Patrick Werr: Egypt’s inflation is just a symptom of a greater problem

The sharp devaluation of the Egyptian pound, an increase in fuel prices and the three percentage point increase in the valued added tax late last year triggered a jump in the country’s price inflation to the highest in three decades.

But the consumer price increases are merely a symptom of a bigger problem, which is that the central bank has been expanding the money supply since the 2011 uprising, in part, by lending directly to the government. Getting this monetary creation under control is one of the most crucial components in Egypt’s reform programme. Failure to do so could be one of the biggest risks to the three-year loan accord that the government reached with the IMF in November.

For years, the country’s political turmoil made it exceedingly difficult for successive governments to cut spending or raise taxes, forcing them to resort to extraordinary means to finance the deficit.

The IMF projects that the government will increase its borrowings outstanding from the central bank to 668 billion Egyptian pounds (Dh134bn) this fiscal year, up from only 176bn in 2011-12.

The policy has contributed to exceptionally swift growth in the money supply. The broad money supply, M2, grew by 22 per cent in November from a year earlier (after excluding for the effect of the devaluation that month). The growth rate in the years immediately before the uprising was hovering at about 10 per cent.

An increase in the money supply means that more pounds are chasing the same number of goods and services. In general, inflation equals the rate of money supply growth minus GDP growth. So if the total amount of money in the economy increases by 18 per cent, for example, and GDP grows by 4 per cent, one might expect inflation of about 14 per cent.

Unfortunately, in Egypt’s case demand had been capped for so long by a rigid currency policy that the pound’s devaluation in November unleashed a surge in prices.

Inflation in February soared to an annual 30.2 per cent, its highest since June 1986, when it reached 35 per cent.

As prices increase, the amount the government must pay to provide subsidised commodities and services swells, heaping even more pressure on the budget and widening the deficit. Even though the government raised fuel prices in November, the weaker pound means the net amount it must pay to import these products from abroad rose.

Services also are starved of funds by the weaker pound. The cost of a ticket on the Cairo metro, which for political reasons has not been increased in 10 years, is now the equivalent of 5 US cents.

The rapid monetary growth over the previous years is ultimately what caused the pound to collapse against the dollar late last year. This is why it is critical that the government reduce its budget deficit and free itself from this vicious circle. It seems to be making all the right moves so far.

One of the main objectives mentioned in Egypt’s agreement with the IMF was adopting a monetary policy aimed at containing inflation that would be achieved by “controlling credit to government and banks”.

“Failure to tighten monetary policy sufficiently could lead to exchange rate and inflationary pressures and loss of reserves,” said an IMF staff report released in January.

The government says it will reduce its deficit and the need to borrow as much from the central bank.

“Short-term direct lending to the government will be used only in exceptional situations to bridge to financing from other sources with strict observance of the overdraft limits,” the central bank governor and finance minister wrote in a memorandum to the IMF.

The IMF projects that Egypt will reduce M2 monetary creation to 16.7 per cent in the fiscal year that will begin in July. It expects M2 growth to slow to 12 per cent by 2020-21.

It hopes this will reduce inflation to single digits by the 2018-19 fiscal year.

The government may feel the urge to relax its resolve as the political costs of the austerity measures increase. But it’s crucial that it keep up the momentum.

Patrick Werr has worked as a financial writer in Egypt for 26 years.

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