Download The EGP Exchange Rate Questions

The EGP Exchange Rate Questions
The Impact of Sterilization, Reasons For Appreciation, and Outlook
July 12, 2017
How do we classify the current exchange rate regime?
The most common question that we hear frequently from our clients is with respect to the
exchange rate regime. We note that the International Monetary Fund (IMF) refers to the
EGP exchange rate as a flexible exchange rate regime. However, we decided to run a
simple quantitative exercise to help support our own view. We applied the Levy-Yeyati and
Sturzenegger (LYS) methodology in order to assess Egypt’s exchange rate regime since
FY2002/03. The LYS methodology uses three indicators to classify an exchange rate
regime*:
•
Exchange rate volatility, which is measured by the absolute exchange rate monthly
change.
•
The volatility of exchange rate changes, which is measured by the standard deviation
of the exchange rate monthly change.
•
The volatility of reserves relative to the monetary base.
Looking into the statistics, the classification of the EGP exchange rate shifted from a
flexible regime in FY2002/03, then reverted back to a de-facto managed exchange rate,
before turning to a flexible exchange rate in FY2016/17. This reflects, significantly, the
sharp devaluation of the EGP exchange rate in January 2003 as the build-up of severe
macroeconomic imbalances contradicted the CBE’s strategy to defend the currency at that
time. A similar situation emerged in FY2016/17, which resulted in loosening the CBE’s firm
grip over the exchange rate regime. Hence, our findings validate our view that Egypt has
shifted to a flexible regime following the CBE announced the liberalization of the EGP
exchange rate on November 3, 2016.
Volatility of
exchange rate
Volatility of
exchange rate
changes
Volatility of
reserves
Exchange rate
classification
FY2002/03
2.3%
4.5%
1.3%
Flexible
FY2003/04
0.2%
0.5%
1.4%
Intermediate
FY2004/05
0.5%
1.3%
4.7%
Fixed
FY2005/06
0.0%
0.2%
5.3%
Fixed
FY2006/07
0.1%
0.1%
2.4%
Intermediate
FY2007/08
0.5%
0.7%
4.5%
Fixed
FY2008/09
0.4%
1.1%
0.8%
Intermediate
FY2009/10
0.2%
0.8%
0.7%
Intermediate
FY2010/11
0.4%
0.6%
1.9%
Intermediate
FY2011/12
0.1%
0.2%
2.5%
Intermediate
FY2012/13
1.2%
1.8%
1.4%
Intermediate
FY2013/14
0.2%
0.8%
1.6%
Intermediate
FY2014/15
0.6%
1.8%
0.4%
Intermediate
FY2015/16
1.3%
3.9%
1.2%
Intermediate
FY2016/17
8.8%
30.1%
1.3%
Flexible
Source: CBE, Pharos research
*An annual figure is calculated in order to reflect Egypt’s fiscal year and compared versus the sample average.
A low exchange rate volatility, low standard of deviation and a high volatility of reserves relative to the
monetary base signify a fixed exchange rate regime. The monetary authorities would defend the exchange
rate (low volatility) by depleting its reserves (high volatility).
ANALYST CERTIFICATIONS AND REQUIRED DISCLOSURES ON LAST PAGE OF THIS REPORT
Ramy Oraby - Economist
[email protected]
The EGP Exchange Rate Questions; The Impact of Sterilization, Reasons For Appreciation, and Outlook
Why the EGP exchange rate did not depreciate beyond the level of EGP18 per USD
According to the latest available data, Egypt’s external position has shown signs of
improvement following the exchange rate liberalization on November 3, 2016. The current
account deficit narrowed significantly as the merchandised non-oil trade deficit narrowed,
tourism revenues increased and remittances continued to return through the official
channels. Meanwhile, the gradual foreign direct investment (FDI) improvement remained
concentrated in the oil and gas sector. The adjournment of approving the new Investment
Law can also be blamed, in addition to the fact that the FDI recovery normally takes more
time to materialize. On the other hand, foreign portfolio investment (FPI) rose significantly
to take advantage of the high nominal interest rate on the EGP-denominated treasuries, in
addition to the undervalued local currency. The aforementioned dynamics, in addition to
the fact that the EGP exchange rate remains undervalued, explain why the exchange rate
did not depreciate beyond the level the level of EGP18 per USD.
Why the exchange rate has not appreciated despite USD9.8 billion inflows in the local
treasuries
A typical foreign investor buys EGP-denominated treasuries through the CBE’s repatriation
mechanism in order to minimize risk. According to the CBE’s instructions, dated March
2013, commercial banks are obliged to sell the foreign currency proceeds to the CBE at
the prevailing market rate. Then, the CBE would place these funds into an off-reserve
account in order to hedge against a sudden capital outflow. Afterwards, the CBE would
undertake an opposite transaction to absorb the additional local currency liquidity
provided to the commercial banks in association with purchasing the EGP-denominated
treasuries (Graph). In reality, the surge in the foreign currency liquidity did not reach the
commercial banks, hence, the impact on the exchange rate remains limited.
Why would the CBE sterilize hot money inflows?
Unsterilized foreign inflows would lead to:
• A surge in the foreign currency liquidity in the banking sector following the foreign
inflows in the EGP-denominated treasuries would lead to an exchange rate
appreciation.
Accordingly, foreign investors would rush to lock in profits, taking advantage of the high
interest rate and a better exit exchange rate. Hence, the exchange rate would shortly
depreciate. Such a sharp volatility would erode confidence and fuel inflationary pressures.
• Accumulating more foreign assets would be reflected in a domestic money supply
increase, which in the absence of a sterilization intervention would initiate further
inflationary pressures. Raising the nominal interest rates in that case would attract
further foreign inflows, leading to a self-fulfilling vicious cycle.
Therefore, the CBE’s repatriation mechanism, which implies a sterilized intervention,
serves the economy well by keeping the money supply growth in check, avoiding further
inflationary pressures, preserving Egypt’s competitiveness by preventing a short-term
unsustainable real exchange rate appreciation and evading an unneeded negative
confidence shock to the economy.
Would the CBE’s FCY inflows sterilization be indefinite?
The short answer is no. Sterilization intervention has costs. We note that the CBE absorbs
excess liquidity through three options:
• The variable interest rate auctions: The sterilization cost is associated with the interest
rate that the CBE pays on such funds. The average paid interest rate rose from 17.1% in
December 2016 to 19.9% in June 2017.
• The Open Market Operations (OMO): Exchanging cash from the commercial banks
with government treasuries from the CBE’s balance sheet would decrease the CBE’s net
domestic assets. Accordingly, the CBE keeps the money supply growth under control.
• Increase the government deposits at the CBE: Raising the government deposits parked
at the CBE would help control the money supply growth by decreasing the CBE’s net
domestic assets. Similarly, the interest rate paid on such amount represents the direct
cost. Another cost may arise from the opportunity cost of holding these funds at the
CBE.
2
The EGP Exchange Rate Questions; The Impact of Sterilization, Reasons For Appreciation, and Outlook
In order to calculate the sterilization cost, we use the difference between the local interest rate
paid to commercial banks and the foreign interest rate that the CBE receives on the foreign
assets it holds. We note that the interest rate differential has risen from 16.2% per annum in
December 2016 to 18.7% per annum in June 2017. Hence, we estimate the sterilization cost to
be standing currently c.3% of GDP per annum.
Foreign holdings of EGP denominated treasuries are getting closer to the all time high figure
of USD12 billion (24% of the total issued treasuries) in 2010.
Share of total (RHS)
12
Foreign holdings of EGP denominated T-bills (USDbn)
30%
10
25%
8
20%
6
15%
4
10%
2
5%
0
0%
• FCY inflows out of the repatriation mechanism: The BoP fundamentals gradual
improvement implies a higher foreign currency liquidity in the banking system.
Hence, foreign investors’ confidence in the economic reform program is growing,
which may encourage some FCY inflows off the CBE repatriation mechanism. Since it
is not obliged to undertake a sterilized intervention in this case, the CBE would
slightly tolerate such an increase in the FCY liquidity as foreign investors demand on
the EGP-denominated treasuries peaks.
Where do we see the Exchange rate settling in FY2017/18?
We reiterate that the Egyptian Pound is currently 20 - 25% undervalued on a real effective
exchange rate (REER) analysis. Moreover, we expect the current account deficit to narrow from
6.3% of GDP in FY2016/17 to 4.0% of GDP in FY2017/18, as the trade balance continues to
improve, tourism revenues strengthen and FDI inflows pick up. Accordingly, we expect the EGP
exchange rate to appreciate from 17.9 per USD (November 2016 - June 2017) to an average of
16.00 - 16.50 per USD by the end of 2018. Meanwhile, we also expect the EGP exchange rate to
remain undervalued for quite some time in order not to hurt Egypt’s competitiveness.
Jun-17
Jan-17
Aug-16
Oct-15
Mar-16
May-15
Jul-14
Dec-14
Feb-14
Sep-13
Apr-13
Jun-12
Nov-12
Jan-12
Aug-11
Mar-11
Oct-10
May-10
Dec-09
Jul-09
Feb-09
Apr-08
• A behavioral reaction to the reported news of more funds into the system would lead
more economic agents to offload their USD holdings as the EGP exchange rate
appreciates
Sep-08
• Lower imports since the Ramadan/Eid season ends.
Nov-07
• Higher remittances as the inflationary reaction to the recent fuel price hike may
encourage Egyptian diaspora to transfer more money to support their families.
Jan-07
We believe there are four possible factors that explain the recent EGP appreciation:
Jun-07
Why did the exchange rate appreciate recently?
Source: CBE, Pharos research
Trade balance to improve on EGP flotation, export-incentivizing programs and new gas
discoveries
Services Balance (USDbn)
Trade Balance (USDbn)
Balance of goods and services (% of GDP) (RHS)
20
0%
10
-2%
0
-4%
-10
-6%
-20
-8%
-30
-10%
-40
-12%
-50
-14%
Source: CBE, Pharos research
3
CBE sterilized intervention to offset the impact of the hot money inflows on the local liquidity
The Repatriation Mechanism
$$$
2
At prevailing market rate
EGP
An off-foreign-reserve account
5
$$$
1
3
EGP
4
7
8
EGP
6
MoF may deposit some
of the EGP proceeds
back at the CBE
9
EGP
Open Market Operations (OMO) / Variable interest rate deposit
auctions
Sterilization / Absorbing the additional EGP liquidity
On the CBE’s balance sheet:
1 – The repatriation mechanism:
Assets
•
•
Net foreign
assets (NFA)
Net domestic
assets (NDA)
Source: Pharos research
2 – The sterilization via OMO / Government deposits at
the CBE:
Liabilities
Currency in
circulation (CIC)
Assets
•
•
Net foreign
assets (NFA)
Net domestic
assets (NDA)
Liabilities
Currency in
circulation (CIC)
•
•
•
Offsetting the impact of the foreign inflows on the domestic money
supply growth
Avoiding further inflationary pressures
Preserving Egypt’s competitiveness by avoiding a short-term
unsustainable real exchange rate appreciation
4
Source: CBE, Pharos research
60
Source: CBE, Pharos research
Apr-17
-8
Dec-15
70
Aug-16
-6
Apr-15
80
Dec-13
-4
Aug-14
90
Apr-13
-2
Aug-12
0
Apr-11
2
Dec-11
4
15-Yr Avg
Aug-10
6
Real effective exchange rate (REER)
Apr-09
Fundamental BoP indicator (taking into account net errors) (USDbn)
Dec-09
Therefore, the sustainable items of the BoP recorded a significant inflow for the first time
since 1Q FY2010/11
Dec-07
-2
Net FDI (USDbn)
Aug-08
2.9
Apr-07
0
Aug-06
-1
Apr-05
3.1
Dec-05
Source: CBE, Pharos research
4
Aug-04
3.5
Apr-03
1
Dec-03
3.7
Dec-01
2
2
Aug-02
3
3.9
Apr-01
4.1
Aug-00
4
4.3
Dec-99
8
Remittances of Egyptians working abroad (USDbn)
Apr-99
5
Q1 2009/10
Q2 2009/10
Q3 2009/10
Q4 2009/10
Q1 2010/11
Q2 2010/11
Q3 2010/11
Q4 2010/11
Q1 2011/12
Q2 2011/12
Q3 2011/12
Q4 2011/12
Q1 2012/13
Q2 2012/13
Q3 2012/13
Q4 2012/13
Q1 2013/14
Q2 2013/14
Q3 2013/14
Q4 2013/14
Q1 2014/15
Q2 2014/15
Q3 2014/15
Q4 2014/15
Q1 2015/16
Q2 2015/16
Q3 2015/16
Q4 2015/16
Q1 2016/17
Q2 2016/17
Q3 2016/17
Tourism revenues (USDbn)
Non-petroleum Exports (USDbn) (RHS)
Aug-98
Tourism revenues and non-oil exports are picking up following the EGP exchange rate
liberalization, while remittances continued to return through the formal channels
Dec-97
1
Q1 2009/10
Q2 2009/10
Q3 2009/10
Q4 2009/10
Q1 2010/11
Q2 2010/11
Q3 2010/11
Q4 2010/11
Q1 2011/12
Q2 2011/12
Q3 2011/12
Q4 2011/12
Q1 2012/13
Q2 2012/13
Q3 2012/13
Q4 2012/13
Q1 2013/14
Q2 2013/14
Q3 2013/14
Q4 2013/14
Q1 2014/15
Q2 2014/15
Q3 2014/15
Q4 2014/15
Q1 2015/16
Q2 2015/16
Q3 2015/16
Q4 2015/16
Q1 2016/17
Q2 2016/17
Q3 2016/17
6
Q1 2009/10
Q2 2009/10
Q3 2009/10
Q4 2009/10
Q1 2010/11
Q2 2010/11
Q3 2010/11
Q4 2010/11
Q1 2011/12
Q2 2011/12
Q3 2011/12
Q4 2011/12
Q1 2012/13
Q2 2012/13
Q3 2012/13
Q4 2012/13
Q1 2013/14
Q2 2013/14
Q3 2013/14
Q4 2013/14
Q1 2014/15
Q2 2014/15
Q3 2014/15
Q4 2014/15
Q1 2015/16
Q2 2015/16
Q3 2015/16
Q4 2015/16
Q1 2016/17
Q2 2016/17
Q3 2016/17
Egypt’s external position is gradually improving
Also, both the net direct investment and net portfolio investment are showing encouraging signs of
improvement
Net PDI (USDbn) (RHS)
10
3
8
6
4
2
0
0
3.3
-2
-4
-6
-8
Source: CBE, Pharos research
Meanwhile, the Egyptian Pound remains undervalued on a REER analysis. We expect it to remain so
for the next two years
Exchange rate (EGP per USD) (RHS)
130
3
120
5
110
7
100
9
Overvalued
11
Undervalued
13
15
17
50
19
5
The CBE sterilized intervention by the numbers
Keeping money supply growth in check, the CBE decreases its NDA to offset the rising NFA, the
slope difference partly reflects depending on variable rate auctions for absorbing the excess
liquidity
CBE's net domestic assets (EGPbn)
The sterilization ratio, taking into account the hot money inflows, has been hovering around 1.00 since
December 2016. (No sterilization = 0 , Complete sterilization = 1)
CBE's net foreign assets (EGPbn)**
650
Total sterilization ratio, including Foreign holdings of EGP-denominated bills
250
200
600
1
150
100
550
0.8
50
0
500
0.6
-50
-100
450
0.4
-150
400
-200
0.2
0
Dec-16
** Including foreign holdings of EGP-denominated treasuries and revalued at January exchange rate
Source: MoF, Pharos research
Jan-17
The CBE’s off-reserve deposits are moving alongside the foreign holdings of EGP
denominated treasuries
Mar-17
Apr-17
May-17
The variable interest rate deposit auctions have been the key tool to absorb the excess
liquidity in the banking system
Variable interest rate deposits auction volume (EGPbn)
Open market operations (EGPbn)
Government deposits at the CBE (EGPbn)
Foreign purchasing of EGP denominated T-bills (EGPbn) (RHS)
Deposits not included in official reserve assets (USDbn)
Foreign holdings of EGP-denominated treasuries (USDbn)
Total other foreign currency assets (USDbn)
12
Feb-17
Source: CBE, Pharos research
300
10
8
70
250
60
200
50
150
40
100
30
50
20
0
10
6
4
2
-50
0
Nov-16
Dec-16
Source: CBE, Pharos research
Jan-17
Feb-17
Mar-17
Apr-17
May-17
Jun-17
0
Dec-16
Source: CBE, Pharos research
Jan-17
Feb-17
Mar-17
Apr-17
May-17
Jun-17
6
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8