Rising inflation called for a change to Egyptian monetary policy

For the past year, discussion surrounding Egypt’s monetary policy has been almost completely dominated by a single criterion: a spiralling inflation rate which is having a deleterious effect on business growth, as well as on the lives of ordinary citizens. After an elevated, but manageable, average inflation rate of just over 10% going back to February 2014, the November 2016 flotation of the currency marked the beginning of an upward trend which saw the inflation rate rise to over 30% in early 2017. By July 2017 the rate had reached what appeared to be its year high of 32.95%, before settling at a level of 30.8% in October. However, this level remains politically challenging for the government. With food price inflation breaking the 40% barrier in the first half of 2017, Egyptians have experienced a sharp increase in the cost of living.

Causes

To place this inflationary trend in perspective, the last time the core rate broke the 30% barrier was in the mid-1980s, an era when it was claimed the government still played too big a role in the economy, distorting the distribution of economic resources. A key factor in the inflationary period of three decades ago was a fundamental mismatch of demand and supply in the economy, a scenario which was exacerbated by a monetary policy that sought to bridge the growing budget deficit through issuing money. A study of Egypt’s inflation dynamics conducted on behalf of the Arab Monetary Fund in 2011 found that during this period 82% of the change in inflation was attributable to this demand-pull factor. This time around, the causes of the high inflation environment are more numerous, but the government’s attempts to meet budget deficits by expanding the money supply have remained a core theme of inflation dynamics over the past decade.

The government’s apparent adhesion to a loose monetary policy has had another unfortunate result in the form of expectation-driven inflation: a persistently high inflation rate means that businesses factor in regular price increases when planning their operations, workers demand higher wages and – as the natural consequence of this unvirtuous circle – the problematic increases in demand are further sharpened.

Converging Factors

The underlying causes of the more recent rise in the inflation rate, however, extend beyond the government’s monetary stance. The devaluation of the currency in late 2016 led to an almost immediate 50% drop in its value, a shift that was quickly felt by Egyptian importers and households. A US dollar which was worth around LE8.90 in October 2016 could be exchanged for more than LE19 by the end of the year. The rebound in the value of the domestic currency which was widely predicted in the weeks after the flotation has been less substantial than hoped. By the end of 2017 the US dollar was trading at approximately LE17.80 – a level it had remained at with only minor fluctuations for much of the year.

This factor alone would be enough to explain the current inflationary trend. However, several other drivers are supporting the currently elevated level. The government’s ongoing reform of its costly and inefficient system of subsides for a range of staples from food to energy is a further addition to inflationary pressure, for example. At the end of June 2017 the authorities increased fuel prices for the second time since the currency flotation, with some fuel items seeing sticker prices rise by as much as 50%. Accordingly, the price of 92-octane gasoline has risen from LE3.50 ($0.23) per litre to LE5 ($0.33), while the price of diesel and 80-octane gasoline has climbed from LE2.35 ($0.15) to LE3.65 ($0.24). The official price for cooking gas cylinders has gone up by 100% from LE15 ($0.99) to LE30 ($1.98), although street vendors have been selling them at prices well above the official rate for some time.

Egyptians are also paying more for electricity. As the new fuel prices were being revealed to the population, the prime minister announced that a planned hike in electricity rates would be made effective from August 2017. The decision came after a period of uncertainty, during which some members of the House of Representatives petitioned the government for a delay in the schedule of tariff rises which aims to remove electricity subsidies by 2019. The price hike followed a 40% increase in electricity charges made a year earlier.

Yet more inflationary pressure is arising from some of the government’s attempts to reform the taxation system – most notably the recently implemented value-added tax (VAT) framework, which has replaced the old 10% sales tax. The VAT law was officially gazetted in September 2016, at which time it was applied at a general rate of 13% for local and imported goods and services. As Egypt began its new fiscal year in mid-2017, however, the VAT rate was raised to 14%. As well as the obvious effect on individual consumers, the rise also has an impact on core economic activities such as construction. By the end of June 2017 Egypt’s cement companies had already informed dealers that sales prices would rise from the beginning of July.

Monetary Response

The currency devaluation, subsidy reform and tax rises combine to make one of the most challenging inflationary environments that the government has faced for years. The government has responded by abandoning its loose monetary stance and instigating a series of interest rate hikes. The first, a 3% rise in key policy rates made in November 2016, was timed to coincide with the flotation of the Egyptian pound, and was widely interpreted by the market as an appropriate attempt to shore up the newly liberalised currency’s value. A subsequent 2% rate rise in May 2017, however, came as a surprise to most market observers. The week before the move, 13 out of 14 economists polled by Reuters incorrectly predicted that the rate would remain unchanged. Just two months later the Central Bank of Egypt (CBE) surprised the market once again with another rise of 200 basis points – a decision which elicited complaints from some economic sectors which considered the move to be detrimental to business. The pharmaceutical industry, which is not permitted to raise its prices without ministerial permission, was particularly aggrieved by the decision.

Pros & Cons

Some see the decision of the CBE’s Monetary Policy Committee to raise key rates in 2016 and 2017 as a potential restoration of the central bank’s monetary policy credibility. According to this argument, the most damaging phenomena of recent years have been the rise in expectation-driven inflation and an assumption that the CBE will bow to criticism from the private sector rather than prioritise inflation-tackling interest rate policies. Two rate rises in quick succession in 2017 may suggest a reversal of this policy, and a new willingness on the part of the Monetary Policy Committee to place the fight against inflation at the top of its list of priorities. Establishing an anti-inflationary policy and adhering to it will do much to restore the central bank’s reputation as an independently minded body, despite the short-term challenge of justifying the rate increases to the business sector.

However, for many, the decision to raise rates runs counter to economic orthodoxy during a time of low lending growth. In this view, increasing the cost of debt threatens to undermine economic expansion by throttling lending to the private sector at a crucial stage in the nation’s recovery. While raising the interest rate might be acknowledged as a challenging but unavoidable response to rising inflation in most circumstances, in the Egyptian context its efficacy is questionable. With just 14% of the adult population owning a bank account, according to the World Bank, interest rate changes are a less powerful monetary policy tool in Egypt than in countries with higher levels of financial inclusion.

In December 2017 annual urban consumer price inflation eased, falling to 21.9% from 26% in November, according to the Central Agency for Public Mobilisation and Statistics. In January 2017 the Ministry of Finance expected inflation to fall to 10-12% during 2018. The challenge of dealing with such high inflation is likely to top the agenda of economic discussion for some time.