Farah Halime Guide to the end of the world (or explainer on currency devaluation)
By Farah Halime, Rebel Economy Egyptian President Mohamed Morsy has proved to be a recalcitrant negotiator with the opposition movement in Egypt over the past month, raising questions about the sudden move toward magnanimity in his speech Wednesday night where he appealed for calm and national dialogue. Politically, he may be trying to seal the issue of the constitution once and for all through some compromises. (It passed with slim approval by 63.8 per cent of voters and only about a third of registered voters took part in the referendum.) But a bigger concern for the president and his Islamist supporters is the economy. The reputation of the Muslim Brotherhood's new political power is on the line. The last thing the group wants is to be the stewards of a full-blown economic crisis, something that could tarnish their reputation and electoral viability in years to come. If Egypt remains unstable, foreign donors will be wary of lending, investors will wait on the sidelines and tourists will stay away. In the short-term, the Egyptian pound has moved to centre-stage. It hit a near eight-year low on 26 December, dropping to EGP 6.175 per dollar. It has slowly declined over the past two years from about EGP 5.7. Monetary policy and impacts of a currency devaluation – which many are predicting as imminent – can be bewildering, so Rebel Economy has prepared this explainer. Let's start from the beginning. What is a currency devaluation? The textbook definition of currency devaluation, according to Investopedia, is: A deliberate downward adjustment to a country's official exchange rate relative to other currencies. In a fixed exchange rate regime, only a decision by a country's government (i.e central bank) can alter the official value of the currency. Contrast to “revaluation". A devaluation is a policy decision by the government, as opposed to a depreciation, which happens when a free-floating currency reacts to market forces. Although Egypt officially floated the pound in 2003, it has a policy of managing the pound in what is known as a “managed float rate regime". That means that the currency rate fluctuates, but is ultimately managed by the Central Bank of Egypt through capital controls and trading of foreign currencies. The Central Bank's primary tool of supporting the domestic currency is by using the country's reserves of foreign currency. In short, it has to be willing to meet all of the offers to sell Egyptian pounds at the established rate to keep it at the level it wants. That means the pound's nominal exchange rate has remained almost unchanged since 2004. So, what's the problem? The Central Bank cannot carry on using its foreign reserves for much longer. The Central Bank's policy has led to a rapid decrease in foreign reserves to just $15.04bn from $36bn in late 2010, a dangerously low level that is just enough to cover three months worth of imports. The two most important sources of foreign currency (which would normally keep foreign reserves replenished), tourism and foreign direct investment, have dried up because of Egypt's economic crisis. Tourism revenues have declined by about a third and foreign direct investment was just $2.5bn in the first half of 2012 versus $4.1bn in the first half of 2010, according to the UN. GDP growth has slowed to 2.2 per cent, from annual rates of 5.5 per cent before the revolution, and unemployment has increased to 12.6 per cent. The Central Bank has not been able to hold off a depreciation and the pressure on the pound from continued political instability has reached crisis point. Egyptians are swapping their pounds for dollars in a process better known as “dollarisation", exacerbating the depreciation of the pound, and meanwhile the Central Bank is struggling to fight against market forces that are pushing the currency down. Why does Egypt want to protect its currency? Protecting the currency prevents a scenario where real wages decline. (The actual wage for a professor, for example, would stay the same but he or she would be able to buy less with the salary if the currency depreciated.) A depreciated currency would also lead to a rise in exports (because they would be cheaper for foreign buyers) but a decline in imports (because they would become more expensive for domestic buyers). Finally, inflation would rise more quickly with a cheaper pound. In general, it would lead to a more difficult period for Egyptians, especially for those who are already suffering the most. Analysts have been predicting for more than a year that Egypt would be forced to devalue the currency when it no longer had enough reserves to prop up the pound. The question, they have said, is only when it would happen. A forced devaluation can also happen merely due to speculation on the market and the perception that a devaluation is coming. If everyone panics and tries to exchange their pounds for dollars, which is already happening in Egypt to some extent, then the level of foreign reserves will decline even more rapidly. This can cause a balance of payments crisis, which occurs “when a nation is unable to pay for essential imports and/or service its debt repayments". Other consequences of a devaluation include an increased cost of borrowing from abroad. “If reserves are depleted, the government would need to start borrowing to buy commodities, pushing prices higher and demand lower, and risking a currency explosion similar to what happened in 2003. That could lead to stagflation, a period of high inflation and slow growth." From AmCham Magazine What impact does the IMF loan have on the currency? The International Monetary Fund's $4.8bn loan package to Egypt would act as an important stimulus for providing more foreign currency to protect the pound, but it has now been delayed by President Morsy. By many accounts, he believed the country was not yet ready for the austerity measures (higher taxes and lower subsidies) that are part of the economic programme created by Egypt to appease the IMF. Without the IMF loan, a devaluation may be “disorderly", according to this research note from Capital Economics: “The key question is whether the necessary devaluation is orderly or disorderly. Failure to secure help from the IMF would make a disorderly devaluation more likely. In this scenario, the pound could overshoot, falling by perhaps 50 per cent or more against the US$. The costs to the economy would be severe. This is likely to lead to a spike in inflation, sharp hikes in interest rates, a potential banking crisis and rapid fall in asset prices." The IMF is not the only potential saviour for Egypt's economy. It is supported by the US and Qatar, among others, who could also step in to support the government in the event of a dire crisis. Benefits/Disadvantages of controlled devaluation: Many economists have also called for Egypt to initiate a devaluation to restore balance in the economy and make Egypt more competitive globally. A devaluation can help reduce the trade deficit because exports typically rise. Right-siding the economy could also ease the need to keep borrowing money to plug gaps in the budget. The IMF is a lumbering, technical organisation, but a good insight into their thinking in unusually clear terms can be found in their lessons for teenagers. It is important to note that many development economists have sharply criticised the IMF because its solutions have made the situation worse in developing countries. Joseph Stiglitz famously said the IMF “was not participating in a conspiracy, but it was reflecting the interests and ideology of the Western financial community." “A key effect of devaluation is that it makes the domestic currency cheaper relative to other currencies. There are two implications of a devaluation. First, devaluation makes the country's exports relatively less expensive for foreigners. Second, the devaluation makes foreign products relatively more expensive for domestic consumers, thus discouraging imports. This may help to increase the country's exports and decrease imports, and may therefore help to reduce the current account deficit. A significant danger is that by increasing the price of imports and stimulating greater demand for domestic products, devaluation can aggravate inflation. If this happens, the government may have to raise interest rates to control inflation, but at the cost of slower economic growth. Another risk of devaluation is psychological. To the extent that devaluation is viewed as a sign of economic weakness, the creditworthiness of the nation may be jeopardised. Thus, devaluation may dampen investor confidence in the country's economy and hurt the country's ability to secure foreign investment. Another possible consequence is a round of successive devaluations. For instance, trading partners may become concerned that a devaluation might negatively affect their own export industries. Neighbouring countries might devalue their own currencies to offset the effects of their trading partner's devaluation." From The IMF In Action: How Can the IMF Help In Time of Crisis? The worst consequence for Egypt is the prospect of rising inflation. Egypt is a food importing country, so the cost of feeding a family would inevitably increase. This is what political figures mean when they talk of the coming “Revolution of the Hungry". Many families in poor areas of Egypt are already hard-pressed to afford the unavoidable private education and healthcare costs as well as basic necessities. A family in Saft el Laban, a poor neighbourhood in Giza, explains in detail how quickly a month's wages disappear. Said Abdel Hameid, who is married with three children, earns 1,500 pounds a month through two jobs, but most of it is gone within a few days: “About 500 pounds a month goes on paying his debt for household goods: two fans, an old television and a battered tabletop. Another 25 pounds is paid for a natural gas connection – a rarity for many – that will be amortised over seven years. That does not include the cost of gas used, which averages another 10 pounds a month. Then comes education costs. The public school system is so dysfunctional that nearly every family in Egypt, poor and rich, pays for private lessons in a bid to improve their children's' chances at getting a job. The school of Mr Abdel Hameid's daughter, Sama, 7, requires 100 pounds a month for after-school lessons. Another 150 pounds is paid for other private lessons from teachers. Rent for their flat, which consists of two small bedrooms and a living room, is 250 pounds. That leaves the Abdel Hameid family with about 465 pounds to get through the month. It is barely enough to put basic food on the table. At five pounds a kilo, tomatoes are a luxury. To keep up with hungry mouths, the only option is to buy macaroni and rice in bulk. Fuul, a boiled bean dish, is a mainstay of their cuisine." From The National, August 26, 2012 His income does not include the cost of healthcare, which is supposed to be free in Egypt but the system is so dysfunctional that nearly everyone shells out for private treatment if someone is really sick. The Abdel Hameid family can only pay for medicine if the whole family bands together to raise enough money. Looking Ahead No matter what happens in Egypt – an abrupt devaluation, a government-managed devaluation or a continuation of the same Central Bank policy of backstopping the pound – the impacts will be most heavily felt in Egypt's most vulnerable population. The government has done a poor job of explaining their economic plan for the future (if they have one) and without this, there will be no buy-in from the population, especially if they are afraid of an even worse form of poverty than they already endure. A devaluation is by no means a strategy by itself. The government must prove that it will take other measures to soften any impacts and get Egypt's economy growing again. “Renaissance", which Morsy called for in his speech on Wednesday, is only a word.
