Serenity Now

July 8, 2017

 

I was as surprised – correction, shocked – as everyone else last Thursday when the central bank of Egypt announced yet another raise of benchmark interest rates by 200 basis points for the second time in a matter of months. My initial reaction was one of deep concern. How could they do this, again?

 

The latest rate rise represents an overall raise of 700 basis points since the Egyptian pound was floated in November 2016. The rationale for the multiple rate hikes has remained consistent; raising benchmark interest rates is an effective monetary policy tool to curb inflation, which has risen to around 30% since the Egyptian pound was deeply devalued as a result of the floatation of the currency.      

 

Officially, the Monetary Policy Committee, led by central bank of Egypt governor Tarek Amer, is the independent body that sets benchmark interest rates and they have argued in favor of this policy for quite some time. Unofficially, however, the market view is that this policy comes straight out of the IMF playbook, who have publicly lobbied for this approach across the globe and applauded the Egyptian Monetary Policy Committee for their implementation of this policy in Egypt.

 

The basic economic theory argued by those who believe adjusting interest rates is an effective monetary policy tool to deal with inflation is that when interest rates go up, people save more and spend less, hence inflation comes down. This theory has proved to be somewhat effective in advanced economies where almost everyone has a bank account and access to financial products that allow them to make intelligent saving and investment decisions.

 

So, looking to Egypt, who has benefitted from these interest rate hikes? For the first rate rise of 300 basis points back in November 2016, the state-owned banks offered very generous certificates of deposit that certainly had an impact and many savvy Egyptians bought into this product. The policy reversed the dollarization trend and pulled valuable hard currency back from the black market into the formal banking system. It did not, however, have any impact on inflation.

 

As far as I am aware, after the last rate hike in May, none of the banks offered more favorable financial products to customers and, therefore, it would be hard to argue that the rate rise led to people saving more and spending less.

 

Apart from Egyptian savers, the Egyptian government have also benefitted, to some extent, from the rise in interest rates, as they were able to issue sovereign debt instruments that have been lapped up by foreign investors. The central bank of Egypt confirmed last week that FX reserves have reached a high of over USD 31 billion, so clearly this policy is working on that front. It has not, however, had any impact on inflation.

 

Those who disagree that the use of interest rates is as an effective tool against inflation in Egypt argue that inflation is not demand driven, but rather supply driven.  The rapidly increasing cost of energy and the cost of new taxes is what is driving up inflation, not increased demand from consumers.

 

Further, even if we were to assume that inflation is demand driven, one would have to question how effective interest rate rises are in a country where, at best, only 20% of the population have access to bank accounts. If you are one of the many unbanked with no access to financial services, what difference does it make if the interest rate is 1% or 20% on a certificate of deposit?  

 

The detractors further point out that the hyperinflation we are experiencing, which is stated in year on year terms, reflect a one time trigger event, which was the deep devaluation of the Egyptian pound in November of last year. It makes more sense to think of inflation on a month on month basis, which started to stabilize before the last 200 basis point rate hike in May.

 

So who are the biggest losers from the rise in interest rates? Anybody who is borrowing in Egyptian pound, which means almost all medium to large sized businesses operating in Egypt and, more worryingly, the government itself.

 

If you are a business and your cost of capital is north of 20%, then you have only one option, which is to try to increase prices to make up the difference, which leads to higher inflation.

 

For basic goods and services, such as energy and food, most businesses can do this because consumers simply do not have a choice.

 

But for most other businesses, where the power between buyers and sellers is more balanced, increasing your prices will probably lead to decreased sales, sometimes significantly, which means you are in serious danger of going bankrupt. Is this really how we want to promote investment in key industries, such as manufacturing and agriculture?

 

I have real sympathy for those businesses right now and I am deeply worried about the aftermath if those businesses go bust. Thinking of the tens of thousands of jobs that could be lost is actually quite scary, especially at a time when the cost of survival is spiraling out of control.

 

As for the government, they are in a similarly precarious position. What is the point of introducing tough and unpopular economic reforms to increase tax revenues and remove subsidies, when your cost of borrowing is increasing rapidly and approaching credit card interest rate levels?

 

Sure, the government are now tapping up international markets for foreign currency borrowing as opposed to Egyptian pounds, but this also comes at a cost. When governments who borrow in their local currency run into trouble, they just print more money (which, by the way, we have done regularly since 2011 and, surprise surprise, leads to higher inflation).

 

You cannot do this when you borrow in foreign currency and, as we have seen with Argentina, lenders on the international markets will be merciless if we were to have a change of fortunes. The hot money pouring into our FX reserves from carry traders could evaporate overnight.

 

The more I think about our self-made current predicament, I can’t help but to see the funny side of life as a coping mechanism and I had a quiet laugh to myself as I compared our situation to the “The Serenity Now” episode from Seinfeld. A must watch if you haven’t already seen it.

 

Jokes aside, we can and we should reverse this stillborn policy as soon as possible. There is no one size fits all solution and the IMF have got it wrong as far as Egypt is concerned. The Monetary Policy Committee can reduce interest rates back to sustainable levels anytime they want.

 

I agree with most Egyptian economists’ argument that controlling Egypt’s currency is a more effective tool of combating inflation, providing this does not mean central bank of Egypt’s intervention in the FX markets to artificially prop up the Egyptian pound. We tried that and it failed, let’s learn from our mistakes.

 

Instead, the government needs to re-double its efforts to stimulate foreign currency inflows, by promoting and supporting tourism, export and local substitution businesses. How can an exporter or a local substitution business operate with 20% plus interest on the cost of debt? What is the point of promoting tourism if no tourism businesses are left by the time the tourists arrive?

 

I sincerely hope that Tarek Amer, as well as the other members of the Monetary Policy Committee, are seriously asking themselves these questions.

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