The Central Bank of Egypt’s (CBE) decision to raise its interest rates by 2 percentage points on May 21, 2017 caught the Egyptian business community and investors by surprise. In a Reuters survey of economists following the Egyptian market conducted five days prior, all but one of the fourteen experts expected the central bank to hold rates steady. The central bank had already raised interest rates by 3 percentage points in November 2016, in conjunction with their decision to liberalize the foreign exchange market, which saw the Egyptian pound lose more than half of its value against the dollar.
The consensus among investors in the Egyptian marketplace was that interest rates were high enough to stem any outflow of foreign currency and clamp down on demand-driven inflation, and any further increase at this point would simply raise the cost of borrowing money for the private sector. However, in a surprise to many investors, the Egyptian authorities decided to raise the rates following a meeting with the International Monetary Fund (IMF) on May 11 regarding the second tranche of its $12 billion loan to Egypt. While investors applauded many of the initial reforms implemented in conjunction with the loan agreement in November—such as floating the pound, introducing a value-added tax, and reducing energy subsidies—this most recent move, understood to be at the behest of the IMF, drew criticism and condemnation.
This opposition to the rate hike makes sense in the short term given the significant spike in inflation that Egypt has experienced over the last year. When the currency was devalued in November, goods and services imported from abroad cost more in Egyptian pounds, with year-on-year inflation levels rising above 30 percent in early 2017 and remaining there. Although increased interest rates in times of accelerating price increases can boost the incentive to save instead of spend, this is only the case when a substantial portion of the population saves their money in a bank. Estimates from 2014 and 2015—prior to the exchange rate liberalization—indicated that only 7 to 14 percent of Egypt’s population of more than 90 million had an open bank account, making the transmission of monetary policy through interest rates difficult. In addition, even if the number of banked Egyptians were higher, only a sharp appreciation in the value of the pound would lower the level of inflation in the short term.
Egypt’s businesses will also face higher borrowing costs. Unlike most Egyptian citizens, businesses, especially small- and medium-sized enterprises, rely on loans from banks to expand their operations and launch new projects. At higher interest rate levels, fewer businesses will take the opportunity to grow if their expected returns are lower than the rate they can get by keeping their money in the bank. However, while borrowing costs in the short term have nominally increased, businesses still face negative real interest rates (that is, the nominal interest rate offered by the bank, minus the rate of inflation) in the short term. Only if inflation slows substantially but interest rates remain high in the long run do businesses face prohibitively high real interest rates.
As critics of the CBE and the IMF have argued, these rate increases will likely have little to no effect on continued high inflation in the coming months. Even the Ministry of Finance has revised its inflation expectations for the coming fiscal year upward, stating that inflation will still average 22.8 percent and only fall to pre-devaluation levels the following fiscal years, after the one-off effects of the currency devaluation have already taken their toll, with prices settling at a much higher level.
However, these critiques have largely failed to take into account the long-term implications of the CBE’s rate increase and the signals it sends to the market. While much of the business community is understandably focused on the cost of borrowing in the short term, the CBE, and implicitly the IMF, must take a longer view. Their aim is not simply to satisfy the demands of the business community in the short term, but to restore credibility to Egyptian monetary policy by bringing inflation under control.
Prior to the float of the pound, year-on-year headline inflation averaged just over 10 percent for every month going back to February 2014. Though this was partly due to the CBE’s gradual devaluation of the pound during this time, this inflation was primarily instigated by the government continually papering over its budget deficits by expanding money supply—and perpetuated by Egyptian consumers, who built an annual 10 percent price increase into their expectations. Given that the annual pre-float inflation rate had held steady around 10 percent, the CBE and IMF had little reason to expect inflation to fall any lower even after the immediate effects of the depreciation had worn off. In fact, it is precisely because of this expectation that, without a somewhat draconian interest rate policy, prices will continue to rise in the coming years.
Expectation-driven inflation is the quintessential self-fulfilling prophecy. Strong inflation expectations can cause businesses to assume a certain price increase over time. When workers see these price increases, they begin to demand higher wages. As wages rise, demand increases, causing businesses to see their expectations become reality, thus hardening their future inflation expectations. Interest rate increases by the central bank can lower inflation levels, but only if businesses and consumers believe that the higher interest rates, or lower inflation levels, are here to stay. In other words, monetary policy can only control inflation when people actually believe that the central bank will back up its words with actions.
Decades of profligate spending by the government on energy and food subsidies, combined with a loose monetary policy, have badly hurt the CBE’s credibility with Egyptian consumers, and distrust of the government and banks in general runs too high for promises of future prudence to have much of an impact. Instead, if it does indeed intend to usher in an era of low inflation in the coming years, the CBE needs to upset inflation expectations for the medium- and long-term by actively eliciting surprise and dissent from the business community.
This focus on the long-term economic outlook by the CBE and the IMF is not without its detractors from outside the business community as well. Another criticism of the recent hike in interest rates has noted that the government is allocating an increasingly large portion of its budget to interest payments, often at the expense of social programs and subsidies. But again, this argument focuses on political stability and the plight of the poor in the short term. In the long term, curbing inflation would raise the real value of the pound, slowing the growth of subsidies and social spending in the future, especially on imported goods bought with dollars. Subsidies do need to come down over time, but if lower-income Egyptians can retain more purchasing power over time, the effects of subsidy cuts can be at least partially offset.
Ironically, given the IMF’s past emphasis on austerity measures, after rumors of a subsidy cut sparked protests in March, Minister of Supply and Internal Trade Ali Moselhy promised that there would be no upcoming cuts to food subsidies at all. Chris Jarvis, the IMF mission chief for Egypt, explicitly praised the expansion of social protections in the draft 2017-18 budget following the IMF’s meetings with Egyptian authorities in May over the second installment of the loan. While increased interest payments in the future should certainly prompt caution, these officials recognize that a lower level of inflation and appreciating currency offset these increases.
Still, given Egypt’s myriad macroeconomic problems, this strategy of raising interest rates is certainly risky. History is rife with examples of central banks struggling and failing to regain credibility among the people. In order to genuinely change the expectations of the market, the CBE must be patient and possess the fortitude to keep interest rates elevated in the face of government and business criticism. An extended period of high interest rates could substantially hurt Egypt’s economic growth, but loosening up too quickly could entrench the sentiment that the CBE lacks the will to fight inflation. For the time being, the interest rate hike indicates that the government and CBE are trying to back up their words with actions for once and looking toward Egypt’s future.
Brendan Meighan is a macroeconomic analyst focusing on the Middle East. Follow him on Twitter @BrendanJMeighan.