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FISCAL FALLOUT
CRISIS SPURS REVIEW
BY TAMER HAFEZ
In 2003, Egypt experienced its most significant change in fiscal and monetary policies to date when the Central Bank of Egypt (CBE) floated the pound. What followed was increased volatility in the black market for currency and two years of chaos.
As the country enters the second decade of the 21st century, managing the Egyptian economy to prevent another free fall and assessing whether current domestic fiscal and monetary policies should be adjusted is likely to be trickier than ever.
Fiscal policy allows governments to influence national economies by balancing revenue and expenditure. Central banks use monetary policy, including interest rate changes, to control the supply of money. These policies directly influence access to and the cost of credit, as well as aggregate demand – including from households, businesses and government – and aggregate supply, which consists of local and imported goods.
Economists agree that Egypt was fortunate to avoid the severe problems that plagued the EU region and the US. For 2009, Egyptian gross domestic product (GDP) growth was 4.7 percent. By contrast, the International Monetary Fund (IMF) forecast that 2009 GDP in the UK would contract by 4.2 percent and in the US by 2.6 percent, and grow by 7.5 percent in China and 5.4 percent in India.
At the end of September 2009, Egypt’s debt of LE 689 billion represented 58.6 percent of GDP, up from 54.9 percent in September 2008, according to Prime Minister Ahmed Nazif. Though economists usually don’t worry if debt remains in the neighborhood of 50 percent of GDP, Hany Genena, head of the macroeconomics team at Pharos Holding Company, sees a potential problem. “What is announced in the newspaper is ‘direct debt,’ which is the official debt,” he says. “What really worries me is contingent liability. The balance of payments can be excellent, but the private and household sectors can be drowning in debt... The situation in Egypt is critical, with a large oil-subsidies account in addition to large debt accounts in the National Bank of Egypt and Banque Misr.”
Debt is high partly as a result of government borrowing in recent years. The situation is worse than before the global economic crisis, when non-Egyptians owned 22 percent of Egypt’s treasury bills. “This figure has fallen to less than 1 percent,” Genena says. “Foreign investors took off due to the recession and lack of trust regarding how the emerging markets would react.” This may force the government to turn to the banking system. “The government has announced that it will need LE 100 billion more in 2010 for its annual budget,” he says. “And with no [significant new] foreign investors in sight, the government will look to domestic banks for financing.”
Meanwhile, corporate investors are beginning to see market opportunities and want bank financing to take advantage of them. “This scenario is very critical indeed because there is a certain level of dependency on the private sector to stimulate the economy. And the sector was almost stagnant during 2009 and therefore has no cash reserves to finance future projects and therefore needs banks,” Genena says.
Hanaa Kheir-El-Din, an economics professor at Cairo University and head of the Egyptian Center for Economic Studies, explains that, theoretically, the government should make up for any decrease in aggregate demand. “Household spending is dropping and new investors are shying away,” she says. “So to compensate for the drop in demand, the government targets spending to retain suitable demand levels.” The problem is that household spending uses savings and foreign investors access credit from outside Egypt. But the government will tap into domestic bank resources, and banks will prefer lending to the government because those transactions are less risky and more lucrative. “There is no problem in the government taking loans from banks, but it should be careful not to create a ‘crowding effect’ and to invest in labor-intensive rather than capital-intensive projects,” Kheir-El-Din says. “The bottom line is creating employment opportunities.”
So should the government increase spending to compensate for decreased aggregate demand or leave it to the private sector? The dilemma is complicated by the existence of a central bank independent from the central government and the bank’s use of monetary policy that aims to curb inflation and stabilize exchange rates, thereby offering a solid macroeconomic environment for prospective investors.
Balancing fiscal and monetary policy needs has created a scenario in which the government and private sector compete for bank financing, and the CBE has decided to tighten the money supply to maintain a stable macroeconomic outlook. “The natural step in this case is that interest rates would increase; official interest rates didn’t,” Genena says. “But that didn’t stop the banks, as each one started creating new products that yield higher interest rates to encourage people to save.” The Egyptian inflation rate was 13.3 percent in 2009, compared to 12.1 percent in 2008, according to the CBE, in part due to increased food and energy costs.
One possible solution might be found in recent history. In 2003, there was a liquidity crunch that forced the central bank to enforce capital control measures that limited how many pounds could be converted to dollars. If such controls were implemented today, the CBE could simply print more money again. Genena thinks that would be unlikely: “The central bank floated the pound [in 2003] to negate capital limiting and allow the pound to adjust to the market.”
A more realistic solution, he says, might be to rely on a recovery in the US, which would directly affect Egypt’s economy. In the US and the UK, there is little indication interest rates will increase soon or that fiscal and monetary policies will move toward a contraction strategy. “In the US and UK, there has been a significant amount of quantitative easing, where the central banks have pushed interest rates close to zero to stimulate the economy. It is important to see when this easing will end, because this will affect the value of the US dollar and pound sterling and hence the cost of financing in Egypt,” he says. The euro, however, seems safe from sudden changes because the European Central Bank has not done any quantitative easing. “The consequence is that the euro is an extremely resilient currency,” Genena says.
Angus Blair, head of research at Beltone Financial, expects major changes in some of the world’s large economies. “Over the next few months, the markets will be looking at the effects of the ending of the fiscal stimulus programs introduced over the past 18 months by a number of countries and whether some governments will raise taxes to cut their debts, dampening consumer demand and, in turn, slowing the economic recovery,” Blair says. “There is still much to make the overall market nervous, so many governments globally are going to have to tread carefully in terms of new policies over the next few years.”
Internal regulation and close monitoring could be critical if Egypt is to avoid a mini-recession. “If there is any lesson from the crisis of the last two years, it is that central banks and governments must be much more alert to the creation of asset bubbles and over-lending,” Blair says. “Over-lending is much less of an issue for Egypt, given the relatively low banking penetration rate among the overall population... While there has been a sharp rise in real estate prices over the last decade, there is much less of a bubble than in several of the GCC [Gulf Cooperation Council] states, for example.”
It’s nearly impossible to predict Egypt’s economic future based on fiscal and monetary policies that are reviewed regularly by the CBE. “It is difficult to predict as far as six months ahead. It is all scenarios,” Genena says. “In 2003, floating the pound had the desired long-term effect, but the bad thing is that this change came under pressure.”
As for the responsibilities of governments and central banks, Blair says: “There is no room, going forward, for mediocrity.”
FISCAL, MONETARY LESSONS LEARNED
A major fiscal and monetary policy change occurred in 2003 in Egypt due to a consistent increase in the balance of payments (BOP) deficit. It started in FY 1996-97, when the BOP went over a period of three years from a surplus of $1.9 billion to a deficit of $3 billion.
“The economic situation was becoming significantly worse with reserve levels dropping to threshold levels of $13 billion. There was no money to finance imports. The CBE [Central Bank of Egypt] was forced to act,” says Hany Genena, head of the macroeconomics team at Pharos Holding Company. The CBE floated the pound in 2003 in an effort to stabilize the rate of inflation. “This meant the foreign exchange rate needed to be kept under tight control after the flotation, which meant that money supply had to be limited,” says Hanaa Kheir-El-Din, political science professor at Ain Shams University and head of the Egyptian Center for Economic Studies.
The result was a massive black market in currency until 2005, when a new CBE board was appointed. “The black market was caused by the CBE resorting to monetization [of debt] by printing money to finance the government without respecting the US dollar backing while maintaining the same exchange rate. The value of the pound deteriorated as individuals and corporations starting selling the pound for dollars, reducing supply,” Genena says.
Despite the obvious mess, Egypt has enjoyed a healthy economy, recording a BOP surplus of $5.4 billion and GDP growth of 7 percent in FY 2007-08. “The central bank has subsequently been highly successful in almost creating a new start from which all other changes were to flow,” says Angus Blair, head of research at Beltone Financial. He says that has allowed banks to tackle bad debts and encouraged new financial products. In addition, he notes, the CBE is managing the foreign exchange process more efficiently and adhering to international standards. “The CBE became independent of the government; hence, fiscal policy became independent from monetary policy,” says Kheir-El-Din, noting that a committee was formed to facilitate coordination between the bank and government. |
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