Monday, 30 November 2015

Can Egypt’s new central bank governor solve its currency crisis?

To tackle Egypt’s currency crisis, the authorities need to address the root cause of the problem: declining exports volume.

The new governor of the Central Bank of Egypt, Tarek Amer, whose term only began on 27 November, faces an immediate currency crisis. The crisis manifests itself through downward pressures on the Egyptian pound, a shortage of foreign currency and a burgeoning black market. The government is trying to solve this problem by raising foreign currency, either through a loan from the World Bank or investments from Saudi Arabia. But this is merely a short-term fix. The authorities need to address the root cause of the crisis, which is the decline in Egyptian exports volume since 2008. Here is why.

1. The value of a country’s exports relative to imports is an important determinant of the price of its currency. More exports imply higher demand for the country’s currency, leading to an appreciation. Conversely, more imports typically lead to a depreciation.

2. Egypt has almost always imported more than it exported, but the gap in the early 2000s was small enough to be filled by the stable inflow of foreign currency remittances from Egyptians abroad. However, this gap began to widen and, since 2008, became too large to be offset by transfers from the Egyptian diaspora. Successive governments relied on different sources to finance this gap, including foreign inflows into Egypt’s stock and debt markets, withdrawing from international reserves and support from the Gulf. But none of these sources proved sustainable, which is why there is a crisis today.

3. Why has export growth lagged import growth since 2008? To identify the source of the problem, assume for the sake of argument that Egypt exported oil. Is the problem due to Egypt’s exporting fewer barrels of oil (a volume issue)? Or is it due to lower oil prices (a price shock)?

At least part of the problem is due to exports volume, which has not only failed to keep up with imports volume growth, but it has actually been declining since its peak in 2008 (see chart).

4. One way to quantify the impact of declining exports volume is through a counterfactual analysis. This is done by asking what would have happened to Egypt’s external balances if exports volume had remained at the 2010 level, but everything else (export prices, exchange rates, imports and transfers) had evolved as in the actual data.

Under the counterfactual scenario, Egypt’s current account (the sum of trade balance and transfers from foreign governments and Egyptians abroad) would have been in a surplus of 2.2% of GDP in 2014 instead of a 2.0% deficit. Even if we exclude public transfers (mainly support from the Gulf amounting to about $15bn in 2013-14), the current account would have been in a slight deficit of 0.5% of GDP.

This suggests that if Egypt had maintained its exports volume at the 2010 level, let alone succeeded at growing it, it would have probably averted its ongoing currency crisis.

5. So why did exports volume decline so much? Potential reasons include: First, slow growth in Europe—Egypt’s main export destination—which reduced demand for Egyptian exports. Second, less tourism due to the worsening security situation. Third, reduced traffic through the Suez Canal due to the slowdown in global trade.

6. In conclusion, reviving exports should be the main solution of Egypt’s currency woes. But this is a problem that cannot be readily solved by a new central bank governor or monetary policy. Certainly not on their own.