Understanding the Egyptian Pound’s Volatility (for dummies)
Many of you have asked me to explain why the Egyptian pound has taken a turn for the worst as of late. Let me begin first by saying that the value of a country’s currency is a standard measure of its overall health. If an economy was a human body, the strength of its currency would be the equivalent to the strength of its heart. If blood circulation is too low, meaning the heart is not pumping enough, we are not exporting at a high enough level to sustain good health.
Let me explain. A number of factors affect the valuation of any currency. A country has a balance of payments which reflects all the transactions between a country and the rest of the world. The current account on the balance of payments shows the inflow and outflow of goods. If a country experiences a current account deficit, the country is spending more capital on foreign trade than it is earning in foreign trade, meaning the country is importing more than it is exporting. In order for the country to compensate for this deficit, it must borrow capital. In the case of Egypt, the supply of the Egyptian pound is higher than foreign demand for the Egyptian pound because Egypt is spending more capital on imports than its foreign counterparts are spending on Egyptian exports. As such, this excess demand for foreign currency lowers Egypt’s currency foreign exchange rate.
Foreign direct investment, known as FDI, is investments from foreign investors into a country. FDI contributes to overall country economic growth by contributing extra funds needed for country development. If a country such as Egypt is experiencing a balance of payment deficit, they will acquire debt in order to pay off the deficit to other countries. When the country acquires this debt it becomes less attractive to foreign investors and lowers FDI because there is an inherent economic risk in investing in a country that could potentially default on its debt payment. Investors may also fear that a rise in country debt could contribute to rising inflation. Inflation will occur if the government decides to print more currency in order to pay debt. Additionally, they will worry about shortages in hard currency and their inability to convert their profit back into their national currencies either the dollar, or Euro, etc.
The Egyptian pound is a managed floating currency, meaning the Egyptian central bank often intervenes in order to reduce fluctuations. As opposed to a free float when a government does not intervene in the currency valuation, a managed float allows the central bank and government to influence the valuation of a currency. Over the past half decade, Egypt has experienced a decline in incoming capital due to a decrease in tourism and foreign investment. As such, the Central Bank devalued the pound by 13% in March and devaluations continue unabated.
Egypt has a significant trade gap (imports are higher than exports) due to its dependence on foreign oil and wheat. Egypt is expected to import 28.6 million tons of crude oil, liquefied natural gas and other oil products worth a total of almost $16 billion in 2015-16. This is putting immense pressure on the valuation of our currency.
As Egypt’s balance of trade has been in deficit for many years, meaning imports have exceeded exports, this has contributed to the large amount of debt borrowed in order to finance the trade gap. Egypt has continued to incur debt in order to pay off its debt from imports so the cumulative effect is as follows: our imports are greater than our exports forcing us to borrow hard currency. This only makes the problem worse because as our foreign debt grows, it has to be serviced putting us in a situation where our hard currency shortages become more acute. We need hard currency to finance the deficit in our balance of trade, and then we need even more hard currency to pay back what we borrowed to finance this trade gap. And, this goes on and on making the situation worse and worse.
Exasperating this is the decline in tourism in the country, thus lowering our overall country income. Egypt has continued to lose tourism revenues and we now earn around $4 billion annually (as of the end of 2016), compared to $6.1 billion in 2015 versus a peak of $12.5 billion in 2012. With tourism proceeds down significantly, along with FDI, the availability of our hard currency from these two sources makes financing our trade deficit even more difficult, and the trade deficit too is rising. On top of this, hard currency inflows from the Suez Canal and worker’s remittances has also remained flat or fallen making the situation even worse creating a significant hard currency shortage, more specifically a dollar shortage.
The dollar shortage in Egypt has impacted imports of important commodities such as wheat and fuel, causing need for devaluation of the Egyptian pound. As Egypt’s dollar supply decreases as a result of low external funds, the Egyptian pound weakens. To account for this, the Egyptian pound must be devalued in order for country goods and services to be seen as affordable by foreign entities and to therefore promote an inflow of foreign funds. In theory, devaluation may help the economy by causing exports to appear cheaper due to the attractive exchange rate to foreigners which should increase the demand for exports. This also makes imports more expensive, slowing their pace, and improving the balance of trade overall.
But, why hasn’t the devaluation of the Egyptian pound made the balance of trade position significantly improve? This is because of Egypt’s dependence on imports, and its weak exports, so devaluation in the short term does not improve our balance of trade position significantly. We must import the same levels of wheat and fuel, this cannot decrease due to significant demand, and our exports are limited, so regardless of how cheap our commodities are in the eyes of the world they tend not to grow in significant terms when our currency becomes weaker.
Is there a fix?
If there is a fix, faster economic growth in Egypt would be it. We need to grow at a faster peg, and we need to export more and import less. Economic growth gets us the exports we need, but the importing less part of this equation is more complicated. Our two major imports are wheat and oil and the demand for both will continue to rise with population growth. There is no obvious fix for this in the short term which means borrowing becomes necessary to manage our trade deficit.
This is why the IMF standby is so important for Egypt. We are currently finalizing terms for a $12 billion loan from the International Monetary Fund in order to focus on easing the current dollar shortage and to stimulate its economy. And, we need this money badly. The reason we need this money badly is to compensate for the shortfall in hard currency driven by decreases in tourism and in FDI. If we don’t see improvement in either area soon, or without additional inflows coming in from the Suez Canal and worker’s remittances, this shortage of hard currency coupled with our trade deficit will lead to further trouble.
So, in sum, let’s not forget that the problem of Egypt’s currency signifies that the heart of our economy is weak. This is a result of a balance of trade deficit that has lingered for decades and is now coupled with a lack of foreign exchange coming in from tourism and FDI. If there is an interest, I will explain in more detail what potential radical “fixes” there are that we can consider, each of which will have both positive and negative consequences on our economy and our own individual well being.