Egypt’s economy is still reeling from the decision to float the Egyptian Pound (LE). The decision, enacted on November 3, 2016, allows the value of the country’s currency to be determined by the market rather than a government peg. While the Egyptian pound has seen some recent gains against the US dollar, the CBE’s actions have nonetheless left the country’s economy vulnerable to international market shocks. The CBE took a more tentative position earlier in March 2016, when it allowed the value of the pound to slide to 8.88 LE to the dollar — still far above its black market value. The full devaluation saw the pound fall more than 50%, fluctuating between about 15 and 18 pounds per dollar in the weeks that followed.
The risks to investors posed by a floating currency, in which currency value is largely determined by the market, comes from the potential for investors playing the market to lose their capital should the currency swing dramatically. But in the case of Egypt, the convergence of the currency’s official exchange rate and its black market rate should give investors the confidence that the worst of the fluctuations are over.
Reform and Risk
Devaluing the pound was part of a broader package of reforms made by the Egyptian government in response to the country’s nearly depleted foreign currency reserves. States need a source of foreign reserves to engage in international trade, but emerging markets like Egypt are generally net importers and thus lack a stable source of foreign currency entering the country. For Egypt, two of its most important sources of dollars — tourism and foreign investment — dried up amid the violence and instability that plagued the country following the January 2011 revolution.
Without a steady supply of foreign currency entering the country, the BOE was forced to auction off scarce dollars to finance what the government deemed to be high-priority industries, such as wheat and medical equipment importers. Between 2011 and July 2016, Egypt used up $10 billion of its foreign reserves, leaving only $50 million. Businesses without access to dollars could not import needed inputs, forcing many to pay a premium on the black market or shut down altogether. Government budget deficits ran over 10%, among the highest in the Middle East, and public debt expanded to over 90% of GDP. Wealthy Arab neighbors like Saudi Arabia supported Cairo with cash infusions and subsidized oil in the years following the Arab Spring, but the drop in oil prices starting in 2014 caused fiscal problems in Gulf countries that forced them to pull back their support.
To stem the growing financial crisis, Egypt negotiated a bailout from the International Monetary Fund (IMF) Extended Fund Facility program, agreeing to a loan of $12 billion on the condition that the North African state abandon the pound’s peg to the dollar, alongside other economic reforms. The IMF delivered the first $2.75 billion tranche on November 11 2016, with the remainder to arrive periodically based on IMF reviews. Other conditions for the loan program included subsidy reform, reducing public spending, and raising revenue through new taxes. President Abdel Fatah al-Sisi introduced plans for reforming Egypt’s expensive system of energy and food subsidies in 2014, and Parliament implemented a 13% Value-Added Tax (VAT) for most goods and services beginning in September 2016.
Between 2011 and July 2016, Egypt used up $10 billion of its foreign reserves, leaving only $50 million
Markets signaled their approval of the CBE’s decision to float the Egyptian pound. The EGX30 stock index, comprising the 30 largest Egyptian companies, jumped nearly 35% from November to December 2016, and increased nearly 100% over its previous 5-year average. Deputy Finance Minister Ahmed Kouchouk noted that more than $1.5 billion of foreign currency entered domestic banks in the week following the devaluation. And foreign investors began buying up more short-term public debt, thanks to its relatively high yields among other junk-rated bonds. Sales of more than $6 billion in international bonds are also planned through 2017, according to Finance Minister Amr El-Garhy. All are signs of growing confidence in Egypt’s investment environment and in the government’s ability to manage its finances.
Reasons for Pessimism
Egypt faces two major sources of risk stemming from the pound’s devaluation. The first is economic. Firms in emerging markets like Egypt tend to have their liabilities denominated in foreign currency while their revenues are typically earned in the now-devalued domestic currency. They buy international and sell local, in other words. This dynamic makes it more difficult for local firms to pay off their debts and exposes them to the depredations of forex traders, as well as general market movements, forcing some firms out of business. And if enough businesses are exposed to the currency’s depreciation, then allowing the local currency to float can impede economic activity to the point that the economy goes into recession. Research by economist Michele Cavallo of the Federal Reserve Bank of San Francisco found a strong correlation between how much a country’s economy contracted following a currency devaluation and the extent to which that country’s firms had foreign currency debts.
The second risk posed by the pound’s devaluation is socio-political. Like many emerging markets, Egypt imports many staples like wheat and medicine. But as imported goods must be bought with devalued local currency, those firms face falling profits and, as a result, raise prices. Annual urban inflation was already more than 13% prior to November 3. But that increased to more than 19% following the pound’s devaluation. Combined with a new 13% VAT on most goods, higher prices could lead to popular unrest among Egyptians, half of whom live at or below the poverty line. While earlier protests against price increases failed to materialize, inflation-driven social unrest has the potential to disrupt economic activity and could continue to drive away tourism and foreign investment.
Egypt faces the additional risk that its leaders may be unable or unwilling to follow up the currency devaluation with other much-needed economic and political reforms. Despite the recent influx of foreign investment, Egypt remains one of the most difficult places in the world to do business, according to indices maintained by the World Bank and World Economic Forum. The country’s notorious regulatory system needs to be streamlined so that it is easier to start and invest in businesses. Its bloated public sector has to be shrunk and, eventually, partially privatized. And corruption must be tackled at all levels. In this way, Egypt can follow other successful emerging market countries in driving sustainable and broad economic growth.