Egypt: New president, old challenges?
A week is a long time in politics – the announcement of Mohammed Morsi as president demonstrates political life is on the path to some sort of resolution. Serious economic concerns however remain. On-going demonstrations (and jubilation) aside the newly fangled government will likely be occupied in untangling Mubarak's legacy as the economy continues to teeter on the abyss. It is almost goes without saying that devaluation of the Egyptian pound is imminent. This begs the question - how much room does Egypt have to manoeuvre and what are the trade-offs?
A week is a long time in politics – the announcement of Mohammed Morsi as president demonstrates political life is on the path to some sort of resolution. Serious economic concerns however remain. On-going demonstrations and post-election stand-off in Tahrir aside, as the newly fangled government will likely be occupied in untangling Mubarak’s legacy the economy continues to teeter on the abyss.
Despite the suspicious Central Bank claims that reserves actually rose in May, the economy may about to veer over the edge. The ‘early’ warning signs of disorderly currency devaluation are omnipresent. According to Central Bank statistics, net foreign currency reserves fell to $15.3 billion in May from $36.1 billion in December 2010 (inset chart below). Foreign exchange reserves now cover around three months of imports and freely convertible reserves (deposits), have waned from $30 billion at the start of the year. These are not new or relative lows – rather, they are potentially insolvent lows should something go wrong – such as a belief that the pound will devalue. The paradox is that imposing foreign currency conversion limits only seeks to exacerbate anxiety over the overall economic context. Venezuela is a case in point. In short, if imports slow (due to exchange restrictions), everything slows.
What happens there is scant foreign exchange to pay for imports? When imports are no longer affordable, Egypt can either (a) imports less (and spend less as a government), (b) source existing product imports from markets that offer lower prices (and eventually produce what it imports) or (c) forego more Egyptian Pounds for what it does import (at a weaker exchange rate) – or a variation of all three.
The current composition of Egypt’s imports (by product and country) doesn’t give much for manoeuvre. The single biggest import items are energy and food – the increase in the cost of these anchor products contributed to unrest in the first place.
The single biggest import item for Egypt is fuel – some $9.3bn last year. Kuwait, Saudi Arabia, Turkey and Algeria jointly supply approximately 60% of this. European refineries providers supply the rest. The second most survival-dependent item in the import bill, Cereal, is also relatively concentrated. More than 55% of cereal comes from the United States and Russia. Argentina, Brazil, the Ukraine, Romania, France, Australia and Canada supply an additional 42%. The recent $1bn ITFC loan is a pale in comparison to Egypt’s import needs.
The good news, if any, is these products are coming down in price. Oil has tapered off its 2012 highs. The bad news is global cereal production insofar as the first half of this year doesn’t look promising. A heatwave is threatening the US grain harvest and the Latin American yield is lower than last year. This doesn’t mean Egypt will spend less but it doesn’t necessarily mean less product will be imported. Egyptians are already paying more. For everything – the likelihood of the average worker spending more time in working for the same amount of foreign exchange is much higher. Inflation in Egypt averaged over 10% in 2010 and 2011. Over the same period the Egyptian pound ‘slipped’ only 6% against major currencies.
More bad news – some prices will remain sticky for some time. The price of some items has forged ahead faster than others in recent years creating a skewed consumer basket. The average Egyptian, if such a person exists, is estimated to be spending twice as much on food compared to five years ago.
What can Egypt do?
1) $1bn banked, negotiate with the IMF and apply another $3bn ‘band-aid’?
The real question is what happens when the $3bn runs dry? The reality is that Egypt needs $30bn. The Minister of Planning and International Cooperation and other officials suggested that Egypt was aiming to sign an agreement with the Fund in February, March, April, May, June and now July perhaps? It’s no surprise that there is a complete disregard or political currency for the IMF’s key conditions. They are (almost everywhere) hugely unpopular and come at time when there are more pressing matters at play. Ultimately the stand-off with international creditors is likely to leave the central bank in a position whereby it would no longer be able to defend the currency. The irony is, in the context of a devaluation, Egypt would probably need the IMF funding more. Governments world over are no longer borrowing at competitive rates – foreign investors have largely abandoned Egypt’s debt market sending yields on one-year government bills to about 16% from 11% at the start of last year. Foreign holdings of Egyptian treasury bills are one-twentieth of the level they were last year. Other sources of band-aid financing are available and Egypt has sought to apply these as soon as possible:
2) Let the pound slide, impose capital controls and write lots of ‘I owe you’ stick-it notes. AKA, ‘do nothing but pretend you’re doing something’ scenario. Assuming the government is caught flat footed with very little vestibile currency banked, virtually little more than a few chestnuts in the coffers, there would be almost no room for manoeuvre on the currency. Ironically, letting the pound slide would make the fuel and food subsidy fix unsustainable and the IMF would not needed to advise how to perform the burdensome task of impoverishing millions of Egyptians. It would be a systemic outcome.
According to some REER estimates from the smart guys at Capital Economics, the pound is likely to slide around 15%. I think 30% is much more likely. What happens if the pound slides? It would give tourism the much needed boost provided operators don’t ramp up their prices immediately. Tourist arrivals in Egypt are down 40% in May this year compared to the October 2010 season peak of 1.48 million visitors. [Updates on the impact analysis available by email]
3) Do the hard things first – get back to work and restore investor sentiment.
Egypt has the ability to produce what it imports domestically– an import substitution cum industrialisation strategy – which would require at least a decade of industrial resolve geared on the productive and technical constraints seen elsewhere. Import taxes can only partially band-aid the hefty productivity gashes. Investing in a post-industrial complex mind-set requires an education system geared to producing entrepreneurs who can go from ‘0 to 1’. The ‘1 to n’ is relatively straight forward. We are perhaps a generation away from this.
Should the confluence of outcomes 1) and 2) prove difficult to bear for the population at large there is always the option of targeted subsidies. The most vulnerable voted and they will rightly be protected. The Brotherhood has nominal control of the parliament and the constitutional assembly and now the presidency but they too understand that it could all be lost if they fail to manage the economy. Their allies could too well be the military in this regard. February’s military’s cash transfer of $1bn towards to the government budget is a linchpin as much as the possibility an IMF hand out. Further, (low-spend) tourists are coming to Egypt while prices are depressed, and its Peace Pipe (critical gas pipeline) to its neighbour underlines that there is more foreign exchange slack than most statistics currently show.
Verdict: Rhetorical discourse is likely to be directed at maintaining political plurality, crafting of a new constitution – and we all know this does little to resolve Egypt’s finances. This, however, bodes well for the IMF because right now it’s the cheapest creditor in town.
Disclaimer: The commentary is entirely a personal view, comes without guarantees and does not represent the view of the entities or establishments the author works, or has worked for.