Is Devaluation Inevitable for Egypt's Currency?

It’s been just over a year since former Egyptian President Hosni Mubarak stepped down after 18 days of protests, but the country’s grueling transition continues to weigh heavily on its economy.

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The Central Bank of Egypt (CBE) has been struggling to arrest a steep fall in foreign currency reserves, with the latest figures showing another loss in excess of $1.7 billion in January. Notwithstanding capital controls pertaining to the movement of foreign currency, reserves have fallen over 50 percent since the revolution in January of last year to reach $16.35 billion.

Last week, Standard & Poor’s (S&P) lowered Egypt’s long-term foreign- and local-currency sovereign credit ratings to B from B+, with a negative outlook.

“We believe the sharp decline in Egypt’s foreign reserves, in combination with ongoing political uncertainties, is weakening sovereign policy flexibility,” S&P said in a statement.

After an initial rejection of a loan offer, talks with the International Monetary Fund appear to have gained renewed momentum after Egyptian authorities decided to go back to ask for a $3.2 billion facility. A large proportion of international aid pledges from last year have yet to be fulfilled.

Magda Kandil, Executive Director at the Egyptian Center for Economic Studies (ECES), told CNBC that reserves were already at critical levels.

“They are barely adequate for three months of imports, plus commitments to external borrowing. We need to have a cushion of international reserves to support the pound immediately,” Kandil said.

Despite the lack of popular support for accepting aid, international assistance has long been seen by analysts as key to addressing Egypt’s financing needs.

Government borrowing costs have risen steadily, with the last debt auction seeing an average yield for the 357-day T-Bill at 15.975 percent.

Officials now expect the budget deficit to reach 9.4 percent of gross domestic product (GDP) , at least the fourth revision in as many months, when the current fiscal year ends in June. Finance Minister Mumtaz El Saeed also told the local Al-Ahram Newspaper that Egypt would need some $11 billion to finance economic reforms in the coming year.

The Egyptian pound, which traded at 6.0355 against the US dollar

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[.DXY  Loading...      ()   ]on Monday morning, has lost almost four percent since the uprising. The relatively modest decline has mostly been attributed to extensive support operations from the country’s central bank at the expense of its reserves.

Kandil warned that with an absence of a recovery soon, a “devaluation could be inevitable and could be large”.

Lasting political turmoil, in addition to a range of policy errors, is a frequently cited reason for sudden devaluation episodes, as was the case in Argentina in 2002.

Dwindling foreign currency reserves and a volatile political scene have not kept Egypt’s stock exchange from posting a positive start to 2012, with the EGX30 gaining 37 percent so far this year, one of the world’s best performers. The Market Vectors Egypt ETF in the U.S. has “only” advanced just over 25 percent as of Friday’s close.

Violence and protests have marred the past year as the Supreme Council of the Armed Forces (SCAF), which assumed power after the resignation of Mubarak, has been attempting to facilitate a fresh start for the country. But the council’s popularity has gradually receded over recent months, with growing skepticism over motives and goals. The vote for a new President is expected to take place this summer.