Egypt made a brave but correct decision last month by floating the pound.
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The move could only be unpopular, as the currency immediately dropped 48 percent against the U.S. dollar and subsequently lost half its value. The result was a sudden spike in the price of basic consumer goods that cut the purchasing power of Egyptians, poor and middle class alike.
As President Abdel-Fattah El-Sisi himself admitted, this decision was no “picnic.” But let us consider the alternative. Continuing the previous policy of pegging the Egyptian pound at far too strong a level amounted to a continuous tightening of monetary policy. This squeezed aggregate demand at a moment when the economy was already struggling with a negative supply shock from high political uncertainty and the lack of basic reforms.
Egypt in recent years had entered stagflation – a situation where negative supply shocks pushed up inflation and monetary tightening was causing growth to slow. By floating the pound, Egypt at least removed the monetary straightjacket on demand.
Price of weakness
Floating the pound and seeing half its value evaporate in minutes was a shock to most Egyptians. But it is worth keeping in mind that for a country with weak political institutions and a weak economy, it is essential to have a weak currency as well.
The drop in the pound was not caused by the Egyptian central bank’s decision to float it. This was not a devaluation – it was the market determining the currency’s fundamental value based on the state of the economy and the quality (or rather lack thereof) of Egyptian institutions.
Therefore, Egyptian policymakers would be mistaken to prop up the pound by returning to intervention on the foreign exchange market. Instead, they should try to stabilize the currency by implementing economic and political reforms.
The only sustainable recipe for a stronger currency is structural reform, not tighter monetary conditions
Egypt has huge economic potential. Its population is North Africa’s largest, with a fast-growing workforce that could propel economic growth of 6-8 percent or more. The authorities should be doing everything in their power to unleash this potential.
Thanks to the pound flotation, Egypt secured approval of a $12 billion loan from the International Monetary Fund. To obtain the loan, the government had already committed itself to important reforms – including cuts in energy subsidies, a reduction in red tape and licensing requirements, and the introduction of a value-added tax (approved by the Egyptian parliament in August).
Much more needs to be done. Import tariffs should be lifted and the country opened up to trade and investment. State-owned companies could be privatized, and the legal framework significantly strengthened so the rule of law applies and private property is adequately protected.
Such reforms would boost the supply side of the economy and lift potential growth, in turn supporting the pound. For a stronger currency, the only sustainable recipe is structural reform, not tighter monetary conditions.
Freeing up capital movements and allowing the pound to float freely is only a first step in revamping monetary policy. The central bank now needs to focus on formulating a clear rule-based monetary policy framework that will ensure nominal stability in Egypt.
I would certainly recommend a framework where the Egyptian central bank targets nominal GDP growth rather than inflation.
The main reason to prefer gross domestic product to inflation as a nominal target is that in a low-income country – particularly one undertaking structural reforms – many short-term price movements are caused by supply-side factors (for example, commodity and food price shocks and variations in political uncertainty). The central bank should not react to such developments, and the best way to avoid that is to target nominal GDP.
That does not mean that policymakers should not think of a long-term “inflation target.” Perhaps it might make sense to set the NGDP growth target every five years, for example, based on assumptions about the trend in real GDP growth and inflation.
Assuming the economy can average 5 percent real GDP growth does not seem unrealistic
At present, the International Monetary Fund forecasts Egypt’s long-term real GDP growth at 5-6 percent in 2020-2021. Given the extremely fast growth in the country’s labor force, this is not particularly optimistic. Assuming the economy can average 5 percent real GDP growth over the medium term does not seem completely unrealistic, given its present structures and somewhat less political uncertainty.
If policymakers then say that they would like to see inflation of 5 percent (half the level of recent years) that would mean the Egyptian central bank should be targeting 10 percent nominal GDP growth.
This corresponds to the present growth rate of Egypt’s nominal GDP, making it a natural starting point for the new central bank target.
There are of course serious challenges with targeting nominal GDP in Egypt, but they should not be overestimated. Targeting inflation in a country with a lot of supply side-driven variation in consumer prices is no less of a statistical challenge.
Let us now hope that the authorities in Cairo are ready to follow through – the sooner the better.