Co-Author: Ahmed Kheir Eldin
The functioning of a country’s exchange rate regime is a critical factor in the economic policy making. Factors assessed are the size and openness of the economy, inflation rate, labour market flexibility, degree of financial development, the credibility of policymakers, capital mobility. Every country that has its own currency must decide what type of exchange rate arrangement to maintain. In academic discussions, the decision is often posed as a choice between a fixed or a flexible exchange rate. In reality however, there are different varieties of fixed and flexible arrangements, providing a range of alternatives. The different alternatives have different implications for the extent to which national authorities participate in the foreign exchange markets. According to their degree of flexibility, exchange rate regimes are arranged into three categories: Currency Unions, Dollarized Regimes, Currency Boards and Conventional Fixed Pegs are defined as “Fixed-Rate Regimes”; Horizontal Bands, Crawling Pegs and Crawling Bands are grouped into “Intermediate Regimes”; Managed and Independent Floats are defined as “Flexible Regimes”.
Mundell-Fleming Trilemma maintains that it is impossible to simultaneously sustain three desirables yet contradictory objectives facing policy makers viz. fix the exchange rate for relative price stabilization, free capital mobility for efficiency and an independent monetary policy for output stabilization purposes. The ‘Economic Trilemma’ that each government has to deal with cannot be achieved simultaneously. While stable exchange rates are important for keeping inflation expectations down, capital flows are a necessity for enhancing growth and development in developing countries, and monetary policy autonomy remains an essential tool for macroeconomic adjustments. This trilemma raised the debate on what exchange rate policy to implement in developing/emerging economies that are getting deeply involved in the globalization process.
Before the “open door” policy implemented in 1974, Egypt in the context of the ‘Economic Trilemma’ was located near the point D, which was where the majority of countries were positioned post Bretton Woods. Since 1991, the Egyptian government adopted an active monetary policy through Treasury Bonds issues, which led to foreign capital inflows and current account surplus. In the same time, the Central Bank of Egypt (CBE) intervened continuously by buying the excess of foreign currency in order to avoid nominal exchange rate appreciation, and a loss in the competitivity of the exporting sector. This might be interpreted as a position that is still compatible within the A(D)B side of the triangle. Even though the Egyptian government announced its free floating in January 2003 to resolve this ‘alleged’ policy inconsistency (a shift towards point F on the Trilemma triangle), signs pointed to it being more of a ‘managed float’.
In January 2001, the government decided to restore market stability and confidence by announcing a new central exchange rate of EGP 3.85 per USD and introducing a “crawling peg” system. A three-stage devaluation was operated during that year and the Egyptian Pound lost 32 percent of its value, shifting to EGP 4.51 per USD. It was expected that the devaluation, together with some currency injections, would stabilize the market until the drop of the exchange revenues recovered. Unfortunately, the negative effects of the 1997-1998 exogenous shocks owing to the Asian crisis which made Asian imports competitive and contributed to a rise in Egyptian imports (increased trade deficit), the Luxor attack deteriorating tourism receipts were only aggravated after the events of September 11, 2001, with further decline in tourism and Suez Canal receipts. In the mean time, capital controls re-imposed by the authorities encouraged black market operations, which put the exchange rate under pressure, the black market premium being around 10 percent over the past four years. On January 28, 2003, the Egyptian Prime Minister announced a free float of the Egyptian pound. By mid-October the exchange rate had declined by 33 percent reaching EGP 6.15 per USD.
Since the beginning of 2011, when mass demonstrations across Egypt forced Mubarak to step down, Egyptian media and ordinary citizens have been closely watching the FX reserves and US dollar exchange rate against the pound. State linked media as well newspapers then accused demonstrations and strikes for draining FX reserves by hindering production and hurting tourism, saying none about the economic performance of the SCAF ruling the country according to a mandate by Mubarak upon his departure, or about the monetary authority. After the appointment of the third Government after “January 2011 Revolution”, this time by Egypt’s first fairly elected president Mohamed Morsi, state and privately owned media put all the blame for economic deterioration, citing the falling reserves, on Morsi and his Government, and also held them responsible for the depreciation of the pound that fell against the dollar by more than 3% to trade ‘unofficially’ at EGP 8.25 per dollar in only few months after the central bank decided to entirely change its currency regime including the local Interbank FX Market and started to use FX auctions to sell dollars to Egyptian Banks. A lot of arguments supported the action by the Central Bank among them; its inability to control the Exchange rate; and running a low level of FX reserves that barely cover 3 month imports and is mostly supported by foreign aid.
Not much was said during all this period about the responsibility of the central bank in the management of both the exchange rate and FX reserves. Despite the fact that Morsi was always accused of building FX reserves out of foreign aid in the form of deposits Saudi Arabia, Qatar, Libya, and Turkey, this aid remained the main source for building reserves even after Morsi’s removal. And a lot of important questions was never fairly answered; What depleted the FX reserves? And were they rationally and well managed? Was the Egyptian Pound fairly Priced? What allowed, caused, and/or helped dollarization? In theory, dollarisation is a process in which the central bank invites holders of notes and coins to exchange their currency for dollar. In effect, the central bank closes itself down, except as repository of commercial banks’ liquidity requirements. The biggest measurable gain is the elimination of currency risk and is politically more attractive than devaluation. Costs of dollarization is the government binding itself into a straitjacket like situation by its inability to use the exchange rate as a tool of policy. Thus any adjustment the economy needs to go through, say reducing CAD, goes through either via the prices and wages being downwardly flexible or that domestic spending needs to shrink. Thus such economies are faced with the prospect of recession whenever an external shock occurs. Dollarization only makes sense when the inflation and productivity growth of the economy is in line to the US, there exists price and wage flexibility, a large ratio of international reserves to currency in circulation since these reserves will provide the collateral enabling the lender of the last resort function to operate efficiently.
Putting all the past in the background and shedding light on nowadays long waiting lists of dollar buying orders by Egyptian companies and individuals to be able to buy imported goods and services necessary for day-to-day life and for the economy to operate, will enable us to see the importance of a functioning FX market which commercial banks can normally rely on to supply those clients with foreign currency. This market can never exist if all the participants are on the buy side, while the Central Bank stands alone to sell. And its absence erodes the confidence in the Pound, making it harder and harder to find sellers of foreign currencies, adding more pressures on the Pound and complicating this vicious cycle.
When we look deeper at their idea and reasons of their existence, we can brief Markets in one phrase; “Price-setting mechanism by balancing supply and demand” and there we can find what is missing in the Egyptian Foreign Currency Market, the faith in the exchange rate setting process and not the currency itself and its fundamental value. Does the mechanism and its procedures in the official market provide us with a fair exchange rate that reflects the demand and supply of the dollar inside the Egyptian economy? Or is the USD/EGP rate in a ‘metaphoric term’ compressed and is waiting for a release to bounce to a fairer rate? And aside from rate, the amount of dollars being traded in the official market (provided mainly by the central bank) is clearly not sufficient enough to meet the demand, and that’s why a parallel market exist and dollar trades there against the pound well above its official exchange rate.
Lastly, let us conclude what is needed to be done in order to have a functioning domestic currency market and to end the unofficial trades occurring outside of it; that’s to say ending the black market; buyers and sellers should be motivated to move their trade to the official market. This requires two vital things to be done mainly by the central bank:
1) Fulfilling all the orders to buy dollars in the priority lists at banks, thus enabling banks to direct the dollar resources to clients outside those lists or sell it in the interbank market. This might drain the FX reserves at first, but will restore the confidence in the ability of banking system and the central bank to hold grip of the currency market and will urge holders of the dollar for speculation to sell it and at later stages those who hold it as value storage will join.
2) Achieving more liberation in the setting and movement of the exchange rate of the pound against the dollar and the cross rate against other currencies, and rely more on direct intervention transactions in managing the FX policy. This may include a massive devaluation to have the pound trades officially at rate equal to that of the black market, or a minor depreciation if it is accompanied by exceptional FX auctions that include selling to all pending orders in the priority lists.
We consider that there are strong arguments in favor of the implementation of a “basket, band and crawl” (“BBC” acronym by Dornbusch and Park in 1999) regime in Egypt, but we go further the idea of soft bands, suggesting that the parameters of the exchange rate management shall not be announced in order to curb all speculative expectations. It is our belief that the Central Bank of Egypt has a long-lasting experience in managing the exchange rate, and that it has both the potential and the vision to operate such a policy a la Singapore. The stability that is created by a BBC regime with no pre-announced parameters shall counterpart its inherent lack of transparency. As long as the productive investments have a safety net against speculative distortions, and as long as they have confidence in the soundness of the government’s macroeconomic policy, a ‘managed bands’ exchange rate regime shall allow Egypt to maintain it internal and external balances. The first element is defining the center of the bands, which shall relate the domestic currency to a weighted basket of the currencies of the country’s main trading partners. In the case of Egypt, whose pound was long pegged to the US dollar only, the ‘basket’ idea makes a lot of sense nowadays, since its entry in the Euro-Mediterranean free-trade agreements oriented around 50 percent of its foreign trade towards the EU members.
The second element is the crawl. It is generally used to neutralize the inflation differential and to reflect the real adjustment of the economy. It is the crawling in fact that we call in our research “management” of the bands. The central bank can manage the behavior and the direction of its bands in order to achieve its complete economic strategy. The crawl should be used as an essential adjustment policy that would allow for dealing with internal and international imbalances. The advantage of a “crawling band” over a “crawling peg” is that it allows for enough independence of the monetary policy and the use of its tools for anti-cyclical purposes or for countering an important capital flows volatility. By allowing for some exchange rate fluctuations, crawling bands could limit the possibility of speculation and leave room for government adjustment of the nominal exchange rate to cope with internal and external shocks. The final element, on which we will focus more attention, is the band. Bands are needed to allow for the central parity to adjust in line with the fundamentals’ changes without creating distortionary market expectations. The width of the band is a question to be decided by the authorities according to their particular policy program. A possible benchmark for this decision might be the calculation of the average misalignment of the real exchange rate from its estimated equilibrium.
Again, as we maintain it is only about confidence in the market mechanism to define a fair exchange rate, and the central bank, that will end the black market or the foreign exchange anomaly the markets are facing these days, and once this confidence is restored, all or most of the threads will be in the hand of the central bank, or at least the pressures on the pound not related to the Balance of Payment will start to ease.
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