By Christian Richter
On 3 November this year, the Central Bank of Egypt (CBE) liberalised the exchange rate of the Egyptian Pound to all major currencies. The move was hailed by The Economist (2016 article: Egypt devalues its currency, at last) as a long awaited move in So many ways, the bold move by the CBE was a surprise move. Of course, it is clear that the previous managed float regime was not sustainable. In the end, it was the dramatic loss of foreign currency reserves that triggered the surrender for the managed float regime. One should remember that in a fixed exchange rate regime where the exchange rate is set not equal to the market rate, the central has to have enough currency reserves so that excess demand can be satisfied or demand has to be rationed. This is what happened for the last couple of months in Egypt. The shortage of foreign currency is actually the reason why for example the Bretton-Woods system broke down. History is quite rich in breakdowns of fixed exchange rate regimes. So the most recent one is by no means an exemption.
When foreign currency is rationed, this is usually accompanied by a black market of foreign currencies. As with all black markets, they are difficult to control and it is questionable whether the CBE was really able to control this black market. However, the existence of a black market usually exaggerates the problem of a lack of foreign currency. Moreover, shortages of foreign currencies also trigger import bans which is usually not particularly popular but necessary to support the set exchange rate.
All of this implied that the CBE would have to give up at some point the managed float. That it happened so soon was the real surprise. The point I am making is that Egypt has not yet left behind the recent economic turmoil. What the government tried to achieve with the managed float was to keep imported inflation low. As with any inflation, those who suffer most are the low income families. In other words, the government tried to stabilise the economic and social situation. I argue that any government in this situation would have done the same, in the hope that in the not too distant future the economic situation would have “normalised”. Unfortunately, this did not really happen, although progress has been made. For example foreign direct investment is 5% higher than last year.
Yet, this progress was not enough so that the exchange rate was freed. As it could be expected it led to an immediate devaluation of the Egyptian pound with respect to all major currencies. At the time of writing this article, the Egyptian pound is at LE19 per Euro. This is a staggering devaluation of 90%. The question is what are the consequences of this devaluation? To answer this question is should be kept in mind that a devaluation per say is not necessarily a disadvantage for an economy. Southern European countries such as Italy or Greece have lived very well with devaluations of their currencies. The devaluation makes a country more competitive as goods and services produced here will be cheaper elsewhere so the exports should increase and with it aggregate demand will increase. At the same time, imported goods become more expensive so that demand switches to domestic goods and thereby raising domestic production. The problem arises if the country has to import goods which are not produced domestically. In this case, the devaluation of the home currency is directly spilling over into the inflation rate. So this is the scenario that the government actually tried to prevent from happening.
Therefore, the crucial problem for Egypt is not the liberalisation of the exchange rate, but rather how inflation is affected by the devaluation. For this I have done my own conservative estimation. My result based on past devaluations is that for every pound of devaluation, the inflation rate increases by 1.3%. Roughly speaking, as the pound devalued by 9 pounds to the Euro, this will increase the inflation rate by 11.7%. As I said, this is a conservative estimation. Given that the inflation rate currently stands at around 13%, does that mean the inflation rate rises to say 24.7%? The answer is not so straightforward. Together with the liberalisation of the exchange rate, the finance ministry and the CBE have agreed that the financing of the budget deficit by printing money will be phased out (CBE Press Release 2016 “Foreign Market Liberalisation”). This action alone will reduce pressure on the inflation rate. Moreover, the CBE has increased the lending rate by 3% which will also reduce inflation. At the same time though as the government has to balance the budget, subsidies are reduced. This will, of course, increase the inflation rate, although this is only a short term effect. The same holds for any other indirect tax which may be increased to reduce the budget deficit.
The ”Nixon Shock” ending the Bretton Woods system
In 1971, president Nixon practically started the free floatation principle. Under the Bretton Woods system (established since end of World War II), the external values of foreign currencies were fixed in relation to the U.S. dollar, whose value was in turn expressed in gold at the congressionally-set price of $35 per ounce. By the 1960s, a surplus of U.S. dollars caused by foreign aid, military spending, and foreign investment threatened this system, as the United States did not have enough gold to cover the volume of dollars in worldwide circulation at the rate of $35 per ounce; as a result, the dollar was overvalued. Presidents John F. Kennedy and Lyndon B. Johnson adopted a series of measures to support the dollar and sustain Bretton Woods: foreign investment disincentives; restrictions on foreign lending; efforts to stem the official outflow of dollars; international monetary reform; and cooperation with other countries. Nothing worked. Meanwhile, traders in foreign exchange markets, believing that the dollar’s overvaluation would one day compel the U.S. government to devalue it, proved increasingly inclined to sell dollars. This resulted in periodic runs on the dollar.
It was just such a run on the dollar, along with mounting evidence that the overvalued dollar was undermining the nation’s foreign trading position, which prompted President Richard M. Nixon to act. On August 13, 1971, Nixon convened a meeting of his top economic advisers, including Secretary of the Treasury John Connally and Office of Management and Budget Director George Shultz, at the Camp David presidential retreat to consider a programme of action. Notably absent from the meeting were Secretary of State William Rogers and President’s Assistant for National Security Affairs Henry Kissinger. After two days of talks, on the evening of August 15, Nixon announced his New Economic Policy in an address to the nation on “The Challenge of Peace.” Asserting that progress in bringing an end to U.S. involvement in the war in Vietnam meant that it was time for Americans to turn their minds to the challenges of a post-Vietnam world, Nixon identified a three-fold task: “We must create more and better jobs; we must stop the rise in the cost of living; we must protect the dollar from the attacks of international money speculators.” To achieve the first two goals, he proposed tax cuts and a 90-day freeze on prices and wages; to achieve the third, Nixon directed the suspension of the dollar’s convertibility into gold. He also ordered that an extra 10 percent tariff be levied on all dutiable imports; like the suspension of the dollar’s gold convertibility, this measure was intended to induce the United States’ major trading partners to adjust the value of their currencies upward and the level of their trade barriers downward so as to allow for more imports from the United States.
A success at home, Nixon’s speech shocked many abroad, who saw it as an act of worrisome unilateralism; the assertive manner in which Connally conducted the ensuing exchange rate negotiations with his foreign counterparts did little to allay such concerns. Nevertheless, after months of negotiations, the Group of Ten (G–10) industrialised democracies agreed to a new set of fixed exchange rates centred on a devalued dollar in the December 1971 Smithsonian Agreement.
Although characterised by Nixon as “the most significant monetary agreement in the history of the world,” the exchange rates established in the Smithsonian Agreement did not last long. Fifteen months later, in February 1973, speculative market pressure led to a further devaluation of the dollar and another set of exchange parities. Several weeks later, the dollar was yet again subjected to heavy pressure in financial markets; however, this time there would be no attempt to shore up Bretton Woods.
In March 1973, the G-10 approved an arrangement wherein six members of the European Community tied their currencies together and jointly floated against the U.S. dollar, a decision that effectively signalled the abandonment of the Bretton Woods fixed exchange rate system in favour of the current system of floating exchange rates In summary, whether the liberalisation of the Egyptian pound exchange rates will be successful depends to a large degree on government’s actions regarding the budget deficit. If the government does manage to make its finances more sustainable then there is no reason to doubt that Egypt’s economy will recover and that the increased inflation which we will observe is only temporary. Having said that, even in this scenario, there will be a period of uncertainty whether the measures introduced since 3 November will work and that will be reflected in the real economy. This uncertainty would be reduced significantly, if Egypt could attract more foreign investments. We can only wait and see what will happen.
