We try to look behind the line of thinking of Egypt's central bank rationale of raising interest rates.
By Markets Chimp
7/11/17 2:42 AM
The Central Bank of Egypt (CBE) has been raising interest rates more often since it decided to devalue the Egyptian pound back in November. However, the magnitude and frequency of the rate hikes can be explained in two ways.
(1) Inflation targeting
When inflation rates increase, central banks usually start using their munition to combat that ugly beast. They range from raising interest rates to increasing banks' reserve ratio and selling Treasuries. All these actions aimed at reducing the money supply in the market which should eventually reduce inflation.
(2) Exchange rate targeting
When the local currency loses value against other foreign currencies, central banks usually look to raise interest rates to entice investors to hold their local currency. The central banks basically work on the interest rate differential, which leads to what is known as "carry trade".
Which camp is the CBE on?
In Egypt, the CBE has been claiming that it is in the first camp, targeting inflation. However, the reality is that Egypt is more of a cash society as opposed to a leveraged one, especially on the consumer side where inflation usually ends up (inflation is measured by the consumer price index after all). Also, the Egyptian population is underbanked with only 9-10% of Egyptians have a bank account. So, raising interest rates does not really impact consumers much. On the other hand, higher interest rates really impact producers that use debt as a financing tool, which raises the cost of doing business and eventually lead them to pass on that higher cost to consumers (i.e. higher inflation).
Why is the CBE raising interest rates?
Knowing that Egypt's higher inflation is cost push (resulting from higher input costs) as opposed to demand pull (resulting from excessive demand), raising interest rates is not likely going to have the required impact. To the contrary, it will just feed into higher costs of doing business and hence higher inflation, what higher interest rates were set up to combat in the first place. So, why is the CBE raising rates? We think the CBE is – once again – targeting the exchange rate. Although the CBE has let go of the Egyptian pound back on 3 November 2016 adopting a free float mechanism, it is not walking the talk. I have visited my local bank and asked to buy US dollars at the prevailing ask rate shown in its screens, but the bank declined, informing me that I can only buy up to USD800 a month at that rate but with legitimate reasons, like for education or health reasons. Now, this tells me that the current exchange rate being implemented in the market is far from being a true "free" float; it is a "dirty" float where a central bank and its regulated banks intervene to move the exchange rate into a certain direction.
Where will the Egyptian pound end up?
The Egyptian pound recently strengthened by around 1.6% in a couple of days. This was not clearly based on immediate fundamentals as US dollars from two recent international bond issues had long been received in the market. So, it seems the CBE is colluding with its banks to move the needle a bit. But when we realize that the US dollar (as measured by its DXY index) is down over 6% year-to-date while the Egyptian pound has been stable against the US dollar, it becomes clear that the Egyptian pound is becoming a bit undervalued. But how stronger will the Egyptian pound be? I would think the CBE does not want the Egyptian pound to strengthen that much lest carry trade-driven hot money starts flowing out. In other words, the CBE wants to maintain the Egyptian pound as a certain range to do two things: (1) reduce imported inflation resulting from a weaker Egyptian pound and (2) ensure hot money remains within the country a bit longer and probably attract even more funds. I think the CBE is trying to raise forgiven reserves into higher USD30s billion. Until then, the Egyptian pound will likely remain within that tight EGP16-18 per one US dollar range.