant that the financing envelope was pushed to the limit and beyond. There were too many simultaneous mega-projects with long gestation periods that were only possible because of the global euphoria of cheap capital inflows flooding emerging and developing economies. International economists cautioned that the situation could reverse if unexpected shocks materialise. But none were on the horizon, and enthusiasm triumphed.  

Then, Covid came, followed by supply-chain disruptions and the Russia-Ukraine war. The “new norm” of low inflation in advanced economies came to an abrupt end. Major central banks had to react by raising interest rates on their currencies. This was particularly harmful for developing countries, especially those who had become more reliant on inflows to finance their expanding fiscal and balance of payments deficits, and who were reluctant to raise their interest rates. Egypt was a case in point. 

Euphoria does not subside easily. With hindsight, it became clear that optimism prevailed for a bit too long. Eventually, as the exchange rate reached unthinkable levels and foreign financing, including from close allies, dried up, the authorities took the right measures. Interest rates had to be raised meaningfully, the foreign exchange market was liberalised, and the government promised to pause spending on large construction projects and to bring extra-budgetary activities to the purview of the Ministry of Finance. Anxiety in markets and among the population dissipated. However, having suffered for a considerable period, they are now watching carefully.

Typically, the Central Bank of Egypt gets tested first. Speculations in money markets are expected after such a long-awaited reform package. The governor stressed that the bank will not hesitate to use all tools at its disposal to cement this fledgling stability. This should include its most important tool, which just proved highly effective, ie the interest rate. The bank should not hesitate to follow up with further hikes if needed. “Whatever it takes” is usually the best deterrent to speculations and reflection of the authorities’ determination to stick to its new policy.

Experience has shown that, with credible policies and consistent messages and actions, interest rates can come down quickly. Egypt had similar successful stabilisation episodes, particularly during the early 1990s under the government of Prime Minister Atef Sedki.

The currency stabilised and the interest rate did not have to stay high for long. It declined within months. The unification of the exchange rate was also a necessary move.

As the governor mentioned, multiple exchange rates do more harm than good, and the negative impact of higher interest rates on production costs is much lower than the impact of a collapse in the exchange rate. Inflation is particularly sensitive to the latter in an economy like Egypt’s, which imports most of its food and intermediate goods.

In fact, the pound has appreciated since the majority of transactions had been priced at the parallel market rate. If the bank had not reacted that way, the parallel market rate would have fully prevailed, further feeding inflation and substantially raising the cost of the eventual settling of the negative net foreign assets positions of the treasury and the banking sector. Staying the course is clearly crucial. 

The recent experience would highlight five principles to guide the way forward. 

First, policy coordination is vital. The various public entities should not act in silos when managing their revenue and expenditure. The treasury should be the undisputed maestro.

Second, public communication is also key. Raising unrealistic hopes often leads to frustration. Further grand projects should be halted, and contradictory announcements should not be allowed. They put in question the credibility of the new policy.

Thirdly, good policies bring capital inflows and not the other way around. What we lost in workers’ remittances alone last year is larger than the net inflow in the first year of the Ras Al-Hekma project.

Fourthly, while the recent agreement with the IMF mission is a very positive development, we should always implement good policies without delay, regardless of the stage of any negotiations. Delays hurt our economy and, in fact, domestic ownership of the reforms do facilitate smoother negotiations and attract other support.

Lastly, we should never lose sight of the fact that stabilisation is only the first step towards improving income. It should be accompanied by effective social protection that increases cash transfers to the poor, building on the Takaful and Karama programmes, and concentrates subsidies on essential food staples.

It should also be complemented by the implementation of structural reforms that reduce administrative burdens and by mobilisation of more support to improve education and health services to unleash the productive capacity of the population. This is the only way to break from the seven-year alternating cycle that seems to have shaped our economic destiny since Prophet Joseph’s revelation.  

* The writer is a former IMF mission chief to various advanced and developing economies and senior advisor to the dean of the Executive Board.

* A version of this article appears in print in the 14 March, 2024 edition of Al-Ahram Weekly

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