Egypt's central bank floats pound to increase liquidity amid US dollar shortage

The Egyptian banking sector faces two diverging trends in terms of liquidity, depending on whether it is being measured in local currency or foreign currency.

Despite the challenging economic environment, the industry remains adequately liquid in local currency terms. The core liquid assets of Egypt’s lenders, made up of cash held and deposits with the central bank and foreign banks, accounted for 23% of total deposits at the end of November 2015, according to Bank Audi. This figure represented a healthy increase on the 19% liquid assets to total deposits ratio seen at the close of 2014, and is comfortably above the 20% limit established by the regulator, the Central Bank of Egypt (CBE).

Deposit Base

A strong deposit base is key to this phenomenon. In 2015, the first full year of the new low oil price environment, total deposits held by Egyptian banks increased by 20.6% in local currency terms (or 10.1% in dollar terms) by the end of November, according to Bank Audi. The stickiness of government deposits played an important part in this result. Where government deposits in the hydrocarbons-rich Gulf economies have slowed or even reversed, in Egypt government deposits in local currency have remained solid, accounting for 23% of registered growth in the first 11 months of 2015. However, the star performer of Egypt’s deposit base is traditionally the retail depositor, thanks in the large part to the country’s voluminous remittance inflows, as well as the tendency of those Egyptian households who interact with banks to deposit only, rather than borrow. In 2015 retail deposits rose more than any other category, underlining the sense of renewed consumer confidence.

Moreover, while Egypt’s economy continues to face serious challenges, most observers are sanguine about the prospect of continued deposit growth. When ratings agency Moody’s Investors Service gave its 18-month outlook in the summer of 2015, it highlighted the resilience of the Egyptian banking sector’s deposit-based funding structure and likelihood of sustained deposit expansion. “We expect deposits to continue to grow, likely above nominal GDP growth, driven by a rise in remittances from migrant workers and by the banks’ deepening penetration of the bankable population,” Melina Skouridou, CFA Moody’s lead analyst for Egyptian banks, said in a statement at the time.

In practical terms this means that Egypt’s banks are unlikely to find their local currency lending activity constrained by liquidity concerns in the short to medium term, while the overnight interbank rate is likely to remain close to the floor of the interest rate corridor which the CBE utilises as its key inflation managing tool.

Currency Challenge

When it comes to dollar liquidity, however, a very different scenario pertains. The revolution in 2011 resulted in the Egyptian pound losing 13.4% of its value against the dollar over the following two years, and since that time the government has been expending significant quantities of its foreign reserves defending it. Over the past five years economic uncertainty and political instability have squeezed foreign currency inflows from investors and tourists, while lower global trading volumes have had a deleterious effect on Suez Canal receipts. Egypt’s banks have been affected by the limited supply of dollars.

At the end of 2013, as demand for dollars increased to outstrip supply, the CBE introduced a new auction system by which to sell dollars from its foreign reserves to lenders, a move that limited foreign reserve outflows but resulted in backlogs in foreign currency requests from bank customers, prompting an increase in parallel market activity. By September 2015 the ratio of loans to deposits in foreign currency had risen to 69% from 57% as of December 2014, while the ratio of foreign currency liquid assets to total assets had declined to 49% from 57% in the same period. As a result, the government placed restrictions on the dollar deposits that businesses made with local banks – largely from currency secured in the parallel market. During the year the government shut down numerous foreign exchange bureaux for flouting the official exchange rate.

Taking Steps

The situation saw little improvement in 2016, with tourism, traditionally a significant source of foreign currency, down by 46% year-on-year in May due to deepening security concerns.

The conventional currency defence policies typically used by other countries have been shown not work effectively in Egypt, requiring the CBE to take a unique approach to solving currency issues. For example, in many other countries there is an obligation to withdraw remittances in local currency, but Egypt cannot implement this as it simply ends up diverting remittance transfers through unofficial channels.

The CBE has taken steps in 2015-16 to improve confidence. It provided $547.2m in December 2015 to foreign portfolio investors, clearing the entire backlog and enhancing investor confidence. Short-term remedies aimed more directly at banks have come in the form of “surprise” dollar injections into the system aimed at resolving banks’ outstanding letters of credit.

More significant than all this, however, is the new approach to the question of the defence of the pound. In March 2016 the CBE devalued the domestic currency by 14% against the dollar, to LE8.85, a move welcomed by Moody’s as credit positive for Egypt and its banks. Then in November 2016 the CBE allowed the currency to float, devaluing the pound by 32.3% and setting a new exchange rate of 13 to the dollar as a part of austerity measures aimed at securing a $12bn IMF loan. “Currency devaluation and allowing the Egyptian pound to float was a necessary step, not only to receive the IMF loan, but also for Egypt to be able to attract foreign direct investment,” Mohamed S Younes, chairman of Concord International Investments, told OBG.

While a fall in the currency’s rate against the dollar will put pressure on banks’ capital buffers, a sizeable depreciation is the most effective weapon against the parallel market and is likely to stoke portfolio investment and foreign investment. It also allows the CBE to dismantle the last of its foreign exchange restrictions.