The Egyptian pound has declined by 5.46 percent against the dollar since January 18, reflecting a clear shift in the Central Bank’s policy to keep the rate relatively stable against all odds over the past eight months.
Starting January 18, the pound began to fall from LE7.14 to the dollar, dropping to LE7.19, and subsequently falling at each Central Bank auction to reach LE7.53 on Monday. At each sale, the pound reached record lows until Wednesday, when for the first time in 18 days, the exchange rate held steady at LE7.53.
The Central Bank, which controls the official exchange rate via its dollar auctions, has clearly been allowing the value of the pound to fall, after three years of burning through its foreign reserves to prop the currency.
A policy introduced January 29 that allows local banks to sell their dollars at 10 piasters more than the official interbank rate, has de facto pushed the official retail exchange rate to LE 7.63.
Although some observers have speculated that the pound will decline to LE8 ahead of the economic summit planned for March, it is unclear how much lower the pound will be allowed to fall, particularly after rates held steady Wednesday. According to Reuters, Central Bank Governor Hisham Ramez said Monday that the black market “will end soon,” suggesting that official rates might converge with black market rates, which have fluctuated between LE7.75 and LE7.93 to the dollar since the devaluation began.
Although the devaluation has made ordinary Egyptians nervous, it has been well received by economists and investors, who have long believed the pound is over valued. On Wednesday, Egypt’s stock market closed at a six-year high of 10,045.9 points, driven largely by positive sentiment from foreign investors.
For the previous eight months, from May to January, the value of the pound was held steady at 7.14 to the dollar. While the CBE has not released an official explanation for this significant shift in policy, it comes as no surprise to analysts.
“It was always a question of when rather than if,” says Mohamed Abu Basha, an economist at EFG-Hermes, referring to the devaluation.
Throughout the summer and fall, while the Central Bank continued to offer a limited amount of dollars at LE7.14, many businesses were forced to turn to unofficial channels to buy the dollars needed to participate in the global economy.
Hany Genena, head of research at Pharos Securities Brokerage, estimates that virtually all of the companies listed on Egypt’s stock exchange were relying on the black market for 50 to 70 percent of their currency needs.
As months went by and the pound held steady even as global economic trends changed, businesses reliance on the black, or “parallel,” currency market became even more pronounced. By November and December, Genena says, companies were relying almost entirely on the parallel market to exchange pounds for dollars.
In the meantime, the gap between the official and black market exchange rates grew from 3-4 percent in mid-October to 8-9 percent by the end of the year.
Some of that gap can be attributed to speculation by currency traders. In November, for example, the black market rate went up when Egypt made a US$2.5 billion repayment to Qatar with expectations of pressure on the country’s foreign reserves as a result, notes Abu Basha.
For the most part, though, business people and economists seem to agree that the gap between the official and black market rate exchange rate was not driven primarily by speculation among currency rates. Instead, the official rate was simply unrealistic.
Apart from a few movements due to political and economic news, the black market held relatively steady. “This suggests equilibrium versus speculation,” says Genena.
If, as economists say, the CBE intended to get rid of the black market by bringing the official and unofficial exchange rates closer together, the early signs are mixed.
When the pound started to weaken, the black market exchange rate initially shot up close to LE7.93 to the dollar, says Abu Basha. Then, it dropped to LE7.75 per dollar, but was back to LE7.90 by mid-week.
Along with a growing currency black market, Egypt’s declining foreign reserves put pressure on the Central Bank to stop propping up the pound.
When the Central Bank holds foreign currency auctions aimed at holding the pound steady, it is effectively selling off its dollar reserves at an artificially low price. With traditional sources of foreign currency like tourism and investment still far below pre-revolution levels, Egypt was not bringing in enough currency to prop up the pound and pay to import key commodities like wheat and oil.
Even the largesse of supportive governments in the Arab Gulf was not enough to keep reserves up. After former President Mohamed Morsi was removed from power, aid from Gulf countries brought Egypt’s reserves to $18.9 billion by the end of August 2013, and donations of cash and commodities continued to flow into the country.
By the end of December 2014, reserves stood at just $15.3 billion, near critical level.
“Those reserves had influx of almost $20 billion. It should have been used cautiously, instead of trying to maintain an exchange rate for the Egyptian pound that was not reflective of reality,” says Mohamed Farid, chairman and CEO of Dcode Economic and Financial Consulting.
The gap between official and black market rates was also putting off investors. “As an investor, you don’t want to come into a country that has two exchange rates,” says Abu Basha.
Push and pull factors
Declining reserves and a growing black market put pressure on the Central Bank to devalue the pound, but the decision was also helped along by positive factors.
One of the primary downsides of devaluation is that each pound buys less on the global market. Egypt imports much of its food and energy, so a weak exchange rate can drive up prices for consumers at a time when many are already struggling to cope with the cost of living.
Despite cuts to energy subsidies in July, the average rate inflation for the last half of 2014 was slightly lower than in 2013, although still high by international standards at 10.8 percent, Farid says.
A drop in global commodity prices, especially for oil, has helped keep inflation levels from spiking. Although the long term impacts of lower oil prices will likely be mixed—in no small part due to Egypt’s reliance on aid from oil producing states—the timing of the price drop helped keep inflation down, and should help limit the pain of the pound’s lower purchasing power.
Some inflationary pressures are likely to arise, says Abu Basha, mainly because the local market views the dollar exchange rate as an indicator of inflation. But this can be partially offset by other factors.
When oil prices stood at US$100 per barrel and the pound was LE7 to the dollar, it cost Egypt LE700 per barrel to import, Genena points out. Now oil is closer to $50 per dollar. Even if the pound drops to LE8 to the dollar, Egypt would still only have to pay LE400 per barrel.
Local businesses’ dependence on the black market should also minimize the inflationary impact of the official devaluation. “Already, prices in the market are based on the parallel rate,” says Genena.
Another factor that can work in Egypt’s favor is the strength of the dollar. “The US dollar has been strengthening against all other G7 currencies,” adds Genena.
From May to January, while the pound was pegged to the dollar, it rose against global currencies like the euro, and the European Union is Egypt’s number one trading partner.
Even with a market price of LE8.73 to the euro on Wednesday, the pound is still worth more in euros now than it was on May 18, when it stood at around LE9.72 to the euro.
Politics of the pound
Some of the reasoning for devaluing the pound now may be simply political.
“Maybe the Central Bank wanted to do it a long time ago, but failed to because of political pressure,” says Genena.
A tendency to view the dollar exchange rate as a key indicator of fiscal health makes any fluctuation highly sensitive, and can spark negative popular sentiment.
With parliamentary elections due in the spring, the CBE could have made a strong argument for devaluing the pound during the current period of relative political quiet.
The economic summit planned for March, in which Egypt plans to offer $20 billion worth of projects to global investors, has also put pressure on the government to get its fiscal house in order.
“Of course, every investor, every economist had his view that the LE7.14 to the dollar was not reflective of economic fundamentals,” says Farid.
So far, the decision to allow the pound to devalue seems to be well received by foreign investors. Genena, who recently returned from Frankfurt, Germany, says the overall sentiment in meetings is that lowering the pound was a late but “extremely positive” step.
Since the pound dropped, he adds, foreigners have been net investors in Egypt’s stock market.
The long-term success of the devaluation will depend on whether lowering the price of the pound succeeds in attracting more foreign currency into the country.
“If more capital is not attracted, tourism doesn’t recover further, it might be only a short-term measure,” says Abu Basha.