Arab Republic of Egypt
2007 Article IV Consultation: Staff Report; Staff Statement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Arab Republic of Egypt

This 2007 Article IV Consultation highlights that sustained and bold reforms, prudent macroeconomic management, and a favorable external environment enabled the Egyptian economy to register another year of impressive performance. Growth remained high and has become more broad based, creating record numbers of jobs. Inflation has returned to single digits after spiking during the year through March 2007. Strong growth and rising equity and real estate prices have boosted domestic demand. Exports also rose sharply, along with worker remittances, Suez Canal receipts, and tourism revenues.

Abstract

This 2007 Article IV Consultation highlights that sustained and bold reforms, prudent macroeconomic management, and a favorable external environment enabled the Egyptian economy to register another year of impressive performance. Growth remained high and has become more broad based, creating record numbers of jobs. Inflation has returned to single digits after spiking during the year through March 2007. Strong growth and rising equity and real estate prices have boosted domestic demand. Exports also rose sharply, along with worker remittances, Suez Canal receipts, and tourism revenues.

I. Introduction

1. Since last year’s Article IV consultation, Egypt’s economy has continued to grow briskly, and inflation has moderated after a surge in 2006. While the reformist cabinet continues to press ahead with policy and structural changes, opposition to reform has become more vocal, fuelled in part by high food-price inflation and some frustration about the lag in the “trickle down” of the benefits of growth.

2. Egypt made significant progress on the issues raised in the 2006 consultation. The authorities implemented a sizable fiscal adjustment, strengthened tax administration, further liberalized the trade regime, and privatized financial and nonfinancial enterprises. The exchange rate has become more flexible since July 2007.

3. Discussions centered around achieving a macroeconomic policy mix that would support higher growth and investment by ensuring domestic and external stability. The policies discussed included (i) fiscal adjustment to raise national saving and ensure sustainable public debt dynamics; (ii) greater exchange rate flexibility in line with the authorities’ choice of a managed float and the planned move to inflation targeting in an environment of large capital flows; (iii) a monetary policy stance that keeps inflation low while accommodating supply shocks and administered price changes; (iv) and further financial sector reform.

II. Background and Developments1

4. The broad-based economic expansion has created many jobs, public finances have improved, and structural reforms have further liberalized the Egyptian economy.

  • The economy grew at 7 percent a year. Nonhydrocarbon growth surged from 5.8 percent in 2005/06 to 7.1 percent in 2006/07, broadening to labor-intensive agriculture, manufacturing, services, and construction. The spike in inflation was largely the result of one-off factors, but demand pressures and imported inflation also played a role (Box 1).

  • The current growth spurt created about 2.5 million jobs between end-2004 and March 2007, reducing unemployment from 11.8 percent to 9 percent.2 Skill mismatches remain a hindrance to job growth, and formal sector employment is hindered by high nonwage labor costs and expensive firing rules.

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Rising and broadening growth…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…has started to make a dent in unemployment.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Income has been boosted by the coming on stream of gas fields…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…surging work remittances—mostly from the Gulf region—and Suez canal receipts.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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The Egyptian stock market has been one of the best performers in the region, and the index nearly quadrupled over the last three years…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…but P/E ratios only doubled.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Inflation surged in 2006 and early 2007…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…but has moderated since.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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The trade balance weakened as rapid import growth outstripped a sharp rise in exports…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…but other current account inflows did well…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…and the financial and capital accounts registered record levels of FDI and strong portfolio flows.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Egypt’s integration into the world economy is advancing.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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The nominal LE/US dollar exchange rate appreciated by 1.1 percent in the 12 months to July and by another 3 percent through end-October.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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The real effective exchange rate appreciated by 2.2 percent between end-2005 and mid-2007 as Egypt’s relatively high inflation was only partly offset by a depreciation of the LE/Euro.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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The strong balance of payments surplus combined with the pegged exchange rate resulted in a rapid rise in NIR.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Monetary aggregates have been growing briskly despite heavy sterilization.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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The daily variation of the exchange rate has risen recently…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…and LE/US dollar appreciation began accelerating on trend.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Policy rates were raised in late 2006 but had little lasting impact on bank lending rates and T-bill rates.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Bond spreads remained well below other emerging markets.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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Fiscal adjustment has improved both the overall balance…

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

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…and the underlying balance, reducing the need for government financing.

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

  • With surpluses in both the current and the financial accounts, the balance of payments recorded another large surplus in FY 2006/07 (US$5.3 billion).

  • The central bank largely maintained through mid-2007 a de facto peg vis-à-vis the U.S. dollar in the presence of strong appreciation pressures. Broad money growth surged after April to 18 percent as less external inflows were sterilized and money market funds deposited the proceeds from maturing central bank CDs with commercial banks. Annual sterilization costs now approach 1 percent of GDP.

  • To rein in inflation, the authorities raised policy rates in late 2006 but the monetary transmission through interest rates was weak. After initially rising with policy rates, overnight and T-bill rates fell, driven by foreign T-bill demand and low budget financing needs; bank lending rates barely moved.4

  • According to preliminary data, the general government deficit improved from over 9 percent of GDP in 2005/06 to 7¾ percent in 2006/07, while the central government deficit improved from 8.2 to 7½ percent. The underlying central government balance, i.e., excluding one-off factors, improved by about 2 percentage points of GDP, largely from wage restraint and savings on subsidies, transfers, and interest payments due to cash and debt management reforms (see text table). A significant increase in domestic fuel prices helped contain the fuel subsidy bill.3

Central Government Balance

(in percent of GDP)

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Includes: (i) in 2005/06 forward sale of oil; (ii) in 2006/07 mobile license fee (2.1 percent) and reclassified revenues; and (iii) in 2007/08 other license fees.

Includes receipts from sale of 20% stake in Egypt Telecom and bank assets in 2005/06 (1.1 percent), bank restructuring costs (0.8 percent) and reclassified revenues (0.4 percent) in 2006/07.

  • Structural reforms advanced significantly in promoting a private sector driven economy.

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      The fourth largest state bank (Bank of Alexandria) and a large department store chain, along with smaller firms and unused public land, were sold to foreign investors for the equivalent of about 1.3 percent of GDP.

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      The weighted average import tariff (excluding alcoholic beverages) was reduced from 9 to 6.9 percent in early 2007, and tax administration reforms (modernization of tax and customs procedures, the merger of the income tax and sales tax departments into a single tax authority, and the setting up of large and medium tax-payer offices—the latter on a pilot basis) have progressed, with substantial TA provided by FAD.

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      Cash and debt management were streamlined by the consolidation of major government accounts into a treasury single account (TSA) and by the settlement of circular debts among the central government, the National Investment Bank, and the Social Insurance Funds.

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      In July 2007, Egypt successfully issued its first international local-currency bond (LE 6 billion), seeking to widen the pool of investors and foster the establishment of a meaningful benchmark yield curve.

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      Plans to restructure the pension system with World Bank assistance are underway.

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      The government is putting in place an institutional framework for private-public partnerships (PPPs). A central monitoring unit was set up and legislation providing a broad framework for concessions, PPPs, and leasing will soon be submitted to parliament. PPP projects in the pipeline include building and maintaining 2,100 public schools, four hospitals, several potable and waste water stations, and two freeways. These projects are relatively small and would have only a limited fiscal impact in the next few years.

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      Recent steps to facilitate business activities included reducing the time, fees, and minimum capital required to set up a business; sharply lowering fees for registering property; and cutting further the time needed for imports and exports to clear customs.

What Explains Inflation Developments in 2006/07?

Egypt experienced a surge in inflation between March 2006 and March 2007 (see charts). Inflation began to moderate after March 2007, with the CPI falling steadily to 8 percent (y-o-y) by July. The CPI rose again to 8.5 percent in August largely because of an increase in food prices.

Supply shocks: An avian flu outbreak in February 2006 (resulting in the destruction of large chicken stocks, quickly affecting meat and egg prices) and administered fuel price hikes in July 2006 (raising prices for various fuels by 25 to 90 percent) had a sharp impact on prices, and headline inflation rose until early 2007.

Higher world commodity prices: The surge in world prices for several commodities (the global food price index increased by 10 percent in 2006) also contributed to inflation. Some imported food items such as wheat, oils, and sugar are heavily subsidized by the government, but these constitute only about 3–4 percent of the CPI basket by weight compared to 40 percent for all food items. Prices of domestic agricultural produce have also risen because of higher prices for imported fertilizer and seeds.

Figure 1.1.
Figure 1.1.

Output Gap 2001/02-06/07

(in percent, annualized)

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

Demand-side factors and supply bottlenecks: With aggregate demand in Egypt boosted by high growth, rising employment, and wealth effects, signs of demand pressures have emerged. One is the rise in prices not directly affected by supply shocks, such as the CPI excluding food, fuel, and rent (from 2.6 percent (y/y) in February 2006 to 10.6 percent a year later), and similarly the CPI excluding tradables. Another is the surge in imports. While capacity utilization is not high and unskilled labor is ample, there are bottlenecks in some input markets—for example, skilled labor and cement. More generally, as the Egyptian economy has been booming since early 2005, it possibly went beyond one measure of potential output (estimated long-run trend GDP) in early 2006, adding to inflationary pressures.

III. Egypt’s Medium-Term Policy Framework

5. Egypt’s medium term prospects are favorable, provided the external environment remains supportive, the government reduces the deficit by about 1 percent of GDP per year as planned, and efforts continue to overcome structural constraints to business development.

  • Growth is projected to remain at 7–8 percent, assuming continued improvement in the business environment succeeds in raising investment to levels over 25 percent of GDP, while other reforms improve the quality of public expenditures (Table 4).

  • Foreign capital will play an increasing role in financing investment. Staff projects that the current account will turn into a deficit of about 2 percent of GDP over the medium term, to be financed largely by foreign direct investment (FDI) and a small increase in borrowing.

  • The current account would remain close to norms derived from macroeconomic fundamentals and the Egyptian pound broadly in line with fundamentals (see Box 2).

Table 1.

Egypt: Selected Macroeconomic Indicators, 2003/04–2007/08 1/

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Sources: Egyptian authorities, World Bank (poverty rate); and Fund staff estimates and projections.

Fiscal year ends June 30.

Authorities’ estimates based on revised source data and new budget classification adopted in 2006.

Series break in 2005/06, when fuel subsidies were explicitly recorded, and matched by an equivalent notional revenue (from the

Includes acquisition of financial assets.

As calculated by the ministry of finance but adjusted to (i) include the repayment of past arrears as a capital spending spending item (purchase of nonfinancial assets), and (ii) eliminate the creation of arrears from the financing side, as well as from capital spending.

Includes foreign-currency deposits of commercial banks at the central bank.

The estimate for short-term private external debt is likely to be biased downward due to insufficient data.

Table 2.

Egypt: Summary of Budget Sector Fiscal Operations 1/

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Source: Ministry of Finance and Fund staff estimates.

Budget sector comprises central government, local governments, and some public corporations. The fiscal year begins on July 1. The data are presented on a cash basis consistent with the GFS 2001 classification.

Beginning in 2005/06, the cost of domestic fuel subsidies covered by EGPC is recorded on-budget, with a corresponding counter-entry as notional revenues from EGPC.

Measures yet to be implemented (e.g. sales tax reform (approx. 2–2.5 percent of GDP), energy subsidy cuts for industry (approx. 1.5 percent of GDP when fully in place), and fuel subsidy cuts.

Adjusts for one-off receipts from FY2005/06 onward, including the sale of Egypt Telecom, mobile license fee, and other.

Oil-sector revenue includes corporate income tax receipts from EGPC and foreign partners, royalties, extraordinary payments, excise taxes on petrol products, and dividends collected from EGPC.

Table 3.

Egypt: General Government Fiscal Operations 1/

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Sources: Ministry of Finance, Central Bank of Egypt

General government includes the budget sector, the national investment bank (NIB), and social insurance funds. The fiscal year begins on July 1. The data are presented on a cash basis consistent with the GFS 2001 classification.

Beginning in 2005/06, the cost of domestic fuel subsidies covered by EGPC are recorded on-budget, with a corresponding counter-entry as notional revenues from EGPC.

Measures yet to be implemented—e.g. sales tax reform (approx. 2–2.5 percent of GDP), energy subsidy cuts for industry (approx. 1.5 percent of GDP when fully in place), and fuel subsidy cuts.

Adjusted for one-off receipts from FY2005/06 onward, including the sale of Egypt Telecom, mobile license fee, and other.

Oil-sector revenue includes corporate income tax receipts from EGPC and foreign partners, royalties, extraordinary payments, excise taxes on petrol products, and dividends collected from EGPC.

Includes domestic debt of the general government and external public and publicly guaranteed debt.

Table 4.

Egypt: Medium-Term Macroeconomic Framework, Baseline Scenario, 2003/04–2011/12

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Sources: Egyptian authorities; and Fund staff estimates and projections.

The low-growth scenario assumes a relaxation of the reform and fiscal adjustment effort, leading to lower growth and worse debt dynamics compared to the baseline.

6. The risks from external shocks are low, but a weakening of the reform effort could harm investor confidence and growth:

  • The probability of a sudden stop of capital inflows is low. While Egypt has seen a significant increase in capital inflows in the recent past, only a small part is portfolio investment, while the rest is FDI. Geographically, the origin of the capital is also diverse (mostly from Europe, the GCC, and the United States).

  • The vulnerability to a sudden stop is also low because the capital inflows have not been intermediated through the financial system and official reserve levels are comfortable. Stress tests conducted during the recent FSAP update suggest that the banking system is mainly vulnerable to a deterioration in domestic credit quality, whereas vulnerability to exchange or interest rate movements is low.

A weakening of the reform effort could threaten the bright medium-term outlook. The positive investor view of the Egyptian economy is largely because of the economy’s continuing liberalization since 2004, and in particular the willingness of the government to place public debt on a sustainable path. Any dilution of the reform agenda (because of reform fatigue or adverse political developments) could affect investment incentives and growth. Without fiscal adjustment, growth would be lower and debt sustainability worse over the medium term.

Egypt’s Current Account and Equilibrium REER5

Egypt’s external current account (CA) has been in surplus (but on a declining trend) during the past six years. The large downward correction of the nominal and real exchange rates during 2001-03 boosted competitiveness, the oil boom in the GCC region has increased remittances, and Egypt has emerged as a major liquefied natural gas (LNG) exporter. At the same time, the improved availability of foreign exchange and liberalization of trade facilitated a dramatic increase in non-oil merchandise imports, from US$13 billion in FY03 to US$34 billion in FY07. Factoring in the full impact of the real appreciation and reduction in import tariffs in recent years, the present underlying CA balance is estimated to be in a range of 0 to -1 percent, compared to a projected surplus of 0.8 percent in 2007/08.

Using CGER-type methodologies, the external sustainability (ES) approach and the macroeconomic balance (MB) approach indicate a range for the long-run equilibrium CA balance (“norm”) of -½ to -2¼ percent of GDP, close to the underlying balance. Under the baseline scenario, a CA balance of -0.8 percent of GDP would stabilize Egypt’s net foreign assets (NFA) at about -9 percent of GDP, the 2005 level, while under the low growth scenario a CA deficit of 0.5 percent would stabilize NFA. The MB approach, a panel-derived estimate of the CA as a function of a set of macroeconomic fundamentals, indicates an equilibrium balance (“CA norm”) of about -1.7 to -2.3 percent of GDP for Egypt, which would stabilize NFA at around -24 percent of GDP.

In the medium term, the CA is projected to turn into a deficit and remain close to the norms. Strong reforms and a narrowing of the fiscal deficit in line with the authorities’ plans are expected to result in continued strong growth and higher investment, and the CA balance is projected to move to -2.2 percent of GDP over the next 5 years. If the fiscal deficit reverts back to 8-9 percent of GDP and structural reforms lose momentum, growth and investment would moderate over time and the CA would settle at around -1.0 percent of GDP. Under either scenario, external stability would be expected to be maintained over the medium term.

Staff estimates suggest that the REER is broadly in line with fundamentals.

  • With the present underlying CA balance within the range indicated by the various norms, no REER adjustment is required to ensure external stability.

  • Another staff exercise indicates the existence of a long-run cointegrating relationship between Egypt’s REER and key fundamentals. Similar to results found in the literature, the equilibrium REER was found to appreciate with a strengthening of Egypt’s relative productivity (proxied by per capita GDP relative to trading partners) and exogenous current account inflows (Suez canal fees, official and private remittances, net oil exports, and tourism inflows), but depreciate with greater trade openness. Over the last 15 years, Egypt’s equilibrium REER has been on a declining trend mostly driven by relatively weak productivity growth and more recently higher trade openness. The actual REER deviated at times substantially from the estimated equilibrium REER, but by 2006, the gap had virtually closed.

Figure 2.1.
Figure 2.1.

Egypt: The REER and Its Estimated Equilibrium

Citation: IMF Staff Country Reports 2007, 380; 10.5089/9781451811889.002.A001

IV. Policy Discussions

Discussions focused on the authorities’ macroeconomic policy stance which is geared toward sustaining high growth and creating jobs for a rapidly growing labor force.

A. Getting the Policy Mix Right

Fiscal policy

7. Fiscal consolidation remains the overarching priority. It is key for raising national savings to finance the higher investments needed. Given that net public debt is still high at over 70 percent of GDP, it is also critical for consolidating domestic stability and reducing any debt overhang effects on investment. Social expenditures are less efficient in improving health, education, and poverty indicators than in many other countries.6 In particular, food and fuel subsidies remain high, at about 7 percent of GDP. The under-pricing of energy promotes excessive consumption with high environmental costs and has little impact on poverty,7 while attracting investment into sectors where Egypt may not have a long-run comparative advantage, and implies high effective rates of protection in energy-intensive industries.

8. The authorities are committed to reduce the fiscal deficit to 3 percent of GDP by 2010/11, which would put debt dynamics on a sustainable path and create space for private sector-led growth (see Table 8 and Figure 3). Planned adjustment measures include further energy subsidy reductions, including the phasing out, over 3 years, of gas and electricity subsidies to energy-intensive industrial users; containment of wage bill growth, among other things by a partial hiring freeze; sales tax reforms aimed at moving to a full-fledged value-added tax (VAT)—by widening coverage to services, unifying rates, and raising the exemption threshold; and continued improvements in tax administration. In line with this strategy, the 2007/08 central government budget aims to contain the deficit at 7 percent of GDP, implying an underlying adjustment of more than 1 percent of GDP (Table 2). Such fiscal consolidation would also support monetary policy in reducing demand pressures and contain speculative inflows. The rapid introduction of the sales tax reform and of the planned energy subsidy cuts will be critical to achieve the target.

Table 5.

Egypt: Monetary Survey, 2003/04–2007/08

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Sources: Central Bank of Egypt; and IMF staff estimates and projections.

Payments (on original schedule) of public enterprises on debt rescheduled by the Paris Club.

Excludes deposit auctions.

Excludes reserve requirements on foreign currency deposits.

Broad money less foreign currency deposits.

Excludes foreign currency deposits of commercial banks at the CBE.

Includes foreign currency deposits of commercial banks at the CBE.

Ratio of broad money (domestic currency component) to reserve money excluding foreign currency deposits.

Excluding public sector companies. Starting in 2004/05, the growth rate of private credit is reportedly biased downward by large repayments on nonperforming loans in the context of the banking sector restructuring.

Excludes valuation effects.

Foreign currency deposits in percent of broad money.