Thursday 09, August 2018 by Banker Middle East

The price of rebellion


The IMF insists that the pain of short-term austerity will be worth it for long-term prosperity—Egyptians may not agree.

Hosni Mubarak left Egypt a complicated legacy. While he is credited with reforms that spurred economic growth to highs of eight per cent, by keeping the spoils to himself he sparked a costly revolution and left financial carnage in his wake. Following his ousting, annual growth declined to 3.1 per cent in 2011-16 from an average of 6.2 per cent in 2005-10.  In late 2016, waning foreign aid and diminishing reserves saw Egypt run cap in hand to the IMF. The result was a three-year, $12 billion loan programme that came with stringent conditions.

To secure the deal, Egypt was forced to float its currency, introduce new taxes and slash energy subsidies—all of which sent inflation galloping above 30 per cent for most of 2017, a high that had not been seen in a generation.  Egypt’s people have borne the cost of austerity, enduring endless price rises and punishing tax increases. However, the IMF says that while it may be a bitter pill to swallow, the tough economic reforms are for the greater good.  

Almost half way through the term of the loan, the reforms have started to pay off for Egypt’s long-suffering population. Since the currency float, foreign investment in Egypt’s high interest treasury bills has rocketed, plugging holes in the Central Bank’s reserves.  Growth now stands at the highest rate since 2008, inflation has been beaten back, foreign exchange reserves are at record levels, exports are growing, and unemployment has declined.  Fitch Ratings and S&P both upgraded their outlooks on Egypt to Stable earlier this year, and the country has been enjoying some positive press. Heritage Foundation’s 2018 Index of Economic Freedom advertised the fact that Egypt’s economic freedom has increased, and Harvard University’s Centre for International Development ranked Egypt as the third-fastest growing economy in the world.  

“Egypt has begun to reap the benefits of its ambitious and politically difficult economic reform programme,” said Subir Lall, Assistant Director in the European Department of the International Monetary Fund. “While the process has required sacrifices in the short-term, the reforms were critical to stabilise the economy and lay the foundation for strong and sustained growth that will improve living standards for all Egyptians.”  

While the end result sounds promising, rehabilitating Egypt’s economy will be far from easy. The IMF’s plan to modernise the economy includes steps to support exports and reduce non-tariff barriers; support small and medium enterprises; strengthen public procurement; improve transparency and accountability of state-owned enterprises; and tackle corruption.  The reforms have been designed to attract vital private investment. High rates and the reform programme have already attracted a surge of foreign participation in the local debt market, according to Fitch Ratings.  

Egypt’s improved macro stability coaxed the Central Bank into cutting rates for the first time since the 2011 revolution. In February, the Central Bank of Egypt (CBE) cut its overnight deposit and lending rates by 100 basis points (bps) to 17.75 per cent and 18.75 per cent, respectively.  Its main operation and discount rates were also cut by 100 bps, to 18.25 per cent. The CBE had increased rates by 700 bps since devaluing the Egyptian pound in November 2016.  Interest rates on domestic government debt started to fall before February’s rate cut, with the 91-day T bill rate 450 bps lower than its July peak and the one-year T bill rate close to its pre-devaluation rate of around 16.5 per cent.  

“With rates falling, we think the CBE will be mindful of the risk of some outflows, even though its stock of FX reserves has risen to $38 billion and it has other reserve assets linked to its portfolio repatriation scheme,” the rating agency said.  Much to the relief of Egypt’s population, annual headline inflation dropped to 13 per cent in April, down from its July peak of 33.0 per cent. Food price inflation declined sharply from more than 40 per cent to 16.6 per cent, according to data from Fitch Ratings.  “The CBE remains committed to reducing inflation to single digits over the medium term, with monetary policy underpinned by a flexible exchange rate regime that is critical for maintaining competitiveness and adjusting to external shocks,” Lall said. 

Inflation is expected to gradually decline to an average of 15 per cent in 2018/19— within the Central Bank’s 10-16 per cent target range, according to Bloomberg. This is due to the expected drop-out of exchange rate depreciations and the introduction of value-added tax from year-on-year calculations in 2018/19.  As inflation moderates, the Central Bank should unwind some of its monetary tightening. Bloomberg Economics forecasts rates will be reduced by 400-500 bps over the course of 2018. This should boost further growth and tease out more investment.  

“We think inflation will fall further this year but remain in double digits, averaging around 13 per cent,” said Fitch in a statement. “This assumes that further subsidy reform in July leads to energy price increases, especially given higher oil prices. Even so, we expect the CBE to cut rates further this year—another 200- 300bps—even as global rates rise, while maintaining positive real interest rates.  Since exchange rate reform, the CBE has set out to control inflation expectations. In delivering the rate cut, it said that it would “not hesitate to adjust its stance to achieve its mandate of price stability over the medium term.”  

The IMF seems impressed with the Egyptian Government’s progress, as reserves have risen, and the current account deficit has started to narrow. It cheerfully noted that Egypt is on track to achieve a primary budget surplus excluding interest payments in 2017/18, with government debt as a share of GDP expected to decline for the first time in a decade. The budget for 2018/19 targets a primary surplus of two per cent of GDP, which would keep public debt on a firmly downward path.  Exchange rate reform has proved a turning point for Egypt’s external finances and the economy, with a growth of around five per cent in the first half of the current fiscal year, notwithstanding the tight monetary and fiscal stance.  

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