Monday, 27 May 2013

Unpleasant arithmetics at the Central Bank of Iraq

In its conflict with the central bank, the Iraqi government got its economics wrong. Twice.

The last few weeks saw a further decline in the value of the Iraqi dinar. The gap between market and the official exchange rates reached its peak in the second week of May when the dollar was being sold for around 1290 dinars; 10% above the official rate of 1166 dinars to the dollar. This might be surprising since for several years prior to 2012, the Central Bank of Iraq (CBI) managed to maintain a narrow gap between the official and market rates using its daily currency auctions.

The story of how the Iraqi foreign exchange market went from stability to volatility in the space of 18 months can be divided into three episodes.

Episode 1 (Jan 2012 – May 2012): Two explanations for an emerging gap

In early 2012, The CBI and the government offered two different explanations for a newly-emerging gap emerged between official and market exchange rates. Mudher Salih, then the deputy governor of the CBI, attributed the gap to excess demand from the neighbouring Syria and Iran—which were facing foreign currency shortages due to sanctions. Meanwhile, Izzat Al-Shahbandar, an MP and an aide to PM Maliki, blamed the stringent measures of the CBI, which hindered the foreign currency supply, for the emergence of the gap. Shahbandar claimed that prior to 2012, the CBI sold $200 million on average in its daily auctions, but that figure fell to $100 million in 2012.

Contrary to Shahbandar’s claims however, CBI’s data (summarised in the table below) show that the amount of dollars sold had in fact increased in the period from January to May 2012 relative to previous years. The data leaves little doubt which of the two explanations is more plausible - the only question mark is about the source of Shahbandar's figures.

Episode 2 (May 2012 – Oct 2012): The CBI increases supply and gets its governor sacked

To meet the excess demand, the CBI significantly increased its supply of dollars, successfully bringing the market price down to within 3% of the official rate in early October (see the chart below). At that point, an arrest warrant was issued against its governor, Sinan Al-Shabibi, over allegations of “of financial irregularities” related to the currency auctions. A more detailed report by the Board of Supreme Audit (BSA) concluded that the CBI’s loose control over the auctions encouraged smuggling of the dollar out of the country and money laundering.

The change in tone is notable: in October, the CBI was being accused of leniency in running its currency auctions, having been (falsely) accused of stringency in May!

Episode 3 (Oct 2012 – present): The CBI restricts dollar supply

Over this period, volumes in the CBI’s auctions averaged $177 million—a significant drop from the previous episode. This appears to be a deliberate policy as can be inferred from the appointment of the head of the BSA as the interim governor and CBI’s statements on 18 and 24 October 2012.

An unsurprising outcome of restricted supply is the significant rise in the market value of the dollar, which reached a high this month. It is hard to tell what is going to happen next, but the politicians who have been actively involved in the saga now seem concerned with the uncomfortable fall of the dinar.


The last part of the chart shows a sharp pick-up in the auction volumes over the last few days (almost to the levels reached by Shabibi before his dismissal) coupled with a narrowing of the gap between market and official rates. It would be a positive change if this trend continued. Currency smuggling, unnecessary depletion of CBI’s resources and money laundering must be fought of course. But this should be done through a legal and supervisory framework not through the excessively powerful tools of monetary policy. One should not starve the patient to death in order to kill the bacteria.

Monday, 20 May 2013

The IMF programme in Iraq

Iraq was fortunate to avoid an external financing crisis, but failed to deliver on structural reforms.

Arab countries that are seeking help from the International Monetary Fund (IMF) fall into one of two categories: countries which have experienced recent political change such as Yemen, Tunisia and Egypt; and oil-importing ones exposed to high price shocks. It may then seem surprising that Iraq—an oil-exporter with an unchanged prime minister since 2006—has been until recently engaged in a programme with the IMF.

A little historical background may help explain this. Oil prices experienced a large drop in 2009 following the global financial crisis and the economic recession that ensued. The price of an Iraqi barrel of oil fell from $124 in mid-2008 to $35 in early 2009 before picking up later in the year. For an economy where oil accounts for 95% of total exports and 90% of the government’s revenue, this risked creating a hole in the financing of both the government’s budget and imports.

The second column of the table illustrates this by showing the calculations carried out in February 2010 when Iraq applied for help. Assuming an average oil price of $62.5 per barrel and average exporting volume of 2.1 million barrels per day, Iraq would have had a $5 billion gap in financing its transactions with the outside world through 2011. Faced with this risk, Iraqi officials agreed with the IMF on a two-year programme and a $3.7 billion loan was approved on 24 February 2010

As it turned out, the risks did not materialise and oil prices recovered from their 2009 lows. My calculations—shown in the third column of the table—suggest that the financing gap was reduced to $3 billion by the end of 2010 as Iraqi oil price averaged $74 per barrel in 2010, more than compensating for the failure to meet the export volume target. By the time the programme had its second assessment in March 2011, the financing gap was all but eliminated under the government’s new conservative assumptions for oil price ($76.5) and export volume (2.2 million barrels per day) as shown in the last column of the table.

At the stage, the programme’s main focus shifted from “covering the balance of payments needs” to providing “a framework for advancing structural reforms”. This included improving accounting, auditing and reporting practices; restructuring and recapitalising the two main state-owned banks; and improving public financial management. However, the programme became a frustrating affair from this point on. Progress slowed down, reviews were delayed and eventually never carried out, and the programme deadline was extended twice, first to July 2012 and then to February 2013, when it finally expired.

In summary, the programme was one of two halves. The first focused on avoiding a balance-of-payments crisis, which Iraq managed to do more by luck than judgement. But higher oil prices, which were the main reason for preventing the crisis, weakened the appetite for change. It is fair to say that the second half of the programme, designed to advance structural reforms, was a complete and utter failure.

Sunday, 12 May 2013

Three phases of Egypt’s economic crisis

Egypt is going through the third phase of its economic crisis. It will not be the last one.

A cabinet reshuffle was announced last week in Egypt. Nine ministers were replaced including the incumbents of the three economic posts in the ministries of Finance, Planning and International Cooperation, and Investment. The new government faces considerable economic challenges, arguably the most urgent of which is related to Egypt’s balance of payments with the outside world.

The problem stems from the conflict between Egypt’s desire to prevent the value of its pound from falling and direction of fundamental economic forces. Even before the 2011 Revolution, Egypt was experiencing a deficit in its current account—which includes net purchases of goods and services as well as remittances from Egyptians abroad. The crisis has unfolded in three phases determined by how the current account deficit was financed.

Phase 1: Current account deficit financed by foreign investments. Foreign investments include direct ones such as buying factories and infrastructure projects and also financial investments into the Egyptian stock market or government bonds. As the chart shows, direct and portfolio investments were more than sufficient to cover the current account deficit in the years just before the Revolution. As a result, reserves at the Central Bank of Egypt (CBE) reached a peak of $36 billion at the end of 2010, a date that marks the end of this phase.

Phase 2: Larger current account deficit and financial account deficit financed by CBE’s reserves. Three things changed after the Revolution. First, despite the rise in remittances, the current account deficit grew larger mainly due to the fall in tourism. Second, direct investments halted to near zero. Third, foreign capital flows into the Egyptian stock and bond markets quickly reversed course and flowed out of the country (the light blue bar in the chart).

The changes put downward pressure on the pound but the currency was supported by the CBE’s intervention in the foreign exchange market using its international reserves. This phase continued until reserves fell below the minimum safety level—estimated by the CBE to be around $15 billion—in the second half of 2012.

Phase 3: Current account deficit financed by loans from other countries. With international reserves all but exhausted, the government—loathed to accept a currency depreciation—started to look for alternative sources of external funding. It was during this phase that it reached a preliminary agreement with the IMF in November 2012 only to backtrack on the deal. Instead, the government managed to finance the current account deficit with loans from Turkey, Saudi Arabia, Libya and especially Qatar. Most of these loans are in the form of deposits at the CBE, some of which can already be seen as the dark-grey bar in the chart and more are likely to show up when the CBE publishes the balance of payments figures for the latest quarter. Indeed, thanks to these loans the CBE announced last Wednesday that its foreign currency reserves had increased by $1 billion in April.

The current phase is both unsustainable and undesirable, and a correction is needed. The IMF may or may not be involved in the correction process (although it is likely that it would), but chances are there will be a fourth phase in Egypt’s economic tale.

Sunday, 5 May 2013

Will Egypt go bankrupt?

Morsi has secured sufficient funding to delay unpopular economic decisions until after parliamentary elections

The Egyptian president, Mohamed Morsi, has already answered the question in the title by declaring that “Egypt will never go bankrupt”. But judging by some of the recent headlines, sceptics are still unconvinced. What does it mean for a country to go bankrupt anyway? And is Egypt really on the brink of financial collapse?

Rather than using the poorly-defined term “bankruptcy”, an alternative way for analysing the financial sustainability of a country is to assess its ability to meet its external financing needs, which consist of:

·      Trade deficit (excess imports over exports)
·      Interest payment on existing debt
·      Paying back external debts as they fall due

In the short term, external financing needs can be met by borrowing or drawing from foreign currency reserves. But no country can borrow forever and reserves will eventually be exhausted, so the economy must eventually adjust to rebalance external finances.

In an ideal world, the adjustment is done in a benign manner in which the country gradually winds down its debt, boosts exports and reduces imports costs. But in times of crisis, a country may be forced to do the whole adjustment momentarily by defaulting on debt and instantaneously cutting imports—including food, medicines and energy needs. This is the dreaded “going bankrupt” scenario. One reason for the unpopularity of the IMF standard conditions is that the speed of adjustment they require is too quick for most countries’ liking.

So what are the external financing needs for Egypt over the next few months? And does it have sufficient funds to avoid hard-landing?

The IMF currently estimates Egypt’s external financing needs to be $11.7 billion. This figure can be split into $5 billion of expected current account deficit (that is trade deficit plus interest payment), and $6.7 billion of maturing external debt over the next 12 months. Raising $11.7 billion over 12 months may seem formidable, especially without the help of the central bank’s foreign currency reserves which are near their minimum safety level. But a more careful look at the numbers suggests it is not so bad.

According to the Central Bank of Egypt (CBE), of the $6.7 billion of external debt maturing this year, $4 billion are Qatari deposits which are unlikely to be paid back anytime soon. On top of that, Egypt has recently managed to borrow $2 billion from Libya and an additional $3 billion from Qatar. With a further $1 billion transfer from Turkey and a potential loan from Russia, the Egyptian government seems to have secured most of its external financing needs for the next few months as the table below shows.

Despite its success in securing loans, the government’s strategy carries some risks. First, it could unravel if the financing needs increased unexpectedly as a result of energy or food price shock. A second risk is that of a speculative attack on the Egyptian pound, especially with the CBE unwilling and unable to fend them off. Third, the over-reliance on Qatari funds to keep the Egyptian economy on its feet may raise questions about the political price being paid. Fourth, even if this tactic proves successful, it is at best a short-term fix rather than a long-term solution.

But the Egyptian government seems willing to take these risks rather than embarking on the unpopular and painful economic measures requested by the IMF. Perhaps it is hoping to kick the can just far enough down the road beyond parliamentary elections.