One year later, jury still out on Egypt's free float

(MENAFN- Gulf Times) A year ago today, Egypt unexpectedly allowed its currency to float freely. The decision has had mixed results and delivered a shock to the economy from which it's still adjusting. In the immediate aftermath of the move on November 3, 2016 inflation rose sharply, squeezing consumer spending. At the same time, exports and capital inflows have increased. The shock has been severe but the float has ended speculation over the peg against the dollar and shut down black market dealing in the currency.
A devaluation of the pound was inevitable given the mounting pressures on the currency - demand for foreign currency far exceeded the limited supply and restrictions by the government to limit the sale of dollars stifled the economy and stoked speculation. But a free floating of the pound was not anticipated by financial markets.
The magnitude of the subsequent move in the currency was also unexpected. The pound was widely forecast to depreciate by 25%-30%, but ended up losing half its value against the dollar and has not recovered since, barring a brief false dawn in the first quarter.
The economic implications of the move were significant. Inflation spiked as the price of imported goods rose and continued to accelerate as the full impact of the free-floating pound fed through to domestic prices. Inflation has moderated gradually recently but remains in excess of 30%. It should decline further as the currency effects drop out of year-on-year calculations. Still, the time it takes for import costs to pass through to the rest of the basket means inflation will probably stay elevated for few more quarters.
Consumers were squeezed by the currency depreciation which, along with subsidy cuts and the introduction of a value-added-tax, reduced their disposable income and therefore spending power.
But while private consumption took a hit, currency depreciation improved Egypt's outward-facing sectors. Exports have increased significantly, partly due to a pick-up in tourism. The number of tourists arriving in Egypt has risen since the currency flotation although it remains below levels seen before a terrorist attack in October 2015 downed a Metrojet flight returning from Egypt to St Petersburg. In addition, visitors are staying longer than they used to with the country proving an attractive and relatively cheap holiday destination the average number of nights per tourist has almost doubled reaching 11.3 nights in July 2017 compared with 5.8 in July 2016.
The improvement in exports has helped reduce the current account deficit, which also benefited from a recovery in remittances from Egyptians working abroad. These temporarily dipped in the third quarter of 2016 as workers withheld their transfers in anticipation of a decline in the value of the pound.
The most notable improvement has manifested itself in portfolio flows into Egypt's financial assets. The country saw net inflows of about $8bn in each of the first two quarters of this year compared with an outflow of $800mn in the third quarter of 2016.
Three factors contributed to this. First, currency devaluation made Egyptian equities cheap in dollar terms, which encouraged investment in local equities. Second, Egypt was able to successfully issue international debt with investors reassured by support from the IMF and the removal of foreign currency restrictions. Third, large amount of foreign capital has found its way into domestic Treasury bills as investors sought to benefit from the sizeable interest rate differential between Egypt and the US. This carry trade became particularly attractive after the central bank hiked rates by 500 basis points since the currency flotation to combat high inflation.
A smaller current account deficit and bigger portfolio inflows have resulted in a build-up of international reserves. Net reserves rose to $36.5bn in September 2017 from a low of $15.5bn in July 2016. This could help cushion the impact of any potential reversal of investor sentiment.
Struggling domestic consumption coupled with a better external sector have resulted in weak but improving economic activity. The Emirates NBD Egypt PMI, a survey of non-oil private businesses, continues to score below 50 suggesting the economy is contracting.
Overall, the signals remain mixed on the economic impact of the flotation and subsequent depreciation of the currency. But authorities had little choice in the matter. The shortage of foreign currency and the capital controls imposed to ration its distribution had suffocated the economy. Speculators were circling in anticipation of another round of devaluations and the dollar price in the parallel market differed wildly from the government target. Scant foreign exchange reserves also meant that the authorities had little ammunition to protect a new level for the peg if it came under attack.
The decision to float the currency, rather than manage it lower, may or may not have been the right one. However, policymakers had few options.

A man counts Egyptian pound notes outside a bank in Cairo. The currency was widely forecast to depreciate by 25%-30% after the float, but ended up losing half its value against the dollar and has notrecovered since.


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