Mohamed Assaad, head of public debt management at the Egyptian Ministry of Finance, has said that the country is not ready to issue inflation-linked bonds in the local markets. Speaking at a recent conference in London, he recognized potential investor appetite for such instruments, but emphasized that greater sophistication in Egyptian monetary policy would be a prerequisite.
“The consumer price index basket is less than two years old, and the central bank is only beginning to release core inflation data this year, so it could be another two years before the measures of inflation have bedded down,” Assaad said.
Egyptian CPI jumped to 12.4% at the end of 2006, from 3.7% in March that year, after an avian flu outbreak drove up food prices, and the government hiked administered domestic fuel prices in July in order to cut its subsidy bill. This volatility means that inflation-indexed debt could appeal to investors as a way to protect their returns, allowing the government to extend its local yield curve, which currently has a longest maturity of seven years, and an average maturity of two years.
However, Caroline Grady, EMEA economist at Deutsche Bank in London, agreed with Assaad that the visibility on Egyptian monetary policy is limited at present.
“The central bank does not release the complete breakdown of the components of inflation, so they have a much better gauge than the market on what is caused by one-off factors,” Grady said. This will be improved once the core inflation index is published, which will exclude elements like administered price changes.
Despite the sharp surge in inflation in 2006, the central bank only raised its benchmark overnight lending rate by a total of 75 basis points, to 10.75%, suggesting that it is expecting CPI to ease once the base effects of last year’s events drop out the index. Assaad said he anticipated inflation returning to single digits in 2007, and this confidence seems to have been justified so far, with CPI falling to 11.7% year-on-year in April, and 10.5% in May.
Yet, Reem Mansour, economist at HC Securities in Cairo, noted that further rises in fuel and utilities prices are on the cards, possibly as early as July 2007. The government does not pre-announce the price hikes, perhaps in a deliberate effort to minimize public resentment, but this also makes inflation even harder to predict.
Moreover, the central bank’s tools to influence credit in Egypt are not very effective, said Mansour.
“Mostly, the central bank is relying on open market operations, because commercial interest rates are already well above the benchmark rate,” Mansour observed.
Grady concurred, pointing to credit growth of just 5% 2006. This means total credit has been falling as a proportion of GDP (which grew by around 7% in 2006), in marked contrast to most other countries in the EMEA region.
Low levels of credit to the private sector also concerned Assaad. He said the favourable tax treatment of investments in government bonds, together with the high rates of non-performing loans early in the current decade, had diminished commercial banks’ appetite for corporate lending.
“Liquidity is high in the banking sector, so we are getting bid ratios of eight times supply on seven-year government paper. So there is no problem for government issuance, but it does suppress private sector lending. The central bank estimates that this could take another two years to recover,” Assaad concluded.
Indeed, a lower government borrowing requirement could help Egypt exit this conundrum. Cuts in fuel subsidies will be beneficial in the long term, but the government recently raised public sector wages by 10%, which is not good news for the budget or inflation.
“It is not clear if public sector wages are being indexed, but they seem to get big rises regardless of what inflation is doing, and the early discussions of next year’s budget are showing a further increase in the wage bill.” said Grady.
One additional tool at the disposal of the authorities to combat inflation would be to allow exchange rate appreciation. The central bank claims that it has not intervened significantly since the exchange rate peg to the dollar was officially ended in 2003, but reserve accumulation of US$2 billion in the first few months of 2007 suggests otherwise.
The Egyptian pound only appreciated by around 1% in 2006, despite the country’s current account surplus, and Mansour at HC Securities has calculated that the currency is undervalued, perhaps by more than 10%, based on the changes in the supply and demand of foreign exchange in 2006.
“If the worst comes to the worst, I think that officials would need to consider a currency appreciation to curb the inflationary trend,” she said. “But I do not see it coming in the near future, especially now that the inflation rate has shown signs of a downward trend.”