Egypt floats for recovery

In January of this year Egypt shocked the markets and finally allowed its currency to float, abandoning its managed peg against the USD.

The move took local and international participants by surprise. Given the backdrop of high regional tension and a weak domestic economy the timing, at least at first sight, appeared strange. Regardless, the move was unambiguously welcomed. The local stock market had its largest one week rally in two years.

Multilateral donors had been pressing Egypt to reform its currency regime. Indeed this had been the one key condition for the release of USD10.3bn in soft loans and grants promised to Egypt at a Sharm el Sheikh donor conference in 2002.

The immediate impact was for the currency to depreciate by 16% to match the unofficial rate of 5.3 against the USD. The Central Bank remains worried about a free fall in the value of the currency. It has therefore been actively managing the float.

This explains the orderly decline in the value of the pound to 5.7. But it also means that dollar shortages have continued. The parallel market has sprung up again and the Central Bank has therefore lost an excellent opportunity to build confidence in the new regime.

Indeed recent policy steps have represented a move away from liberalisation and run the risk of compounding problems that existed under the currency's old fixed peg. The government has introduced a rule that requires hotels and exporters to convert their hard currency earnings into Egyptian pounds. This is aimed at increasing local hard currency liquidity.

However it will reduce companies immediate access to hard Currency and make it more difficult to purchase imports. It also increases the incentive to keep USD profits offshore or use the unofficial market, negating the benefit of floating the pound in the first place.

In light of the external shock an Iraqi war could have on the economy the Central Bank's concern is understandable. The government's own estimates suggest the regional situation could cost the economy USD6-8bn, mainly in lost tourism revenues. But a free-floating currency is the best shock absorber an economy can have.

It would also facilitate the release of the considerable aid money promised. The World Bank has begun the payment of a USD1bn loan but it is not known whether the current currency regime meets the requirements for the other grants promised in 2002.

The value of the Egyptian pound against the US dollar has fallen by almost 70% over the last three years. The exchange rate's last decade of misalignment has been mostly eliminated and competitiveness restored.

Already trade data is improving. The current account reported a USD153m surplus in the first half of the 2002/3 fiscal year compared to USD359M deficit for the same period the year before. Iraq and higher import costs will hit these numbers in the second half of the year but an improving trend should now be possible.

There are also signs that the domestic economy has bottomed. The number of final corporate bankruptcies peaked in 2000 at over 12,000 and has been on a downward trend since. There has also been some anecdotal evidence of a pickup in demand, but private investment and spending remains constrained by high real interest rates and a lack of access to local credit.

As the government has sought to finance its rising public deficit the private sector has been crowded out. The high level of bad loans in the banking system, officially estimated at 13% of total assets, but privately thought to be much higher, has also reduced banks lending appetite to the private sector.

A truly free floating currency would be a big boost to the economy. Interest rates would fall and capital and trade restrictions could be relaxed, allowing domestic companies access to imports and foreign financing. A free floating currency would also be an important symbol that the government is serious about reform and restoring some of Egypt's tarnished reputation with investors.