V Capital Inflows: Managing Success
- Howard Handy
- Published Date:
- May 1998
The increase of capital inflows into Egypt during the past two years represents a marked change in investor sentiment and a recognition in financial markets that there has been a fundamental improvement in economic policies. While the recent episode reflects the authorities’ clear commitment to break with the past, capital inflows are by no means a new phenomenon in Egypt. Between 1991 and 1994, capital inflows soared, spurred by fiscal and structural policy reforms. A tightening of credit conditions also played a role, as high interest rates created strong incentives for capital inflows in the context of the ongoing stabilization effort. When this policy mix proved unsustainable, and monetary policy was relaxed, the inflows gradually subsided before resurging in 1996/97, following the adoption of a more comprehensive stabilization and structural reform program.
This current episode of inflows appears to be built on a firmer basis, and early evidence is that the economy has withstood reasonably well the recent volatility witnessed in other emerging markets. Nonetheless, continued efforts are required to strengthen policies, including through the development of a deep and effectively supervised financial sector, if Egypt is to reap the benefits of a dynamic world market and consistently attract higher inflows of foreign investment, technology, and know-how. In charting Egypt’ future course, the broader experience of reforming emerging market economies that have experienced surges in capital inflows in the 1980s and 1990s provides important insight on how to deal with the “challenges of success.”
Capital Inflows in Egypt During 1991/92–1993/94
Following the Middle East regional crisis in 1991, the launching of a comprehensive stabilization program comprising strengthened financial policies, and exchange and interest rate liberalization, Egypt experienced a substantial surge in capital inflows. Net international reserves rose by over $11 billion for the three years beginning in 1991/92, following three years of small declines, on average (Table 11). While data limitations cloud the assessment of the motivation and source of inflows, they appear to have included repatriation of flight capital of Egyptians, a move abetted by the then unsettled conditions in the region, as well as increased workers’ remittances, and other inflows from international investors attracted by a high interest rate differential.26 Compared with the pre-inflow experience, workers’ remittances, short-term flows, and errors and omissions increased by about $3 billion (6 percent of GDP) during 1991/92–1992/93.
|Services balance (net)||1.4||3.0||2.6||3.5||4.0||5.8||6.2|
|Remittances and foreign aid||4.9||7.0||6.9||4.0||4.2||3.5||4.1|
|Medium-and long-term loans (net)||0.2||0.3||0.1||0.2||0.2||-0.2||-0.3|
|Foreign direct investment||0.7||0.5||0.5||1.3||0.7||0.6||0.7|
|Errors and omissions||0.0||-1.7||1.2||-0.6||-0.1||-0.0||-0.7|
|Net international reserves|
Changing conditions in the industrial world and notably the reduction in interest rates between 1990 and 1992 played a contributing role in inducing mobile capital to seek more profitable investment outlets, particularly in emerging markets (Calvo, Leiderman, and Reinhart, 1993). The political disruptions in the Middle East in 1990–91 further bolstered the perception of Egypt as a safe haven for regional investors.
In addition to the external influences, there were policy changes affecting the domestic economy. Egypt introduced a major fiscal adjustment beginning in 1991/92 (see Section III). This durable improvement in the public sector created expectations of lower inflation, stable exchange rates, and a more viable external position. Further, the Paris Club debt-reduction agreement of 1991 offered the promise of sharply lower debt service for Egypt, contributing to an improved perception of Egypt’ external viability. Domestic productivity improvements may have also played a role, although stagnant or declining non-oil export growth and rising unit labor costs in the public sector would appear to belie the importance of that factor. Moreover, while some microeconomic reforms were initiated in 1991, for example, decontrol of interest rates and unification of the exchange system, productivity-boosting structural reforms were not comprehensively implemented.
A more important proximate cause of the capital inflows in 1991/92 was a sharp tightening of credit policies that led initially to high real interest rates. The interest differential with U.S. interest rates rose to 14.2 percent in 1991/92, before declining to 13.2 percent in 1992/93 and 10.5 percent in 1993/94. The interest differential drew capital into Egypt and prompted portfolio shifts by domestic residents reflected in both sides of banks’ balance sheets. On the liability side, dedollarization accelerated during the capital inflow period. On the asset side, there was an upsurge in demand for foreign currency borrowing by residents, resulting in the growth rate of the aggregate rate rising from less than 7 percent in 1990/91, to over 30 percent a year during 1991/921993/94 (Figure 10).
Figure 10.Financial System Confidence Indicators
Source: Data provided by die Egyptian authorities.
The policy response to this early episode of capital inflows relied on sterilization, at the level of the central bank, as the first line of defense (see Figure 11). Sterilization could be implemented quickly and provided time to assess the more durable options. It was effected through sales of government securities, the proceeds from which were deposited into a government account at the central bank, reducing the net domestic assets of the CBE. Consequently, the net domestic assets (NDA) of the CBE declined sharply between 1990/91 and 1993/94; this policy found its counterpart in an increase in the outstanding stock of treasury bills by about LE 31 billion ($9 billion) to LE 35 billion during the capital inflows episode (see Figure 12). The direct fiscal costs of sterilization were significant because of the large differential between the U.S. and Egyptian financial assets; on an uncovered interest parity basis, these costs amounted to a cumulative 3.9 percent of annual GDP between 1990/91 and 1993/94. Capital inflows also were absorbed through increased excess reserves holdings by the commercial banks, some of which received interest from the CBE; over five years, the costs from these operations totaled about 1,3 percent of GDP, for total sterilization costs of over 5 percent of GDP.27
Figure 11.Sterilization indicators
Source: Data provided by the Egyptian authorities.
Figure 12.Monetary Indicators
Source: Data provided by the Egyptian authorities.
Continued tight fiscal policy through the capital inflow years also helped to absorb the inflows but was not in and of itself seen as a response to the inflows; in any case, further adjustment would have seemed to be excessively deflationary. During this period, the trade and capital account regime remained relatively stable.
Surges in capital inflows contributed to substantially easier conditions in the domestic money markets. In 1993/94, the last year of the inflows episode, nominal interest rates had fallen by over 4 percentage points and real credit growth had rebounded. This fall in the nominal interest rate ensued in the face of aggressive sterilization and increased money demand (there was a decline in velocity of about 7 percent over the three-year inflow period), reflecting increased credibility of the fixed exchange rate. Eventually, declining interest rates moderated the inflows. Notwithstanding the increase in liquidity, inflation declined appreciably and in a very short space of time–over the three-year period–from over 21 percent to 9 percent. The sharp fiscal contraction just prior to and coincident with the inflows as well as the tight monetary stance helped in the battle against inflation.
The increased inflows led to a sharp increase in the net foreign assets of the central bank (see Figure 13). Over the period, the import coverage of gross reserves of the central bank rose from about 6.7 months at the beginning of the episode to 19 months toward the end, giving Egypt a large cushion of reserves, strengthening external viability, and contributing to the growing credibility of the exchange parity. Given that one of the main risks associated with a surge in inflows is their volatility, an important indicator of a cushion against reversal is the ratio of cumulative inflows to reserves. At the end of the first episode of capital inflows, this ratio stood at about 3.5, substantially higher than countries such as Spain and Thailand at that time (see Schadler, Carkovic, Bennett, and Kahn, 1993).
Figure 13.Gross Official Reserves
Source: Data provided by the Egyptian authorities.
The capital inflow years, particularly the first two (1991/92–1992/93), coincided with reduced real activity occasioned inter alia by the fiscal contraction, as well as a decline in the terms of trade. Private consumption rose appreciably during the inflow years as pent-up demand pressures were released. Investment, especially public investment, had faced a severe contraction in the years leading up to the inflow of foreign capital and remained broadly unchanged during the inflow episode. Banking system problems did emerge at the start of the period, involving the accumulation of bad debts requiring an infusion of capital for insolvent banks at a significant budgetary cost (5.5 percent of GDP in 1990/91).
Egypt responded to the capital inflows by preserving the nominal anchor and resisting any nominal appreciation of the exchange rate. During the inflow episode, the real exchange rate appreciated cumulatively by about 27 percent owing in large part to the inflation differential with its trading partners.
The Interregnum, 1994/95–1995/96, and Current Phase, Post–1995/96
During 1994–96 capital inflows slowed markedly. The slowdown reflected a number of factors, including a decline in the interest differential and a pause in the adjustment effort, as well as concerns about economic prospects. The capital account surplus declined to ¾ of 1 percent of GDP, remittances steadied, and the process of dedollarization was in abeyance. During this period, the interest rate differential between Egyptian and dollar-denominated assets was about 5 percentage points.
Capital inflows picked up again beginning in 1996. Preliminary estimates for 1996/97 indicate net capital inflows of about $2 billion, stronger than in the previous two years (inflows averaged around $0.6 billion in 1994/95–1995/96) but about the same level in dollar terms as in 1993/94. Portfolio investment is now estimated at $1.5 billion, compared with $250 million in 1995/96). Nonresidents’ net purchases of equities (buoyed by the privatization program) amounted to some $700 million in 1996/97 accounting, in part, for the doubling of equity prices through the end of January 1997.28 Nonresidents’ net purchases of treasury bills and bonds, which had previously been modest, picked up in the second half of 1996/97 and are estimated at $700 million for 1996/97.
The most recent capital inflows appear to differ in character from those of the early 1990s (see Table 12). Whereas the latter represented, in large part, repatriation by residents of flight capital, the more recent inflows include portfolio inflows by foreign institutional investors. Overseas demand for Egyptian equity and treasury bills increased after agency ratings on Egyptian sovereign debt improved. The timing of the second phase of inflows, coming at a time of strengthened financial policies and a significant advance in privatization, and the consequent decline in nominal interest rates to below 9 percent (the interest differential vis-à-vis U.S. assets narrowed to less than 4 percent) suggest a credibility effect resulting from the policy commitments and actions of the government.
|Indicator||Phase I (1991/92–1993/94)||Phase II (1996/97)|
|Characteristics||Probably return of flight capital to banking system.||Portfolio investment by foreign institutions in domestic equities and government securities.|
|Investors||Probably residents and overseas workers.||International financial institutions (private).|
|Magnitudes||Cumulative net flows of $6,4 billion (14 percent of GDP).||$2.1 billion (2.8 percent of GDP).|
|Influences||External and internal.||Predominantly internal.|
|Policy responses||Aggressive sterilization.||Some sterilization, but mostly feeding into liquidity growth.|
|Effects of inflows|
|Nominal interest rates||Decrease.||Decrease.|
|Real interest rates||Decrease.||Increase.|
|Monetary aggregates||Deceleration in growth rate of liquidity.||Increase in liquidity growth.|
|Equity prices||No impact.||Sharp increase.|
|Real exchange rate||Appreciation.||Appreciation.|
|Savings and investment||Decrease.||Increase.|
As a result of the policy of preventing a nominal appreciation, the increased inflows amounting to about $1.5 billion (or 9.8 percent of reserve money) led to a sharp increase in the net foreign assets of the CBE. Unlike in phase 1, reserve money and liquidity growth did pick up by about 2 percentage points. Broad money growth might have been higher still, but for the decline in the money multiplier resulting from the buildup of excess reserves in the banking system. The growth in credit aggregates remained steady, providing financing for the higher level of activity.
The capital inflows have thus far not imparted inflationary pressures on the Egyptian economy. Higher monetary growth has been consistent with declining inflation, reflecting in part a higher demand for money and continued fiscal restraint. A further appreciation of the real exchange rate was due more to the nominal effective appreciation of the Egyptian pound (by about 9 percent in the year to June 1997), as the dollar appreciated against other major countries, than to an inflationary impulse occasioned by the capital inflows.
Impact of Flows on Capital Markets
Inflows have had a significant impact on capital market activity. Since 1994, the Egyptian capital market has witnessed an enormous increase in activity; trading value has recorded a 43-fold increase between 1993 and 1997; market capitalization has increased from about 8 percent of GDP in 1993/94 to 24 percent of GDP in 1996/97; the number of transactions has risen from about 12,000 in 1993 to more than 23 million in 1996; and the number of new equity issues (excluding fixed-income instruments), an index of primary market activity, has increased from LE 2.1 billion in 1993 to about LE 18 billion in 1997. Foreign participation in the stock market has similarly displayed a strong increase, accounting for nearly 35 percent of transactions in 1997 from negligible levels in 1992.
This market performance has been founded on a number of factors, including the achievement of macroeconomic stability in the first half of the 1990s, and more recently by the acceleration of the structural firms. It has also been facilitated by the improved regulation of the capital market. In 1992, Egypt adopted the Capital Market Law aimed at streamlining all preexisting regulations and providing the legal framework for the further development and enhanced regulation of the capital market.
Although prices on the stock market increased 54 percent in the first two months, generating fears of exaggerated valuation that could subsequently lead to a disruptive meltdown, there has been a correction of prices of about 20 percent (between the end of February and mid-June 1997), resulting in more realistic valuations. The price-earnings ratio of about 13 for the Egyptian market is not high by the standards of other emerging markets. Indeed, even at the peak of prices in February, Egyptian P/E ratios were lower than in many other emerging markets (Table 13).29
|Price-Earnings Ratio||Price-Earnings Ratio|
|Poland||14.2||Taiwan Province of China||28.7|
|Middle East and North Africa||Sub-Saharan Africa|
One potentially worrying sign is the behavior of stock prices of housing-related firms and what it signals about the real estate market. Between the end of June 1996, and the end of December 1996, housing stock prices increased 378 percent, compared with 62 percent for the general market index. From their peak, prices have declined by about 20 percent for the general index and about 13 percent for the housing index. In 1996/97, price-earnings ratios increased from 6.9 to about 14 for the general index, but from 9 to about 25 for the housing index. Although, it is premature to infer overheating in the real estate market on the basis of these Figures (in part because the housing index comprises five companies of which two account for the bulk of market capitalization), they nevertheless bear close monitoring.
Policy Dilemma of Capital Inflows
While capital inflows are inherently desirable as a means of supplementing domestic financing for investment, surges in capital inflows (and outflows) can pose difficult policy challenges as they also entail macroeconomic and institutional risks. Certainly, the task of macroeconomic management is more complex as, in the absence of policy measures, inflows drive monetary expansion, undermining inflation-reduction efforts; real exchange rate appreciation, not offset by productivity growth, can entail adverse consequences for the tradable goods sector. Further, banks and other financial institutions face increased opportunities but higher risks. While inflows can generate higher returns, the reversal of such inflows can pose risks to institutions with unsound portfolios or low capitalization; insofar as surges in capital inflows lead to rapid credit growth, this can overwhelm the capacity of markets to allocate such resources effectively and may support unprofitable investments, or unsound consumer credit.
There is no unique or simple way of maximizing the beneficial impact of capital inflows while minimizing the risks for the macroeconomy and the integrity of the financial system. The various policy options, which include a rebalancing of the macro-economic policy mix, structural actions, and direct disincentive measures, need to be weighed carefully as each involves important trade-offs. This means giving due consideration to (1) the magnitude of the inflows; (2) the composition of the flows; (3) the macroeconomic impact of inflows: capital inflows put upward pressure on monetary aggregates, prices, the real exchange rate, and external accounts; and (4) the robustness of institutions in the financial sector in terms of their ability to intermediate the funds while limiting risky exposures.
Macroeconomic Policy Stance
To reduce the risks, the following policy options were available to Egyptian authorities when faced with substantial capital inflows:
Sterilized intervention. This has been the cornerstone of the Egyptian response to the capital inflows to date and has effectively served to counter upward pressure on the currency while allowing a temporary respite for the implementation of fundamental reforms. To date, the fiscal costs have been modest.
Unsterilized intervention with tighter fiscal policy. In the spring of 1997, the authorities allowed domestic interest rates to decline in line with market forces, reducing the incentives for capital inflows. At the same time, tight Fiscal polices minimized the inflationary pressures associated with such capital inflows.
Nominal exchange rate appreciation. If the level of capital inflows exceeds the authorities’ capacity for policy correction as outlined above, a degree of real effective appreciation of the exchange rate may be inevitable. In this event, nominal exchange rate appreciation will hinge on the extent to which productivity and efficiency gains are taking place in the economy. It should not be regarded as irreversible and thus would need to be combined with changes to the system that impart greater flexibility. In Egypt, the buildup of sizable reserves would suggest that external viability is in no immediate danger from the 10 percent real appreciation over the past year. However, given the large real appreciation of the pound and the consequent lackluster performance of the tradable goods sector, an outward-looking strategy must involve market-oriented policies aimed at preventing any further deterioration in competitiveness.
Direct disincentives to inflows. In some cases, countries have found it necessary to implement measures that aim directly at discouraging capital inflows. If such measures are used, they are best limited to taxation measures (as opposed to quantitative controls), which impact short-term portfolio flows and are imposed for a short period as market participants often find ways of circumventing such measures. Consequently, such measures should be seen as a last resort.
Supportive Structural Reforms
In addition to adjusting the macroeconomic stance, structural reform initiatives can also form part of a strategy to deal with capital surges:
Trade liberalization. Import liberalization can minimize the inflationary impact of higher capital inflows (as higher demand feeds through into imports rather than monetary growth) and can establish the basis for higher levels of investment and growth.
Other structural reforms to encourage investment. Measures to strengthen private sector investment, including privatization, deregulation, and the elimination of excessive bureaucracy, have helped to ensure that increased capital inflows (foreign saving) Finance higher investment rather than current (consumer and public) spending.
Banking reform is an important complement to the policy options outlined above. The Egyptian authorities are continuing their efforts to strengthen banking and supervision, and the institutional capacity of the Capital Market Authority (CMA), and the CBE to enforce effectively the prudential regulations; improving the standards of reporting and disclosure and enforcing them more effectively; activating the secondary market for debt instruments to increase liquidity and improve price setting (this would include greater securitization of existing debt instruments); and ensuring a steady supply of assets, through privatization, to prevent overheating and to improve market liquidity. To date, there is little evidence to suggest a shift to riskier or less efficient banking activities. Overall credit growth in 1996/97, at 22 percent, has been slower than in the previous three years, and available information on sectoral composition of lending does not suggest a problem.
Various IMF studies have identified a number of characteristics common to several countries experiencing surges in capital inflows during the past two decades; a track record of fiscal consolidation; a recent depreciation of the real exchange rate; structural reforms improving supply conditions and liberalizing financial markets; debt restructuring or reduction; and a tightening of credit policies. Some of these characteristics are applicable to the present Egyptian economic situation: fiscal performance has been good, with the 1996/97 deficit expected to be under 1 percent of GDP; the structural reform effort has been accelerated; the Paris Club has approved the last tranche of debt reduction further alleviating debt overhang concerns.
There are a number of important differences between the two periods of capital inflows that Egypt has experienced:
There is presently confidence that capital inflows can be sustained because the policy signals are primarily internal and driven by improved fundamentals relative to the past. As a result, Egypt’ situation appears less vulnerable today than that in other major emerging markets that have recently witnessed market pressures—the current account stronger, die size of the inflows smaller, and the pressures on the financial system more limited. But caution is still required in the period ahead.
Capital inflows have also been influenced by external developments—although probably to a limited extent up to now relative to the past. There have been modest movements in domestic interest rates both in Egypt and the United States over the past year, but the resulting change in interest differentials has probably been insufficient to trigger major capital shifts between the two currencies. More important, in this respect, has been the shift in confidence in favor of Egypt, which will have reduced the risk-adjusted interest differential. Consequently, the fiscal costs of sterilization are likely to be small in the current episode as interest differentials have narrowed considerably compared with the previous episode.
Finally, real exchange rate appreciation in the period preceding the current phase of inflows, and the attendant lackluster performance of the tradable goods sector (in contrast, services have performed quite admirably), highlights the need for focused reforms that address competitiveness in these sectors.
In view of the market volatility and the possibility of contagion and bandwagon effects, and the likely continuation of inflows as investor confidence is maintained, continued vigilance is warranted.