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?

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.

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.

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.

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.

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.

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.