Raising interest rates may help contain inflation, but Sherine Abdel-Razek finds out that more is needed After subsiding in the second half of 2007, inflation rebounded in the first months of 2008 thanks to high levels of growth -- which is usually accompanied by increased consumption and demand on money -- and imported inflation resulting from rising global commodity prices. The Consumer Price Index (CPI), Egypt's main measure of inflation, surged to 10.5 per cent in January and 12.1 per cent in February, compared to 6.9 per cent in November and December, 2007. The increased burden on Egyptian families stirred public uproar, which peaked this week with calls for a public strike. Concerns escalated in political circles, reaching the presidency which became directly involved in the issue and called on the army to provide low-cost bread to the public. Meanwhile, new administrative measures such as increasing subsidies, imposing export tariffs on scarce goods and plans to lift tariffs on imports were introduced. Also, monetary authorities and the Central Bank of Egypt (CBE) were asked to adopt the needed policies to bring inflation down to 6-8 per cent. According to economic theories, the spiralling increase in prices and drop in purchasing power of a currency can be dealt with through monetary policies which influence the price of money, i.e. changing interest rates on deposits and loans. And again, in theory, the intervention of a central bank by changing its policy rates should be followed by similar actions in commercial banks, tightening the demand on money and eventually helping to lower prices. In practice, and particularly in Egypt, this is not easy. In an attempt to restrain rapidly escalating inflation, the CBE's Monetary Policy Committee (MPC) twice this year increased its overnight interest rates. The last time was on 24 March, pushing it up to 9.5 per cent on deposits and 11.5 per cent on loans. Two weeks later, only a handful of commercial banks, including the two state-owned Banque Misr and National Bank of Egypt, followed suit and increased rates on their deposit and saving accounts. This deprived the CBE's move of its significance. Recent data shows that M2, one measure of money supply that shows money available in short-term saving accounts and time deposits in banks, is growing at its highest level in the last few years. "High levels of liquidity in the banking system mean that policy rate changes at the CBE are not being reflected in the rates offered by banks," commented a recent EFG-Hermes report on inflation. Commercial banks are not obliged to follow suit, explained a banker who preferred to remain anonymous. "The sector has huge liquidity in deposits which is not being used," the source said. "In theory, banks should lend this money to companies to encourage investments, but there are only very few companies which we, as bankers, can now trust to extend credit to." The source added that this requires good managers and should be in sectors with good potential such as IT or in exporting industries. "To lend money to a company, I have to have reliable figures and projections on the economy, the sector as a whole and the company -- a prerequisite that is hard to find," the source said. Banks have been following a strict credit policy after a series of default cases hit the sector hard in 2002-2003, resulting in huge non- performing loans portfolios. The banker, who tops the credit department in one of Egypt's leading commercial banks, said that banks currently prefer to use the deposits in financing the retail banking activities, like financing house and car purchases, rather than corporate finance. So, is the CBE move unfruitful? Not in every sense of the word since at the end of the day some banks might lose depositors to other more profitable investments if they did not increase their rates. "Commercial banks will follow suit in light of the increase in inflation rates and the post office offering 9.25 per cent for one year's deposit rate, against 6.75 per cent on one year's deposit rate in commercial banks. Otherwise, depositors might shift their savings to the post office," noted a research report issued by HC Securities. However, economists preparing the EFG and HC reports agree with the banker that current inflationary pressures will not be short-lived, and thus the CBE might resort to more rate increases and that changing the interest rates is not the only solution. In light of the fact that 70 per cent of Egyptian imports, expected to largely increase, come in the form of intermediate and capital goods as well as basic commodities on which demand will stay robust, resorting to tightening the import bill by appreciating the value of the pound is describes by HC's report as a good policy, coming hand-in-hand with interest rate hikes to put a ceiling on inflation. "We believe that the government has the luxury to appreciate the EGP against the USD in the remaining months of FY08, with the exchange rate hovering between LE5.3-5.43 to $1," the report stated. EFG's report echoed the same opinion: "With a significant share of recent inflation being driven by higher prices of imported food items like wheat, maize and cooking oil, an Egyptian pound appreciation will reduce price growth of these items, and will also reduce the costs of subsidising key commodity imports." A 2005 IMF paper found that the exchange rate pass-through onto inflation was limited and occurred after a long delay in the case of the devaluation of the Egyptian pound. However, EFG stressed that this time the inputs are different, as global food commodity prices play a bigger role in feeding current inflation in Egypt. Also, that improvements in CPI measurement since 2000-4 will mean a more rapid pass through of exchange rate adjustment to inflation in 2008. The value of the Egyptian pound against the dollar appreciated at the beginning of the year, but the government intervened by buying a huge amount of dollars for fear that this would negatively affect its imports. "If the government left the market with no intervention, the rate will reach LE5.4 to the $1 in a matter of a couple of months," asserted the banker."
