Fitch: New Egypt FX regime positive step in tough circumstances

A more market-determined exchange rate, arising from the central bank auction system introduced on 30 December, is potentially positive. Allowing depreciation can boost competitiveness and indicates that the central bank will not defend the currency at all costs. The auction runs in parallel with the existing interbank market, but has quickly become the market's new reference rate.

The central bank can change the frequency and size of auctions giving it some control over the exchange rate but making its interventions transparent. At the end of the third auction on Wednesday, the pound had fallen by 3.3% against the dollar since the change in policy, bringing cumulative depreciation over the last two years to 10%.

But the change was accompanied by capital controls and a central bank statement that reserves had reached a "critical" level. Banks had reported dollar shortages as retail depositors rushed to convert pounds into hard currency after the approval of a contentious new constitution in late December.

After dropping by 55% in just over a year, foreign exchange reserves have held at around $15bn (about three months' current external payments cover) since end-March 2012, bolstered by bilateral transfers. Qatar and Turkey have pledged a further $500m each for January, which should cover funding needs until end-month.

An agreement with the IMF is essential for more substantial and sustainable external support and for restoring domestic and external confidence in the pound. The IMF has endorsed the decision to maintain an appropriate level of reserves, but may take a less favourable view on capital controls.

The Egyptian authorities have indicated their keenness to re-engage with the Fund in January, after asking it to delay signing off on an agreed programme last month. The fragility of the reserve position will be weighed against the political impact of introducing agreed fiscal measures ahead of February's parliamentary elections.

The modest depreciation in the pound so far is unlikely to provide much support to the balance of payments, which has suffered from the impact of political unrest on tourism and capital inflows. Suez Canal receipts, remittances and oil export revenues (55% of total current external receipts) are not sensitive to movements in the pound and currency weakness will deter foreign portfolio investors in the short term. However, if the pound stabilises and capital controls are removed, uncertainty for foreign investors and local companies will reduce.

Depreciation is likely to have little fiscal impact, owing to roughly balanced dollar-denominated revenue and expenditure. The effect on inflation will be more pronounced. Some retailers have already adjusted prices in anticipation of higher costs for imported goods and further rises will occur as depreciation works through the supply network. Measures in the IMF programme will also add to inflation.

Containing the inflationary impact is crucial if the nominal depreciation is to boost real export competitiveness. Nonetheless, with weak demand helping reduce inflation to a six-year low of 4.3% in November, an abrupt surge in prices appears unlikely.