Economic recovery yet to inspire Egyptian pound

Egypt rightly won many plaudits when it announced the floating of its currency in January. The IMF welcomed it as a move that would "inspire the confidence of the financial markets and pave the way for further economic and financial reforms".

The Hermes stock index duly rallied and is now 60% above its pre float levels. However, the domestic currency market has not been similarly inspired. Since announcing the float the Egyptian pound has lost 34% of its value against the dollar.

On the surface it is hard to see why the pound has continued to depreciate. The economy coped much better with the war in Iraq than many had feared. Growth has subsequently rebounded.

Export receipts are up, helped by higher oil prices. Suez Canal dues are at a record level and tourist numbers have been quick to recover. Although domestic demand has yet to recover, it has at least stopped getting worse. Monthly bankruptcies are running below 100, compared to 350 a year ago and over 500 in 2001.

Indeed our Real Effective Exchange Rate (REER) model suggests that the Egyptian pound may have fallen too much. The REER is calculated using the weighted inflation differentials between Egypt and its main trading partners combined with the movements in the currencies.

As such changes in the real effective exchange rate give a better picture of a country's competitiveness than simply looking at its bilateral exchange rate.

The message is positive. The REER is at its most competitive for a decade and all of the overvaluation present since the late 1990s has gone. Indeed, according to fundamentals at least, the pound should appreciate from here.

However, currencies rarely trade on economics alone and the near-term risk to the USD/EGP is still to the upside. Current government policy is not helping.

There has been an understandable reluctance to let the pound freely float for fear of a free fall in its value. But official and unofficial attempts to support it have been counterproductive.

For example, a March decree that companies must convert 75% of their USD export earnings immediately into Egyptian pounds has encouraged companies to keep money offshore to avoid such regulations, starving the economy of FX liquidity.

Dollar shortages have continued and the spread between the black market and official FX rate has reopened. This runs the danger of cementing devaluation expectations among the public, which can become self-fulfilling.

There is also considerable uncertainty over what monetary policy will replace the USD peg, which had been in force since 1991. There is a risk that an upsurge in inflation will undermine the benefits of the devaluation and encourage individual's to dollarise, undermining the pound further.

The full impact of the devaluation can be seen in wholesale prices, which are running at 18.5% y/y (consumer price inflation is a more benign 3.9% y/y, but most of the basket is subject to government subsidies).

A sound monetary policy is needed quickly to provide an alternative anchor and limit the inflationary impact of the depreciation. It is worth remembering that it was runaway inflation that led to the adoption of the USD peg originally.

The government has taken steps to provide such an anchor by passing a new Unified Banking Law in June, which established an independent Monetary Policy Co Ordination Council. However, it will take time for the new regime to achieve credibility,! particularly in combating inflation.

The Central Bank's task would be made easier if the government embraced wholesale reform and liberalisation. Relaxing trade restrictions are critical if companies are to gain from the benefits of floating the pound, namely more competitive exports and easier access to foreign inputs and capital.

Current government policy runs the risk of squandering these gains. Last week's decision by Standard and Poors to downgrade Egypt's local currency debt rating to BBB- provided a timely reminder that floating the currency was a necessary, but not sufficient, step to restart the economy. S&P left its outlook on negative, we hope that the prospects for reform are brighter.