Monday,18 December, 2017
Current issue | Issue 1367, (2 - 8 November 2017)
Monday,18 December, 2017
Issue 1367, (2 - 8 November 2017)

Ahram Weekly

An aggressive policy

Central banks usually use interest rates as a tool to control inflation and stabilise forex markets. Sherine Abdel-Razek asks if the CBE overused it since the devaluation

One of the decisions taken on the same day the Central Bank of Egypt (CBE) decided to float the pound was a three per cent hike in interest rates. This was followed throughout the year by two similar moves with a two per cent increase in each, bringing the overall increase to date to seven per cent. This brought  the overnight deposit rate to 18.75 per cent and the lending rate ant 19.75 per cent. 

According to traditional economic thought, central banks opt to increase interest rates when they devalue their currencies as a way to compensate people for the decline in the value of the currency by paying more on their savings and deposits. 

That is why the first hike back in November last year was welcomed and justified. 

The aim of the first rise was to compensate people for the decline in the value of the currency, according to Noeman Khaled, a macro economist at CI Capital Asset Management (CIAM).  

Khaled explained that this happened in Russia in 2014 when oil prices declined and the ruble lost around 48 per cent of its value in a couple of days. “Back then interest rates hiked from eight per cent to 17 per cent in one night.”

The banks followed this by offering investment certificates at 18 per cent and 20 per cent for one and a half years and three years respectively. 

The increase in interest rates was translated into a higher yield on treasuries, a reason for the heated demand for the papers. With one of the highest yields in the emerging economies, the treasuries attracted $18 billion of foreign money since November. 

However, with the effect of tough reform policies starting with devaluation, slashing energy subsidies and introducing VAT fed inflation to start registering record increases one month after the other.

The CBE reacted by raising the rates in both May and July.

“I believe that the CBE initially was planning to lower the rate three to four months after its first hike in November but it decided to increase it again after the IMF alluded in late April that Egypt should raise interest rates further to contain inflation,” Khaled said.

Annual headline inflation was at an eight-year high of 19.4 per cent in November only to maintain an upward trend to reach 29 per cent in April. 

In April, Jihad Azour, director of the IMF’s Middle East and Central Asia Department, told reporters that interest rates are “the right instrument” to manage Egypt’s inflation.

However, Omar Al-Sheneti, managing director of private equity firm Multiples Group, believes that using interest rates to reduce inflation was not the right approach as it was taken on the assumption that the increase in prices was because of increased demand which the CBE tried to hamper by making deposit rates higher. “There was no excess liquidity in the market to be absorbed by higher interest rates. Inflation is due to supply shocks,” according to Al-Sheneti. 

Khaled believes that the two rate hikes in May and July 2017 failed to put a lid on inflation as the market did not witness what is known as transmission of policy which is transferring the effect of the increase to the market.

For this to happen, he says, banks should increase interest rates in their short- and long-term saving deposits to absorb liquidity from individuals as the government ups the yields on treasury bills to attract money from banks. 

“The four per cent increase had zero effect on treasury bills. The yield on one-year treasury is now 19.3 per cent compared to 18.98 in May. That of the three years came to 16.8 per cent compared to 17.2 per cent in May.”

“So what we have here is that the treasury bills yield before the four per cent increase is higher than the yield after the hikes.”

As for banks, only the National Bank of Egypt increased its short-term deposit rate by two per cent after the first hike and one per cent following the second hike. Meanwhile, almost none of the private banks have changed their long-term deposit rates. 

“The four per cent increase was not transmitted to the economy,” Khaled said. 

Inflation rate peaked in July to reach 33 per cent, its highest level in 30 years. It started to ease downwards during August and September.

Putting himself in the shoes of members of the CBE’s Monetary Policy Committee (MPC), Al-Sheneti explains that the aim of the increases was not only to target inflation. 

The CBE wanted to close the gap between the interest rate and the inflation rate which makes real interest rates negative. “When you deposit money at 13 per cent and the inflation is 18 per cent then the real interest rate is minus-5. This discourages people to deposit their money in banks.” 

Narrowing this gap is important to attract more money to the banking sector, he stressed.  

Also, Al-Sheneti points out that the several increases in interest rates on the pound encouraged people to abandon dollars and start investing in the local currency. 

“Using the interest rate as a monetary tool is okay but the magnitude of the increase is controversial,” Al-Sheneti said.

“The first three per cent increase was understood, the following two per cent was controversial, and the last two per cent hike was neither justified nor understood,” he said.

Analysts fear that the increase in interest rates would make the private sector less reluctant to borrow at such high rates, an attitude that would slow down economic growth and limit job opportunities.

Loans acquired by non-government borrowers in Egyptian pounds retreated to LE715.5 billion in July, LE1.4 billion on the previous month.

“Here we have to underline a fact: even if they are getting more credit this does not mean there is an improvement in economic activities as more pound-denominated credit would pay for fewer production requirements after the devaluation of the currency,” Khaled said.

Another shortcoming is the inflated debt payment as each one per cent increase in yields paid on the treasuries is translated to a LE15 billion increase in debt payment, according to Al-Sheneti.

This means that the interest rates hikes added LE75 billion-LE100 billion to the budget deficit, he said.

The CBE held interest rates in the MPC’s last two meetings on 17 August and 28 September. 

Jason Tuvey, senior analyst in the London-based Capital Economics, expects the first cut in interest rates to be announced at the MPC meeting towards the end of December with overnight deposit rate projected to be lowered to 12.75 per cent by the end of 2018 and 10.50 per cent by end-2019. 

The CBE is targeting an inflation rate of 13 per cent, plus or minus three per cent in the last quarter of 2018.

Khaled pointed out that the expected reduction in interest rates together with last month’s CBE decision to increase the money commercial banks deposit at the CBE from 10 to 14 per cent of overall deposits, would balance the level of liquidity with banks.

He explained that if banks extended more loans after reducing interest rates there would be extra liquidity, demand would increase and inflation would soar again. “The reserve requirement would limit this.” 

“We are in the right direction and we are moving very fast,” CBE Governor Tarek Amer told Bloomberg in September.  

“We’ve been aggressive in our monetary policy, and this has been resisted a bit. But we thought it’s important so we can get our shop fixed very quickly.”

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