ECONOMIC TRILEMMA AND EXCHANGE RATE MANAGEMENT IN EGYPT
Bassem Kamar* and Damyana Bakardzhieva**
Paper to be presented at the 10th Annual Conference of the Economic Research Forum for the Arab countries, Iran and Turkey, December 16th-18th, 2003, Marrakesh, Morocco
(Preliminary version. Please do not cite or quote without authors’ permission.)
* Professor of Economics at the International University of Monaco
Send correspondence to: Prof. Bassem Kamar, International University of Monaco,
2, avenue Prince Héréditaire Albert, MC 98000 MONACO
E-mail:
** Ph. D. student in Economics at the University of Nice – Sophia Antipolis
Send correspondence to: Damyana Bakardzhieva, CEMAFI,
University of Nice-Sophia Antipolis, 7, avenue Robert Schuman, 06015 Nice Cedex 1, France
E-mail:
The authors would like to thank Richard Manirakiza and Anna Tikhnoneko from the CEMAFI research laboratory at the University of Nice for valuable help and comments. All errors remain our responsibility.
This paper has been created with the Microsoft Word and Excel 2000 software.
I. Introduction
The economic trilemma that each government has to deal with in our actual open economy is how to maintain a stable exchange rate with growing capital flows and monetary policy oriented toward internal goals. The three objectives cannot be achieved simultaneously. While stable exchange rates are important for keeping inflation expectations down, capital flows are a necessity for enhancing growth and development in developing countries, and monetary policy autonomy remains an essential tool for macroeconomic adjustments. This trilemma raised the debate on what exchange rate policy to implement in developing economies that are getting deeply involved in the globalization process and are becoming emerging markets.
IMF staff advocates that the only exchange rate regimes are the two corner solutions – either fixed or floating – and that the intermediary spectrum has been hollowed out (Fisher 2001, Mussa 2000). Other economists (Williamson 1998, 2000) believe that intermediary policies are viable and more efficient than the two extremes.
The recent exchange rate crises in Latin America, East Asia, Eastern Europe, Turkey and Egypt have proven that fixed exchange rates are unsustainable in the growing financial globalization context. The globalization of free capital flows leads to balance of payment crises and exchange rate fluctuations (Krugman 1979, Krugman and Obstfeld 2003). Rapid financial market liberalization in emerging markets can lead to banking crises (Eichengreen and Arteta, 2000), usually followed by exchange rate crises (Kaminsky and Reinhart, 1998). The empirical evidence shows that it is becoming more and more difficult to maintain a fixed exchange rate regime in the long-run for a country that is getting integrated in the international trade and financial systems. The IMF exchange rate arrangements survey shows that the emerging market countries convert themselves from fixed to floating regimes (Fisher, 2001). Yet, here comes the question does a free float really exist? Are there central banks in the world that completely abstain from intervention in the currency markets?
The free float makes economies subject to higher fluctuations. Calvo and Reinhart (2000) demonstrate that most of the emerging market countries with rates described as floating had more volatility than the fixed-rate ones. They also reveal that few of the emerging economies that describe themselves as having floating exchange rates content themselves to allow their rates to float as freely as the United States or Japan do. Instead, they often use direct or indirect intervention to limit exchange rate fluctuations (Velasco, 2000).
Therefore, we consider that the main question for most emerging market economies today, and particularly for Egypt since January 2003, is no longer to float or not to float, but what kind of managed float to adopt. Managing the exchange rate means that the government imposes limits to its fluctuations, either explicitly in the form of announced bands, or as an undisclosed benchmark for intervention. These limits determine the band’s width within which the government leaves the exchange rate to fluctuate. For the convenience of our research, we shall name the managed float exchange rate “managed bands”.
In Table 1 we expose three different exchange rate regime classifications, and add to them our own classification. We consider that any exchange rate regime that allows for less than 3 percent-fluctuations on an annual basis can be classified as the fixed extreme of the “managed bands”. We exclude completely the “no separate legal tender” (or dollarization) option, since it supposes that the country has no longer its own currency and therefore has no longer an exchange rate policy. To the other extreme, any exchange rate regime that allows for fluctuations above 15 percent, and where the central bank does practically not intervene, can be classified as free float. We group all the intermediate exchange rate regimes in the class of “managed bands”.
Table 1. Comparison of Exchange Rate Regimes Classifications:
IMF / Frankel / Yayati and Sturzenegger / Authors’ classificationNo separate legal tender
Currency board
Other conventional fixed peg / Currency union
Currency board
Truly fixed / Fixed / Fixed
(Currency board or fixed peg within 3% bands)
Within crawling bands
Crawling peg
Pegged with horizontal bands / Adjustable peg
Crawling peg
Basket peg / Crawling peg / Managed bands
Managed floating / Managed float / Dirty float
Independently floating / Free float / Flexible / Free float
(Bands larger than 15%)
Note: The first three columns are given as cited in El-Refaie (2001).
The paper is organized in 6 sections. It starts by describing the development of the Egyptian exchange rate since 1960, and shows the different policies adopted by the government and the exogenous political and economic shocks that have influenced it. The following section exposes the theoretical framework of the economic Trilemma facing the policymakers of an open developing economy. Section four presents the econometric methodology for the identification of the determinants of the real exchange rate behavior in Egypt from 1971 to 1999, and comments on the empirical results. Section five analyzes the policy implications of the results, namely the choice of “managed bands” as a most viable intermediary regime, and the need for regional monetary and exchange rate cooperation to create a safety net against speculation. The final section concludes the analysis.
II. Recent History of the Egyptian Exchange Rate Policy
Since the 60s, Egypt had a “fixed adjustable peg” to the US dollar, combined with foreign-exchange controls and multiple exchange rates, operating adjustments in 1979, 1989 and 1990 (see annex Graph A1). With the beginning of the economic reform program in 1991, the Egyptian government unified the exchange rate system and announced the adoption of a “managed floating” regime. In fact, the exchange rate was simply devalued in 1991-1992, and then maintained fixed until June 2000, as can be seen from annex Graph A2, and as was concluded by the calculations of El-Refaie (2001). Therefore, the IMF revised its classification in 1998 and ranked Egypt as having resumed its “conventional fixed peg” arrangement.
As synthesized in Annex Figure A1, the Egyptian exchange rate became subject to numerous external shocks[1], starting from 1997. The East Asian crisis in mid-1997 provoked capital outflows, a slowdown in the capital market investments and significant losses for the investors (Abu El Eyoun, 2003). The devaluation of the Asian currencies made their exports much more competitive, which led to a rise in the Egyptian imports from these countries, increasing the trade deficit by US $1.6 billion in 1998. In the same time, capital flows were drained out of Egypt by the attractive world stock markets performances. The Luxor terrorist attack in 1997 led to a decrease of the tourism revenues for several years ahead, a slowdown in the tourism sector, and a consequent general economic growth slowdown. In 1998 world oil prices fell from US $15.6 per barrel to US $9.7 per barrel, which reinforced the deterioration of the current account balance, turning it from a surplus to a deficit of US $2.4 billion. The revival of tensions in the Middle East peace process in the end of the 90s and the Second Palestinian Intifadah launched in October 2000 impacted negatively the economy of the entire region and the Egyptian economy in particular. Capital flight increased and the stock exchange performance reached its lowest level since 1993.
In January 2001, the government decided to restore market stability and confidence by announcing a new central exchange rate of EGP 3.85 per USD and introducing a “crawling peg” system. As can be seen from annex Graph A2, a three-stage devaluation was operated during that year and the Egyptian Pound lost 32 percent of its value, shifting to EGP 4.51 per USD. It was expected that the devaluation, together with some currency injections, would stabilize the market until the drop of the exchange revenues recovered. Unfortunately, the negative effects of the 1997-1998 exogenous shocks were only aggravated after the events of September 11, 2001, with further decline in tourism and Suez Canal receipts. The aftermath of the New York terrorist attack with the subsequent wars on Afghanistan and more recently on Iraq, together with the increasing Israeli-Palestinian violence at the Egyptian border, darkened the image of Egypt as an attractive localization for international investments. In the mean time, capital controls re-imposed by the authorities encouraged black market operations, which put the exchange rate under pressure, the black market premium being around 10 percent over the past four years.
On January 28, 2003, the Egyptian Prime Minister announced a free float of the Egyptian pound. By mid-October the exchange rate had declined by 33 percent reaching EGP 6.15 per USD (see Annex Graph A3).
The declaration of the Egyptian floatation came as an attempt to resolve policy inconsistency, originating from a combination of exchange rate rigidity, reluctance to use international reserves to support the peg to the dollar, and an attempt to reduce the interest rate to activate the economy (Galal, 2003).
The above-mentioned inconsistent trinity exposed by Robert Mundell in 1967 has become known in the economic literature as the “economic trilemma”, which faces policymakers having to choose between three desirable, yet contradictory, objectives (Obstfeld, Shambaugh and Taylor, 2003):
· To fix the exchange rate, for relative price stabilization purposes;
· To have free capital mobility, for efficiency and flexibility purposes;
· To engage in activist monetary policy, for output stabilization purposes.
This “Holy Trinity”, as well as the IMF exchange rate “corner solutions” doctrine, strengthen the idea that the only alternative is either fixed or floating exchange rate. Yet, as we saw in Table 1, the IMF classifies 8 different exchange rate regimes, acknowledging the existence in the real world of several intermediary exchange rate policies. If an intermediary policy does exist, where can it be placed on the Trilemma triangle?
III. The Economic Trilemma Revisited
On Figure 1 we expose the Trilemma triangle. In our analysis we consider that the three corner points (A, B and C) are extreme cases, and that in the reality a country’s policy mix is always somewhere inside the triangle, at least concerning emerging markets economies in the actual globalized system. As we will see, it is rather difficult for this type of countries to remain on any of the three sides of the triangle for a long period of time without jeopardizing economic welfare and economic development.
Economic theory and practice have proven that exchange rate stability is incompatible with an activist monetary policy directed toward output stabilization. As the quantity theory of money puts it, the price level is directly related to the stock of money or monetary base (Fisher, 1911). Knowing that the real exchange rate is a relationship between national and international prices, this implies that any variation in the monetary base that induces a price level change different from the international price level change will provoke a variation in the real exchange rate.
FIGURE 1. The Economic Trilemma Triangle
Later on, the Mundell-Fleming model, admited as well that an increase in the money supply (a shift of the LM curve to the right) will lead to changes in both the real and currency markets (shifts in both the IS and BB curve), ending up to higher interest rates, higher national income and an exchange rate depreciation. Therefore, we consider the AB side of the Trilemma triangle as practically unsustainable in the long-run, unless the government adopts inflation targeting[2] indexed on the weighted inflation rates of its trading partners, and imposes capital controls – point D. However, we have high doubts about the sustainability of that point either, since the current account in an open economy is seldom balanced, requiring liberalization of capital flows. The alternative of continuous central bank interventions can possibly hold in the case of net capital inflows, which will be compensated by the accumulation of international reserves, but can hardly hold in the case of massive net capital outflows since reserves will be drained out sooner or later. Therefore, we consider a country adopting an open door policy as closer by definition to point C than to point D, with its position on the CD axis depending on its degree of openness.
The BC side of the triangle implies a complete sacrifice of the monetary policy that can no longer be used for any domestic economic purposes such as output or employment dynamization. Policy makers are in general rather reluctant to the idea of abandoning one of the major tools for economic adjustment to external and internal shocks, not to mention the threat for the domestic financial system in the absence of a lender of last resort. The problems that arise from the removal of the nominal exchange rate as an adjustment instrument found harsh evidence in Argentina’s financial and economic turmoil.
The Argentinean crisis revealed an important failure in the fixed exchange rate regimes. The lack of exchange rate cooperation or coordination within the regional framework of the Mercosur trading block has repeatedly led to economic turmoil in Brazil and Argentina (Eichengreen, 1998). When Brazil devalued its real in 1999, its goods became about 50 percent cheaper than those of its main trading partner Argentina (Husson, 2001). The fixed peso-dollar exchange rate led to a significant loss of competitiveness of the Argentinean exports, a growing current account deficit, a loss of confidence, and the collapse of the currency board.