Egyptian Central Bank stunned traders on November 3, 2016, with a decision to float the Egyptian pound (EGP) against the dollar (USD), setting an initial guidance rate of 13 EGP to the USD in inter-bank transactions, compared to the previous official rate of 8.88 EGP. The move was primarily aimed at curbing speculation on the exchange rate of the EGP against hard currencies as well as closing the gap between the black market and official rates. The bank's ultimate goal is to stabilize the foreign exchange market after a period of confusion witnessed since early 2016.

The move was made as the Egyptian government was expecting to fulfill conditions needed to obtain a 12 billion USD loan from the International Monetary Fund (IMF), as well as funds from other financial institutions to cover the growing shortage in hard currency reserves, and eventually strengthen the pound's exchange rate in the short term in order to carry out economic reforms in the country, in cooperation with financial institutions.

Unfavorable Circumstances

Confusion in the foreign exchange market in the past period was the major challenge that faced the Egyptian government, especially in late October 2016 when the difference between the official and parallel exchange rates at times exceeded nine EGP. The confusion resulted in a negative impression that the Egyptian pound was at less than its equilibrium value, and at 50 per cent higher than its official value, in many cases. 

In March, the central bank devalued the pound by 112 piasters to 8.88 EGP against the dollar in interbank transactions, but the move failed to fulfill its desired effect in stabilizing the foreign exchange market. The results were attributed to the fact that devaluation of the currency by 14 per cent in March was made without proper tools, that is, without a cover from sufficient foreign currency reserves at local banks, which later caused speculation on the dollar, according to previous statements by the Prime Minister Sherif Ismail.

The previous market distortions, among other factors such as burdens of economic reforms, led to unprecedented levels of inflation. The consumer price index rose to 16.4 per cent in August, the highest since 2008, because a significant number of companies rely on the parallel market to secure their hard currency supply. Moreover, a shortage of the US dollar in Egyptian banks had an impact on the activities of a vast number of domestic and foreign companies, where the latter, in particular, faced more restrictions on transferring their profits in hard currencies abroad. 

More Flexible Policy

It is evident that the measures taken to amend the situation in the foreign exchange market in March were not effective enough to overcome the turbulence. Accordingly, the central bank was forced on November 3 to adopt a more flexible policy, allowing banks to freely price foreign currencies through interbank dealings, which allowed the dollar to float freely with an initial guidance rate of 13 EGP to the USD within a 10 per cent margin above or below the new rate.

By setting this pricing mechanism, it is apparent that the foreign exchange market will be managed free from the direct intervention of the central bank – in other words, a highly decentralized process. Hence pricing will be decided by the banks, depending on the mechanisms of supply and demand and within the margin set by the central bank, providing an indication that the foreign exchange market is heading towards full floatation of the currency in the near future. To make the market more attractive for foreign currency liquidity, the central bank took a number of parallel measures to ensure liquidity flows of hard currency along with encouraging savings in pounds. 

Among the major guarantees, offered by the central bank to provide an economically efficient management of supply and demand of foreign currency, was its pledge not to impose any additional restrictions on deposits and withdrawals of foreign currencies by individuals and companies. However, caps for businesses importing non-basic commodities will stay in place at $50,000 for monthly deposits and $30,000 for daily withdrawals.

To deliver on its previous pledges, the Central Bank raised deposit and lending interest rates by 300 basis points to 14.75 per cent and 15.75 per cent respectively and rates for credit and debit transactions by 300 basis points to 15.25 per cent. Hiking the interest rates would help the Central Bank to attract liquidity from local markets to slow inflation, and at the same time encourage savings in local currency and dissuade individuals from speculating on hard currencies. 

In another endeavor to strengthen stable exchange rates, the Egyptian government is working on closing down local foreign exchange centers, accused in recent months of speculating in the foreign exchange market. Two key actions have been taken by the government to tighten the grip on foreign exchange dealings outside banks. First, exchange centers were closed in cooperation with security services. Second, establishing alternative entities affiliated with government banks, such as the National Bank of Egypt and Banque Misr.

Two Major Impacts

Floating the Egyptian pound would have the following varying impacts on the Egyptian economy as follows:

1. Curbing Speculation. Liberalizing the foreign exchange rate exposes traders in the parallel market to potential losses due to the dwindling margins between the official and parallel markets, which would discourage traders in the parallel market from speculation. Consequently, the volume of foreign exchange trading in the black market will reduce, especially in the first weeks after the central bank's decision went into effect. 

If the exchange rates of the pound in the official and the parallel markets continue to be on par, or almost on par, at least in the short term, the move would allow for foreign exchange dealings to recover in the banking sector. This would allow the real market supply and demand forces to emerge, in the context of the wider structural and financial reforms announced by the Egyptian government earlier this year.

2. Fluctuating Impact of Prices. One of the main causes that led to high prices in the past period was the rise of exchange rates reaching record rates in the parallel market, of which many companies rely on to secure hard currency. Therefore, following the decision to let the pound float freely, prices are expected to be impacted in three different directions.

First, increasing prices of a group of commodities and services according to the previous official exchange rate of the dollar (8.8 pounds). Secondly, price stability for another group of commodities and services based on the higher exchange rates in the parallel market. Lastly, prices of some commodities, which went to new highs in the recent past would fall. This is evidenced by the fact that some companies were planning on slashing prices of their products once the floating of the pound currency would be announced.

Regarding the ultimate impact of floating the pound on prices in general, the decision- which implies that prices of some commodities and services would be stable or rise while prices of other commodities and services would only rise- can ease potential pressures resulting from inflation in the coming period following the central bank's decision. In subsequent periods, it is likely that inflation rates would further settle in conjunction with recovered stability of the foreign exchange market.

Determinants of Success

In the long term, the success of the decision to float the pound in boosting the stability of foreign exchange rates will hinge on whether the supply and demand of foreign currencies can be managed more efficiently: 

1. Lending Arrangements. The scope of impact that the decision has on the stability of the foreign exchange market in the coming months would hinge on Egypt's ability to secure an agreed loan of 12 billion USD from the IMF as well as funds worth 6 billion USD from other countries and other funding institutions. Egypt's ability to secure the approval from the Executive Board of the IMF in a short time after the floating of the pound would, in theory, improve the country's foreign currency liquidity required to stabilize the foreign exchange market, whether through the outcome of the loans or an international bonds offering.

The Egyptian government can secure the dollars needed to restore equilibrium to its foreign exchange market, which has always succeeded in reviving the economy, improving the investment climate as well as reinvigorate tourism and exports, goals that are expected to be achieved as the implementation of economic reforms program continues.

2. Attracting Liquidity. Regarding supply, the ability of the banking system to attract foreign currency liquidity accumulated by speculators will rely on other deeper reforms to banking products- deposits and foreign currency accounts. 

However, in terms of demand, in the event the foreign exchange market stabilizes, the banking system should continue to restructure foreign currency transactions within the country's banking system itself to further streamline and liberalize them, and eventually attract dollar assets from both individuals and companies.

To conclude, it is safe to say that the decision to float the Egyptian pound can undoubtedly provide a sound basis for stabilizing the country's foreign exchange market in the coming period. Furthermore, if the Egyptian banks manage to run the supply and demand of foreign currency efficiently, the parallel market would not be able to restore its previous monetary and financial status.