Egypt’s rate rise was wise, given rampant inflation

It was absolutely the right decision, and it was long overdue.

In a move designed to dampen inflation, Egypt’s central bank on Sunday raised its main interest rates by two percentage points: banks wanting to borrow funds will now have to pay 17.75 per cent interest, up from the previous 15.75 per cent.

Inflation has become one of the biggest dangers to Egypt’s economy. It shot up to an annual 31.5 per cent in April, which was the highest inflation rate of any of the world’s larger economies, with the exception of the disaster that is Venezuela.

Critics of the rate hike argue it was inappropriate because Egypt’s high inflation rate was the result of several one-off shocks that pushed prices up, in particular the sharp devaluation of the Egyptian pound in early November, which made imports more expensive, quickly followed by an increase in fuel prices. An earlier three percentage point increase in the value-added tax to 13 per cent helped push up prices. Once these price shocks work their way through the system, inflation will gradually decline on its own, their argument goes.

The problem with this line of reasoning is that Egypt’s inflation rate was already among the highest in the world even before these price shocks.

Inflation was at 15.5 per cent in the year to August 2016, well before the shocks took place. Among emerging markets, only Venezuela and Nigeria had higher rates of inflation at that time.

No. The main cause of Egypt’s inflation is not the devaluation or fuel price hikes. It is rather the rapid expansion of the money supply over the past few years. Since the 2011 uprising, successive governments, not wanting to further anger an already rebellious population, ran huge budget deficits that they have financed in effect by printing money. This has resulted in too much cash chasing too few goods and services, pushing prices up.

At the same time, this expansion of the money supply caused the pound’s value to fall against the dollar and other currencies. This is why the central bank was forced to devalue in November.

The amount of Egyptian pounds in circulation or in demand deposits surged by 19 per cent in the year to the end of March. This was at a time when the economy was growing by less than 4 per cent. It is a classic case of stagflation and the remedy is to bite the bullet and get it over with as quickly as possible. Delays merely prolong the suffering.

By increasing interest rates, the central bank will slow inflation. The rate hikes will induce people and businesses to shift away from spending their money before prices rise and instead begin putting it into savings, thus lowering the money supply and consumption. Fewer pounds will be chasing the country’s goods and services, and prices will not rise as quickly. As inflation falls, the central bank can begin lowering interest rates again.

Before the interest rate hike, there was not much inducement to save. The average yield on 91-day treasury bills sold just before Sunday’s rate increase was an annual 19.5 per cent, which is well behind the inflation rate. Meanwhile, in April, nearly six months after the devaluation, prices were still rising by 1.69 per cent a month. This works out to more than 22 per cent a year. People who bought the T-bills will earn a negative interest rate of about 3 per cent, assuming inflation remains at its current high level.

One benefit of lowering the inflation rate is that this will keep the cost of government subsidies in check. A disadvantage is that it will increase the cost of financing the budget deficit, at least in the short term.

This brings us to another point. One of the main criticisms of Sunday’s interest rate hike is that it will make it more expensive for businesses to invest at a moment when the economy is suffering and desperately needs the stimulus. But the sad truth is that Egyptian banks haven’t been lending all that much to private businesses, but rather have been directing the bulk of their funds to help the government finance its budget deficit, mainly in the form of treasury bills and bonds.

Many of the few corporations that have been receiving bank finance will probably have little problem borrowing in dollars to finance investments until pound interest rates come down again.

And those people who are concerned that a temporary increase in interest rates might hurt the nation’s poor should perhaps worry more about the damage Egypt’s high inflation rate has been inflicting upon them.

Patrick Werr has worked as a financial writer in Egypt for 27 years

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