Inflation remains key concern for Egyptian central bank

The Central Bank of Egypt (CBE) left its benchmark policy rates unchanged at its 28 January monetary policy committee (MPC) meeting, with the overnight deposit and lending rates held at 9.25% and 10.25%, respectively. The discount rate was left unchanged at 9.75%, while the seven-day repo rate remained at 9.75%. The CBE last moved in December 2015 to rein in inflation, raising interest rates 50 basis points.

Consumer price inflation held steady at 11.1% in December 2015, providing room for the CBE to let interest rates stand at the January meeting. Food prices fell on a monthly basis for the second straight time, which kept annual food inflation unchanged at a still-high 14.7%. Currency weakness has pushed up import costs, and importantly food costs. The authorities have attempted to limit food-price increases given concerns over a public backlash. The Egyptian government has lowered food prices at state-run supermarkets, subjecting certain products to price controls, while also beginning to supply imported food products to the private sector in an effort to rein in prices, along with other measures.

The CBE estimated that core inflation, which excludes food and energy, edged lower to 7.2% y/y in December, from 7.4% in November. The slide in global oil and commodity prices to start 2016 should have kept inflation in check in January, with IHS estimating headline inflation at 10.8% for the month.

Pressure points

The CBE will need to monitor inflationary developments closely given the pressures on the currency, but also look ahead as Egypt continues to move slowly on subsidy reform. Since January 2015, the central bank has periodically devalued the Egyptian pound while also allowing banks to exchange currency at a rate of plus or minus 0.15 pound from the official rate. Former CBE governor Hesham Ramez moved twice in October 2015 to weaken the value of the Egyptian pound, devaluing the currency to EGP8.02:USD1.00 by end-October. The pound snapped back to EGP7.82:USD1.00 in November, where it has remained steady thus far through January 2016.

In defending the pound, the CBE has drawn down the country's foreign reserves to critical levels, edging lower to USD16.4 billion at the end of 2015. Debt repayment and the trade deficit have weighed on the reserve base as well. In December, the CBE under new governor Tarek Amer tightened import controls in a bid to help ease foreign-exchange pressures. The measure requires local banks to obtain import documentation directly from foreign banks, rather than the clients (importers), and clients would need to supply 100% cash deposits on letters of credit for imports. This compares with the 50% cash requirement previously. Exclusions to this includes food, medicine, machinery, and other manufacturing goods.

The CBE on 27 January also eased the restrictions on US dollar-denominated bank deposits for select sectors. The cap was increased from USD50,000 per month to USD250,000, with the daily deposit limit of USD10,000 removed, for imports of food, medicine, machinery, and other manufacturing goods. The CBE is trying to ease the difficulties in financing critical imports, as these same sectors are excluded from the aforementioned tighter import controls, while at the same time trying to limit other imports in a bid to provide relief to the trade deficit.

Financing the current-account deficit has proved challenging given the country's slumping foreign exchange earnings, chiefly tourism and investment. A recovery in tourism revenues has been sidelined following the Metrojet attack last October, with an expected slump in tourism over the coming quarters leaving Egypt to rely on foreign investment, Suez Canal receipts, remittances, and foreign aid to bolster its reserve position. Net foreign direct investment (FDI) has rebounded over the past year, rising 49% to USD5 billion through the first three quarters of 2015. However, its resilience to the Metrojet attack will be a key signpost for developments over the coming quarters. Suez Canal receipts have proven resilient to the domestic turmoil, and along with remittances will continue to help underpin foreign-exchange earnings, but these sources are vulnerable to weak global trade activity given the lethargic state of the global economy.

Much-needed aid

Injections of foreign aid have provided support for Egypt's foreign reserves and fiscal resources for the government. Gulf countries such as Saudi Arabia, Kuwait, and the United Arab Emirates have provided billions of dollars of aid and investment to help pull the Egyptian economy out of its malaise. Recently announced loan agreements with the World Bank and African Development Bank (AfDB), as well as financing from China and Saudi Arabia, are positive signs for the Egyptian economy, and are likely help to further drive foreign investment into the country. The World Bank programme works alongside the AfDB programme, helping the Egyptian government's efforts to set a sound policy framework for its economic reform plans over the next three years. The areas of focus - fiscal consolidation, energy reform and sustainability, and improving the business environment – are key to Egypt's ability to foster stronger economic growth, create jobs, and help bring down the fiscal deficit and public debt levels. The World Bank and AfDB partnerships with Egypt promote greater confidence regarding policy measures, which are positive signs for foreign investors and underlie the importance international institutions like the World Bank and AfDB place on Egypt's success over the medium term. Relations with the International Monetary Fund have improved as well, if not culminating in a standby credit arrangement.

Outlook and implications

The CBE will continue to monitor and guard against inflationary pressures, particularly as the authorities work to steer Egypt out of its current foreign-exchange problems. Should high inflation persist for January in the upcoming release, and taken against a backdrop of sharply lower global oil and commodity prices, the likelihood of another interest rate hike by the CBE would increase. With the Egyptian pound's exchange rate holding steady the past three months, the CBE seems to have prioritized bringing inflation back down to single-digit annual rates before addressing the currency. The bank's restrictions to manage the dollar shortages have been a hindrance on business and investment, while a sizeable gap between the official and black market rates remains.

IHS continues to expect the CBE to weaken the currency further during 2016, with the pound ending the year at EGP8.25:USD1.00. The CBE may opt for a managed depreciation of the currency, rather than the current policy of devaluing it periodically without real notice of the timing. This would help narrow the gap between the official and black market rates, ease pressures on the central bank's foreign reserves, and help to improve the competitiveness of the pound, particularly compared with the euro, which weakened markedly against the US dollar in 2015. Continued efforts to support the currency, on the other hand, would be a greater drain on precious reserves and would leave challenging conditions for business and investment activity already squeezed by the current limited dollar availability.

The vulnerabilities of Egypt's reserve position remain significant, but support from the World Bank, AfDB, Gulf states, as well as improving inflows of FDI should lead to greater (albeit gradual) improvement by year's end. Foreign investor sentiment should receive a lift from the World Bank/AfDB loan agreements and additional financing deals with China and the Gulf states, with sentiment and FDI activity key signals for the economy's prospects ahead. Meanwhile, a recovery in tourism by mid-2016 is expected to provide more support to reserves by the end of the year, although carries continued risk concerning security developments.

Overall, IHS expects real GDP growth to slow to 2.7% in fiscal year (FY) 2015/16, down from 4.2% in FY 2014/15. Egypt's economic prospects will remain tied to the government's ability to adhere to its reform plans and maintain political and security stability. This remains a tall order amid concerns of public backlash and protests. The government will need to push through fiscal consolidation in the next budget (FY 2016/17) in order to make further progress reining in the fiscal deficit and public debt, but will likely continue to tread carefully and in small steps to avoid unrest. Subsidy cuts are likely to be revisited, although implemented gradually, while tax reforms such as a value-added (VAT) and capital gains tax could come under more scrutiny with a risk of being delayed. Egyptian authorities will nevertheless have to produce some signs that economic imbalances are being addressed to assure businesses and investors on the country's medium-term prospects, which remain favorable despite the near-term crunch.