Inflation rate concerns: Why the CBE is loosening monetary policy, countering global trends

(Photo courtesy of Ibrahim.ID via WikiCommons)

With the global trend of central banks worldwide tightening monetary policies by increasing interest rates and borrowing costs in an attempt to curb inflation rates and excessive economic growth, the Central Bank of Egypt (CBE) has decided to lower interest rates on 14 February 2019, despite the International Monetary Fund (IMF) warning against it in July 2018.

The CBE had cut the overnight deposit and lending rate by 1 percent to 15.75 percent and 16.75 percent, respectively. Economists had expected the interest rates to remain unchanged amid increasing inflation, which had reached 12.7 percent last January, compared to 12 percent in December 2018. However, a recent research note by Pharos Holding expects interest rates to be cut once more by 1 percent at the CBE’s Monetary Policy Meeting on March 28.

The loosening of monetary policy by lowering interest rates has been unprecedented since May 2018. The steadiness was supported by a surge in inflation that resulted from previous subsidy cuts – the latter of which more is expected in July 2019.

Is a cut necessary?
Head of research at EFG Hermes Ahmed Shams tells Business Forward that high rates tend to attract fixed-income investors to government debt which improves the liquidity of the Egyptian pound and US dollar.

“The CBE’s move was not only necessary but also long overdue because the significant policy rate hike was way too far and inflation would have still normalized over time with lower rates,” he adds.

However, the circumstances around the cut need to be carefully reviewed before its implementation.

“Egypt’s macroeconomic adjustment has been exceeding expectations; however, inflation needs to decrease and interest rates need to increase, before being brought down at a later point. To strengthen local currencies, inflation rates need to remain low,” chief economist at the European Bank for Reconstruction and Development (EBRD) Sergei Guriev tells Business Forward.

Shams explains that the cut should not come at the expense of economic growth and the production value added by the corporate sector which had recently suffered a massive financial burden.

Why did the CBE loosen its policies?
In a statement, the CBE pointed out some positive macroeconomic indicators that encouraged its decision to cut interest rates. These include a 0.2-percent increase in GDP growth quarter-on-quarter to 5.5 percent in the last quarter of 2018 and a drop in unemployment for the first time since 2010 to 8.9 percent. Additionally, the decrease will lower borrowing costs for businesses; therefore, boosting economic growth amid moderate inflationary pressures.

Lower rates will also pave the way for the government’s ambitious initial public offering (IPO) program through restraining the increasing interest payments on public debt, according to a report by Prime Holding.

Business growth under loose monetary measures
According to Shams, lower interest rates are a positive sign for the private sector in Egypt, which has been impacted by high borrowing costs and the banks’ preference to lend businesses who have a working capital.

Growing businesses may benefit from loose policies, as well as survive under tight ones, he points out. Their challenges go beyond monetary policies. Weak institutional capacity, high costs, prolonged bureaucracy and the investment reluctance of the private sector are all factors that are deemed much more significant to those enterprises than the CBE’s policies, in that sense.

Real challenges to foreign direct investment (FDI) in Egypt include the crowding out of the private sector and the high costs of doing business in Egypt that coincides with a low return on capital, Shams emphasizes.

While Egypt’s currency risk is indeed lower today, the risk premium for all emerging markets remains high due to a strong US dollar which weighs heavily on external balances and currencies, Shams further elaborates.

Business opportunities will also be more available if inflation is properly addressed, according to Guriev.

Business challenges go beyond monetary policies

Good faith in Egyptian economic growth
Egypt’s Purchasing Managers’ Index (PMI) figure dropped to 48.2 in February 2019 compared to 48.5 a month earlier, indicating an increasing rate of economic contraction, according to a nine-year survey released by Emirates NBD. A score above 50 reflects growth while a score below 50 indicates contraction.

The survey outlines that a boost in economic activity is expected to occur in 2020. MENA economist at Emirates NBD Daniel Richards said in a statement that the CBE’s decision to cut interest rates will increase private sector demand.

Tighter monetary policies strengthen currencies and reduce spending, which in turn keeps inflation lower, but they curtail growth in many countries. On that basis, Guriev believes that high interest rates are necessary in Egypt; however, there are fears about a current economic slowdown in the United States (US) and Europe, making it unlikely for interest rates to go up again in developing economies.

Egypt is well positioned on the foreign reserves level and is able to manage acceleration in outflows due to the flexible exchange rate under a consistent monetary policy, according to Shams.

“[The country] has witnessed real improvements in the current account deficit due to returning tourism, higher gas production and steady remittances from Egyptians abroad. These factors will reduce the US dollar funding gap in the next 24 months, taking into account that the external debt service is set to rise further,” he explained.

Guriev concludes that macroeconomic adjustment in Egypt has brought back sustainability, saying that banks are in good shape but inflation needs to be addressed and the local currency market needs to be developed.

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