Pound sets for modest depreciation in 2018/19: Capital Economics

The currency has weakened by 50% against the dollar since it was floated last November

A recent report issued by Capital Economics, the London-based consultancy group, has expected the Egyptian pound to depreciate again in the next fiscal year, albeit at a modest pace.
The note, which has been issued to comment on Egypt's economy one year after the currency flotation, added that a weaker pound has yet to support a major improvement in the current account position, and the recent surge in capital inflows is starting to ease.
On a more positive note, some sectors have benefitted from a relaxation of FX restrictions, while inflation has now passed its peak and looks set to fall sharply.
Pound fall sharply, inflation jumps to 30-year high
After five years of struggling to maintain a tight grip on an overvalued currency, the Central Bank of Egypt (CBE) announced last November that it would move "with immediate effect, to a liberalised exchange rate regime."
Since the CBE's decision to float the pound, the currency has fallen by around 50% against the US dollar—from 8.88/$ prior to the flotation to around 17.6/$ at present.
This makes it, by some distance, the worst performing major emerging market currency over this period.
The research note said that devaluation has inevitably resulted in some short-term economic pain. In particular, the pound's decline has pushed up the cost of imports, and this, combined with administered price hikes and the introduction of a new value-added tax, has fed through into a sharp rise in inflation.
The headline inflation rate peaked at a 30-year high of 33.0% y/y in July.
In a bid to contain inflationary pressures, the CBE has raised its benchmark interest rate by a cumulative 700bp since the flotation.
Higher inflation has eroded households' real incomes, and this appears to have weighed on consumer spending. There are reasons to take Egypt's GDP expenditure breakdown (which records household consumption) with a pinch of salt, but the more reliable production breakdown shows that growth in consumer-facing sectors, such as wholesale and retail trade, has slowed.
Manufacturers benefit, capital inflows surge
According to the research note, other sectors of the economy have fared better. The imposition of FX restrictions in 2015/16—in particular a $50,000 limit on dollar deposits at banks—had made it increasingly difficult for manufacturing firms to import intermediate parts, leading to disruptions to activity.
The CBE relaxed those FX restrictions last year, and this already seems to have had a marked impact on the manufacturing sector.
Meanwhile, a weaker pound has helped to improve the country's external position. This is most evident in a pick-up in net capital inflows.
These stood at close to 12% of GDP in the four quarters to Q2, their highest since at least the mid-1990s.
This has been driven almost entirely by stronger portfolio inflows as investors have bought up cheaper Egyptian financial assets, including stocks and bonds.
Foreign investors now hold almost a third of all of Egypt's outstanding government treasury bills, up from practically zero prior to the pound's decline.
However, the research note said that the surge in capital inflows is likely to prove temporary, given that it largely reflects investments that had been held back pending a devaluation.
"In fact, there are already signs that foreign investors' appetite for Egyptian assets is starting to wane—net purchases of Egyptian stocks by foreign investors stood at an eight-month low in October," the report noted.
Moreover, there has only been a modest narrowing of the current account deficit—in the four quarters to Q2, it remained wide at more than 6% of GDP.
While a weaker pound has provided some support to exports, it has not been dramatic given the size of the currency's fall. In addition, the relaxation of FX restrictions mentioned earlier has meant that imports have not fallen back as might have been expected.
CBE intervening to rebuild reserves
The report added that despite their claims to the contrary, there are signs that the Egyptian authorities may not be fully adhering to a floating exchange rate.
The central bank appears to have been intervening in the foreign exchange market in order to take advantage of the surge in capital flows to help rebuild its FX reserves.
Reserves have risen by around $20bn over the past year, and they now cover around eight months' worth of imports.
This seems prudent given that reserves had previously been stuck at perilously low levels, which left the authorities with limited buffers in the event of an external shock. That said, a prolonged period of pound stability would raise fears that policymakers were reverting to their old habits of trying to maintain a tightly managed exchange rate.
Pound set for modest depreciation in 2018/19
"So long as the central bank does adhere to its promise of a floating exchange rate, we think the pound will record a modest depreciation over the next couple of years. We expect the currency to weaken to 19/$ by the end of next year and to 20/$ by end-2019," the report noted.
"The key point, though, is that the big currency adjustment has now happened, and, as the effects of the pound's previous steep decline begin to drop out of the annual comparison, inflation should fall sharply in the coming months. We think it could fall to 22-24% by the end of this year, which should pave the way for the CBE to start lowering interest rates," it added.
The report expected a first rate cut to come at the MPC meeting in late-December, and there are a number of reasons to think that inflation and interest rates will ultimately fall by more than most expect.
Rates on hold, but cuts come into view
"We expect the Central Bank of Egypt to keep its benchmark overnight deposit rate unchanged at 18.75% when the Monetary Policy Committee meets in mid-November," the report noted.
The latest consumer price data show that, as the effects of last year's devaluation of the pound have started to fade, inflation eased for a second consecutive month in September.
The headline rate fell 31.6% y/y, from 31.9% y/y in the previous month and a peak of 33.0% y/y in July.
"While we wouldn't rule out a rate cut at this meeting, we think policymakers will hold off until there is firmer evidence that inflation is on a downward path. Given the MPC's increased emphasis on tackling the country's long-standing inflation problem, any move to ease policy at this stage could dent the MPC's improving, but still fragile, credibility," it added.
Firmer evidence of easing price pressures should arrive with November's inflation figures, which will be released in early December and are likely to show inflation falling sharply to 22-24%.
"The MPC will have these figures to hand when it meets on 28 December, and we think the first cut in interest rates, probably a 100bp reduction to 17.75%, is likely to come at this meeting. We expect further easing in 2018 and 2019, and for interest rates to fall by more than most expect."
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The pound worst performing major emerging market currency over this period