What Does The Egyptian Pound’s Devaluation Mean?

After months of economic standstill and a slow brewing forex crisis the Egyptian government has devalued the Egyptian Pound (EGP). That doesn’t mean the crisis is over though.

On Thursday the Central Bank of Egypt (CBE) finally threw in the towel against the US Dollar, devaluing the currency by more than 32% and promising that it would allow it to fully float in the market. Here are a few initial thoughts on what’s happening:

1. Broadly speaking, a devaluation, and a move to a flexible exchange rate regime is good for the Egyptian economy. The economy has been at a standstill for the past few months as businesses struggle to import key parts, price their goods and deal with uncertainty. Availability of dollars, even at a high price, could jump start parts of the economy and the removal of some uncertainty could make business people more comfortable investing.
2. If you must devalue, devalue on a Friday. Or in Egypt’s case, where the weekend is Friday/Saturday, do it on a Thursday. You get one day of market turmoil, which they’ve done a decent job controlling so far with their staggered auction announcements, then two days to control the message with limited market movements (even if you decide, as in this case, to keep exchanges open).
3. A real float means that dollars are made available to ordinary consumers and businesses via official channels, like banks. So far, that isn’t the case. The CBE has announced a series of extraordinary forex auctions to provide dollar liquidity to the banks, the first auction, that happened on Thursday soon after the announcement was for $100 million, far below the amount needed to quench the dollar demand. Egypt’s private sector seems to be hoping for about $4 billion in liquidity made available, roughly 25% of Egypt’s net forex reserves before the crisis. That’s a huge number, which is probably not necessary but it’s not clear what happens if the CBE falls short of expectations. Will the black market price surge? Will hoarding continue? Much will depend on the CBE’s communication strategy, staggered auctions and whether it can calm the markets.
4. There were good reasons why the government didn’t want to devalue. The cost of subsidized wheat and fuel will increase, putting added pressure on government coffers and downward pressure on the EGP and inflation, across the board, will go up. The “success” of this devaluation will depend on how the government deals with these two issues. Businesses had already been expecting a devaluation for some time, so, in a way, much of that inflation is already priced in, but that provides very little solace to Egyptians who have been struggling to make ends meet. The official devaluation will give workers just cause to ask for wage increases, which will also stoke inflation. Worker struggles will be compounded as the government moves to remove subsidies, probably a precondition for much needed IMF funding. Expanded welfare programs and export revival initiatives might mitigate some of that pressure but they are difficult to implement and could take time. Egypt’s middle class will suffer in the short/medium term, and politically, that’s what worries the government the most.
5. To manage inflation the CBE has raised interest rates by 3%. Interest rates are a blunt instrument for managing inflation expectations, especially in situations like Egypt’s, where much crowding out of the private sector has already occurred. Also, higher interest rates and a fiscal deficit means the cost of financing that deficit will increase. Sure, the government can print money to finance that but, again, that will put downward pressure on the EGP. The CBE can expand its toolkit by adopting an “inflation-targeting” framework for monetary policy. Such an approach would let the bank rely on transparent communication and target setting as tools to bring down inflation expectations without dramatic rate movements.

We shouldn’t get too excited though, we’ve had plenty of moments of false of hope in Egypt over the past five years, most of them have subsequently led to disappointment. While, the government could benefit from some increased confidence in how it manages the economy, it should be wary of over-promising only to under-deliver later.