Monday, 30 November 2015

Can Egypt’s new central bank governor solve its currency crisis?

To tackle Egypt’s currency crisis, the authorities need to address the root cause of the problem: declining exports volume.

The new governor of the Central Bank of Egypt, Tarek Amer, whose term only began on 27 November, faces an immediate currency crisis. The crisis manifests itself through downward pressures on the Egyptian pound, a shortage of foreign currency and a burgeoning black market. The government is trying to solve this problem by raising foreign currency, either through a loan from the World Bank or investments from Saudi Arabia. But this is merely a short-term fix. The authorities need to address the root cause of the crisis, which is the decline in Egyptian exports volume since 2008. Here is why.

1. The value of a country’s exports relative to imports is an important determinant of the price of its currency. More exports imply higher demand for the country’s currency, leading to an appreciation. Conversely, more imports typically lead to a depreciation.

2. Egypt has almost always imported more than it exported, but the gap in the early 2000s was small enough to be filled by the stable inflow of foreign currency remittances from Egyptians abroad. However, this gap began to widen and, since 2008, became too large to be offset by transfers from the Egyptian diaspora. Successive governments relied on different sources to finance this gap, including foreign inflows into Egypt’s stock and debt markets, withdrawing from international reserves and support from the Gulf. But none of these sources proved sustainable, which is why there is a crisis today.

3. Why has export growth lagged import growth since 2008? To identify the source of the problem, assume for the sake of argument that Egypt exported oil. Is the problem due to Egypt’s exporting fewer barrels of oil (a volume issue)? Or is it due to lower oil prices (a price shock)?

At least part of the problem is due to exports volume, which has not only failed to keep up with imports volume growth, but it has actually been declining since its peak in 2008 (see chart).

4. One way to quantify the impact of declining exports volume is through a counterfactual analysis. This is done by asking what would have happened to Egypt’s external balances if exports volume had remained at the 2010 level, but everything else (export prices, exchange rates, imports and transfers) had evolved as in the actual data.

Under the counterfactual scenario, Egypt’s current account (the sum of trade balance and transfers from foreign governments and Egyptians abroad) would have been in a surplus of 2.2% of GDP in 2014 instead of a 2.0% deficit. Even if we exclude public transfers (mainly support from the Gulf amounting to about $15bn in 2013-14), the current account would have been in a slight deficit of 0.5% of GDP.

This suggests that if Egypt had maintained its exports volume at the 2010 level, let alone succeeded at growing it, it would have probably averted its ongoing currency crisis.

5. So why did exports volume decline so much? Potential reasons include: First, slow growth in Europe—Egypt’s main export destination—which reduced demand for Egyptian exports. Second, less tourism due to the worsening security situation. Third, reduced traffic through the Suez Canal due to the slowdown in global trade.

6. In conclusion, reviving exports should be the main solution of Egypt’s currency woes. But this is a problem that cannot be readily solved by a new central bank governor or monetary policy. Certainly not on their own.

Sunday, 13 September 2015

Does currency devaluation help Egyptian exports?

There is little evidence supporting the case for devaluing the currency in order to promote exports in Egypt.

Talks intensified last week about the possibility of devaluing the Egyptian pound. The Investment Minister, Ashraf Salman, told a conference in Cairo that depreciation may no longer be a choice. His colleague, the Minister of Industry and Trade, blamed a strong pound for the recent dismal performance of exports. The latter’s logic suggests that some devaluation of the currency could help Egyptian exports and preserve the dwindling reserves. But is this true? Does currency devaluation actually boost Egyptian exports?

Two considerations are important in answering this question:

1. When it comes to boosting exports, inflation matters as much as the exchange rate. In theory, currency devaluation supports exports by making them cheaper when expressed in a foreign currency. But the gains from the exchange rate devaluation could be wiped out if the cost of exports increases due to high inflation. This suggests using a measure of the exchange rate that also takes into account changes in prices. This measure is called the “real exchange rate”.

2. It is important to look at broader measures of the exchange rate beyond the value of the Egyptian pound against the US dollar. Nearly a quarter of Egypt’s trade was with the Euro Area in 2014 compared to only 7% with the US. This means that movement of the Egyptian pound against the euro is almost four times more important than its movement against the dollar. To account for this, a broad measure of the exchange rate against a basket of currencies can be constructed, with each currency weighted by Egypt’s trade exposure to that country. This measure is called the “effective exchange rate”.

The two considerations suggest we should look at the “real effective exchange rate” (REER) when we want to evaluate the impact on exports. Now, back to the original question: is there a relationship between REER and export growth in Egypt?

The chart above displays the change in Egypt’s REER (on an inverted scale, positive values mean the pound is appreciating) against the change in real net exports. If exchange rate depreciation (red line moving up) drives export growth (blue line moving up), then the two lines should move together. As the chart shows, there is a very weak link between changes in REER and Egyptian exports growth. In fact, over the period 2007 to 2011, the two lines were moving in opposite directions!

The Egyptian authorities are very much aware of this fact. In a statement earlier this year, Hazem Beblawi, the former prime minister, wrote:

The authorities consider imports and exports relatively inelastic to the exchange rate as exports are constrained by non price factors and given the large share of wheat and intermediate inputs in imports. Indeed, the large depreciations of the REER in 2003 were not followed by a strong response in net exports.

This is what the authorities believed then. Have they changed their mind now?

Tuesday, 25 August 2015

Unpleasant fiscal artihmetics in Iraq

The Iraqi government is struggling to finance its increasing deficit.

Things used to be simple in the Iraqi economy. The government received large revenues from oil exports. The revenue trickled down to the rest of the population through salaries to the large number of unproductive (and sometimes non-existent) civil servants employed by the government, with corruption taking a slice of the revenue as it moved down the pyramid.

But the world changed in June 2014 as the war with ISIS intensified and oil prices tumbled almost simultaneously. The government’s oil revenue fell by more than a half, and a significant chunk of the reduced income had to be spent on financing the war with ISIS. 

The new reality manifests itself most strikingly through the 2015 budget, where the government is struggling to finance an increasing deficit.

The initial budget law stipulated a deficit of around 26tn dinar ($22bn). But things have not exactly gone according to plan. Lower oil export volumes and delayed introduction of non-oil taxes mean that revenues are likely to fall short of their budgetary target. Expenditure is higher than anticipated as a $10bn payment to international oil companies was not adequately included in the budget. But the government plans to make up for this by cutting investment spending. As a result, the deficit is now likely to reach 42tn dinar, or around 20% of GDP. 

How is the government going to finance this deficit? It intends to raise around 8tn dinar through external borrowing. This includes borrowing from the International Monetary Fund and the World Bank, but also involves plans to issue bonds in international markets. Iraq has recently managed to obtain a credit rating from Fitch for the first time (hint: not a good one), which could facilitate its attempts to tap international bond markets.

But nearly half of the deficit (19tn dinar) is expected to be indirectly financed by the Central Bank of Iraq (CBI). This works as follows: commercial banks would lend the government by buying its T-bills, then sell these loans to the central bank and receive newly-printed money in exchange.

Getting the central bank to finance the government’s deficit is dangerous and could have painful implications for inflation and the value of the Iraqi dinar. And even with this, the government still admits a financing gap equivalent to a third of its deficit (13tn dinar) which it hopes to fill with unidentified “domestic and foreign sources”. 

The two shocks (oil prices and the war with ISIS) are creating a messy reality in Iraq. And with oil prices remaining low for longer, and the war with ISIS unlikely to end anytime soon, the shocks may turn out to be less transitory than first anticipated. The urgency of the situation could force a major overhaul in policy. But this remains more of a hope than an expectation.

Monday, 17 August 2015

Oil - shale giveth and Iran taketh away

Oil markets to remain over-supplied through 2016.

The consensus among oil analysts was that 2015 would be a bad year for oil prices, but things should improve after that. Their thesis was that lower oil prices would make the business of high-cost US shale oil producers unviable, pushing some of them out of the market. This should slow down the growth of oil supply, allowing demand to catch up and prices to recover. The consensus is now changing, and the reasons is: Iran.

Let’s take this step by step. In 2015, oil markets are expected to be over-supplied by around 0.8m barrels per day (b/d), even if OPEC sticks to its production ceiling of 30m b/d. Consequently, oil prices should remain low—in the $50s range—during the year.

How about 2016? US shale is doing its bit to rebalance the market. The US is expected to add only 0.3m b/d to existing production (compared to 0.9m b/d in 2015 and a whopping 1.4m b/d in 2014). As a result, demand growth was expected to outpace supply growth by around 0.3m b/d, reducing inventories and pushing up prices. This was the consensus before Iran.

Following the agreement on its nuclear programme and the prospect of lifting economic sanctions in 2016, Iran is expected to return to the oil market. Estimates vary on how much additional oil Iran could produce once the sanctions are lifted, but they range between 0.2-0.8m b/d. Whatever it is, it will almost certainly wipe out the 0.3m b/d of excess demand which was expected to drive the recovery in oil prices. With the return of Iran, inventories are expected to stabilise, or even increase, and prices will continue being low (again in the $50s range) into 2016.

In theory, Iran should not matter for the oil market. After all, it is a member of OPEC and the cartel has a production ceiling of 30m b/d. If Iran produces more, other OPEC members should produce less to maintain the ceiling. But this is unlikely to happen in practice: OPEC producers will probably continue pumping as much oil as they can to meet their financial obligations in an environment of low oil prices.

The latest production data support this. In July, Iran’s supply increased to its highest level since 2012. As a result, OPEC production reached a three-year high of 31.5m b/d, well above the self-imposed ceiling.

If this is a sign of things to come, then whatever shale gives to reduce excess supply and rebalance the market, Iran will take away. Oil markets will remain over-supplied through 2016.

Monday, 10 August 2015

The puzzle of electricity in Iraq

Weak infrastructure, corruption and lack of fuel are behind the chronic power shortage in Iraq.

The ongoing protest movement in Iraq is developing fast and, judging by the list of reforms proposed by Prime Minister Haider Al-Abadi yesterday, is shaking up the political landscape. The movement was triggered by power shortage amid a scorching heatwave that is engulfing the country. It is a puzzle why electricity remains in short supply more than 12 years after the fall of Saddam. Iraq earned large financial windfalls from the oil price boom of recent years, and directed a lot of resources towards investment in the electricity sector. Iraq is also one of the world’s largest and fastest growing oil producers, so it should not have trouble finding energy to operate its power plants. So where is the problem?

A recent study by the World Bank on the electricity sector in Iraq clarifies some aspects of the puzzle. I summarise the main points below.

·         What is the extent of problem?

There is a serious shortage of electricity in Iraq. Demand for power in Iraq was estimated at 13.7 gigawatts in 2010, but supply fell well short at 8.3 gigawatts. This restricted electricity supply to eight hours per day on average. The problem is clearly one of insufficient supply rather than excessive consumption. Iraq’s electricity consumption per capita (1,187 kilowatt hours) is much lower than countries with similar income level such as Serbia (4,359 kilowatt hours) and South Africa (4,581 kilowatt hour).

·         What are the causes of the problem?

1. Weak and inefficient infrastructure. Iraq’s nameplate power generation capacity in 2010 was 15.3 gigawatts, but it has one of the most inefficient generation systems in the region. This meant that the maximum technical capacity was 12.3 gigawatts. Shortage of water and fuel reduced production by 3 gigawatts, and aging by a further 1 gigawatt. Beyond generation issues, the transmission and distribution infrastructure is very weak due to under-investment and depreciation.

2. Widespread corruption. Electricity projects require many signatures and approvals, encouraging bribes and short-cuts at every step of the way. This slows down the investment process, and results in the under-execution of capital budgets. So although large allocations were made to the electricity sector, a big share were returned unspent to the central government at the end of each year. Corruption also comes in another variety: In 2011, the Ministry of Electricity signed contracts for electricity generation with a company that was bankrupt and another that did not even exist!

3. Shortage of fuel feedstock supply. 37 out of 47 power plants operate on natural gas. Former Prime Minister, Nouri al-Maliki, famously complained on TV about importing gas-operated power plants, when Iraq had no gas to supply them with. In reality, Iraq does not lack natural gas: large quantities of associated gas are produced but then flared due to the lack of infrastructure to refine and consume it. The government has therefore resorted to importing natural gas from Iran, but there are issues with the stability of this supply and the logistics required to transport it to the power plants.

·         Is the electricity shortage problem likely to be resolved anytime soon?

The issues here are structural and systematic. The problems of weak infrastructure, inefficient use of resource, red tape and corruption take time to resolve. There have been many false dawns and many broken promises. The World Bank report cites the Ministry of Electricity projections of meeting all demand by 2014, which seems laughable now. Abadi’s reforms include a clause calling for coming up with “a set of measures to end the problems of electricity production, transmission, distribution and tariffs within two weeks”. To say this is unrealistic would be an understatement.

Monday, 13 July 2015

Boosting Egyptian exports – why inflation matters

When it comes to boosting exports, inflation matters at least as much as the exchange rate.

The decision by the Central Bank of Egypt (CBE) to let the Egyptian pound depreciate was applauded by some commentators. They argued that a weaker pound can boost exports by making them cheaper relative to their competitors. However, even in theory, this argument is incomplete and misses important ingredients. Careful analysis shows that when it comes to boosting exports, inflation matters at least as much as the exchange rate.

Let’s take an example. Consider a situation in which Egypt and the US produce an identical good, which they export to the rest of the world. Suppose that the price of the Egyptian good is 100 pounds, and the price of the US-produced good is $100. Now, assume that the exchange rate is such that 1 pound = $1. This means the price of the Egyptian good in dollars is $100, exactly the same as the price of its American counterpart. Consumers will therefore be indifferent between buying either.

Suppose that the CBE then decides to let the pound depreciate by 10%, so that $1 = 1.1 pound. The price of the Egyptian good is still 100 pounds, but its price in dollars is now $91 (=100/1.1). Because the Egyptian good costs less than the American one (which is sold at $100), consumers will choose to buy more of the Egyptian good at the expense of the American one. This is exactly the argument that proponents of the recent depreciation of the pound make.

Assume then that inflation in Egypt is 20% but it is zero in the US. This level of inflation implies that the Egyptian good now costs 120 pounds.  This is equivalent to $109 (=120/1.1). The Egyptian good is now more expensive than the American one, which still costs $100. Inflation has basically wiped out all the competitiveness gains from the currency depreciation.

What are the lessons of this simple example?

1. Inflation is at least as important as the exchange rate when it comes to making exports more competitive in international markets. In other words, it is real exchange rate (which also takes inflation into account) not nominal exchange rate that matters for exports.  

2. With Egypt running double-digit inflation and most of the rest of the world operating at below 2% inflation rates, the CBE has room to improve the appeal of Egyptian exports by reducing inflation, not just the value of the currency.

Of course, these conclusions are under the assumption that Egyptian exports respond to improvements in price competitiveness (equivalently, a fall in the real exchange rate)—an assumption that is not uncontroversial. But this is another story.

Monday, 6 July 2015

Egypt’s revised budget is too optimistic to be true

Paradoxically, by aiming for a lower budget deficit, Egypt may hurt its growth prospects and end up with a higher deficit than it is hoping for.

There was some last-minute drama in the release of Egypt’s budget for the current fiscal year which began on July 1. The president, Abdel Fattah al-Sisi, rejected the initial budget that was presented to him. He asked the Ministry of Finance to reduce the deficit, which was expected to reach 281bn Egyptian pound (9.9% of GDP). In the space of a few days, the ministry re-evaluated its figures and came up with a revised budget and a new deficit of 251bn pound (8.9% of GDP). These events raise two questions: How did the ministry manage to reduce the deficit by 30bn pound? And can the new deficit be realistically achieved?

The answer to the first question is that revenues were revised up by 10bn pound while expenditures were revised down by 20bn pound. As the table below shows, the higher revenues are a result of higher non-tax revenues, which include profits from publicly-owned companies, the central bank and the Suez Canal. Why are these expected to increase by 10bn pound now compared to a few days ago? It is not clear.

Meanwhile, half of the expected cut in expenditure (10bn pound) is due to lower spending on salaries and wages. The other half comes from either decreased purchases of goods and services or lower spending on other items (which include defence, national security and judiciary, among other things). The published figures do not allow for a full distinction.

Now, can the new deficit be realistically achieved? Probably not, and for three reasons.

First, the rush in getting the revised budget out suggests that the revisions were not carefully thought through. And the scrambling to revise the numbers is evident from the Ministry of Finance publishing the wrong figure for expenditure on its website (868bn pound instead of the correct 865bn).

Second, commodity prices—whose decline in 2014/15 helped control spending and reduce the deficit—are projected to rebound. The budget expects oil price to average $70 per barrel in 2015/16, up from the current price range of $55-$65. This is likely to increase the burden on spending, making it harder to achieve the 8.9% of GDP fiscal deficit.

Third, and most importantly, the revised budget assumes that the lower deficit has no impact on growth. The initial budget assumed a growth rate of about 5% in 2015/16—the same growth rate assumed under the revised budget, even after slashing the deficit by 1% of GDP. The assumption that the reduced budget deficit will have no growth impact contradicts the recent experiences of the US, UK and the Euro Area. In each of these regions, tighter fiscal deficits had a significantly negative impact on growth, and these economies only picked up when the drag from fiscal policy dissipated. One would not expect the experience of Egypt to be any different.

And there is a feedback loop from lower growth to the budget: Slower growth could result in lower tax revenues and a higher fiscal deficit, the very thing the Sisi’s revision to budget sought to reduce. Paradoxically, by aiming for a lower budget deficit, Egypt may hurt its growth prospects and end up with a higher deficit than it is hoping for.

Monday, 29 June 2015

Egypt fiscal cutback broadly on track

Higher growth and lower commodity prices are helping Egypt to reduce its budget deficit.

Egypt is rotating its economic policy towards a new model based on two arrows: lower government spending and higher investment. The move is prompted by Egypt’s backers in the Gulf—who seem unwilling to continue writing blank cheques—and the unsustainability of the old model—which saw the Egyptian government spending beyond its means. The Egyptian authorities and the International Monetary Fund are optimistic that the new model will lead to higher economic growth. And the latest numbers show that at least one of the arrows is on track to hit somewhere close to its mark.

According to the Ministry of Finance data, the budget deficit (the difference between the government’s spending and revenue) for the period July 2014 to April 2015 was 9.9% of GDP. The Ministry expects the deficit for the whole fiscal year, which ends on June 30, to reach 10.8% of GDP. This is quite a bit lower than the 2013/14 deficit, which was 12.8% of GDP, although still higher than the original deficit target (10% of GDP).

The expected deficit reduction will be achieved despite reduced support from the Gulf and the postponement in the implementation of capital gains tax. The former, which fell by $5.7bn compared to a year earlier, would have reduced the budget deficit by 1.9% of GDP if maintained at last year’s levels. The impact of the capital gains tax is less significant: it would have only reduced the deficit by less than 0.1% of GDP if it had been implemented.

So how was the deficit reduction achieved? First, higher growth has resulted in higher tax revenue for the government. Real GDP growth accelerated to 5.6% in the first half of the current fiscal year compared to 1.2% in the same period a year earlier. As a result, Egypt’s tax revenue increased by 22.6% over a year ago. Second, lower food and energy prices have helped the government to control its expenses.

Going forward, Egypt plans to continue tightening fiscal policy. The government has recently announced the deficit target for 2015/16 (9.9% of GDP), and Egypt’s five-year macroeconomic strategy expects the deficit to continue declining to 8.1% of GDP in 2018/19. There are risks to this outlook. Not least because commodity prices are expected to recover and may increase expenditure. In addition, too rapid a fiscal consolidation can sometimes be self-defeating: it can be detrimental to growth and hence to revenue and the deficit itself. But Egypt and its regional and international backers are intent on continuing firing the fiscal arrow.

Monday, 27 April 2015

Who is right about the currency auctions in Iraq?

Ahmed Chalabi’s campaign against the currency auctions is based on weak economics.

The currency auctions continue to divide opinions in Iraq. The Central Bank of Iraq (CBI) is appealing before the Supreme Court against the imposition of Article 50 in the budget law. The article, imposed by parliament, prevents the CBI from selling more than $75m a day in the auctions. Meanwhile, Ahmed Chalabi, the chairman of the parliamentary finance committee who is now spear-heading the attack against the auctions, has claimed that they have been a source of corruption, which led to the depletion of the country’s reserves. Undeterred by critics, the CBI has restarted the auctions on 6 April, after a few weeks’ suspension. Its daily sales averaged $133m in the first nine sessions, well above the limit set by parliament. Who is right and who is wrong in this debate?

1. On form alone, it was wrong to include Article 50 in the budget law. The budget law should be about fiscal policy: the government’s expenditure, sources of revenue, new taxes etc. Article 50, however, was about the conduct of monetary policy. It can be debated whether it intrudes into on the CBI’s independence, but the article was certainly out of place in a budget law.

2. Chalabi’s argument that the auctions were a source of corruption and have wasted the country’s reserves might be right. Around a quarter of the dollars sold in the currency auctions in 2013 were not used for their intended purposes, which is funding the private sector imports. But imposing a limit on dollar sales is not the right response.

If Iraq wants to maintain its peg to the dollar and eliminate the black currency market, it has no choice but inject enough dollars to meet demand. Failing that, market prices would decouple from the official price, making the peg redundant.

This is something that was confirmed time and again by Iraq’s recent experience, and is happening now too. Although the CBI no longer publishes data on the market rate, press reports suggest that the price of the dollar has reached 1340 as a result of the suspension of the auctions. This is 15% above the official exchange rate and represents the highest deviation probably since the data became available in 2004.

3. It may be argued that the official exchange rate itself should be revised. Iraq may need to either devalue its currency by choosing a higher price for the dollar or even let its currency float freely. Chalabi has hinted at that in his interview, saying that “the price set by the central bank is its choice and is not based on a particular rule”. This is a debate that could be had, especially against the background of of lower oil prices. But as long as Iraq wants to maintain its current peg and as long as it wants to eliminate the need for an unofficial currency market, the CBI should to be allowed to supply enough dollars without restrictions. 

Tuesday, 14 April 2015

Economic consequences of the peace with Iran

A final deal with Iran could depress oil prices by around $9.

On 2 April, the world’s major powers (the so-called P5+1) and Iran announced a framework for a final agreement on Iran’s nuclear programme. The P5+1 are demanding limits on Iran’s nuclear programme in exchange for lifting the sanctions which have crippled the country and its economy. The impact that this announcement will have on the oil market depends on three related questions: Will the announcement lead to a lifting of the sanctions on Iran? How much will Iran produce once the sanctions are lifted? And how will the extra Iranian production affect oil prices?

Will the announcement lead to a lifting of the sanctions on Iran?

The announcement was far from being a final deal. It merely represented a set of parameters which will form the foundation of the final agreement. Long and hard negotiations are expected before the 30 June deadline, and “nothing is agreed until everything is agreed”.  But, a deal looks now more likely than it before the announcement, if only because the framework was more detailed than expected.

Sanctions, in particular, remain a thorny issue. The framework suggests that sanctions will be lifted only after “after the IAEA has verified that Iran has taken all of its key nuclear-related steps”. This could take six months to a year after reaching a final agreement, according to John Kerry, the US secretary of state. So sanctions are unlikely to be lifted until the first half of 2016, which runs contrary to the Iranians’ desire for their removal on the day of the agreement.

How much will Iran produce once the sanctions are lifted?

According to the latest estimates by the International Energy Agency, Iran has a spare oil capacity of 0.76m barrels per day (b/d) which can be reached within 30 days. It is fair to assume that Iran will try to produce and export the bulk of this spare capacity once the sanctions are lifted.

How will the extra Iranian production affect oil prices?

Useful lessons can be drawn from the Libyan supply shock in 2011. In that episode, Libya’s production declined from around 1.7m b/d to only 0.5m b/d resulting in a 25% increase in oil price from mid-February to end-April 2011. Assuming that Iran will impact the market proportionally but in the opposite direction, the additional expected Iranian production will probably lower oil prices by 16% (=25%*0.76/1.2). This means that the lifting of sanctions on Iran could depress oil prices by around $9. This assessment is similar to that of the US Energy Information Administration, which expects that additional Iranian production would lower oil prices by $5-$15.

Conclusion. While there is still a long way before a final deal with Iran is reached, the recent agreement on a framework is an important step in that direction. Once a final deal is reached, it could result in a lifting of the sanctions in the first half of 2016. This would add 0.76m b/d of extra Iranian oil into the market, which could depress oil prices by around $9.

Monday, 30 March 2015

Will the conflict in Yemen impact oil prices?

The impact of the conflict in Yemen on the oil market is likely to be limited, unless it spreads outside its borders.

Oil prices jumped by almost 5% when the Saudis launched air strikes against Yemen on 26 March. The strikes have raised questions on whether this could cause a significant supply disruption in the oil market. The answer depends on how the conflict unfolds and how widespread it becomes. For this, it is useful to consider three scenarios.

Scenario 1: The conflict stays within the Yemeni borders. This is the most likely scenario. The regional foes have tended to fight their wars through domestic proxies, as in the case of Syria. The scenario promises Yemen years of chaos and misery, but is likely to have little impact on oil prices. With a production of just 150 thousand barrels a day (b/d), Yemen is a small producer accounting for less than 0.2% of global oil supply. Any losses from the Yemeni oil production can be easily replaced with the Saudi excess capacity. And in any case, the oil market is ridiculously over-supplied, so a small loss will hardly be noticed. 

Scenario 2: The conflict spills over in a limited way. This could take the form of the closure of the Bab el-Mandeb Strait. The strait is an important trade route, where 3.8m b/d of crude oil and refined products passed through in 2013, mostly going from the Gulf to the Mediterranean. But the closure of the Bab el-Mandeb Strait does not take this supply out of the market; it just means that the oil tankers have to use an alternative route around Africa. This would add time and transit cost, but the impact on the oil market should still be contained.

In this regard, the strait of Bab el-Mandeb is far less important than that of Hormuz both in terms of oil flow (17m b/d in Hormuz versus 3.8m b/d in Bab el-Mandeb) but also in terms of the availability of alternative routes to bypass each strait (there is not enough pipeline capacity to bypass the strait of Hormuz, while alternative routes exist to bypass Bab el-Mandeb).

The closure of the Bab el-Mandeb Strait is unlikely. There is a heavy presence of international warships in nearby waters as well as an American military base in Djibouti. And if necessary, the Egyptian, Saudi or even the Israeli navy could be deployed to keep the strait open.
Source: Energy Information Administration

Scenario 3: A widespread regional war. This scenario is extremely unlikely. But if it did materialise, it would represent a major shock to the oil market. At risk would be a third of the world’s oil production. However, it is difficult to imagine how an outright war can come about. After all, the regional powers have shown a preference to fight their wars through local proxies and possibly by exporting fighters rather than engage in a direct conflict.

Conclusion. The impact of the conflict in Yemen on the oil market is likely to be limited, unless it spreads outside its borders. The prospect of a regional spillover currently looks unlikely. Perhaps realising this, oil prices declined sharply on the second day of the Saudi strikes, reversing all the gains made on the previous day. 

Monday, 9 March 2015

Are lower oil prices impacting the Iraqi dinar?

Lower oil prices and confusing policies are starting to cause a dollar crunch in Iraq.

1. Iraq gets almost all of its US dollars from the government’s sale of oil. To meet the private sector’s demand for dollars (to pay for imports, travel and medical expenses etc), the Central Bank of Iraq (CBI) holds daily auctions in which it sells dollars to the private sector at the official exchange rate (1,166 Iraqi dinar per 1 US dollar) as long as import receipts are provided.

2. The 2015 budget imposed a new restriction preventing the CBI from selling more than $75m a day in its currency auctions. The imposed limit reduces the volume of dollars available to the private sector by two thirds (daily volumes averaged $204m in 2014). The limit was not in the initial draft of the budget, but was later added by the parliament to prevent the depletion of international reserves as oil prices declined, reducing the availability of dollars in the economy.

3. The restriction on the currency auction brings back memories of the dollar crunch of 2013. Following the sacking of its governor, Sinan al-Shabibi, the CBI significantly reduced the volumes of dollars on offer at the auction. As a result, the market price of the dollar deviated from the official price. At its peak, the dollar was sold at 1,292 dinar in the market, almost 11% above the official price. But even during this episode, the volumes sold at the auction were about double the new $75m limit.

4. Following the approval of the budget, the CBI reduced the volume of the dollars sold in its daily auction to an average of $80m—above the ceiling imposed by the budget, but much lower than the $204m it sold daily in 2014. Unsurprisingly, the market price of the dollar began to deviate from the official price. It reached 1,237 dinar to the dollar on 19 February, 6.1% above the official price.

5. The CBI suspended the daily dollar auction after 19 February, leading to speculations that it would stop selling dollars altogether. The CBI denied these speculations, claiming that it has merely replaced the daily auction with a new mechanism based on direct bank transfers. Meanwhile, reports suggest that the government and the CBI are likely to appeal against the article restricting the CBI sales to $75m a day. Against this backdrop of policy uncertainty, the dinar has continued falling against the dollar. Anecdotes suggest the dollar was trading at 1,264 dinar a few days ago.

6. Why is the currency auction so controversial? Its controversy led to the sacking of a former CBI governor, the imposition of a limit on the auction’s daily sales and, ultimately, its outright suspension. Opponents claim that the CBI was lenient in selling dollars against fake import receipts. The dollars sold were then used for speculation and sometimes smuggled out of the country.

Are these claims right? Probably yes. My estimate of private sector imports of goods of services in 2013 is $41bn, which is below the $54bn sold in the CBI’s auctions in the same year. This suggests that some of the dollar purchases were indeed used for speculation and probably smuggled out of Iraq.

7. But is tightening the supply of dollars the correct response to this? Probably not. As in 2013, supply restrictions will only lead to a decoupling of the market price from the official price—a process that is ongoing now despite the CBI’s insistence that it is only temporary.

Monday, 2 March 2015

Egypt’s new growth strategy

Egypt’s new strategy of less government spending, more investment and higher growth is a little ambitious

The economy of Egypt has slowed down considerably since the 2011 revolution. Annual real GDP growth, the standard measure of economic activity, has averaged 2.1% in 2011-14 compared to 5.6% between 2004 and 2010.

Almost half of that growth differential was due to a slowdown in investment. It is hardly surprising that investors have been spooked by the political and legal uncertainty which have followed the revolution. In the chart below, the contribution of investment to real GDP growth over 2011-14 is reduced to a barely visible grey strip below zero. The other half of the growth differential was equally split between private consumption and net exports as the overall environment proved detrimental to consumer sentiment and competitiveness.

Faced with this, the government’s strategy was to increase public spending to shore up the economy. As a result, the government’s contribution to annual real GDP growth has increased a little in 2011-14 relative to 2004-10 unlike all the other components.

But this strategy is now reaching its limits. The government’s budget deficit in the fiscal year 2013/14 was 13.8% of GDP. Excluding grants from the Gulf, the deficit was a massive 17.6% of GDP. This is very large and not sustainable for two reasons. First, because domestic banks—which have lent out large sums to the government in recent years—will eventually run out of liquidity. And second, because Egypt’s Gulf backers are showing reluctance to continue writing blank cheques and are seeking a change in the direction of economic policy.

The Egyptian government is therefore moving to a new strategy, which is based on replacing government spending with investment. In its latest survey of the Egyptian economy (which is published for the first time after a five-year pause), the International Monetary Fund (IMF) predicts annual real GDP growth will average 4.5% over 2015-19 despite a significant tightening in government spending. This is because the IMF expects investments to grow at annual rate of 6.1% over the same period, which is high but still lags the 2004-10 rate.

To achieve this, the government has been designing and promoting large infrastructure projects. These include the Suez Canal Regional Development project as well as preliminary plans to build a large number of housing facilities and construct roads. The authorities also aim to attract foreign investment and the forthcoming economic conference on 13-15 March is one platform to advertise the new strategy.

The new strategy is sound in theory but has its risks. After all, the factors which have inhibited investment post-2011 are still largely in place. Egypt needs to attract enough investments not only to counteract the substantial cut in government spending, but also to raise growth from its current levels. This might be a little ambitious given its prevailing circumstances. 

Wednesday, 11 February 2015

The Iraqi budget and oil: First as tragedy, then as farce

Iraq might approach the IMF for help, just like it did in 2009 when oil prices fell

The Iraqi parliament approved the government’s 2015 budget on 29 January. Merely passing a budget is normally an unremarkable event, except in Iraq where it was met with relief and jubilation. After all, the country went through the whole of 2014 without a budget.

How does the new budget fare? Starting with the broad figures: Government revenue is expected to be around 94.0tn Iraqi dinar ($80.7bn); expenditure is budgeted to reach 119.6tn dinar ($102.6bn) resulting in a fiscal deficit of $21.9bn. A portion of the deficit will be financed externally (around $8.3bn) with the rest financed through domestic borrowing and the issuance of bonds. The broad picture hides two problems, at least as far as raising the required $8.3bn of external financing is concerned.

1. The budget stipulates that Iraq would use $1.8bn of its special drawing rights (SDR) to finance the deficit. But according to the latest accounts at the International Monetary Fund (IMF), Iraq’s remaining holdings of SDR amount to only $0.6bn, which is the maximum it can use. It is not clear how the shortfall be explained or bridged.

2. The budget suggests borrowing $4.5bn from the IMF to finance the deficit. Problem: This can probably only happen if Iraq agrees a programme with the IMF. An IMF programme would imply conditionality, most likely starting with cutting government expenditure.

Now we can blame declining oil prices for Iraq’s fiscal predicament, but Iraqi policymakers do not seem to have learnt from past mistakes. Iraq did rush to seek the IMF’s help last time oil prices fell sharply in 2009. That programme was a failure as the subsequent recovery in oil prices weakened the appetite for reform in Iraq.

Rather than learning from this experience by building up reserves during the oil boom years, Iraq has managed to blow most of its savings. Reserves at the Development Fund of Iraq (DFI)—whose role is precisely to accumulate oil surpluses in the boom years to finance deficits in slumps—declined from almost $23bn in March 2013 to an estimated $4bn in November 2014. This drawdown would have been enough to finance most of the deficit this year. Why did the government tap the DFI at a time when oil prices were so high? No one knows. Conveniently, by the way, the DFI has stopped publishing its balances since March 2014!

So after four years of record high oil prices, Iraq remains fragile. All it took was a quick drop in oil prices (which has not even persisted yet) to make Iraq consider seeking the IMF’s help, just like it did in 2009/10. But while 2009 might have been a tragedy, 2015 looks more like a farce.