Egypt's revaluation: A prelude to unshackling the pound?

The central bank has maintained the pound within a narrow band through regular dollar auctions introduced in 2012.

By Lin Noueihed/Opinion

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Published: Sun 15 Nov 2015, 11:00 PM

Last updated: Mon 16 Nov 2015, 9:58 AM

Egypt's revaluation of the pound this week has raised expectations of a major shift in how it manages a long-running currency crisis, with evidence growing that the central bank may be preparing for a more flexible exchange rate mechanism.
Economists, especially those with longer memories, believe the action may herald a period of greater volatility for the tightly-managed currency leading to a devaluation and greater flexibility, following a path that Egypt took over a decade ago.
The central bank has maintained the pound within a narrow band through regular dollar auctions introduced in 2012, but downward pressure has persisted, forcing it to allow incremental devaluations every few months.
However, on Wednesday it strengthened the pound by 2.5 per cent, the first such move since 2013, and injected $1 billion into the economy. This surprised bankers who had called for more devaluation to boost competitiveness and crush the black market for dollars that has grown to meet the needs of an import-dependent economy during an acute foreign currency shortage.
Egypt's outgoing central bank governor Hisham Ramez has battled for months to defend the pound, with most bankers saying that he could not hold out indefinitely with foreign reserves at $16.4 billion - enough for only three months of imports. In February Ramez imposed a strict limit on the amount of dollars that can be deposited in banks, curbing the black market and stabilising the pound if only for a few months.
Bankers and business have long argued it was no longer possible to maintain an overvalued pound as the dollar shortage and currency uncertainty hit trade and industry, and spooked investors. Many expressed relief when Ramez resigned, looking to the new governor Tarek Amer to change course.
After the revaluation, bankers struggled to explain why the central bank had intervened to strengthen an already overvalued pound, taking it to 7.73 per dollar and holding it the next day.
In the midst of the leadership change, the central bank has remained silent about its motivations and officials have not responded to requests for comment.
But some economists believe the dollar infusion aims too minimise banks' foreign exchange exposure before a significant devaluation. They say the revaluation is aimed at shaking out speculators making downward bets on the pound, with a view to loosening the peg eventually and allowing a downward drift.
"My hope is that it's a first step in a move towards a more flexible currency regime and that from here, we will see more volatility but with the Egyptian pound on a declining trend," said Simon Williams, chief economist for Middle East and Africa, Central and Eastern Europe, at HSBC in London.
"My hope is that they allow volatility first so it is not a one-way bet, but then allow the currency to move down. We expect the Egyptian pound to be at nine to the dollar by mid-2016."
Egypt's economy has struggled since an uprising in 2011 drove away foreign investors and tourists, straining currency reserves which are now at $16.4 billion - enough for just three months' worth of imports. Last month's Russian plane crash is also likely to hurt the pound by cutting hard currency revenue from tourism. - Reuters
The International Monetary Fund (IMF) urged Egypt to move to a more flexible exchange system in September, following its last visit to the country, and economists predict the country could return to the kind of managed floating system that was in place before the uprising forced the central bank to take action.
Steps taken so far follow a pattern that economists say is often used by central banks seeking an orderly transition to a more flexible exchange mechanism: creating a sense that the currency can move in both directions, allowing more interbank activity, raising interest rates and easing capital controls.
Last week, Egypt's two largest state banks, Banque Misr and National Bank of Egypt (NBE) said they would provide $1.8 billion to cover import demands to get trade activity moving.
On Saturday, they raised interest rates on Egyptian pound certificates of deposit to 12.5 per cent from an average 10 per cent, aiming to encourage investors to switch from the dollar to the now more-lucrative pound.
Wednesday's action was a further step in this direction; bankers estimate the central bank injected about $1 billion into the system at the stronger rate of 7.73 to the dollar to help banks cover a quarter of the dollar overdrafts they had opened up for clients hit by the foreign currency shortage.
Mohamed El Sewedy, chairman of the Federation of Egyptian Industries, told local media that Amer, who has met bankers and industry leaders, had promised to provide $4 billion to the banking system in the coming weeks to cover import needs.
"They could be laying the ground for 1) a devaluation and 2) a shift to a more flexible exchange rate," said Jason Tuvey, Middle East analyst at Capital Economics in London.
Pre-2011 system
Amer was deputy governor at the central bank during an earlier crisis and followed a similar course of interest rate rises and currency volatility to recalibrate the pound.
Hany Genena, head of research at Pharos Securities Brokerage, remembers this period in 2003-5 well and says the latest moves are a "carbon copy" of that previous policy.
The next steps, Genena said, should be for the central bank to raise the cap on making dollar deposits from $50,000 a month or $10,000 a day, a limit that has strangled importers and forced some manufacturers to halt operations.
Like Williams, Genena expects the central bank to encourage a period of volatility, with attractive interest rates on pound deposits drawing one-time speculators to this safe haven.
He then expects the central bank to begin shepherding the pound down to a level closer to its market value - the dollar traded at 8.6 pounds on the black market on Thursday - but within a broader band, allowing greater flexibility and easing pressure on the foreign reserves.
"The key to a sustainable managed float is that the centre of the band is close to equilibrium," Genena said.
Inflation and interest rates
Bankers say such a policy carries risks. A major devaluation will raise inflationary pressure in Egypt, which relies heavily on imports of food and where millions live on the bread line.
This is not lost on President Abdel Fattah El Sisi, who cautioned when he appointed Amer that the central bank should ensure the availability of basic commodities and keep prices under control. A commodities crunch helped to raise public pressure on Sisi's predecessor before his overthrow in 2013.
Adding to evidence the central bank could be preparing for inflationary depreciation, the supplies ministry said on Monday that the state grain buyer, GASC, would begin supplying imported wheat to the private sector to help keep prices down.
Two days later, GASC issued an international tender to buy poultry, another unusual move that Genena said was part of the same drive to ensure the availability of food staples before a possible depreciation.
Many bankers say, however, that the central bank does not have enough foreign reserves to manage such a dramatic shift and could fall prey to speculators betting against the pound if it tries to maintain the new rate or otherwise sway the market.
"Politically, I don't believe Egypt is ready to float. Yes, a free float would solve our problems and the shock would be temporary and we would get over it but the economic prerequisites that are needed for a free float are not there yet," said Hany Farahat, senior economist at CI Capital. "This revaluation is an insignificant move compared to what would need to be done to prepare the economy for a free float."
Like others, Farahat said the most pressing need was for a fast devaluation, pointing out that an expected rise in US interest rates by the Federal Reserve would probably boost the dollar and put renewed downward pressure on the pound and other emerging markets currencies.
Genena said the central bank had to secure new sources of foreign reserves by early next year in tandem with any policy shift. However, this is difficult to achieve with commodities prices low, aid from the Gulf states dwindling and investors generally fleeing emerging markets.
"All these changes need to be done by the end of Q1 at the latest or you risk losing control of the process and ending up with a disorderly float as foreign reserves run out," he said. - Reuters

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