The Central Bank of Egypt’s misdiagnosis of a crisis

The dismal performance of exports, not excessive spending on imports, is behind Egypt’s currency woes.

Correct diagnosis is key to successful treatment. On 21 February, the governor of the Central Bank of Egypt, Tarek Amer, gave a TV interview outlining his diagnosis to the country’s ongoing struggle with a currency crisis, which has led to intense speculations about a possible devaluation of the Egyptian pound. Below are a few remarks on the interview.

1.  What is the central bank’s diagnosis of the problem? The governor was clear in his assessment: the excessive increase in imports over the last few years is to blame for the crisis. This has led to a large demand for the US dollar, which reduced its availability and led to pressures on the Egyptian pound.

2. Is the central bank correct in its diagnosis? No. It is natural for spending on imports to increase with the rise in income. It would only be considered excessive if its growth far exceeded that of national income, which has not been the case in Egypt. Imports grew at an annual rate of 4.7% between 2010 and 2014, lagging the 7.0% annual growth in Egypt’s nominal gross domestic product (GDP), a measure of income for the country. There is nothing excessive about this. In fact, the share of imports in GDP fell from 31% in 2010 to 28% in 2014.

3. If imports are not the root cause of Egypt’s currency crisis, what is? The answer is exports. In 2010, Egypt’s exports were valued at $49bn. In 2014, this number fell to $47bn. As a share of GDP, exports fell from 23% in 2010 to 17% in 2014. The fall in exports meant that Egypt earned fewer US dollars than it did in the past, which led to a shortage of foreign currency.

4. What explains the decline in exports? The main reason is that Egypt lost market share in its export destinations, despite the overall growth of exports to these markets. For example, Egyptian exports accounted for 1.5% of total exports to Saudi Arabia in 2010. But this share fell to 1.2% in 2014. Among the largest 43 trade partners of Egypt, the share of its exports declined in 31 countries between 2010 and 2014.

5. What could explain the dismal performance of Egyptian exports over the last few years? Potential explanations include: First, Egyptian exports may have become less appealing because they have become more expensive, either because inflation has pushed up domestic costs or because the Egyptian currency has appreciated against competitors’ currencies. Second, demand for Egyptian exports could have declined due to either security concerns (affecting tourism), the slowdown in global trade (impacting traffic in the Suez Canal) or the quality of Egyptian exports. Third, the capacity of Egypt to produce exports may have been constrained due to power cuts in factories, the shortage of foreign currency required to buy intermediate goods for production or the destruction of the gas pipeline in Sinai, which reduced exports to Jordan.

The oil production freeze is no game changer

The agreement to freeze oil production will do little to rebalance the market.

Russia, Saudi Arabia, Qatar and Venezuela agreed on 16 February to freeze oil production at January levels, if other countries join in. Despite the publicity, the move does not change the dynamics of the oil market in any significant way. Its impact is likely to be limited for three reasons:

1. The quartet alone have limited potential to increase production anyway. Annual oil production in Qatar and Venezuela is expected to decline in 2016, according to forecasts from Goldman Sachs. And while output in Russia and Saudi Arabia is expected to rise this year, some of this might have already been realised in January. Total production from the quartet is expected to increase by only 270 thousand barrels per day (k b/d), not enough to rebalance the market in a meaningful way.

2. The main growth countries (Iran and Iraq) are unlikely to join the freeze. Iran can convincingly argue that it needs to make up for the lost production during the years of economic sanctions. It currently produces around 0.7m b/d below its 2012 peak. Meanwhile, Iraq is struggling with revenue shortages and a large budget deficit and is unlikely to commit to any cap to its oil production. Indeed, the statement issued after oil ministers from the two countries met with their Qatari and Venezuelan counterparts was polite but lacked any enthusiasm to join the deal.

3. The output freeze is unlikely to be a precursor to a future production cut agreement. OPEC’s strategy to increase production, defend market share and squeeze US shale oil firms out of the market is finally bearing fruit. US oil production is expected to decline by 492k b/d this year as US oil firms are unable to recover their costs under current oil prices. A production cut from OPEC could give these firms a lifeline to come back into the market and fill the gap vacated by OPEC.

In addition, OPEC will probably face internal disagreements on how to allocate any production cut among member countries. Even if these disagreements were resolved, temptations would be high for individual countries to deviate and produce more.

So despite initial market enthusiasm, the production freeze agreement is unlikely to be a game changer.

The McKinsey blueprint for Saudi Arabia

McKinsey makes sensible high-level recommendations but falls short on the implementation details.

A few weeks ago, the deputy crown prince of Saudi Arabia, Muhammad bin Salman, gave an interview to The Economist. The interview created headlines because it outlined the young prince’s ambition to transform the Saudi economy. Bin Salman’s vision was clearly influenced by a recently-published report from McKinsey, a management consulting firm. In fact, the prince, who is an avid reader of consultants’ reports, mentioned the McKinsey report during the interview. Understanding this report therefore sheds light on the advice Saudi policymakers are getting.

What is McKinsey saying? It says that Saudi Arabia can increase the income of its citizens by developing its non-oil sectors. Some of the discussion on the potential of certain sectors to grow is insightful, as in the case of the automotive industry. McKinsey argues that Saudi Arabia has the ingredients to develop this industry given the size of its domestic market, the growth in neighbouring countries and the lack of manufacturing hubs in the region. But in other cases, the imagined potential is unrealistic. For example, McKinsey claims that Saudi Arabia can increase the number of religious tourists five-fold to 50m by 2030 by sustaining all year round the number of pilgrims seen during the Hajj season. And I want to have Christmas every day, please.

That said, the overall case for the potential of the economy to grow is convincing. The question then is how to do it. Economies grow by either increasing the number of people working, or by making working people more productive. McKinsey suggests that the former can be achieved by encouraging more Saudis to participate in the labour market. The participation of women, in particular, is very low. Only 18% of working-age Saudi women participate in the workforce compared with 51% in Indonesia, 44% in Malaysia and 29% in Turkey. McKinsey also suggests that productivity can be boosted by allowing more competition (which would push firms to perform better in order to survive), reducing restrictions on foreign labour to move between jobs, and increasing the productivity of workers through education and training.

But this is where the report falls short. It is all good recommending increased competition in the product market or more flexibility for foreign workers, but the current state of affairs is in place because there are vested interests benefiting from it. Likewise, it is easy to recommend boosting productivity through education and training but Saudi Arabia already spends a quarter of its budget on education with meagre results. Saudi students underperform their international peers in standardised tests, and the university dropout rate is close to 50%.

I would have expected more practical recommendations from a firm like McKinsey given its global reach, its work across different sectors and its “micro-to-macro” approach to economics. I would have expected them to provide insights and lessons from success and failure stories where countries tried to overcome vested interests, increase competition or boost productivity through education and training. The insights on how to achieve these objective are unfortunately lacking in the report.

So overall, the report makes all the sensible high-level recommendations but falls short when it comes to practical implementation.