Will Egypt's Monetary Policy Be Enough To Keep Cross-Border Portfolio Investments In Play? 3

Along with many other countries currently in need of financial assistance, Egypt find itself between a rock and a hard place.  In order to procure financial support for external sources, it was required to undertake tough reform measures. However, these decisions are now taking a toll on the majority of its population.

Though the government’s focus is fixed squarely upon improving its deficit situation and attracting investment, its monetary policy moves are being widely questioned.

Since November 2016, the Central Bank of Egypt has raised its interest rates by 7% or 700 basis points. The latest hike was effected on July 6 when it surprised markets for the second successive meeting by raising its overnight deposit rate, the overnight lending rate, and the rate of main operation by 200 basis points to 18.75%, 19.75%, and 19.25% respectively.

However, similar to its hike in May, the effectiveness of the increase has been questioned.

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Rate hikes, a wild goose chase?

With inflation as high as it is in Egypt, the most expected form of response is hiking key rates. And given that bringing down inflation could solve a lot of macroeconomic problems facing the country, its central bank’s aggressive stance may not seem out of line.

But is it being done for the right reasons?

There are two types of inflation:

  • Demand-pull inflation
  • Cost-push inflation

Egypt is facing both of them.

While rampant expansion of the money supply, which causes too much money to chase too few goods, has resulted in the former, devaluation of the Egyptian pound has caused the latter as it has made imports expensive.

Though in theory, this hike should help suck the excess liquidity out of the financial system, the fact that less than 10% of the population falls under the banking system coupled with the country’s dependence on cash liquidity indicates that the hike may be having less of an impact than expected.

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The hope is that the rate hike will help bring in foreign inflows, which can strengthen the Egyptian pound. This can help in reducing import costs, and thus contain inflation to some degree. The country’s forex reserves have been bulking up as seen from the graph below.

Overall, it seems likely that cost-push inflation has more of an impact at this juncture. Given that the impact of rate increases looks diluted, why is the central bank being so aggressive?

The answer lies in the $12 billion loan that was provided by the International Monetary Fund (IMF). On July 14, eight days after the latest rate hike, the institution agreed to disburse the second tranche of that loan. With the latest installment of $1.25 billion, the total loan amount sanctioned stands at $4 billion.

The IMF has been a vocal supporter of rate increases being the right tool to control inflation in Egypt. And given the financial stakes involved, the central bank has been complying.

However, the possibly diluted impact could turn out to be negative for the country. The foreign exchange it is expected to bring will primarily be portfolio investments, which can reverse course quickly if the macroeconomic picture worsens, thus putting monetary policy in a limbo.

Hence, a sustained foreign exchange inflow is crucial to rein in price-rises and keep the country on course to achieving 13% inflation by the end of 2018.

Monetary policy and inflation levels also have a direct impact on the country’s fixed income market. Let’s take a closer look in the next article.

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