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The ups and downs of Egypt’s interest rates: What does the central bank want?

The Central Bank of Egypt’s Monetary Policy Committee will meet later today to decide whether to cut interests rates for the second time since January 2015.  The 1 percent drop the committee instituted last month had long been anticipated, as interest rates have climbed by 7 percentage points since the decision to float the country’s currency in November 2016.

The Central Bank of Egypt (CBE) has hued close to the same rhetoric since the float, pegging the ups and downs of interest rates to Egypt’s soaring inflation. The surprising 3 percentage-point hike in July 2017 was accompanied by the bank’s assertion that the move aimed to curb the soaring inflation, which had climbed to an annual rate of nearly 35 percent following the slash in fuel subsidies and currency devaluations that accompanied the structural adjustment deal with the International Monetary Fund (IMF).

From that July policy meeting until last month, the overnight deposit rate has held at 18.75 percent and the overnight lending rate at 19.75 percent. Despite the gestures toward curbing inflation, many economists asserted that the high interest rates were ineffective in lowering inflation, adding that they had led to a decrease in investment amid Egypt’s financial recession.

Economists have pointed to several indicators to argue that there will be a gradual decrease in interest rates. Indeed, this is the prevailing expectation for Thursday’s committee meeting, with Pharos Securities Brokerage and HC Securities investment bank forecasting a 1 percent drop, citing continually decreasing inflation rates, with annual urban inflation falling to 14.4 percent in February, compared to 17.1 in January, a significant drop from the 35 percent it had reached in July 2017. The expectation for a 1 percent cut is shared by many economists.

Seemingly past the peak of Egypt’s interest rate saga, there is room to reflect on the CBE’s policy choices: What principles have been guiding monetary policy since the currency flotation? Did the CBE’s decisions achieve their stated goals? And where will Egypt’s monetary policy go from here on out?

Confronting foreign currency scarcity: Linking dollars to inflation

In addressing the period of high interest rates, the underlying logic for the policy diverges depending on whom you listen to. There are the central bank’s repeated claims to have raised interest rates to ease demand-pull inflation by siphoning money into banks with the lure of high interest rates — a fundamental central banking tactic.

But economists argue that the increases were in fact meant to ease pressure on foreign currency supplies and attract portfolio investments to shore up hemorrhaging currency reserves. It is a task, they say, the central bank succeeded in.

Much of the backstory supports this second account. By November 2016, Egypt was facing a severe lack in the availability of foreign currency, resulting in consecutive spikes in the price of the US dollar on the black market. The decision to liberalize the currency exchange rate aimed to eliminate the black market and close the widening gap between the official price and the informal market. With the November float decision, the trading price of the US dollar increased from LE8.88, which had been the pegged official rate, to a peak market price of LE20, before settling at between LE17 and 18.

On the same day as the float, the central bank moved to increase interest rates by 3 percentage points, to bring overnight deposit and borrowing rates to 14.75 percent and 15.75 percent respectively. In explaining the decision, the central bank said that the aim of increasing foreign reserves and lowering inflation had made “constraining financial circumstances” inevitable.

Omar al-Shenety, the managing director at the Cairo and Dubai-based investment bank Multiples Group, tells Mada Masr that the central bank’s aims in the hikes were twofold: First, it wanted to encourage savings in the formal banking sector, with the interest rates serving as incentives for people to place their money in banks using local currency, as opposed to converting it to a foreign currency – what is called “dollarization.” This incentive, in the bank’s logic, would have eased pressure on the supply of hard currency, at a time when the bank was trying to increase its foreign currency reserves.

The second aim, according to Shenety, was to attract portfolio investments: foreign investments in government bonds or local stocks. High interest rates encourage these types of investments due to their high return for investors.

Indeed, foreign investments in the government’s debt portfolio reached a record high in November 2017, coming in at LE19 billion.

While the central bank did not cite either of the reasons provided by Shenety — sufficing only to say it was targeting inflation — both factors are closely tied to inflation.

For Shenety, the bank’s silence on these aims is expected. “It is not common practice for central banks to speak about attracting investments or limiting the purchase of foreign currencies. But their aims often include this, or at least, they understand it will happen and make considerations for its consequences,” he says.

“The central bank was facing a currency meltdown, so stopping the decline was its first priority, and raising the price of interest rates was one of its tools of doing so,” Shenety adds.

That the hike in interest rates was accompanied by the issuance of certificates from public banks, such as the National Bank of Egypt and Banque Misr, with yields of 16 percent and 20 percent, tied a significant amount of local currency to certificates rather than seeing local currency exchanged for dollars, in Shenety’s estimation.

Noaman Khaled, an economic analyst at CI Capital investment bank, agrees with Shenety.

“The central bank was focused primarily on the dollar crisis,” he says. “Its monetary policy was geared toward preventing the crisis from escalating further.” As of February, high interest government certificates had attracted around LE800 billion since they were launched after the pound’s flotation, according to Khaled.

Executives at the National Bank of Egypt, Banque Misr and Banque du Caire, told the privately owned Masrawy website that the two deposit certificates with high interest rates (16 and 20 percent) had attracted over LE784 billion, 14 months from the date of their issuance.

Amr Adly, a political economy researcher at the European University Institute, adds that the way interest rates interacted with inflation in Egypt since November 2016 diverged from traditional economic theory, where a central bank uses interest rates to draw liquidity from the market through raising the cost of borrowing and incentivizing saving. Monetary policy, he says, has been used to limit the purchase of foreign currency, as the instability of the dollar was one of the biggest reasons for inflation.

The reality of Egypt’s political economy, according to Adly, means that any disturbance in the foreign currency market is directly reflected in prices on the market, as Egypt is overly dependent on imports, whether for consumption or for manufacturing. About 40 percent of raw materials and intermediate goods are imported in his estimation.

Inflation, Adly argues, has become linked to the stability of the foreign exchange market and he believes the central bank knows that supply-side factors are the primary reason behind the high inflation, not increased demand, which has been the CBE’s official line of argument.

Economists previously criticized the interest rate hikes, arguing that inflation was being driven by supply-side factors, namely the increasing price of foreign currency, which had led to increases in the prices of goods, goods that were either directly imported or had components that were coming in from abroad.

That Egypt is beholden to imports is why Adly thinks the prevention of peaks and valleys in the pound’s value on the exchange market became the main goal of the central bank’s monetary policy after the devaluation.

All economists Mada Masr spoke to agree that the central bank succeeded in using interest rates as a tool to limit an increasing demand for foreign currency and shoring-up foreign currency reserves after their significant dip before the float. However, some see that this end was achieved with the initial interest rate hike immediately accompanying the float, criticizing the subsequent increases.

Too much?

The interest rates hike accompanying the float was not controversial. “When they raised the first 3 percent, we saw it coming,” Shenety says. “Then came the second increase of 2 percent in May, which was subject to some controversy. But the final 2 percent raise in July was incomprehensible.”

The CBE raised interest rates in tandem with the decision to float the pound in November 2016 by 3 percentage points, which brought overnight deposit rates to 14.75 percent overnight lending rates to 15.75 percent. This was followed by another increase in May 2016, pushing rates up by another 2 percentage points. In the central bank’s estimation, inflation was still high enough to warrant further hikes.

The central bank raised interest rates by another 2 percent for a final time on July 6, 2017, bringing the overnight deposit rate to 18.75 percent and the overnight lending rate to 19.75 percent. It justified the increase by saying that, despite a decrease in annual inflation at the time, inflation continued to “increase beyond the target set by the Central Bank of Egypt, which led to the committee to take this decision.”

The actions of the central bank at the time were consistent with how it views monetary policy, according to Shenety, who says that the CBE operates with a money-supply theory of inflation. In this line of thinking, a central bank draws liquidity from the market by holding out attractive interest rates, which leads to fewer goods and services being bought, easing pressure on demand, which in turn prevents prices from increasing.

However, Shenety emphasizes that an eye on supply shocks as a causal framework explains inflation in Egypt at the time. The increase in companies’ running costs due to the float, he says, led to an increase in prices. This was not caused by a spike in demand due to the availability of money in the market, as the first theory would hold.

The central bank acknowledged supply pressures as a reason for inflation in a statement in February 2017, writing that “the increase in inflation levels in the period between November 2016 and January 2017 goes back to supply factors, exemplified by an increase in the price of traded commodities which was affected by economic reform measures.” For Shenety however, supply-side inflation does not require interest rate hikes.

He points to the example of former head of the US Federal Reserve Ben Bernanke’s decision to not raise interest rates, despite the inflationary effects of the significant increase in oil prices in 2008. The cause of inflation in the US at the time was a supply shock, meaning that the factor behind it was a change in the price of supplied commodities, rather than an increase in demand, according to Shenety.

Mohamed Abu Basha, a macroeconomic analyst at EFG Hermes, says that the monetary policy followed in the past year is fitting with the nature of the crisis in Egypt.

“The central bank did not make the last 4 percentage-point hikes to fight the effects of the pound’s devaluation and the increase in the value-added tax and fuel prices. These were one-off effects which were dealt with primarily in the first increase of interest rates,” Abu Basha says.

Instead, he argues that the central bank was targeting future inflationary pressures caused by an increase in growth rate and a decrease in the unemployment rate, where growth and employment create greater demand in the economy, leading to an increase in prices.

Abu Basha thinks the decision came as a result of a new monetary policy framework, which the central bank adopted for the first time in its history. Under this framework, the CBE became an inflation-targeting central bank, meaning it had joined the category of central banks that set specific inflation level targets for specific periods of time. It was this that led the bank to increase interest rates to 19.75 percent to achieve its target.

Shenety and Khaled think it is probable that the last interest rate increase occurred as a result of IMF pressure, after the fund was surprised by the significant decrease in the pound’s value and the steep inflation levels post November 2016. As a result, the IMF pushed the central bank to use any tools available to control increases in prices, even if with limited effect, according to this account.

While Khaled thinks that the 4 percentage-point increase after the November 2016 initial interest rate hike was perhaps ineffective in curbing inflation, it was not harmful. He says that the increase was not reflected in interest rates in commercial banks, where interest rates remained lower than the price set by the central bank as a standard in the banking sector as a whole.

“After raising interest rates initially by 3 percent, demand for bank loans decreased to a point where demand did not follow the central bank’s subsequent increases, because the first had achieved the desired effect,” Khaled says. In his eyes, then, the effect of the July increase on the economy was minor.

Shenety, however, stresses that while there has been GDP growth over the past year, which surpassed 5 percent in H1 2017/18, most of it was achieved through state spending, and private sector growth has suffered due to the unaffordable cost of borrowing.

More harmful, in Shenety’s opinion, is the rising cost of domestic government debt, which reached LE3.16 trillion by June 2017, compared to LE2.62 trillion a year before, a 20 percent increase. The economist believes the government will have to allocate funds to service this debt in future budgets, at the expense of other more productive expenditure.

More interest rate cuts on the horizon?

The economists Mada Masr spoke to expect that the decrease in interest rate that began in mid-February will continue over the next three years.

Abu Basha predicts that the decline will reach 3 or 4 percent over the course of 2018, and that the 7 percentage point increase will be erased by 2019. Shenety expects the decline to happen over three years, with a 3 percent cut in the current year, followed by 4 percent over the coming two years.

Khaled also expects that the central bank will decrease interest rates in the range of another 1.5 to 2 percentage points by the end of the current year. After that, he forecasts there will be another 2 percentage point cut per year, until it reaches pre-float levels. In the best case scenario, he says that the central bank may erase the 7 percentage points buildup in two years, if influxes of US dollars continue.

Khaled notes interest rate cuts always occurs slower than hikes, as increases are “shock therapy” designed for economic crises, which is what he says happened in Egypt in 2016, when the central bank raised interest rates to draw out liquidity in advance of inflation. But in lowering interest rates, the central bank aims to test the reaction of markets, checks to see to what degree their activity will increase and studies the effect of that on the economy and prices before ladling out more cuts.

Abu Basha asserts that the ongoing effects of inflation as a result of plans to lower subsidies and expected increases in growth rate require a gradual decrease in interest rates. He says that the central bank will try balancing between its aim to lower inflation to less than 10 percent by 2019 and not affecting growth plans.

Abu Basha is optimistic about Egypt’s economy, saying that it will be less affected by crises, such as the one Egypt went through in the last two years. He points to structural factors as preventing recurrent crises, including the fact that the state is moving toward lowering government expenditure. A large portion of government spending went to civil servants salaries and translated into increased purchasing power without a counterbalancing increase in productivity, which has lead to inflation in the past.

In addition, Abu Basha says that the liberalization of the exchange rate brought the valuation of the currency in accord with its real price. This should encourage imports at the expense of exports, he argues, because it boosts the ability of foreign traders to buy Egyptian goods and services at a lower relative price.

However, Adly stresses that Egypt’s potential to transform into an exporting country and to escape the vicious cycle caused by over-dependence on imports would not take place through the current economic policies.

Adly says that monetary policy has a limited effect on economic policy. The state cannot use monetary policy to create the necessary technological and industrial base to escape its vulnerability to exchange rate fluctuations, according to Adly. He insists that such changes require structural transformations achievable via coordination between public institutions and the private sector.

Without this, in Adly’s opinion, the economy will remain subject to the crises which led to Egypt seeking out the IMF time and time again. He emphasizes that the current economic policies, even if the state changes its monetary policy and gets its finances in order, “depend mainly on sources of foreign currency, such as the Suez Canal, remittances by Egyptians abroad and tourism. This will not protect it from consecutive crises, as has been made clear in the examples of past crises, such as depletion of foreign currency reserves, instability of the exchange rate and the need to seek loans from abroad.”

Osman El Sharnoubi