Breather rather than a new equilibrium

On 5 February, brokerage firm Pharos Holding emailed an interesting note analyzing the Central Bank of Egypt’s (CBE) monetary policy measures, and why they don’t agree with it.  Here is the note in full. It is important because it reminds readers and close watchers of Egypt that the CBE is an opaque institution that says one thing, and does another.

The key takeaway from this is that the Bank is in fact targeting a specific exchange rate, contrary to previous statements that it is not doing this and leaving the market dependant on supply and demand. That means the pound is overvalued and again at a level that cannot be sustained with falling reserves:

PHAROS: Yesterday, the CBE executed four simultaneous measures to limit further EGP depreciation:

1) Reducing the cap on EGP depreciation in FC auctions from 0.5% to 1 piastre

2) Reducing the number of auctions to two per week; every Monday and Wednesday

3) Indirectly inducing (via moral suasion in our view) the two largest public banks and Commercial International Bank (CIB) to raise long-term deposit rates by 50-100 bps

4) Removing the 1% commission rate on FC purchases.

The new CBE governor met with the prime minister to discuss possible means to limit further downward pressure on the Egyptian Pound. The above steps suggest that the move from EGP 6.15 to 6.75 per US dollar was not intended to be a move to free float as earlier announcements had suggested. Instead, it was a managed devaluation with an initial target in mind. This policy is known as a “crawling peg”, whereby a currency is pegged to an anchor currency (the US dollar in this case) but the peg is adjusted occasionally to reflect changes in macro dynamics.

Why we “do not like” a crawling peg

1) It contradicts with initial statements made by the CBE governor and accordingly raises credibility concerns. The current governor had earlier explicitly noted that he will not target a specific exchange rate;

2) The current rate is not a rate at which supply and demand are in equilibrium. There are tight capital controls and demand is artificially capped by import rationing (primarily evident in imports of diesel);

3) If the market views the current rate as unsustainable, which is evident given the active black market, investors will actively pursue arbitrage opportunities to benefit from the black market premium (ranges between 5.0%-10.0%);

4) It confuses monetary policy formulation and disrupts the carry trade because foreign investors cannot predict whether interest rates will be used to defend the currency (so go up) or to stimulate recovery (so go down);

5) Finally, if the new rate fails to present itself as a new equilibrium at which current and capital account transactions are cleared, the credibility of the CBE will be significantly shaken and the whole regime will collapse. This is exactly what happened between 2000 and 2003, until the floatation decision was taken on 29 January 2003.

The 6.75 target is only a breather rather than a new equilibrium, in our view. It cannot be sustained without a significant improvement in foreign currency inflows, which we do not see at present.