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.