Why the devaluation? The Egyptian economy has been facing a pressing foreign currency shortage stemming from the decline in foreign direct investment (FDI) inflows and tourism receipts following the 2011 Revolution. This has been reflected in an almost 50 per cent decline in the foreign reserves, which has hurt economic growth and forced regulators to impose capital controls and limit imports. These measures have not only made it hard for investors to repatriate profits, but they have also brought the economy to a standstill as reduced imports of raw materials and equipment have affected production. The scarcity of dollars in the official market has created a thriving parallel market in which increased demand for the dollar has led it to be traded at a premium of more than 45 per cent over its official rate of LE8.88. The dollar on Monday was trading at LE13.6 in the parallel market. With widening current-account and budget deficits, Egypt has resorted to the IMF for help in implementing a reform programme. The main pillars of this are reducing subsidies, introducing a new value added tax (VAT), passing a new civil service law and devaluing the currency. The IMF last month agreed in principle to grant Egypt a $12 billion three-year facility to support the government reform programme. The IMF's annual meetings are scheduled for October 7-9, and analysts believe that Egypt will devalue its currency either before or immediately after the meetings to prove its good faith.
Why didn't the March devaluation succeed? The Central Bank of Egypt (CBE) weakened the currency by 14 per cent to LE8.88 against the dollar in March, the biggest one-time devaluation since 2003. This was followed by increasing interest rates and offering foreign buyers of government treasury bills a hedge against a future currency devaluation. While this was a move in the right direction, it did not succeed in resolving the foreign exchange crunch as “it was not coupled with the injection of sufficient liquidity into the market or the lifting of restrictions governing the forex market for corporates and individuals,” Radwa Al-Swaify, head of research at Pharos Brokerage, said in a research note. In fact, the result was a worsening of the situation as it raised the cost of imports for the economy and deepened the confidence crisis for individuals and corporates, further fueling activity on the parallel market. The move has failed to crush the black market for dollars, where the pound is now trading at a discount of about 45 per cent to the official rate. It also did not succeed in attracting portfolio inflows. Foreign holdings of local debt remain near zero, compared with about $10 billion at the end of 2010. Moreover, inflation has accelerated to the highest level in eight years.
Are there hints of a new devaluation in the making? Talk of another devaluation emerged in July when the parallel market rate rose to LE10.96 from LE 9.5 in March, after the market deemed the devaluation insufficient. On 3 July Tarek Amer, the governor of the CBE, told reporters that defending the pound in the past had been a “grave mistake” and that Egypt needed a more flexible exchange rate system. This resulted in an additional rise in the rate to LE12.75 until 26 September. Last week, President Abdel-Fattah Al-Sisi alluded to a new devaluation in a televised speech which some commentators believe aimed at conveying the message that the government was ready to deal with any unrest that might be triggered by a new devaluation. The rate then jumped to LE13 to the dollar on the parallel market. President Al-Sisi met with Amer on Saturday in a meeting read by many as a final political endorsement of the long-awaited move. Speculation on an imminent devaluation then pushed the rate to LE13.6
Does Egypt have adequate reserves? Egypt's net international reserves rose in September to $19.591 billion up from $16.564 billion in August, the CBE announced on its Website on Monday, the highest level since June 2015. Revealing the $3 billion increase surprised speculators as a step towards devaluing the pound. While the CBE did not elaborate on the source of the increase, it has previously been supported by United Arab Emirates and World Bank deposits. Expecting a devaluation to take place this week, Hani Genena, head of research at Beltone, a financial consultancy, said in a research note on Sunday that the end of October reserve figure would likely not be published until 6 or 7 November, which would enable the CBE to use the reserves relatively freely until then without having to publish figures in the interim. Egypt is expected to raise $3 to $5 billion in the Eurobond market in November and to secure $2 billion from Saudi Arabia and a further potential $1-2 billion through a currency swap with China. According to Genena, if Egypt moves to a fully-fledged floatation of the currency, the IMF could expedite the disbursement of the first tranche of $4 billion. By 6 November, the date of publishing the October reserve figure, the reserves could have jumped by $6 to US$13 billion to $25 to $32 billion, depending on the magnitude of inflows and of the intervention in the forex market.
What are the conditions for a successful devaluation? Analysts agree that an aggressive devaluation in the range of LE11-12 at least will be best for the country. With the sliding of the exchange rate to LE13 against the dollar on the parallel market, an aggressive devaluation should convince forex funds to shift from the parallel market to official channels. To correct disruptions in the forex market, there should also be cooperation with those controlling the parallel market in order to stop the slide of the pound, in addition to the implementation of measures to convince those transferring remittances to do so through the official system. Remittances from Egyptians living abroad are the country's second largest source of foreign currencies after exports, coming in at $19.2 billion in 2014/2015. Meanwhile, the agreement with the IMF entails building up Egypt's net reserves, which means that funding packages have to be properly used and not used to defend the currency.
What are the possible devaluation scenarios? The managed float scenario would enable the CBE to decide on the range within which the pound moves against the dollar. This would limit the drop in the pound's value and thus losses in the light of the fact that Egypt is a net importer of food, raw materials and equipment. However, according to Arqaam Capital, an investment bank, the CBE would have to inject dollars into the official market to satisfy corporate and household demand, clear investors' backlog and satisfy the pent-up demand that has been building up for months, especially from the corporate sector. “This amount would definitely exceed the $5 to $6 billion the CBE has managed to get pledges for in recent weeks and would need extra financing from the precariously low international reserves,” it said. The free-float scenario is less likely and would mean that the CBE left the pound's value to be decided according to the laws of demand and supply. However, it would allow the CBE to build its international reserves at a quicker pace, with the parallel market vanishing and portfolio investors returning following the removal of foreign exchange restrictions and repatriation delays. Arqaam pointed out that the risk with this scenario would be the exchange rate stabilising at a much higher level than the current parallel market rate of LE13, pushing up inflation. It believes that the upcoming devaluation will be a hybrid of the two scenarios. “The CBE could devalue the pound aggressively to at least LE12 per dollar, make a large injection of dollars into the market, hike interest rates by one to three per cent, remove the dollar deposits in banks and wait for the inflows to come,” it said. It could then allow small movements in the exchange rate to signal a flexible system. In a recent research note Capital Economics, a consulting firm, suggested that the IMF was likely to demand that Egypt follow the example of Argentina in devaluing its currency. In 2015, the Argentinian government devalued the peso and moved to a free-floating exchange rate, all within a short period of time. While this resulted in some near-term economic pain, there have been signs that it is having the desired effect. “After capital controls were abandoned, the official and parallel exchange rates converged and the black market for dollars evaporated. Meanwhile, export volumes picked up as a result of improved competitiveness and capital inflows strengthened.” wrote Jason Tuvey, a senior economist at Capital Economics.
What is the expected effect on the capital market? A 24 to 35 per cent devaluation of the pound to between LE11 and LE12 could imply an overall devaluation of 41 to 54 per cent in 2016, which could satisfy investors' need to know that the pound is finally close to its real free market value. Investment inflows to the equity market gradually declined after 2014 as the average parallel foreign exchange rate rose and investors lost confidence in the official market. They rose following the March 2016 devaluation, and they have now risen again on expectations of an imminent and aggressive devaluation. The market saw a 3.2 per cent jump on Monday. Arqaam has picked a number of companies to shed light on the effect of a new devaluation on shares. ElSewedy Electric would be the net beneficiary of a potential devaluation as the group's turnkey contracts are denominated in foreign currencies, including contracts signed with Siemens and the Angolan Ministry of Electricity and Water. The company also exports cables and electrical products in addition to revenues from its international operations in the Gulf and Africa, which are either priced in dollars or in currencies pegged to the dollar. The Suez Cement Group (including Torah Cement) and Sinai Cement continue to partially run their kilns on natural gas at a cost of $8 per mmbtu (million metric British thermal units) paid for in LE converted at the official exchange rate of LE8.8. Arqaam expects a 57 to 59 per cent average downside potential to the company's earnings should the pound devalue to LE12. Another round of devaluation would have a limited impact on consumer names like Juhayna, Domty and Edita and might actually be positive if foreign currency liquidity is restored at banks and food producers are again given priority in dollar allocations from the CBE in order to fund imports. Car assembler and distributor GB Auto, which has increased its prices by almost 20 per cent since the fourth quarter of 2015, might lose market share when dollar availability in the market gives competitors the room to secure imports again, thus exhausting GB's ability to increase its prices without fears of losing its dominance of the market.
