Egypt sharply cuts rates as inflation slides

The Central Bank of Egypt implemented a sharp reduction of interest rates on August 22, cutting rates 150 basis points due to lower inflation.

As a result, the overnight deposit rate now stands at 14.25%, the overnight lending rate at 15.25%, and the rate on the main operations at 14.75%.

The monetary policy committee stressed “annual headline and core inflation continued to decline to record 8.7% and 5.9% in July 2019, respectively, the lowest rates in almost four years”. The policy statement highlighted that this reduction took place in spite of cuts to fuel subsidies.

The central bank’s medium-term inflation target is 9% +/–3%, which the central bank still expects to achieve in the fourth quarter of 2020.

Even more important than inflation data are expectations. “The path for future policy rates remains a function of inflation expectations, rather than of prevailing inflation rates,” adds the statement.

The decision resumes the easing cycle started in February 2018. Back then, the central bank reduced rates by 100bp, a move it repeated in March 2018. Then it paused until last February, when it cut rates by another 100bp.

A lost decade

The Egyptian economy has suffered almost a decade of financial and political crisis following the Arab Spring in 2010–11. In late 2010, massive demonstrations forced out long-time president Hosni Mubarak. Free elections took place from May-June 2012, which resulted in the victory of the Islamist candidate Mohamed Morsi.

Under Morsi’s watch, public spending rose sharply. It increased to 34.6% of GDP in 2013 from 30.8% in 2012. Additionally, amid increased political violence, tourism plummeted, and with it a key source of hard currency. This environment contributed to an increase in the budget deficit, which reached 13% of GDP in 2013.

Against this backdrop, international capital fled the country and the Egyptian pound progressively depreciated. As a result, in Morsi’s first year in office, inflation rose to 9.8% from 7.2% in 2012.

In July 2013, Morsi was forced out in a military coup led by general Abdel Fattah el-Sisi, who remains president. In the new regime, rate-setters reacted sharply, increasing the deposit rate from 8.25% in 2014, to 18.75% in July 2017.

Nonetheless, on their own these measures proved insufficient to correct the long-term imbalances of the economy, and El-Sisi’s government sought the support of the International Monetary Fund. In November 2016, the IMF’s executive board approved a three-year extended fund facility of SDR8.597 billion ($12 billion).

In exchange, the IMF requested authorities eliminate traditional public spending, including fuel subsidies. This was expected to initially boost inflation, but over the long term it would provide more fiscal space for public investments that would boost productivity.

Solid outlook, but exposed to international instability

The reduction in inflation and fiscal consolidation has not prevented the economy from growing stronger. According to a preliminary estimate, real GDP growth reached 5.7% in the second quarter of the year, and 5.6% in the fiscal year 2018–19. If confirmed, this would be the highest rate of growth in 11 years.

The favourable economic outlook has led to a drop in the unemployment rate, which continued to decline during the previous quarter, to 7.5%. This is six percentage points lower than it was at its peak in late 2013.

However, Egypt is not immune to rising global economic uncertainty. “The expansion of economic activity continued to weaken, financial conditions eased, and trade tensions continued to weigh on the outlook,” said the policy statement.

As a net oil importer, another important factor for Egypt are commodity prices. “International oil prices recently declined, yet remain subject to volatility due to geopolitical risks and potential supply-side factors,” added rate-setters.