Recalibrating: Monetary policy aims to balance currency stabilisation and inflation risk

The national monetary policy has undergone a transformative process of evolution over the past decade, and has in recent years been compelled to accommodate both exogenous and domestic shocks of considerable scale. Prior to 2003, the monetary policy decisions of the Central Bank of Egypt (CBE) were carried out with two straightforward policy goals in mind: price stability and the steadying the exchange rate.

At the time, meeting these requirements was seen as essential to being able to achieve the nation’s broader economic ambition to attract foreign investment and spur economic growth. However, the singular concentration on exchange rate stabilisation limited scope for intervention in liquidity growth, export competitiveness or currency confidence.

NEW POLICIES: It was with these considerations in mind that the government of 2003 set about recalibrating its monetary policy mechanism in order to implement a more nuanced approach, and in doing so established the Egyptian pound on a free float basis for the first time in the nation’s modern history. From 2003 onwards, Egypt’s monetary policy has been based on a new set of guiding principles, which, while continuing to seek price stability, are more weighted to maintaining low inflation rates. The fresh approach called for a new governing mechanism, which came in the form of the Monetary Policy Committee (MPC), the principal achievement of which has been the creation of an interest rate corridor, whose floor and ceiling are defined by the overnight lending and overnight deposit rates, respectively. By setting the floor and ceiling rates, the MPC establishes the corridor in which the overnight rate is permitted to fluctuate, and by employing this monetary tool it has been able to significantly reduce overnight interbank rate.

INTERVENTION: In the run-up to the global economic crisis of 2008, Egypt was in the grip of an inflationary trend as a result of rising consumption, increasing demand for labour and raw materials, and the growing cost of imported fuel. The MPC, which had tracked this inflationary progression and deliberated upon the appropriate response through its six weekly meetings, reacted by raising the overnight deposit and lending rates, which delineated the corridor by 50 basis points (bps) to stand at 11.5% and 13.5%, respectively.

However, Egypt’s political landscape was to undergo vertiginous transformation within a short period of time, compelling the MPC to revise its rates once again. While the domestic economy showed a relative resilience to the global economic crisis, the macroeconomic environment of Egypt was nevertheless adversely affected by the slowing demand from Egypt’s traditional export markets and a sharp contraction of foreign direct investment (FDI). Having raised the corridor rates in order to control inflation, the MPC now enacted a series of corridor rate reductions in 2008 and 2009 in order to encourage economic growth, finally settling at an overnight lending rate of between 8.25% and 9.75% in 2009.

The decreased rate was to remain in place for the duration of the post-crisis period, and the MPC instead turned its attention to technical issues, most notably with regard to the way it measures inflation – a question of some importance to the successful management of the corridor range. The MPC’s concern in this revision was the distorting effects played by exogenous factors, such as rising international wheat prices, on the inflation rate. In order to reduce the effect of such “shock” factors, the MPC decreased the weighting of wheat prices in the corridor calculation, bringing about what it believed would be a more consistent approach to inflation management. However, Ministry of Finance estimates suggest that approximately 40% of consumer spending is directed to basic foodstuffs, and therefore the reduction of wheat’s weighting in the inflation mechanism completely sidestepped the issue of chronically elevated food prices.

NEW DIRECTION: The events of early 2011 returned the attention of the MPC to the fundamental issue of the corridor rates. The deteriorating fiscal position and the slowdown of activity across many economic sectors suggested to many observers that the rate would be maintained at a relatively low level in a bid to encourage growth. However, the MCP surprised much of the financial community when it announced in November 2011 that it would raise the overnight deposit rate by 100 bps to 9.25%, while raising the overnight lending rate and the seven-day repurchasing (repo) agreements by 50 bps to 10.25% and 9.75%, respectively. The discount rate, meanwhile, was raised by 100 bps to 9.5%. In explaining the rationale behind its decision, the MPC acknowledged the challenges presented to growth by the economic downturn as a result of civil unrest and policy uncertainty, but also pointed out the growing risk of inflation.

The headline consumer price index (CPI), it pointed out, had crept up by 0.33% month-on-month in October 2011, following a 1.43% increase in September. Core CPI, meanwhile, rose by 0.4% in October, after a 1.13% rise during the previous month. It went on to propose that there remained “supply bottlenecks and distortions in the distribution channels [that] pose an upside risk to the inflation outlook”. However, as the CPI results came in during 2012, it appeared the MPC’s inflationary fears had been largely unfounded. Weak domestic demand brought about a slowdown in the inflation rate to its lowest level since 2006: the average year-on-year monthly rate of 8.8% during July 2011 fell to 5.8% during the corresponding period for 2012. Nevertheless, as the Egyptian Centre for Economic Studies (ECES) noted in January 2013, the spectre of inflation still haunts the Egyptian economy, primarily as a result of the domestic currency depreciation, the high imported content of many locally manufactured goods, and the possibility of subsidy reform, which expose the prices of some products to market forces.

LIQUIDITY BOOST: During the past year, which has been a difficult one for the Egyptian economy, the CBE’s monetary policy activity has been primarily concerned with boosting liquidity in the banking system. Its first move was to introduce seven-day repo agreements at a fixed rate of 9.75%, to which it later added a 28-day repo with variable rates in July 2012. In March 2012 it took another step to increase liquidity in the system by lowering the reserve requirement on local currency deposits by 200 bps to 12%, followed by a further reduction to 10% in May 2012. It is estimated that the reduction of the reserve requirement injected about LE9.5bn ($1.35bn) into the system, although its effect was a limited one, in that much of it was absorbed by the purchase of T-bills by domestic banks seeking easy yields rather than increasing lending activity to the business sector (see Banking chapter). The years ahead will doubtless provide the CBE and the MPC with monetary policy challenges as they continue to balance the currency stabilisation and inflation risk elements of their rate calculation. To date, however, the new mechanism has shown itself to be a useful policy tool.