Floating to credibility

Egypt’s Pound immediately lost 20% of its value against the dollar when the government decided to let it float, but this may be exactly what Egypt needs to put it back on the investment map

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By  Massoud Derhally Published  March 6, 2003

|~||~||~|It was quite a shock. Egypt’s Central Bank Governor, Mahmoud Abu El-Ayoun told an audience at the closing session of an economic conference, sponsored by The Economist, that his country would float the Egyptian pound the very next day.

Atef Obeid, the Egyptian Prime Minister who also addressed the same session, said “As of tomorrow [Jan 29], there is a free market where the rate is set by the market and banks will take care of all transactions...It is a free market.” Bankers, analysts and financial institutions hailed the move as a sign of moving towards a freer market, that will attract foreign investment and put privatisation back on the right track.

The director of the IMF’s Middle Eastern department, George Abed said in a brief statement, “We fully endorse this measure taken by the Egyptian authorities. The floating of the pound in the foreign exchange market is a promising sign of the Egyptian authorities’ commitment to proceed with market-based reforms to stimulate trade and investment.”

The timing of the floatation caught many by surprise. When markets opened on January 29, the Egyptian pound plunged almost 17% of its value against the US dollar. The currency traded between 5.395 and 5.28 against the US dollar. But then five days on (Feb. 2) after the floatation, the benchmark Hermes Index rose 768.28 points (12.4%) to 6,940.40, the highest since early 2001. One week after Egypt’s government-controlled foreign exchange regime came to an end, the pound appeared to be stable, suggesting that the gamble might have paid off.

Before the free float, the pound had only been allowed to trade 3% above and below a core rate of 4.51, with a weakest permitted rate of 4.6453 — which had been the standard rate at banks. Black market levels had hovered around 5.30-5.38. The 57 banks that are licensed to deal in foreign exchange will now be allowed to set their own rates under central bank monitoring..

The initial sagging of the pound doesn’t seem to be worrying bankers. They say the slide of 15-17% of its value against the dollar is because of the difference between the unofficial rate and the market rate that was prevailing prior to the move.

“The rates quoted by banks are very much in line with the parallel market rates over the past weeks and actually the effective rates banks had been working with, taking into account the fees and commissions that they charged. So I would look at it in such a way that this was a correction to bring the rate in line with market rates rather than saying that the pound just lost 17% of its value in a couple of hours,” says Dina El Halaby, a senior economist at EFG-Hermes an Egyptian based investment bank.

Some analysts saw the scrapping of the peg to the US dollar, by the Egyptian Central Bank as a an attempt at sideline the impact from a conflict in Iraq on tourism, the country’s main foreign exchange earner.

“The move was inevitable. Although the timing of the move by the CBE was unexpected, with the current favourable domestic conditions, a balanced current account, a recent surge in capital flows, a build up in net foreign assets and the postponement of the war in Iraq, the authorities preferred to do it now, having sufficient time for the system to settle and function efficiently before the economy is exposed to an external shock,” says El Halaby.

Ala’a Al-Yousuf, Standard & Poor’s credit analyst and director for sovereign ratings in the Middle East and Africa said, “The fixed exchange rate regime for the Egyptian pound, which has finally been abandoned, had long lost its credibility because it had been used to support an exchange rate that was out of line with market conditions and inconsistent with other economic policies.”

How Egypt manages such a momentous transition will have a tremendous impact on the reforms it needs to pull off as it tries to make its way out of an economic slump.

Egypt has had a slowing economy since 1997-98, about the same time as the problems with the exchange rate started when it lost crucial foreign currency because of the Luxor attack. The value of the pound was cut by 24.6% in four devaluations since late 2000, when it was pegged at 3.40 to the dollar. The decline in the value of the pound was triggered by the Luxor attacks and then exacerbated by the slump in oil prices in 1998, and then the problems associated with the South East Asian devaluation affair.
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All of this led to capital flight, says Ben Faulks a senior economist at the Economist Intelligence Unit in London. Official figures from the government show economic growth for 2000/01 at 3.5% and the year before at 5%.

But one analyst who spoke on condition of anonymity says, “Figures seem a lot higher than what they are because people were talking about recession at the time in Egypt, and you don’t get growth of that sort of size when you are talking about recession.”

The move by the central bank is almost certainly going to increase inflation and impact the government’s finances.

“It has potential to impact the governments fiscal position, and it will face larger costs in Egyptian pound terms because it is a large importer of things like wheat,” explains Faulks. “Another result is the higher cost of imports. But the higher rates will also lead to a decline in interest rates, which should spawn more business.

“The government has had to keep the interest rate high to keep depositors from switching to dollars. But the free-float of the pound should have a beneficial effect on the economy because essentially you have a lot of companies that have taken out large loans and are paying high interest rates that have a bit more room to manoeuvre and borrow at lower costs,” says Faulks.

Fitch Ratings, the international rating agency, said, “The positive effects of exchange rate liberalisation will take time to materialise, but centre on developing a more robust export sector. Egypt is one of the least open economies and export-led growth in the medium term could contribute meaningfully to employment generation, which is urgently needed in response to the rapidly expanding labour force.”

In terms of investment and the long-term effect, most analysts Arabian Business spoke to believe the floatation will have a positive impact.

That said, however, most also say not to expect a huge rush of investors into Egypt on the back of the floating of the currency. “There are other problems clouding the investment environment at the moment and there is not much opportunity in many respects; the economy is not doing particularly well and economic growth is slow,” says Faulks.

Investment in terms of privatisation, says Faulks, is difficult because the government is not selling state owned companies at the moment and the regional situation is still somewhat unsure. Essentially, if the government does not interfere and there is a free-floating exchange rate, the market will find what is termed as a market-clearing rate, a rate at which people will start to say, ‘I think that’s a fair rate and will then sell their dollars,’ according to Faulks.

Such a move will, he continues, help restore liquidity to the foreign exchange market in Egypt. “A big problem Egypt has had in recent years is the difficulty in accessing dollars,” says Faulks. “The free float will let the market settle on a rate where people are prepared to trade properly in an open environment and that will have a huge impact on confidence in the economy and allow foreign investors to come in,” says Faulks.

Is this a start of a reformist government policy? Who knows, but it certainly is a belated step in the right direction. ||**||

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