Why Egypt’s improved economic outlook is mostly down to luck, not skill

 

Egypt’s strategic position in the Middle East, its political importance to the US – and proximity to rich neighbours – has allowed it to secure much-needed financial resources.

When it comes to managing a financial crisis, luck is a valuable commodity – and Egypt has plenty of it. A $35 billion investment from the UAE and a $5 billion increase in a loan from the IMF – amounting in all to 10 per cent of Egypt’s $400 billion GDP – will go a very long way towards clearing the economy’s dollar shortage and eliminating any near-term risk of default.  

The luck that has helped Egypt secure such massive financial resources comes from its proximity to rich neighbours, its strategic position in a fragile part of the world – especially its potential role in stabilizing a post-war Gaza Strip – and its political importance to the US, a status which has allowed Egypt to become the IMF’s second biggest borrower after Argentina.  

In the longer term, a country is better off with policymakers who are skilful rather than merely lucky. 

But in the longer term, a country is better off with policymakers who are skilful rather than merely lucky. And although the Egyptian government has committed to some important reforms in exchange for all this dollar liquidity, it is a stretch to imagine that the required momentum behind the reform programme will be sustained.   

The reforms Egypt has promised include the introduction of a new exchange rate regime, monetary and fiscal policy restraint, and an effort to create an economic environment which  ‘enables private sector activity according to the IMF. 

The most visible reform that Egypt has agreed to is a devaluation of the Egyptian pound and the introduction of a floating exchange rate regime. The price of a US dollar has fixed by the central bank for the past year at around 31 Egyptian pounds. Last week it was allowed to find a market-clearing level and is now at around 50 pounds. While that is a big increase in the price of foreign exchange, this is where luck comes in.

The most visible reform that Egypt has agreed to is a devaluation of the Egyptian pound and the introduction of a floating exchange rate regime.

Without the huge inflow of dollars from the UAE – principally to invest in Ras El-Hekma, a vast development area on Egypt’s north coast – the pound’s exchange rate would have been significantly weaker than it is now, resulting in even higher inflation rates and associated pain for low-income households. Only a few weeks ago, before the UAE announcement, the pound was trading close to 70 to the dollar on the parallel market. 

Although the central bank accompanied last week’s exchange rate devaluation with a decisive tightening of monetary policy – to minimize the surge in inflation that inevitably follows a big rise in the price of foreign exchange – it remains to be seen if the devaluation actually evolves into a flexible exchange rate regime as the IMF requires.  

If it does not, excessively high inflation – currently at around 36 per cent – will remain a problem. That is because a flexible exchange is a necessary condition for the central bank to implement an inflation targeting regime, without which it will be almost impossible to anchor inflation expectations towards single digits. 

But will Egypt follow through? It is worth noting that Egypt first committed itself to introducing inflation targeting in 2005, but has yet to do so. 

One big obstacle is the central bank’s long-standing habit of allowing a devaluation of the currency when US dollars become intolerably scarce – as now – but then basically re-pegging the exchange rate at a weaker level. Egypt has a classic case of what economists sometimes call a ‘fear of floating’. 

The reason for this is that Egyptian officials tend to be trapped by the very naive notion that a stable currency is an effective way of exhibiting a stable country. This is entirely wrong. Allowing a currency to find a market-determined level is a much more reliable path to national economic stability, since it assures companies and individuals that the price they pay for foreign exchange always reflects its value. 

Egyptian officials tend to be trapped by the very naive notion that a stable currency is an effective way of exhibiting a stable country.

The instinct of Egyptian policymakers to revert to a pegged exchange rate is so firmly rooted that it will take some doing to convince market participants that it will be different this time.

One measure that might make it easier to float the pound effectively would be to make it more difficult for speculative capital to enter the country. Now that the pound is devalued, many international portfolio managers will be looking to buy Egyptian treasury bills to take advantage of high nominal interest rates and a cheap currency. Capital that enters Egypt in this form is economically useless and should be restricted either through taxation or regulation. Reducing this kind of inflow will also make a flexible exchange rate less volatile and help Egypt manage its fear of floating.

In addition to a poor track record on exchange rate policy, it is also difficult to have confidence in the government’s commitment to fiscal tightening. Egypt’s total public debt, including liabilities of the central bank, amounts to 100 per cent of its GDP.  

The IMF will push the Egyptian government to generate a budget surplus before interest payments of some 2 per cent of GDP, as well as limit spending on big infrastructure projects, including the new administrative capital. President Sisi, however, has made it clear that the limits to fiscal tightening are strict and that his grand projects are necessary to provide jobs

 It is difficult to imagine how President Sisi could visibly diminish the army’s role in the economy without undermining his rule.

Perhaps the stickiest underlying problem in Egypt is the lack of what the IMF politely calls efforts to ‘level the playing field between the public and the private sector. The involvement of the Egyptian army in the economy is widespread: in construction, food production and distribution, pharmaceuticals, tourism, and plenty else. Although this crowds out the private sector and inhibits economic efficiency, it is difficult to imagine how President Sisi could visibly diminish the army’s role in the economy without undermining his rule.

While Egypt may continue to have luck on its side for a while yet – with reports of another very large investment on its way – in the longer term, it would do well to follow the IMF’s advice: a strong economy will produce a stable currency, not the other way around.