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.