Devaluation drama and hot money’s return: What happened with the pound’s historic plummet?

On the morning of January 11, it seemed that the moment of truth had arrived. The pound witnessed an unprecedented fall in value against the dollar. In three hours, the price of the dollar went from LE27.6 to LE32. The long-awaited floatation was finally happening. Many waited for the moment it would stop falling. Would it reach LE35?

But it did not happen. On the contrary, the pound surprised everyone and began to gain value and eventually stabilized by the close of the day at around LE29.7.

The drama of January 11 drove everyone to wonder what would happen the next day. The dollar began rising to exceed LE30, and descended once again to LE29.55.

While all of the attention was on the foreign exchange rate and what is to come next, an important development was playing out in tandem in the debt auctions of the central bank. After weeks of failed attempts to stir appetite for its bond offerings, the government took a plunge back into the world of hot money. In early 2022, as the economic crisis began to sharpen, Finance Minister Mohamed Maiet pledged that the government would never depend on such short-term investments in government debt instruments again because of their noted volatility. With Russia’s invasion of Ukraine, Egypt’s risky reliance on hot money was exposed, as investors pulled out of Egypt to flee for safer debt markets. Maiet said Egypt had learned its lesson.

However, the return of hot money as a policy goal would say otherwise, and it seems like the government is turning to the volatile investments as a final lifeline in the crisis which seems — despite the drama — to not be coming to an end soon.

This is what happened on Wednesday morning. Hot money played an integral role in the day’s events, according to various economic and banking sources who spoke to Mada Masr in recent days. And in light of the fact that Egypt needs tens of billions of dollars in the current year to meet its debt servicing obligations and strategic financing needs, it doesn’t seem that this will be the last time the pound’s value falls or Egypt makes a bid for hot money, as the government will have to walk a tightrope in managing the exchange rate and its need for dollar inflows. According to a prominent source at the Central Bank of Egypt, Wednesday’s scenario will reoccur several times.

When the dollar reached its highest price last Wednesday, Gulf investment funds bought treasury bills (a way to sell debt) from Egyptian banks at around a quarter of a billion dollars before the dollar’s price fell once again to LE29.7 by the end of the day. By buying at a price closer to the black market rate, the funds were able to minimize the risk they’d face in the event of a further devaluation. 

The central bank source says that the large devaluation of the pound against the dollar at the beginning of Wednesday was done with the fact in mind that the entrance of the Gulf funds had already been agreed upon.

The goal, according to the source, was for the exchange price to approach its expected equilibrium rate in the market before the sale of bills happened. And indeed, Gulf funds started buying as soon as the dollar price hit its highest value (LE32.2 against the dollar) as the published data on the Egyptian Exchange’s website shows. After the sale was complete, the descent began.

To understand why this happens, it is necessary to look at how the dollar exchange rate is determined. 

The price of the dollar is a product of transactions in Egypt's interbank system. On this network, all banks working in Egypt sell and buy dollars, either with the goal to profit from speculation against currencies or to cover their dollar needs. For example, Banque Misr may need US$1 million, but it doesn’t have the liquidity. Thus, the bank turns to the interbank network, asks for $US 1 million from other banks in the market and finds that the National Bank of Egypt (NBE) and Qatar National Bank (QNB) are both offering dollars. National Bank of Egypt is selling dollars at LE30, for example, while QNB is selling at LE31. Of course, Banque Misr would then buy from NBE because of the better price, while QNB might not be able to sell its extra dollars at the price it initially offered, so it might need to match NBE’s price to be able to sell.

The opposite is also true. If Banque Misr needs $1 million and no one is offering but QNB, then QNB could set the price it wants.

This process of selling and buying happens hundreds of times every day through the interbank network. The outcomes of these processes determine the price of the dollar at any given moment, which is reflected when you conduct a Google search for the exchange rate. In the end, this depends on the availability of dollars in Egyptian banks and how readily they can sell them on the Interbank.

The central bank works as a regulator of the interbank marketplace.

In order to control the value of the currency before November 2016, when Egypt nominally floated its currency, the central bank sold large quantities of dollars to banks operating in Egypt on the interbank network, and it would force the banks to provide this dollar liquidity to those asking for it at a specific price, controlling the exchange rate in all transactions.

Since that time, the nature of the central bank’s interventions in the interbank marketplace has changed from time to time. In the beginning, it gave banks complete freedom to set the exchange rates they found to be appropriate. What helped regulate the currency exchange rate was the availability of large amounts of dollar liquidity in the form of hot money, with investors merely waiting for the exchange rate to be liberalized before entering into Egypt’s debt market. But, with time, liquidity began to decrease against a steady or even increasing demand at times. Therefore, at the end of 2018, the central bank intervened to regulate the price gradually but in a less straightforward manner.

Under scrutiny from the International Monetary Fund, the central bank could no longer control the interbank system in the same way. Instead of injecting dollars through state banks and forcing them to provide it at a set price, the central bank injected specific amounts of dollars through informal mechanisms to keep the pound value set at a specific price.

With the deepening of the crisis, the central bank will still be intervening to prop up the value of the pound, according to a senior banker who spoke to Mada Masr, because a totally free float would be impossible without securing a steady inflow of foreign currency. “But the central bank will also have to allow for the exchange rate to change and reach the closest value to the black market rate, because this is the only way to control the black market. Without controlling it, there will be no new investments,” the banker says. 

For economist Wael Gamal, the head of the economic and social rights unit at the Egyptian Initiative for Personal Rights, the question of a “full float” is off the table and isn’t really something any central bank in the world does.

“There is no such thing as a 100 percent floatation. All central banks in all countries take steps to control the price of their currencies and increase or decrease it based on economic variables and future targets. For example, China decreases the value of its currency to attract more international importers,” Gamal says.

If not in central bank “intervention” as such, where does the problem with Egypt’s monetary policy reside? 

The central bank’s interventions over the past few years were to control inflation rates. But in an article published last March, economic researcher Mohamed Ramadan argued that this solution is “not sustainable because, in the end, the rules of the market must be obeyed and the currency needs to be pushed closer to the real exchange rate or the real exchange rate must be pushed closer to the official currency price by making structural reforms in the economy that increase the competitiveness of Egyptian exports and correct trade imbalances in Egypt.” What happened over the past few years was only a “feverish race to buy time,” he wrote. 

Buying time was possible because the global situation allowed for it. Debt traders sent hot money to Egypt due to its interest rates being among the highest globally, in addition to the presence of other sources of hard currency, primarily the Suez Canal, tourism, remittances and energy exports.

But the problems began in early 2020, with externalities in the international economy exposing Egypt’s vulnerabilities. 

COVID-19 brought the global economy to a halt and Egypt lost an important part of its foreign currency inflows in a matter of weeks. Around $20 billion in hot money left the country at the time. The halt in global trade and supply chains resulted in a global inflationary wave in 2021.

Gradually, hot money began to return, as did some tourism activity. But the Russian invasion of Ukraine early last year quashed any remaining hope. Most wealthy governments adopted policies to control inflation. And, in the uncertainty, those governments attracted sources of hot money and Egypt once again lost $22 billion.

As a result, the government was gradually forced to abandon this strategy and began negotiations with the IMF to acquire a new loan. Negotiations lasted over the course of months, during which the government tried to resist the fund’s conditions. In July, President Abdel Fattah al-Sisi requested help from “our friends in Europe” to pressure the IMF to forego its stringent lending conditions. But the IMF did not change its position.

One of the most important conditions was to liberalize the exchange rate. Between last March and this January, the central bank allowed three major currency devaluations, with the price of the dollar rising from LE15 to LE30 in less than a year.

But this is not the end of the journey. The fluctuations in the exchange rate are expected to reach a price of LE32–35 to the dollar in the coming weeks, in order to break the demand for dollars on the black market and close the gap between the official price and the black market price, according to the central bank source.

Gamal agrees that the value of the pound will continue to drop against the dollar, as the main problem in Egypt is not the demand for dollars but their availability.

"As long as there is more demand than supply, the price of the pound will continue to decrease. Currently, there are no sustainable sources of hard currency in Egypt. On the other hand, Egypt has debt repayment obligations, not to mention a need to finance imports, even main ones such as petroleum and wheat. Because of the lack of hard currency sources, the price will continue to change,” says Gamal.

Egypt’s foreign debt rose to $155.7 billion at the end of last June, an increase of $17.8 billion from June of 2021, according to the latest reports from the central bank on the international situation of the Egyptian economy. Egypt is supposed to repay $20 billion in loans and debt maturity in the current year, in addition to a financing gap of about $12.6 billion in the current account in the fiscal year 2022/23 budget, according to the estimates of the IMF which Mada Masr has reviewed. 

Gamal explains that the strategy of the central bank is to move the exchange rate gradually to avoid strong shocks to the price and therefore to the Egyptian economy. The aim is to achieve a balance between inflows from abroad and international obligations.

But the problem in this strategy, in his opinion, is the central bank’s limited ability to maneuver. “Pricing amid these fluctuations is problematic and tempts speculators, who are able to benefit from the differences in price over a few days or even a few hours.”

Gamal points to Egypt’s previous experience in following a flexible exchange rate in 2003 under the leadership of then-central bank governor Farouk al-Okdah. 

“Okdah was meeting the demand for dollars in the market at the time, so he was able to fix the price of the dollar,” says Gamal. “Even when the black market rose on some days, the central bank had $9 billion on the side, separate from the reserves, to use to maneuver. Speculators would think there was no money, so they would raise the price on the black market. Then Okdah would inject, for example, $1 billion into the official market. The exchange rate would go down and speculators would have to sell at a lower price to minimize losses, and the official price would go even lower. Now there is no margin for anything like this.”

In order to secure the needed liquidity to manage the exchange rate, it seems that the priority for the central bank is to ensure the return of hot money into the Egyptian debt market by moving the exchange rate closer to its fair levels in the market.

The reason for this is that instability in the price of the exchange rate causes potential losses for debt traders, because they buy bills and bonds in pounds. If the local currency is subject to unexpected situations because of a disparity between its fair price on the market, this amounts to significant risks to the profits of debt traders if they want to collect their money or exit the market. The same applies to all foreign investments, which now mainly consist of the sale of state-owned companies to Gulf countries. Because of this, liberalizing the exchange rate was one of the most important conditions on which the IMF insisted for the loan it approved in December.

In line with this logic, the central bank allowed the pound’s price against the dollar to reach LE32.2 so banks could sell bills at this price before the value rose back up. 

The other side of this policy bet is in the debt instruments that the government is offering. 

The interest rates recently set by the central bank are designed to attract hot money by offering investors the opportunity to buy government debt with a high payout if they are willing to take on a bigger risk. 

This has been clear in the offerings that the central bank has announced since the beginning of the year, especially with the reluctance of investors to buy treasury bills that the central bank offered over the past few weeks, before it started to gradually raise interest rates in the past few days.

Before the end of last year, the central bank issued, on the Finance Ministry’s behalf, four treasury bills with different maturation dates for a total of LE78.5 billion. However, investors only entered LE5.1 billion into Egypt’s debt market.

The worst performance of these offerings was the 182-day bills, where the central bank requested LE20.5 billion and received bids for LE16 billion. The problem, moreover, was that investors requested interest rates over 20 percent. As a result, the central bank only accepted approximately LE249 million in purchases, at an interest rate of 19.17 percent.

But at the start of last week, the central bank went back to the debt market asking for more. This time, the request was done in tandem with a spike in the dollar price.

In its first offering of the year, the central bank offered bills valued at LE20.5 billion. Bids came in at LE24.6 billion, but the central bank only accepted LE2 billion despite raising interest rates to an average of 20.595 percent.

About a week later, the central bank went to auction for another LE20 billion. Bids came in at more than LE67 billion, but banks were asking for an interest rate of 24 percent. In the end, the central bank accepted more than LE51 billion at an interest rate of 21.3 percent for bills that the state would have to repay in only six months.

What this means is that the central bank had to raise interest rates by 3 percent on the same bills three times in a period of under two weeks. 

But will hot money provide Egypt enough margin to climb out of the crisis? 

In Gamal’s opinion, returning to debt markets will only perpetuate the problem that Egypt finds itself in now. Depending on foreign investments in bills and bonds will always be tied to maturity dates and an interest rate that is priced at a quarter of the value of these investments.

According to IMF estimates, Egypt is hoping to offer around $6.1 billion in debt to global and local markets to close its financing gap during the current fiscal year, with next year reaching $7.3 billion and then $8 billion in 2024/2025.

"Foreigner investors make a profit on the interest rate, which they ask for in dollars. And even if they wait until the maturity date, they will get out and still get their money in dollars. So the situation is only buying time at a price of approximately a quarter of the value of the money coming in. In this case, the move is to offer new debt, so the new can pay for the old,” says Gamal. “But when the new isn’t enough, the old cannot be repaid and the new doesn’t arrive, so higher interest rates are offered, and so on. This situation is unsustainable because it is a powder keg waiting to explode. This time it was the Ukraine war, but the problem was always coming.”