According to the economic literature, printing new banknotes increases the supply of liquidity in the markets and if this is not accompanied by increased production it leads to a decrease in the value of the currency (devaluation) and an increase in prices (inflation). This theory was the basis of a lot of criticism directed at the Central Bank of Egypt (CBE) recently, as a result of its aggressively issuing new notes during the past year. Commentators have raised concerns about the effects of this policy on an already ailing economy. In return, the Bank earlier this week issued a statement explaining that it was issuing new notes according to its calculations of market demand. It noted that the increase in issued currency in fiscal year 2013 was LE56.7 billion and that most of this was in months where demand had increased on the back of political instability, particularly in June 2013 which had witnessed the build up of the protests that toppled former President Mohamed Morsi. According to the CBE, the new issues are backed by the Bank's assets of gold (6.5 per cent), government bonds (64.4 per cent) and foreign currency (29.1 per cent). It said that the currency issuance was ultimately tied to growth in nominal GDP, which takes the inflation rate into consideration and thus helps contain inflationary pressures. “Printing money is not a new phenomenon. Central banks all over the world print new notes each year to replace damaged ones, to balance demand due to increases in economic activity and to cover government funding needs,” said Omar Al-Sheneety, managing director at Multiples Group, a regional private equity firm. In Egypt, the value of new issued notes in 2010/2011 came in at LE34 billion, most of it in the second half of the year after the 25 January Revolution. In the following year, 2011/2012, the CBE printed LE28 billion of notes, and in 2012/2013, which saw Morsi take power, it printed LE57 billion. According to CBE figures, the overall value of new money issued since 1993 comes in at LE250 billion. “So, the bank has always printed new money, but the rate has been higher due to the current situation and the government's need for fresh finance,” Al-Sheneety said. Limited revenues in local currency, as reflected in the widening budget deficit, and the parallel shortfall in foreign currency, as seen by balance of payments irregularities, have made the government's options more limited. As a result, the CBE has had to step in and print more money to buy treasury bonds and bills. “Were Adam Smith alive, he wouldn't have acted differently. This practice is called quantitative easing, and it is used all over the world,” said Al-Sheneety. A research note from Pharos Brokerage co-authored by its senior economist Hani Genena noted that quantitative easing had been indispensable to prevent a severe liquidity crunch and exceptionally high interest rates. The persistence of high interest rates would have significantly raised the risk of sovereign default and the spectre of renewed social unrest, he said. Another factor that made printing more money unavoidable, according to Pharos, was the fact that the banks, especially foreign ones, had been reluctant to invest more in government treasury bills. The banks had reached the permitted ceiling for investing in such bills at 30 per cent of total assets, he said, so the CBE had had to increase its own exposure. The CBE bought LE68 billion of treasury bills in 2010/2011 and LE81 billion and LE99 billion in the two following years. “Things are under control,” Al-Sheneety added, explaining that in 2008/2009, at the time of the world financial crisis when a lot of institutional investors fled the local market, the CBE had had to cover for their departure and had bought LE131 billion worth of treasury bills. However, the fact that the CBE alone holds almost one third of the government's overall local debt is worrisome, as this puts the whole financial sector at risk in the case of the government defaulting on its obligations. Another worrying factor is the nature of the backing that the CBE uses for issuing the notes. The Pharos note stated that at present issued notes and coins are not backed by hard assets. There was a shift in the CBE's balance sheet from June 2010 to October 2013, it said, since the issuance of money had been covered by foreign assets before the Revolution. After the Revolution, the CBE had issued local currency backed by a significantly lower-quality asset, namely loans to the government itself. The percentage of net foreign assets to issued money deteriorated from 93 per cent in June 2010 to 12.8 per cent in October 2013. This fact goes beyond the control of the CBE and is rooted in the deterioration of the country's balance of payments after the Revolution. The Pharos note went on to say that if this steep deterioration in the quality of the currency backing remains, together with a delayed recovery in core balance of payments flows, the only way to prevent depreciation would be to impose exceptionally strict capital/current account controls and ration access to foreign currency. The Egyptian pound is officially trading between banks at 6.96 to the dollar, about 11 per cent weaker than it was at the end of 2012, when the Central Bank launched an auction system as a way of rationing hard currency and protecting its reserves. Egypt's net international reserves (NIR) increased by $73 million during January to reach $17.105 billion. The increase was due to further aid and investment from abroad, which included a $2 billion Central Bank deposit by Saudi Arabia. The progress of Egypt's political roadmap with the passing of the constitutional referendum in January and the announcement that presidential elections will first be held has also encouraged an influx of aid and investment. Pharos expected that even in the light of quantitative easing, inflation would remain well contained due to the steep decline in international commodity prices, especially those of agricultural commodities given that food and beverages account for 40 per cent of the headline consumer price index, Egypt's main inflation gauge. It added that international prices of corn, wheat and sugar, the three commodities that directly (as staples) and indirectly (as livestock feed) impact inflationary dynamics in Egypt, were facing further downside pressures in 2014. “If low international commodity prices persist in 2014 and the pound/dollar exchange rate remains stable, the annual inflation rate is expected to stabilise at around the 10 per cent mark in 2014,” Pharos said. Egypt's inflation rate for the whole of 2013 came in at 10.7 per cent. Annual urban inflation eased to 11.3 per cent in January from 11.7 per cent a month earlier, while monthly inflation increased to 1.4 per cent after declining by 0.99 per cent last month.
