- Tomás Baliño, Charles Enoch, and William Alexander
- Published Date:
- July 1995
Egypt’s transition to indirect instruments of monetary policy has two salient elements: pervasive distortions in the economy at the outset of the transition and a drastic improvement in expectations about the country as the transition took hold. Thus, at an early stage of the transition, Egypt faced extremely large capital inflows. The reluctance of the authorities to accept the full consequences of the inflows for the exchange rate led the Central Bank of Egypt (CBE) to undertake large sterilization operations. However, the magnitude and the persistence of the inflows, coupled with the relatively rudimentary state of Egypt’s market-based instruments, put this policy under considerable strain.
Motivation for Reform
In 1990, because of the need to correct the large fiscal imbalances, sluggish growth, high inflation, and a weak external position, Egypt embarked on a comprehensive economic adjustment program. In the context of this program, in early 1991, the Egyptian authorities launched a program of monetary reform.
At that time, monetary policy was essentially accommodating, and the authorities maintained selective credit controls. Stringent exchange controls and price controls were used to cope with balance of payments pressures. Interest rate ceilings resulted in negative real interest rates, and the resulting demand for credit was kept in check through bank-by-bank credit ceilings. Moreover, negative real rates of return on Egyptian pound (LE) assets and expected depreciation raised the share of foreign currency deposits in broad money to more than 50 percent at the start of the reform period.
Prior to the 1991 reforms, government securities were issued on a nonmarket basis and were largely held by the public sector banks. Reserve requirements had been set at 25 percent for an extended period of time (15 percent on foreign currency deposits). The CBE directly controlled credit to the public and private sectors through loan-to-deposit ratios and bank-by-bank credit ceilings for specific classes of credit uses, based on the banks’ shares in the credit market. The CBE maintained a schedule of lending and deposit rates for banks. It also provided liquidity by automatically discounting government bonds. The discount rate was seldom used to discourage access, and there were no formal limits on access. Moreover, the discount rate was used to provide cheap credit to priority sectors. The CBE granted lines of credit to the housing and industrial specialized banks.
Against this background, the reforms aimed to enhance the role of market forces in the conduct of monetary policy, the allocation of credit, and the mobilization of savings. Greater efficiency in financial intermediation was expected over time as a result of increased competition in the financial sector, reduced restrictions on bank entry, and the development of money and capital markets. To assist in this process, prudential supervision of banks was to be tightened, and their capital structure strengthened. With the pressures on the existing control system building up, especially on the external side, it was clear that external liberalization would be a central part of any reform program.
Process of Reform
At the outset of the reform, the exchange rate was unified and floated. Foreign exchange bureaus were recognized in order to give depth to the foreign exchange market. At this time, interest rates were liberalized, with the authorities retaining control only over the floor rate on three-month deposits; this remaining control was abolished the following year.
Weekly three-month treasury bill auctions started in January 1991, with the aim of providing a benchmark interest rate and serving as the main instrument of monetary policy. The CBE began developing its monetary programming capability. Auctions of 6-month bills and 12-month bills were started in fiscal year 1992, with about 25 percent of the offerings purchased by the nonbank sector. In January 1991, the reserve requirement was unified at 15 percent and applied to all classes of deposits and maturities. The supply of reserves through the discount facility was also tightened by raising the discount rate to penal levels—two points above the treasury bill rate—and the CBE strengthened its control over rediscount operations. A substantial volume of automatically rediscountable government bonds held by the banks were replaced by bills that were discountable only at the CBE’s discretion. After April 1991, new lines of credit to specialized banks carried market-related rates. Bank-by-bank credit ceilings were discontinued in October 1992, and monetary targets were established at the level of the CBE’s net domestic assets.
Along with the move to market-determined interest rates and improved instruments of monetary control, the authorities launched a program to address weaknesses in banks and reinforce the prudential and regulatory framework. Some banks were considered vulnerable to the combined effect of the monetary and exchange reforms because of low capital and large foreign exchange exposure. A program to recapitalize weak banks was completed in May 1991, and regulations on foreign currency exposure were articulated in April 1991. Minimum capital requirements were outlined in 1991, and banks were given two years to comply with these standards. Finally, the banking law was amended in June 1992 to provide for the establishment of a deposit insurance scheme.
Monetary reform was accompanied by substantial foreign exchange market liberalization and fiscal adjustment. The resulting rapid turnaround in perceptions of the Egyptian economy caused sizable and persistent capital inflows. In order to contain the resultant exchange rate appreciation, the authorities intervened heavily in the exchange markets, accumulating over $16 billion of reserves. To contain the resultant monetary expansion, there was substantial sterilization of this intervention. The rudimentary state of Egypt’s money and capital markets meant that much of this activity occurred in the treasury bill market, which grew rapidly to more than LE 31 billion (almost $10 billion) by late 1993.
The banking sector remained dominated by four large public sector banks. To foster competition, joint-venture banks with foreign participation were encouraged, and branches of foreign banks were licensed to perform an increasing range of banking activities. Nevertheless, interbank activity has grown only slowly.
In the past three years, Egypt has achieved much progress in the transition to indirect monetary control. Direct controls on credit have been eliminated, and interest rates and exchange rates liberalized.
High domestic yields have resulted in sizable capital inflows and increased remittances. Inflation has dropped dramatically and is running at about 7 percent a year.
However, because of the large budgetary impact of the sterilization of capital inflows, the Ministry of Finance has curtailed issuance of treasury bills. Auction volumes fell from a peak of around LE 1100 a week in December 1993 to about LE 200 a week in April 1994. The 6- and 12-month treasury bill auctions have been discontinued since March 1994.
The introduction of indirect instruments, together with the external liberalization and fiscal adjustment that occurred, has brought sizable economic benefits. The CBE has demonstrated considerable organizational and technical capability in the operation of the treasury bill market. The absorption of the sizable capital inflows and the concomitant success in bringing down inflation demonstrate the effectiveness of the indirect instruments.
However, problems have emerged as a result of the heavy burden put upon the treasury bill as the main indirect policy instrument. The size of the sterilization operations in the face of the capital inflows, while interest rates remained relatively high and fiscal financing needs very low, has caused concern particularly at the Ministry of Finance about the cost of the operation.
It can be seen, therefore, that central banks and finance ministries have to share broadly the same monetary policy objectives. In particular, since the cost of operating monetary policy has to fall ultimately on the government, either directly through paying interest on treasury bills or indirectly through lower profit remittances from the central bank, the finance ministry must be prepared to accept the costs of operating monetary policy. If there is a reluctance to issue sufficient securities, or use other market means to absorb banks’ excess liquidity, this may lead to a reigniting of inflationary pressures and the undermining of the reform process as a whole.
The Egyptian experience also points to the key importance of financial sector deepening early in the reform to generate a vigorous response from the markets. Otherwise, the lack of development of long-term financial markets can encourage capital inflows into the short-term market (the treasury bill market) rather than long-term investments (such as equity stock). Similarly, issuance of medium-term bonds would encourage further financial sector development.