The year's hot potato

Will the devaluation of the pound continue to cast its shadow during the new year? asks Aziza Sami
Over the past 12 months, the "exchange rate issue" has imposed itself as the Egyptian economy's most pressing problem. Devalued by 30 per cent during the year, the pound is now worth LE4.50 against the dollar according to the official rate, and LE5 on the black market. The prospects of further devaluation at a time when the country's sources of hard currency are flagging and the trade deficit stands at approximately $12 billion, have brought to the fore the problems of poor productivity and limited investment in industry.
The declining value of the pound also raises questions as to why Egypt's structural adjustment programme with the International Monetary Fund (IMF) has not been extended to the finance sector. The liberalisation of the finance sector would provide both the Central Bank of Egypt (CBE) and banks with a wide range of monetary instruments needed to activate the market. Concerns were expressed during the past year by several international financial agencies over the CBE's resort to administrative measures to maintain the exchange rate at artificial levels. International financial agencies also questioned the country's artificially high interest rates and characterised the management of the CBE as inconsistent and lacking transparency. And in spite of the changes to the exchange rate, they noted that no thoroughgoing modifications were made to the exchange rate regime.
The CBE's lack of autonomy in supervising banks and making decisions about the exchange rate ultimately led to the end of the tenure of its governor Ismail Hassan. When his successor Mahmoud tried to curb the imports, recommending that banks suspend for three months the use of documentary collections as a means of paying for imports, the market came to a virtual standstill. The documentary collection system allowed importers to conduct their foreign transactions without obtaining letters of credit requiring advance payment in cash, often obtained through high-interest credit.
That the CBE recommended the suspension of documentary collection without taking account of its impact on an industrial sector heavily dependent on intermediate and capital imports raised serious doubts about its decision-making processes. Consequently, the move was a blow to the investment climate, already undermined by a market in the throes of a recession made worse by the fallout from the 11 September attacks on the US. The unpredictable exchange rate -- another factor weakening investor confidence -- shot up to LE5 on the black market in the wake of CBE's recommendation.
The downward pull on the pound had long been clear by May 2000 when the government abandoned a nine-year peg stabilising the pound at approximately LE3.40 against the dollar. Egypt had sustained serious blows to its foreign currency revenues in the past four years with the 1997 attacks in Luxor, plummeting oil prices in 1998 and a discernible decline in expatriate remittances.
Foreign currency reserves have fallen from $20 billion in 1997 to a little more than $13 billion at present, excluding an additional LE1.5 billion in revenue from Egypt's debut eurobond issue in July 2001.
During 2001, the decline in Egypt's economic growth became impossible to deny. The tying up of billions of pounds in mega-projects and real estate during the last three years precipitated the crisis as contractors found they were unable to sell properties and saw their debts mount. Banks, in turn, became tight-fisted. As the recession in the international economy became clear in the first quarter of 2001, Egypt's economic crisis manifested itself in a virtual economic standstill. This stagnation was exacerbated by limited foreign direct investment and capital inflows, a decline in portfolio investment, a liquidity shortfall and increased state expenditures.
Against this backdrop, the CBE devalued the pound three times during the year. In January 2001, in response to market pressures, the bank introduced a new exchange rate mechanism under which the rate was permitted to fluctuate one and a half per cent above or below a central rate. The central rate was assessed every three weeks and readjusted according to the weighted average of transactions at exchange bureaus and banks. Accordingly, in January, the pound slumped to a ten-year-low against the dollar, settling at LE3.85, down from LE3.4 in May 2000. But even then, the pound was still deemed overvalued. Some observers recommended that a margin of fluctuation ranging between five and 10 per cent would allow the pound to settle at its real value. By June 2001, international financial organisations were saying that the official rate for the pound was at least 15 per cent higher than the market value.
In early August, the CBE widened the margin of fluctuation to three per cent above or below the central rate, and the pound fell to LE3.9 against the dollar, down from LE3.85 in January. Days before the move, Standard and Poor's had lowered its rating for the pound to "bbb negative" citing, amongst other factors, an inflexible exchange rate regime, and remarking that LE3.89 was not a market clearing rate compared with the parallel unofficial market rate of more than LE4.
During the second half of December, the CBE made its third and final change of the year to the central rate, setting it at LE4.50 against the dollar, up from LE4.15 in August. Currently, the dollar officially costs between LE4.365 and LE4.635, but the CBE has said that it may modify the rate again in accordance with its ongoing review of market conditions.
In the second half of 2001, the government had pinned hopes on an improved performance by traditional foreign currency earners, based on the prospects of rising oil prices and an increase in tourist numbers during the winter. The hopes, however, were dashed by the events of 11 September, estimated to have caused some $2.5 billion in losses to the Egyptian economy, and reducing the inflow of foreign currency to a trickle.
In a step aimed at supporting the exchange rate and the banking sector, the government is entering into agreements with the IMF and various international and Arab funds. The CBE will also inject a sum of $1.5 billion dollars into the market over the next six months at a rate of $250 million each month.
At the end of December, the CBE governor announced a "new policy" of import rationalisation, restricting only "luxury" items, and allowing foreign currency for the import of intermediate and capital goods. But due to domestic industry's considerable dependence on imports, the policy is unlikely to significantly reduce Egypt's import bill.
Given the size of Egypt's foreign reserves and the spectre of their progressive depletion, the need to activate the domestic economy using a wide range of economic and monetary policies has become all the more pressing. Further liberalisation of monetary policy is recommended in addition to a greater flexibility in interest rates. The CBE has yet to respond to calls for reducing interest rates on loans, given the negligible impact of its reduction of the discount rates in April.
The CBE had cut its key discount rate twice during the past 12 months with the aim of stimulating the stagnant economy and activating demand by making credit available at attractive terms. On 12 April, it cut lending and discount rates by one half of a percentage point from 12 to 11.5 per cent, and then on 26 April to 11 per cent. The discount rate is that at which the CBE lends money to commercial banks. Lowering the rate leads to a reduction in inter-bank rates and in credit lending rates, thus increasing market liquidity. However, the impact of the rate reduction was negligible because of the market recession and the fact that the 12 per cent rate had been in force for 28 months.
Moreover, banks were still facing problems collecting on their loans. They were funding long-term projects to the detriment of medium- term ones and had been pressured into financing projects without adequate feasibility assessments.
The over-extension of credit by some public sector banks, due to administrative mismanagement or corruption, showed that the sector was in need of reform.
The March 2001 announcement by Prime Minister Atef Ebeid that several banks would be merged as a step aimed at "countering global competition," addressed the smaller public sector banks, not the four major banks. Since the public outcry following the announcements, there has been little talk of privatisation.
Standard and Poor's, citing the lack of controls on the state's capital expenditures, had reduced its rating for both long- and short-term local debt because of the increase in net local domestic debt to 54 per cent of GDP in fiscal year 2000- 2001 compared to 49 per cent of GDP in 1997- 98.
In April, Standard and Poor's reaffirmed its long-term currency rating for Egypt at "bbb" with a negative outlook, but it cautioned that it would lower this unless the government met its fiscal deficit target, increased the pace of structural reforms and enhanced the credibility of the exchange regime.
As the economy continued to sink into recession and it became impossible to deny that the private sector was not creating new jobs, the government announced what Minister of Finance Medhat Hassanein described at the beginning of fiscal year 2001-2002 during the summer as "the largest ever budget in [Egypt's] history" with a public expenditure of LE127 billion -- LE12.6 billion larger than the previous year. With LE106 billion in funds available, Hassanein announced that the gap would be filled by taxation and fees for services.
The implementation of the second and third phases of the sales tax this summer put another damper on economic activity and further reduced overall demand. With a new taxation law due to be presented in the new year, businesses are calling for greater consistency in the provision of tax exemptions and the extension of incentives for export-oriented projects. The government has yet to make good on its promise to reduce income taxes and crack down on tax evasion.
Investors are continuing to call for the cancellation of the sales tax on capital goods and a reduction in the prices of land in the newly established communities -- currently a lucrative source of revenue for the state. Projects that offer returns in the medium term and create jobs need to be given a priority in the offering of incentives. In the meantime, reining in government expenditures while sustaining a budget deficit that will allow for a degree of inflation are pivotal to countering the current recession. To stimulate investment, the volume of savings needs to be raised from the current meagre 13 to 17 per cent of GDP to at least 25 per cent.
In an attempt to restore dynamism to the economy by increasing exports, President Hosni Mubarak in November decided to transform the Ministry of Economy to focus exclusively on external trade. Several economists are now calling for a new structural reform programme in conjunction with the IMF, while the CBE is considering pegging the pound to a basket of currencies.
However, it has become clear that the solution lies not only in increasing commodity exports, or stabilising the exchange rate as an end in itself, but in stimulating the entire economy. This goal requires reforming state entities that promote investment and which have not, for the most part, shaken off their "socialist" roots. The changed economy requires the privatisation and restructuring of financial institutions. In the meantime, convoluted customs and tax procedures, the prevalence of bribery and lack of transparency in the entire system are major concerns for both local and foreign investors.
The failure of government policy to create an investment-friendly climate has led, in fact, to the realisation that without political and constitutional reform economic reform will not bear fruit.
Selling the pound at its market value would place a burden on businesses, yet deferring this measure would only bring the economy to a complete standstill. The long- term sustainability of the exchange rate can only be ensured when the gap between supply and demand is permanently redressed by balancing the country's current account. Egypt's substantial trade deficit -- its exports are a quarter of the value of its imports -- is expected to continue unabated in the coming phase.
This situation highlights the economy's chronic malaise: the industrial base is still heavily dependent on imports. Intermediate and capital goods equivalent to more than 50 per cent of production output and industry is still directed at the domestic rather than the global market.
Without a long-term industrial strategy and under the current taxation and customs regimes, Egyptian goods will continue to be at a disadvantage compared to foreign goods.
What is required of the government, then, is to support production with monetary and fiscal policies and to step up its promotion of both domestic and foreign investment.
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