Wednesday, 17 July 2013

Why Egypt may eventually need a larger IMF loan

Despite the recent support from the Gulf, Egypt's reserves remain below safety levels.

One of the first things the new political order in Egypt did was to dispatch Hisham Ramiz, the governor of the Central Bank of Egypt, on a fund-raising trip to the United Arab Emirates. His visit was evidently fruitful as it resulted in an aid package consisting of grants, loans and energy products worth $12 billion not just from the UAE but also from Saudi Arabia and Kuwait.

Some of these loans will enter as deposits at the central bank, boosting the headline figure for international reserves, which took a hit in June largely due to the fall in gold prices. The significant inflow of funds from the Gulf notwithstanding, it remains unclear whether Egypt's reserves are sufficient for the economic needs of the country and an analytical framework to assess that question is needed.

Reserves act as a precautionary tool to absorb shocks to the economy and ensure the availability of sufficient funding to pay for imports and debt service if and when crisis hits. Given this role, there are at least two methods to evaluate the adequacy of reserves.

Method 1. Reserves should be large enough to cover three months’ worth of imports. On this measure Egypt’s reserves are only just about sufficient as both current reserves and quarterly imports stand at around $15 billion. This means that if Egypt lost all its income from tourism, Suez Canal and other exports and investments abroad, it would still be able to cover the cost of all its imports for three months. However, it would not have any funds left to service its debt.

Method 2. This method asks if a country can cope with a shock which simultaneously reduces exports, makes borrowing harder and results in capital flight. More specifically, it is assumed that the shock would result in a 10% drop in exports; 30% fall in short-term debt; 15% reduction in medium-and long-term debt; and 5% decline in broad money as a proxy for capital flight. For reserves to be considered adequate, they are recommended to be around 100-150% of the total loss of funds from the shock.

Without the Gulf’s aid, Egypt's reserves are below the safety range at around 78% of the potential losses under the scenario described above. Reserves should rise to about $21 billion with the Gulf support but that is still lower than the safety level of $25 billion implied by the method.

While the choice of the particular reserve-assessment method may be a matter of taste, the IMF has applied the second method in its recent agreement with Tunisia. Under this method, and even with the new deposits from the Gulf, Egypt's reserves are $4 billion short of adequacy and therefore need to be supplemented. The implication is that if Egypt decides to fill this gap with a loan from the IMF, it may need to negotiate a larger sum than $4.8 billion given its other fiscal and external needs.

Wednesday, 10 July 2013

Morsi’s deadly economic sin

The Muslim Brotherhood inherited a difficult economic situation, but their lack of coherent policies made things worse.

July 1st was the day after millions of Egyptians took to the streets to protest against the Muslim Brotherhood and their president, Mohamed Morsi. This was symbolic not because it resulted in the army’s removal of Morsi two days later, but because of the sheer scale of popular rejection of political Islam’s biggest party in the country where the ideology had been born.

The symbolism of 1 July extends beyond politics into economics. It is the first day of Egypt’s fiscal year in which the government’s new budget becomes effective. The process and the product of writing Morsi’s first (and last) budget encapsulates his administration’s approach to economic policy: an approach characterised by the absence of a clear plan and a preference for short-term fixes over long-term solutions under conditions which do not afford this luxury.

Having churned through three finance ministers during his one-year-and-48-hour term, Morsi’s budget was only approved by the Shura Council—Egypt’s upper house with temporary legislative powers—on 27 June. Despite the delay, there was no attempt to tackle the hard issues such as the persistence of large deficits (around 10% of domestic output) or the large subsidy provisions. As the table below shows, in terms of broad spending patterns and overall deficit size, Morsi’s budget (fourth column) does not look different from last year’s budget plan (second column) or last year’s actual turnout of spending (third column). If anything, his budget looks worse than his predecessor’s.

Egypt’s most urgent economic problem, namely its currency crisis, provides another example of Morsi’s economic management. For years, Egypt’s spending on imports has exceeded its revenue from exports. What prevented this from becoming a crisis under Hosni Mubarak was the inflow of foreign investments, which helped to finance the trade deficit. When these fled the country after the 2011 revolution, the Supreme Council of Armed Forces, which was running Egypt then, used up the significant international reserves to preserve the value of the currency. Morsi therefore inherited a chronic imbalance and depleted reserves, but his confused response ensured that the problem did blow up in his face.

Initially he sought the IMF’s help, reaching a preliminary agreement in November 2012. Presumably as a step towards implementing the agreed programme, he introduced consumption tax hikes on 9 December only to abandon them hours later. From that point onwards, he ceased to take the IMF option seriously despite other Egyptian officials’ repeated claims to the contrary.

Instead, he resorted to borrowing from Turkey, Libya and, especially, Qatar to finance the country’s foreign currency needs. As with the budget, he chose to coast along rather than face the fundamental problems heads-on.

There is a common theme running through these two examples and indeed others such as the ones highlighted by Rebel Economy. The Muslim Brotherhood inherited a difficult economic situation, but their lack of viable plans and reluctance to tackle difficult issues made things worse.

Monday, 24 June 2013

Reserves adequacy in Tunisia

The IMF loan will be used to increase Tunisia’s international reserves to adequate levels. But what is adequate?

On 7 June, Tunisia entered a two-year programme with the International Monetary Fund (IMF) worth $1.7 billion, making it the fourth country in the region to get the IMF’s help since 2011 after Yemen, Jordan and Morocco. One of the aims of the programme is to strengthen Tunisia’s external position by increasing foreign exchange reserves to adequate levels. How large should reserves be before they are considered adequate?

One standard measure of reserves adequacy is a rule of thumb stating they should cover three months worth of imports. Underlying this rule is the question of whether import purchases can be sustained when a country’s income from abroad (through exports and financial assets) falls to zero. On this metric, Tunisian reserves are adequate as they are expected to cover more than three months of imports.

This measure, however, suffers from at least two drawbacks. First, it does not consider important drains on reserves such as capital flight. Even with unchanged export revenue, imbalances could occur if investors sold their domestic assets and transferred capital abroad. This risk is not captured by the import coverage rule. The second drawback is that it is too pessimistic on the income side when it assumes that export revenue would be completely annihilated.

Aware of these drawbacks, the IMF seems to be adopting an alternative analytical method for assessing reserve adequacy. The new measure considers a scenario where four events occur simultaneously:

1.    Export earnings drop by 10%;
2.   Short-term debt falls by 30%;
3.   Portfolio investments into the local stock and bond markets fall by 15%; and
4.   Investments into other liquid domestic assets decline by 5%.

Note that different types investments (events 2 to 4) are assumed to fall by different amounts depending on their riskiness and liquidity, with the more risky and liquid investments experiencing larger drops. Let us call the sum of assumed losses under this four-risk scenario the emergency stock. (The IMF gives it the more awkward name: risk weighted liability stock). IMF research suggests that, for a typical country, international reserves need to cover between 100 and 150% of emergency stock to be regarded as adequate.

So how does Tunisia fare on this new measure?

My calculations displayed in the table below show that Tunisian reserves are currently below the recommended range at around 82%. Furthermore, in the absence of the IMF’s intervention, they would remain below the 100% threshold even as late as 2015. With the IMF loan, however, reserves are expected to be at the low end of the adequacy range by the end of this year and to increase further into the safety zone reaching 115% by the end of 2015.

It remains to be seen whether Tunisian reserves will actually build up to the planned levels or whether they will prove sufficient if economic shocks hit. But the IMF’s adoption of a new framework for assessing reserve adequacy might have consequences beyond Tunisia.

Monday, 27 May 2013

Unpleasant arithmetics at the Central Bank of Iraq

In its conflict with the central bank, the Iraqi government got its economics wrong. Twice.

The last few weeks saw a further decline in the value of the Iraqi dinar. The gap between market and the official exchange rates reached its peak in the second week of May when the dollar was being sold for around 1290 dinars; 10% above the official rate of 1166 dinars to the dollar. This might be surprising since for several years prior to 2012, the Central Bank of Iraq (CBI) managed to maintain a narrow gap between the official and market rates using its daily currency auctions.

The story of how the Iraqi foreign exchange market went from stability to volatility in the space of 18 months can be divided into three episodes.

Episode 1 (Jan 2012 – May 2012): Two explanations for an emerging gap

In early 2012, The CBI and the government offered two different explanations for a newly-emerging gap emerged between official and market exchange rates. Mudher Salih, then the deputy governor of the CBI, attributed the gap to excess demand from the neighbouring Syria and Iran—which were facing foreign currency shortages due to sanctions. Meanwhile, Izzat Al-Shahbandar, an MP and an aide to PM Maliki, blamed the stringent measures of the CBI, which hindered the foreign currency supply, for the emergence of the gap. Shahbandar claimed that prior to 2012, the CBI sold $200 million on average in its daily auctions, but that figure fell to $100 million in 2012.

Contrary to Shahbandar’s claims however, CBI’s data (summarised in the table below) show that the amount of dollars sold had in fact increased in the period from January to May 2012 relative to previous years. The data leaves little doubt which of the two explanations is more plausible - the only question mark is about the source of Shahbandar's figures.

Episode 2 (May 2012 – Oct 2012): The CBI increases supply and gets its governor sacked

To meet the excess demand, the CBI significantly increased its supply of dollars, successfully bringing the market price down to within 3% of the official rate in early October (see the chart below). At that point, an arrest warrant was issued against its governor, Sinan Al-Shabibi, over allegations of “of financial irregularities” related to the currency auctions. A more detailed report by the Board of Supreme Audit (BSA) concluded that the CBI’s loose control over the auctions encouraged smuggling of the dollar out of the country and money laundering.

The change in tone is notable: in October, the CBI was being accused of leniency in running its currency auctions, having been (falsely) accused of stringency in May!

Episode 3 (Oct 2012 – present): The CBI restricts dollar supply

Over this period, volumes in the CBI’s auctions averaged $177 million—a significant drop from the previous episode. This appears to be a deliberate policy as can be inferred from the appointment of the head of the BSA as the interim governor and CBI’s statements on 18 and 24 October 2012.

An unsurprising outcome of restricted supply is the significant rise in the market value of the dollar, which reached a high this month. It is hard to tell what is going to happen next, but the politicians who have been actively involved in the saga now seem concerned with the uncomfortable fall of the dinar.


The last part of the chart shows a sharp pick-up in the auction volumes over the last few days (almost to the levels reached by Shabibi before his dismissal) coupled with a narrowing of the gap between market and official rates. It would be a positive change if this trend continued. Currency smuggling, unnecessary depletion of CBI’s resources and money laundering must be fought of course. But this should be done through a legal and supervisory framework not through the excessively powerful tools of monetary policy. One should not starve the patient to death in order to kill the bacteria.

Monday, 20 May 2013

The IMF programme in Iraq

Iraq was fortunate to avoid an external financing crisis, but failed to deliver on structural reforms.

Arab countries that are seeking help from the International Monetary Fund (IMF) fall into one of two categories: countries which have experienced recent political change such as Yemen, Tunisia and Egypt; and oil-importing ones exposed to high price shocks. It may then seem surprising that Iraq—an oil-exporter with an unchanged prime minister since 2006—has been until recently engaged in a programme with the IMF.

A little historical background may help explain this. Oil prices experienced a large drop in 2009 following the global financial crisis and the economic recession that ensued. The price of an Iraqi barrel of oil fell from $124 in mid-2008 to $35 in early 2009 before picking up later in the year. For an economy where oil accounts for 95% of total exports and 90% of the government’s revenue, this risked creating a hole in the financing of both the government’s budget and imports.

The second column of the table illustrates this by showing the calculations carried out in February 2010 when Iraq applied for help. Assuming an average oil price of $62.5 per barrel and average exporting volume of 2.1 million barrels per day, Iraq would have had a $5 billion gap in financing its transactions with the outside world through 2011. Faced with this risk, Iraqi officials agreed with the IMF on a two-year programme and a $3.7 billion loan was approved on 24 February 2010

As it turned out, the risks did not materialise and oil prices recovered from their 2009 lows. My calculations—shown in the third column of the table—suggest that the financing gap was reduced to $3 billion by the end of 2010 as Iraqi oil price averaged $74 per barrel in 2010, more than compensating for the failure to meet the export volume target. By the time the programme had its second assessment in March 2011, the financing gap was all but eliminated under the government’s new conservative assumptions for oil price ($76.5) and export volume (2.2 million barrels per day) as shown in the last column of the table.

At the stage, the programme’s main focus shifted from “covering the balance of payments needs” to providing “a framework for advancing structural reforms”. This included improving accounting, auditing and reporting practices; restructuring and recapitalising the two main state-owned banks; and improving public financial management. However, the programme became a frustrating affair from this point on. Progress slowed down, reviews were delayed and eventually never carried out, and the programme deadline was extended twice, first to July 2012 and then to February 2013, when it finally expired.

In summary, the programme was one of two halves. The first focused on avoiding a balance-of-payments crisis, which Iraq managed to do more by luck than judgement. But higher oil prices, which were the main reason for preventing the crisis, weakened the appetite for change. It is fair to say that the second half of the programme, designed to advance structural reforms, was a complete and utter failure.

Sunday, 12 May 2013

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.

Sunday, 5 May 2013

Will Egypt go bankrupt?

Morsi has secured sufficient funding to delay unpopular economic decisions until after parliamentary elections

The Egyptian president, Mohamed Morsi, has already answered the question in the title by declaring that “Egypt will never go bankrupt”. But judging by some of the recent headlines, sceptics are still unconvinced. What does it mean for a country to go bankrupt anyway? And is Egypt really on the brink of financial collapse?

Rather than using the poorly-defined term “bankruptcy”, an alternative way for analysing the financial sustainability of a country is to assess its ability to meet its external financing needs, which consist of:

·      Trade deficit (excess imports over exports)
·      Interest payment on existing debt
·      Paying back external debts as they fall due

In the short term, external financing needs can be met by borrowing or drawing from foreign currency reserves. But no country can borrow forever and reserves will eventually be exhausted, so the economy must eventually adjust to rebalance external finances.

In an ideal world, the adjustment is done in a benign manner in which the country gradually winds down its debt, boosts exports and reduces imports costs. But in times of crisis, a country may be forced to do the whole adjustment momentarily by defaulting on debt and instantaneously cutting imports—including food, medicines and energy needs. This is the dreaded “going bankrupt” scenario. One reason for the unpopularity of the IMF standard conditions is that the speed of adjustment they require is too quick for most countries’ liking.

So what are the external financing needs for Egypt over the next few months? And does it have sufficient funds to avoid hard-landing?

The IMF currently estimates Egypt’s external financing needs to be $11.7 billion. This figure can be split into $5 billion of expected current account deficit (that is trade deficit plus interest payment), and $6.7 billion of maturing external debt over the next 12 months. Raising $11.7 billion over 12 months may seem formidable, especially without the help of the central bank’s foreign currency reserves which are near their minimum safety level. But a more careful look at the numbers suggests it is not so bad.

According to the Central Bank of Egypt (CBE), of the $6.7 billion of external debt maturing this year, $4 billion are Qatari deposits which are unlikely to be paid back anytime soon. On top of that, Egypt has recently managed to borrow $2 billion from Libya and an additional $3 billion from Qatar. With a further $1 billion transfer from Turkey and a potential loan from Russia, the Egyptian government seems to have secured most of its external financing needs for the next few months as the table below shows.

Despite its success in securing loans, the government’s strategy carries some risks. First, it could unravel if the financing needs increased unexpectedly as a result of energy or food price shock. A second risk is that of a speculative attack on the Egyptian pound, especially with the CBE unwilling and unable to fend them off. Third, the over-reliance on Qatari funds to keep the Egyptian economy on its feet may raise questions about the political price being paid. Fourth, even if this tactic proves successful, it is at best a short-term fix rather than a long-term solution.

But the Egyptian government seems willing to take these risks rather than embarking on the unpopular and painful economic measures requested by the IMF. Perhaps it is hoping to kick the can just far enough down the road beyond parliamentary elections.

Sunday, 28 April 2013

A two-speed region in a three-speed world

Oil is the difference between faster and slower-growing economies in 2013

The International Monetary Fund (IMF) is not just an international emergency lender, it is also an important research institution, home to 2400 employees, many of whom are economists. Its annual spring meetings (held jointly with the World Bank) present an opportunity to learn its views and outlook for the region and the world as a whole. In this year’s meetings, which took place last week, the Fund divided the world economies into three groups: countries that are doing well (mostly emerging markets), those on the mend (like the US, Switzerland and Sweden), and others still in trouble (the Euro Area and Japan). The Fund’s classification for the region was more one-dimensional: slower-growing oil-importing economies, and faster-growing oil-exporting ones.

Outlook for oil-importing economies

Growth in this group has been held back by four factors:
1.   Political uncertainty and social unrest: Egypt is a prime example of how this factor reduced investment inflows, increased capital outflows, deterred tourism and had an overall negative impact on growth.
2.   Regional spillovers especially from the conflict in Syria: most obviously seen in Jordan where regional problems disrupted both its gas supply from Egypt and trade routes through Syria.
3.   Economic problems in Europe: which had its biggest impact on the Maghreb countries affecting their exports, tourism, remittances and foreign direct investment.
4.   High commodity prices, especially food and fuel: this and the third factor were the main reasons Morocco turned to the IMF for help.

Looking ahead, the outlook for oil importers depends largely on the turnout of the four factors, but the IMF expects members of this group to grow faster in 2013 than last year. The notable exception is Egypt where the IMF expects growth to slow down to 2%, and unemployment rate to rise to 14% in 2014 from its current level of 12%.

In terms of policy recommendation, the IMF wants the usual mix: greater exchange rate flexibility, less energy subsidies and smaller government deficits. But since many of the countries in this group (Mauritania, Jordan, Morocco, Egypt and Tunisia) are either in a programme with the Fund or discussing the possibility of one, the implementation of these policies must have formed a central part of the negotiation process.

Outlook for oil-exporting economies

This group of countries is more homogeneous, and although they are expected to grow faster this year than oil importers, the IMF predicts that both groups will converge to the same average growth rate of 3.7% in 2014 (see the table below). The slowdown that exporters are likely to experience is a result of weaker global oil demand.

Unlike importers who face short-term problems, the economic challenges that this group faces are mostly medium term. To overcome them, oil exporters need to diversify their economies to develop non-oil economic activities and to create enough jobs to absorb their young populations.

However, a prolonged fall in oil price can turn medium-term challenges to short-term problems. If that happens, countries in this group may end up joining oil importers in seeking the IMF’s help.

The IMF role in the global economy

The international emergency lender is likely to have a big influence in shaping the region's policies

The International Monetary Fund (IMF) is very busy in the region these days. It has existing arrangements with Mauritania, Jordan and Morocco; provided Yemen with an emergency loan last year; has ongoing negotiations with Egypt; and is finalising an agreement with Tunisia. If we also counted the recently-expired programme with Iraq and the possibility that other countries could soon seek its help, the result would be one of the most active periods of the Fund’s involvement in the region.

What is the role of the IMF in the global economy? The Fund helps countries experiencing crises created by the mismatch between the payments they make to the outside world (for example debt service and imports) and the reverse payments from the world into the country (such as export of goods and tourism). Jordan experienced such imbalances when it was forced to buy expensive fuel from international markets following interruptions to the gas supply from Egypt in 2011. Similarly, Egypt’s balance of payments deteriorated as capital flowed out of the country and number of tourists declined after its 2011 revolution. When such imbalances persist, they can lead to crises manifesting themselves through currency crashes, runaway inflation or default on external debt.

To avoid such fate, the IMF provides loans to finance short-term payments. In return, it requires recipient countries to implement policies that should eliminate—or at least reduce—payment mismatch. Examples of such structural policies include asking Jordan to diversify its energy sources or—more controversially—asking Egypt to allow its currency to float hoping that the resulting depreciation would reduce imports by making them more expensive, and boost the competitiveness of Egyptian exports by making them cheaper.

In this sense, the IMF’s role is different from that of the World Bank. The former handles short-term financing crises while the latter focuses on long-term development projects. Yet despite the difference in the time-span of policies, both institutions aim to improve economic conditions by promoting changes in the structure of economies.

The IMF’s funding comes primarily through member countries subscriptions. Each country makes payments according to a quota system reflecting its size in the world economy. Linked to each country’s subscription is its voting power in the Executive Board—the body responsible for running the IMF. The quota system has left the Fund open to criticism of being dominated, both in thinking and decision making, by a few countries. Indeed, the five most powerful voting members of the Executive Board (the US, Japan, Germany, France and the UK) have 37% of total votes between them.

In response to criticism, the IMF has been undergoing a reform process to give more weight to emerging countries and to better reflect recent changes in the global economy. Irrespective of how these reforms pan out, one thing is for sure: for the next few years, the IMF is going to have a big influence on economic policy-making in the region.