Egypt: Shift to Flexible Exchange Rate Is Crucial Even at Risk of Exacerbating Debt Challenges

The Egyptian authorities’ commitment last October to a durable, flexible exchange-rate regime helped the government IMF support in December to shore up the external liquidity position, given challenging market conditions with the sovereign’s USD 1.5bn three-year Sukuk pricing on 21 February at 10.875%.

However, the strategy so far of moderate but repeated devaluations – rather than full liberalisation – casts doubt on the authorities’ ability to stick to this objective in the long run. The issue is not just one of currency policy but more broadly that of the government’s reluctance to scale back State intervention in the economy despite the urgency of doing so to tackle macroeconomic imbalances.

The Central Bank of Egypt (CBE) has devaluated the pound three times since March 2022 – equivalent to more than 40% in total (Figure 1) – which is similar in magnitude to the one-shot devaluation in November 2016 (50%). The CBE’s objective is to avoid large exchange-rate fluctuations and cushion the socio-economic impact of rising, double-digit inflation, running at 26.4% a year in January 2023. Core inflation was 31.2%.

Figure 1. Pound fluctuations reflect gradual transition to a flexible exchange rate

EGP per USD (LHS); Real effective exchange rate index (consumer price index (CPI)-based) (RHS)

Exchange-rate Flexibility Would Offset More Limited, Uncertain Foreign Exchange Inflows

Although the significant devaluations have enabled the real effective exchange rate to return close to 2016 levels, the incremental policy risks dulling the benefits of a weaker currency. Administrative indecision, such as the back and forth over the requirements for importers to secure letters of credit, is also complicating the creation of more fluid trading conditions for importers and exporters.

The uncertainty helps fuel speculation against the Egyptian pound as investors test the credibility of the CBE’s currency regime, discouraging full liberalisation and creating downward pressure on the pound’s value that will persist through the year.

Reducing external risks for the Egyptian economy is contingent on the government undertaking tough reforms as international financial support diminishes. The size of the IMF Extended Fund Facility approved in December 2022 is relatively modest, with upfront disbursements representing about 12% of the total financing envelope of USD 3bn compared with about 23% in 2016 out of USD 12bn. Egypt has benefited from four IMF arrangements over the past six years including Covid-related assistance.

Figure 2. Shift in international financial assistance puts focus on privatisation plans

Contribution to close the financing gap over a five-year period, % of total

Pound Flexibility to Drive Debt-serving Costs, Call for a Sustained Fiscal Consolidation

Egypt can count on other multilateral and bilateral partners to meet external financing requirements (Figure 2). Gulf Cooperation Council countries, for example, have rolled over official deposits with the CBE. Still, this strategy may have reached its limits, with USD 28bn in new or rolled-over deposits since 2016.

Privatising non-strategic State-owned enterprises could contribute to meeting dollar shortages by ensuring a level-playing field with foreign investors, though again it tests the willingness of the authorities to relinquish control of the economy, possibly to the disadvantage of military-owned companies. The IMF expects sales of State-owned assets to reach USD 8.7bn by 2026/27.

Benefits of other initiatives supporting foreign-exchange inflows such as raising competitiveness and boosting energy exports will not arrive fast enough to bridge an external financing gap estimated by the IMF at USD 17bn by 2026.

Figure 3. Central bank rate increases ratchet up debt-serving costs, spike in Treasury bill rates (%)

The CBE has complemented devaluation with rate hikes of 800bp since January 2022 that have increased government borrowing costs (Figure 3), with interest on domestic public debt, equivalent to 78% of the total, running at around 45% of revenues.

The government could turn to certificates of deposits offered by State-owned banks for short-term relief, thereby supporting national savings and funding flexibility while partially offsetting the decline in non-resident holdings of Treasury bills and tighter offshore financing conditions, with spreads on 10-years bonds of around 1,800bp. Still, this would deepen the sovereign-bank nexus. Egyptian banks hold more than 60% of public debt, equivalent to 100% of GDP in Q2 2022, and crowd out the private sector.

In these circumstances, the government will struggle to meet its goal of a primary surplus above 2% of GDP given rigid public expenditure. Interest payments, subsidies, and wages account for about 60% of total expenditure. With the government embarking on several costly national investment projects, such as building a New Administrative Capital, Egypt’s fiscal outlook remains deeply challenged over the medium term.

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Thomas Gillet is an Associate Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.