by Karanta Kalley
Until the end of January 2003, the main focus of Egypt’s monetary policy was to maintain the pound’s peg to the dollar. This resulted in a real appreciation of the pound and made it difficult for the Central Bank of Egypt (CBE) to alter monetary policy in response to changes in economic conditions. Following a series of devaluations since August 2001, the CBE abandoned the pound’s peg to the U.S. dollar and adopted a “freely” floating regime on January 29, 2003. Upon announcement of the new exchange-rate regime, the pound fell to E₤5.50 per dollar down from the previous day’s official rate of E₤4.64. While the parallel market rate has fluctuated around E₤7.00 since then, the official rate was not allowed to depreciate below E₤6.20/dollar. This is because the CBE has intervened several times in the foreign exchange market to limit the decline of the currency, via informal pressure on the banking industry. In one instance, several banks had their forex licenses revoked for trading in the parallel market.
Following the flotation of the Egyptian pound, consumer price inflation accelerated as the prices of food, beverages, and tobacco climbed. CPI inflation for urban areas rose to 4.7% year on year (y/y) in September 2003, up from 4.5% in August and 3.0% a year earlier. Inflationary pressures continued to mount in December 2003, when CPI inflation reached 5.5% y/y, compared with 5.1% the previous month and 3.0% a year earlier.
The CBE’s adoption of a floating regime last year will continue to fan inflationary pressures this year and significantly raise the risk of higher inflation through 2005. Money supply is expected to grow at levels comparable with those in previous years, putting more pressure on CPI inflation. The currency depreciation that resulted from the float will not only increase the cost of imports, but may discourage the large sums of remittances that flow into the country from abroad. Demand for the U.S. dollar will likely increase, putting more pressure on the pound. Prices would be bid up accordingly, given the importance of imported goods. The lagged effect of higher prices for imported goods used as manufacturing inputs will put further pressure on prices in the short term. The CBE has so far been careful not to sharply raise interest rates to counter the inflationary pressures due to the currency depreciation, given that such a move could dampen private investment and slow down economic recovery. The government has instead increased direct subsidies to nine commodities, to bring their prices down to pre-flotation levels.
Although the January 2003 timing of the float took many analysts by surprise, some in the investment community perceived the move as a “very good one.” Others, however, remain skeptical as to whether the CBE will allow the pound to slip further and make foreign exchange more readily available. Given today’s fragile domestic and risky regional economic environments, it would be very tempting for the CBE to intervene in an attempt to stem any further slide in the pound. But too much intervention would undermine the very essence of the new exchange-rate regime.
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