Did CBE miscalculate including part of hot money within foreign exchange reserves?

A debate among analysts about the CBE's inclusion of foreign investment in treasury bills in its reserves

The Central Bank of Egypt (CBE) disclosed that its foreign exchange reserves rose to $36.036bn at the end of July 2017, compared to $31.305bn at the end of June 2017, an increase of $4.731bn.
This is the first time that reserves have crossed its highest level in December 2010, when they recorded $36.005bn. This reserve level is the highest in Egypt's history.
Meanwhile, foreign exchange reserves increased by $20.5bn in one year, reaching $36bn in July 2017, compared with $15.5bn in July 2016, an increase of 132.5%.
According to the numbers that were obtained by Daily News Egypt, foreign currency at the CBE by the end of July 2017 amounted to about $4.696bn, reaching $32.6bn against $27.904bn in June.
The value of gold listed in the reserves rose by about $27m at the end of July to reach $2.629bn against $2.602bn in June.
Special Drawing Rights (SDRs) in reserves amounted to $778m against $770m, while loans to the International Monetary Fund (IMF) amounted to about $31m.
This large increase in the volume of foreign exchange, which entered the reserves in July 2017, amounting to about $4.7bn, raised many questions in the market about the source of all this liquidity, especially since Egypt received only about $1.25bn from the IMF this month—while, on the other hand, it paid about $750m to the Paris Club nations and did not raise any new bonds on international financial markets.
The answer to these questions came from Rami Aboul Naga, a deputy governor of the CBE, who revealed in his remarks that the reasons for the increase in foreign exchange reserves during July 2017 are the entry of the second tranche of the IMF loan of $1.25bn and the investments of foreigners in Egyptian government debt instruments. He added that another reason for came on the back of increased confidence in the Egyptian economy.
Aboul Naga pointed out that Egyptian banks achieved dollar inflows during July 2017 at a value of $7.8bn as a result of a marked increase in foreign investments in Egyptian treasury bills, as well as increased concessions from customers on foreign currencies, resulting in a large proportion of remittances from Egyptians abroad.
Aboul Naga stated that the CBE received part of the liquidity flowing into banks during July and was included in its foreign exchange reserves, which led to its rise in this manner.
But how do these funds enter the CBE?
This question is answered by the head of the treasury sector at a bank, who preferred not to be named. He explained to Daily News Egypt that the foreign investor is selling the dollar to banks and getting the equivalent in local currency to invest in the EGX or in government debt instruments. There is more liquidity that the banks receive from their customers, workers abroad, or proceeds of exports collected from some exporters.
He added that banks cover their customers' foreign exchange requests from the proceeds and then inject a percentage of their surplus in the interbank market if another bank needs foreign exchange. In case there is no demand for foreign exchange in all banks, as is currently the case in the market, the liquidity is sold to the CBE, which injects it into foreign exchange reserves.
According to the source, any liquidity in foreign currency enters the state for a year or more, whether the proceeds of loans, bonds, or treasury bills offered by the CBE in dollars or euros, enter foreign exchange reserves, while the same liquidity maturing in less than a year are not included in the reserves.
The question posed by Daily News Egypt here is whether the CBE is entitled to include the value of foreign investments in treasury bills within the foreign exchange reserves, even though they are hot money and may come out of the Egyptian market at any time.
There are those who believe that the behaviour of the CBE is normal and is carried out by many central banks in the world, and there are those who see otherwise, where they believe that the CBE, despite managing to boost the foreign exchange reserves to a record high, makes the reserve weak and fragile because it is built on loans, bonds, and hot money that may overthrow the record at any time, rather than being based on the resources of the state's own foreign exchange.
"We are in exceptional circumstances. Therefore, the inclusion of a portion of foreign investments in government debt instruments in the foreign exchange reserves is not a problem at all, which is done by central banks in most countries of the world and not only by the Central Bank of Egypt," the source said.
According to earlier statements by Farouk al-Okdah, former governor of the CBE, who earlier was accused of wasting the reserves, reserve balances increase or decrease by surplus or deficit in the balance of payments.
Foreign currencies, which constitute the foreign reserve of Egypt, consist of the major currencies: the US dollar, the euro, the British pound, the Japanese yen, and the Chinese yuan, all of which Egypt holds in different rates according to the exchange rates of these currencies and their stability in international markets. The amount held by the CBE changes according to a plan put together by its officials.
The main function of the CBE's foreign exchange reserve, with its various gold and international currency components, is to provide commodities, repay premiums and interests of external debts, and cope with economic crises, in exceptional circumstances where foreign currency natural resources are affected.
A fragile and weak reserve
Prime Investment Holding Company (PRMH) was not happy with the latest leap in foreign exchange reserves and reached its highest level in Egypt's history. The company said in a report that although foreign reserves rose to the highest level, they were built mainly on external loans, making them weak reserves.
The report pointed out that short-term investments amounted to $10bn since the flotation decision in November 2016, of which $7bn will be due before the end of 2017, in addition to $1.7bn that are supposed to be repaid before the end of this year in debt services for medium- and long-term loans, including a $1bn one obtained from Turkey in 2012 and is expected to be repaid in October 2017, and settle debts of $500m to Libya and $100m to Saudi Arabia.
In its latest report issued several days ago, the CBE noted that the short-term foreign debt was about 44.2% of net international reserves by the end of March 2017.
The PRMH predicted that the rise in the appreciation of the Egyptian pound will lead to the exit of foreign investments and hike imports, which will then bring the exchange rate to its current levels again. It expected the current volatility of the exchange rate and fluctuation around EGP 17-18 to the dollar to continue until the end of 2017. The report did not expect any real appreciation of the value of the pound unless foreign exchange sources are sustainable again, such as foreign direct investments (FDI), export earnings, and tourism revenues, which the PRMH expects to see by the end of fiscal year (FY) 2017/18.
In contrast, the PRMH said the country is waiting for $1bn as a third (and final) tranche of the World Bank loan, planned for 2017.
The PRMH added that the increase in reserves would have been greater if Egypt had not paid $720m by the beginning of July 2017 to the Paris Club, pointing out that the increase in foreign reserves came after obtaining the second tranche worth $1.25bn from the IMF, next to foreign currency inflows by investing in short-term domestic debt instruments and treasury bills, which exceeded $2.5bn in July, especially after the CBE's Monetary Policy Committee (MPC) decided to raise interest rates by 200 basis points.
The increase in foreign exchange reserves is a strong indicator that the decline in the trade balance deficit and the sustainable sources of foreign income (tourism revenues and FDIs) are in the recovery phase, in addition to the return of Egyptians working abroad, which are expected to increase with the summer vacation season, according to the PRMH.
Vice Minister of Finance for Fiscal Policies and Institutional Reform, Ahmed Kouchouk, said in previous remarks that the volume of foreign investment in government debt instruments reached about $3.5bn in July 2017. He pointed out that this month witnessed the largest demand of foreigners to subscribe to the Egyptian debt instruments since the exchange rate flotation in November 2016.
He added that the volume of foreign subscriptions in government debt instruments since the flotation until the end of July 2017 amounted to about $14bn.
Credit for the economic reform programme
HSBC noted that Egypt's foreign exchange reserves jumped by more than $17bn since the Egyptian government and the CBE began implementing the economic reform programme and the signing of the loan agreement with the IMF.
The bank said in a research note issued after the CBE announced reserve figures at the beginning of August that the net foreign reserves increased by $4.7bn in July 2017, becoming the largest monthly increase since mid-2015. The reserve registered then its highest level since December 2010.
According to HSBC, Egypt's economic reform programme, supported by the IMF, helped boost reserves to cover purchases of about six months of imports.
"For the first time, the trade deficit during the first five months of 2017 decreased by 21% on the back of an increase of 16% in the volume of exports and a decrease in imports by 7%, as well as the increase in the proceeds of remittances of Egyptians working abroad," the report read.

It added that the Egyptian economy attracted investments of about $13bn in government debt instruments during the current year, including $3bn in July. The assets of foreign currencies also increased to slightly less than $10bn by the end of the same month, bringing the total foreign assets of the CBE to $45bn.
The jump in Egypt's foreign exchange reserves reflects the growing confidence of foreign investors in the growth of the Egyptian economy after the success of the IMF-supported economic reform programme, according to a report published by Bloomberg News.
Bloomberg noted that the move to liberalise the exchange rate in Egypt in November 2016 attracted significant investment flows to the Egyptian banking system, in addition to securing the IMF loan of $12bn, of which Egypt already received $4bn.
The latest report issued by the CBE indicated that Egypt's external debt reached about $74bn at the end of March 2017. The external debt ratio reached 41.2% of GDP at the end of March, compared to 37.6% at the end of December 2016.

Of these, $22bn are owed to Saudi Arabia, the United Arab Emirates (UAE), Kuwait, Oman, Turkey, and Libya; $4bn from the first and second tranche of the IMF loan; $2bn from the World Bank; $2.6bn from China; $1bn from the African Development Bank; $700m from the European Union; $13bn in international bonds; and $2.2bn to international oil and gas companies.
The question we are asking here is whether Egypt's foreign exchange reserves stand up to all these debts.
This question is answered by a prominent banker with yet another question: will all these debts be due in one day? Certainly not, he said.
The source explained that the maturity of loans and bonds in the reserve is varied and up to 30 years. Therefore, he is not worried about reserves, especially if there are strong expectations of the return of natural income resources, such as tourism, foreign direct investment, increasing Suez Canal income, remittances, and export.
Reserve management is not instantaneous
According to Mohamed Abdel Aal, board member of both the Suez Canal Bank and the prominent expert on exchange markets, the management of foreign exchange reserves in all countries of the world is not instantaneous, but is managed according to future scenarios, which are very carefully placed on future resources and future needs of foreign exchange to meet the obligations of the state and secure its imports for certain months.
He stressed that the team that manages the foreign reserves at the CBE is a professional team and at the highest level of efficiency, and we must trust them.

In response to a question about the CBE's right to include hot money within its foreign exchange reserve assets, Abdel Aal said that the CBE has the right, of course, to do so, and what it is doing is not heresy, but is practised in countries all over the world.
He pointed out that the inclusion of hot money in foreign exchange reserves may be dangerous if there is a shortage of foreign exchange in the country, which is not the case in Egypt now, as there are almost daily flows of foreign exchange into the Egyptian market from foreign investors to invest in government debt instruments. He added that if one investor leaves, hundreds replace them.
"There is a stable flow of foreign investors to invest in the 3, 6, 9, and 12-month debt instruments. There is a strong possibility of renewing these deals. The interest rate differential and the current exchange rate attract foreign investors and, therefore, there are no concerns that their exit will impact flows to the Egyptian market, especially in the presence of pledges by the CBE to ensure the transfer of these funds at any time," he explained.
Moreover, he pointed out that if the Egyptian market, for example, has access to hot money of $4bn, there is a strong possibility that 70% of these investments will be renewed again, next to a 60% chance that other investors will enter the Egyptian market.
According to Abdel Aal, the foreign investor is borrowing from his country with a yield of 0.5%. He comes to the Egyptian market to sell the dollar at EGP 18 and invests in debt instruments with a yield of 19% and thus profits in millions.
He stressed that in light of all these advantages that investors find in Egyptian government debt instruments and the continued flow of their investments, these have turned from hot money to stable investments. Therefore, the CBE did not make a mistake in including part of them in its foreign exchange reserves.
Psychological, economic, and political reassurance
A question that was posed by Abdel Aal was: what is the disadvantage of having a part of, or even all, of the reserve in loans, bonds, and hot money? He answered it with saying that countries the world over do this as long as there is psychological, economic, and political reassurance in the state.
He pointed out that the foreign exchange reserves are the net foreign currency held by the state and held by its central bank to meet its needs for a specified period of time. He added that there is no standard or limits on which the foreign reserves of any country can stand. Yet, a reserve commensurate with the state's circumstances and time conditions, taking into account the monetary crises experienced by countries from time to time.
"Each country maintains a foreign exchange reserve that guarantees at least the possibility of repaying its imports of basic commodities to its citizens over a future period, and this period has no specific scale or number," according to Abdel Aal.
He pointed out that the closer the number of months of imports covered by the reserve is to three months or less, the more the country is in danger. The more months, the better, he added.
However, Abdel Aal believes that there is often no link between the size of the reserves in a given country and the size of its foreign exchange needs with the level of its economic progress or the standard of living of its people.
The example was given by the China, whose foreign exchange reserve stood at the end of Q1 2017 at more than $3.3tn, a level that has nothing to do with China's import size nor with the size of its external commitments. Japan also has the world's second largest reserves of $1.3tn. India at $360bn, Brazil at $358bn, Germany at $138bn, Britain at $159bn, America at $118bn, and Saudi Arabia, which has the largest reserves among Arab countries, at $616bn.
The total reserves of the world are more than $12tn, and the IMF expects the figure to drop by 5.6% by the end of 2017.
According to a statement issued by the fund, it expects the size of the reserves in nine Arab countries headed by Egypt to increase, next to a decline in seven other Arab countries.
Benefit of reserve growth
According to Abdel Aal, the rise in foreign exchange reserves is one of the main strengths of the Egyptian pound against the dollar, which will inevitably increase the supply of foreign exchange.
He added that the lesson here is not the sources of the reserve building, but the feasibility of making it available to the CBE, and its adequacy to meet Egypt's needs of financing the import of strategic goods and payment of interest and external debt installments.
"The reserve growth phenomenon is considered to be the most important factor of strength that reassures the international institutions that financed and funded Egypt on the ability of the state to pay the instalments and interest on time. The confidence of foreign and local investors also raises the possibility of stability of the exchange rate," Abdel Aal said.
Foreign reserves are also used to maintain adequate liquidity to deal with sudden economic crises, crises resulting from natural or human disasters, and sudden stop of production, export, and shortages of foodstuffs and essential commodities locally.
It is known that Egypt imports an average of $5bn worth of goods per month, totalling over $60bn per year. Thus, the current average foreign exchange reserves cover about 7.2 months of commodity imports to Egypt—higher than the world average of about 3 months.
An important positive factor for the rise in foreign reserve balances is the strengthening of foreign investors' confidence in the Egyptian economy and the economic reform programme, which increases Egypt's credit rating by international credit rating institutions, increasing foreign investments in Egyptian government debt instruments and FDI inflows.
Reserve and the president's expectations

President Abdel Fattah Al-Sisi expressed his hopes that Egypt's foreign exchange reserves will reach $350bn.
Asked about the extent to which this could be achieved, Abdel Aal said that, according to what the president said in this regard, "I think that this is the next objective of the CBE." He pointed out that countries such as India and Brazil have managed to achieve economic renaissance in the same way that Egypt is currently attempting to implement. These countries reached high levels of foreign exchange reserves and have been maintaining them.
Abdel Aal said there is nothing to prevent Egypt from fulfilling the president's expectations regarding reserves within three years, but on several conditions: completing the economic reform programme; reforming the balance of payments structure; improving the credit rating; maintaining the stability of the exchange rate; postponing some debts to the long terms to relieve the pressure on the reserves; as well as working on the development of natural resources for foreign exchange and reducing their use by limiting or permanently stopping imports.