The Central Bank of Egypt's efforts to ease pressure in the foreign-exchange market culminated on 14 March with the devaluation of the pound and a move towards a flexible exchange rate policy.
IHS perspective | |
Significance | The Central Bank of Egypt devalued the pound by 12.5%, to 8.85 per US dollar at an exceptional interbank currency auction yesterday, following the removal of capital controls last week. |
Implications | The CBE has not provided any specific details yet on how it may approach a freer exchange rate policy, but the latest measures signal a more decisive plan to manage the currency and foreign reserves. |
Outlook | IHS expects the CBE to tighten monetary policy significantly at its upcoming policy meeting on 17 March. We project the bank's benchmark interest rates will increase by 50 basis points in order to head off the anticipated inflationary impact of the currency devaluation. |
Following recent measures to roll back capital controls, the Central Bank of Egypt (CBE) announced yesterday (14 March) a devaluation of the pound and a move towards a flexible exchange rate policy. In an exceptional interbank currency auction on Monday, the CBE sold USD198.1 million at an exchange rate of EGP8.85/USD1.00, compared to EGP7.73/USD1.00 previously. In its statement, the CBE noted recent monetary policy measures were aimed at addressing pressures in the foreign-exchange market, including helping to narrow the gap between the official and black-market rates and reduce the strain on the country's foreign reserves.
In setting the stage for the 12.5% currency devaluation, the CBE under governor Tarek Amer in the past week removed capital controls employed in early-2015 to help stem the drain on the country's foreign reserves. The CBE announced on 7 March that limits on foreign currency withdrawals and deposits for individuals had been removed, while a day later the central bank reported that caps on foreign currency withdrawal and deposits for companies importing critical goods were also eliminated. Companies importing goods deemed non-critical would still be subject to the previously imposed caps, with foreign currency deposits limited to USD50,000 per month.
The CBE noted that the measures are aimed at improving liquidity in the economy, as companies and individuals have found it difficult to obtain dollars to finance imports. Capital controls have been difficult for businesses to absorb and created additional hurdles to their normal business activities. Removing the deposit and withdrawal restrictions should help clear a backlog of critical imports that have been stranded at the border due to the dollar shortages.
Authorities are also trying to dampen demand for imports, tightening import controls last December 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 include food, medicine, machinery, and other manufacturing goods. Companies importing non-critical goods, therefore, continue to face uphill challenges in sourcing dollars for letters of credit.
Reserve pressures
In defending the pound, the CBE has drawn down the country's foreign reserves to critical levels, edging lower to USD16.5 billion at the end of February 2016, from a peak of USD36.0 billion at the end of 2010. Difficulties obtaining hard currency through official channels led to an increasingly active black market. As previously mentioned, capital controls have been difficult for business to absorb, leaving them to turn to the black market to purchase dollars, albeit at a much higher cost. The pound has traded as high as nearly EGP10/USD on the black market, while the official rate had been held steady at EGP7.82/USD1.00 since Amer took over leadership of the CBE last November.
The removal of the limits on foreign currency withdrawals and deposits for individuals and select companies would have, on their own, helped improve liquidity in the economy, but the rollback would have threatened to place further strain on the country's foreign reserves given the pent-up demand for US dollars. The currency devaluation looks to address this issue by reducing the drain on reserves to support the pound, while also narrowing the gap between the official and black-market rates. Following the removal of capital controls last week, the black-market exchange rate had strengthened to about EGP9.5/USD1.0, while reports indicated a further gain to under EGP9/USD after the devaluation.
Outlook and implications
Since assuming leadership of the CBE, IHS has expected Amer to usher in a new exchange rate policy given the persistent foreign-exchange pressures. The slew of recent measures to return capital markets back to normal set the stage for yesterday's pound devaluation, with the central bank also noting a move to a more flexible exchange rate. The devaluation itself was steeper than expected, highlighting the degree of dysfunction and imbalance in the foreign-exchange market.
The CBE has not provided any specific details yet on how it may approach a freer exchange rate policy, but the latest measures signal a more decisive plan to manage the currency and foreign reserves. Moreover, this should help improve the competitiveness of the pound, particularly compared with the euro, and remove some of the uncertainties that have to date held back foreign investors. We have updated our March forecast with the recent developments, and we now expect the pound to weaken to between EGP9.25/USD1.00 and EGP9.50/USD1.00 by the end of 2016.
Foreign-exchange earnings are expected to gradually recover, as debt repayment and the trade deficit continue to weigh on the reserve base. A slump in tourism stemming from the Metrojet attack will limit any significant recovery in foreign-exchange earnings over the next few quarters, leaving Egypt to rely on foreign investment, Suez Canal receipts, and aid (from Gulf states, the World Bank, and the African Development Bank) to bolster its reserve position in the near term. The CBE has targeted foreign reserves recovering to USD25 billion in 2016; however, this will prove challenging in our view, with reserves falling short of the USD20-billion mark this year.
Additionally, IHS expects the CBE to tighten monetary policy rather significantly at its upcoming policy meeting on 17 March. We project the bank's benchmark interest rates will increase by 50 basis points in order to head off the anticipated inflationary impact of the currency devaluation. This would follow December's 50 basis point rate hike, and we would expect the CBE to raise rates at least once more this year as well. Consumer price inflation dropped to a 9.1% annual rate in February, its lowest rate in the past six months. However, inflation is projected to climb back to double-digit rates in response to the weaker currency, averaging close to 12% for the year. We will be monitoring price developments closely in the months ahead as the prevalence of the black-market exchange rate could to an extent limit the impact of the pound's devaluation.