Since the beginning of 2023, the Central Bank of Egypt (CBE) has used a flexible mechanism to set the exchange rate of the Egyptian pound. This mechanism introduces a great deal of uncertainty into the process of setting the exchange rate, which has a significant impact on business operations in Egypt and forces businesses to add extremely high profit margins to their products as a hedge against exchange rate fluctuations.
Typically, product prices are set by adding a profit margin to the direct expenses to recover manufacturing expenses and generate a profit. Since a portion of the cost is dominated in dollars, companies operating in Egypt run a constant risk due to the fluctuation in the exchange rate. As a result, if a business bases the price of its goods on the market rate, it will suffer losses if the value of the Egyptian pound declines. Producers can therefore add very high profit margins to offset the effects of any potential currency depreciation and protect their capital.
To illustrate how the flexible exchange rate could impact businesses, consider the following scenario: a company submits a tender to implement a number of dollar-dominated projects. If the company sets its tender prices based on the flexible exchange rate, it may incur significant losses if some of the project supplies are imported from abroad. If, after being awarded the tender, the exchange rate of the US dollar changes beyond the company’s expectations, the company will be left with no profit and may incur losses in the contracted project. Failure to implement the tender on time would result in hefty fines, in addition to the company’s loss of market reputation and potential legal issues. This makes it impossible for the company to back out of its implementation commitment. The same is true for Egyptian businesses that sell their goods on the Egyptian market while sourcing some or all of their production inputs from abroad. In these cases, costs fluctuate due to the flexible exchange rate, whereas revenues stay constant based on the selling price structure. Against this, the CBE had to introduce a new tool, namely forward exchange contracts, or FECs, to assist businesses doing business in Egypt in hedging against these risks. But what are FECs?
Forward Exchange Contracts
The CBE announced the activation of FECs in the fourth quarter of 2022, in conjunction with the second change in the exchange rate of the Egyptian pound. A FEC is, in essence, a contract between the bank issuing it and the importer or company under which the exchange rate is fixed immediately for delivery at a specified future date, say four months. So, if a company agrees to implement a project that requires importing $10 million worth of goods four months later, rather than waiting until the time of payment and asking the bank to provide US dollars at the market rate at that time, the company can enter into a FEC with the bank and agree on an exchange rate for the dollar against the pound after four months. This enables the company to hedge against the risks associated with exchange rate fluctuations and to set reasonable prices for its products.
Several variables affect how forward exchange rates are priced, but three in particular stand out: the current exchange rate, the current market interest rate, and the interest rate in the US (if the transaction currency is the US dollar). Without getting into the specifics of the formula used to determine the forward exchange rate, in general, if the interest rate (inflation) on the Egyptian pound (in Egypt) is higher than its equivalent in the United States, the exchange rate of the Egyptian pound will probably decline during that period. If the current exchange rate is 30 pounds to the dollar, the firm can negotiate with the bank to meet its dollar requirements at an exchange rate of EGP 31 to the dollar after four months.
Overall, FEC terms vary depending on the buyer and seller’s perceptions of the dollar and are typically founded on projections and estimates. By entering into FECs, the buyer is able to fix production costs and eliminate any uncertainty about how much to charge for their product or how much to offer in a tender without running the risk of exchange rate volatility. But who pays the price difference if an exchange rate is decided upon at 31 after 4 months and the value of the pound has dropped to EGP 35 per dollar?
As stated earlier, regardless of the exchange rate on the market, the importer will receive US dollars at the agreed-upon price. As a result, another party must pay the difference in price, or EGP 4 in this case (the difference between the dollar’s market price of EGP 35 and the dollar’s price at the time of the contract of EGP 31), and it is unquestionably not the bank since it is only acting as an intermediary for that contract. Here, an exporter who received their returns in US dollars and wished to convert them to Egyptian pounds does so. In order to protect themselves from exchange rate fluctuations, such an exporter wishes to agree with the bank at this time that the contract will be carried out four months from now. Therefore, the selling party is the exporter, who anticipates that the value of the Egyptian pound will be EGP 27 to the dollar after four months. They want to secure his export revenues by signing a contract to sell the dollar at an EGP 31 to the dollar price after four months.
Thus, the bank acts as an intermediary between the importer, who seeks to secure his costs and insure against the risks of fluctuating currency exchange rates, and the exporter, who anticipates a decline in the value of the currency. By offering FECs, the bank has protected both parties from the risks associated with currency price fluctuations and enabled both parties to realize the required returns on their investments. But how could this affect the stability of Egyptian commodity prices?
As was already mentioned, both parties (the seller and the buyer of the dollar) want to protect themselves from the risks associated with exchange rate fluctuations. Rather than aiming for the highest return possible, they try to achieve the necessary return on investment. Consequently, ensuring the fixation of the currency exchange rate through FECs permits the importer or local producer to determine the costs and prices of their products by adding reasonable profit margins that cover the costs and the required profit margin. By refraining from including obscenely high profit margins on the selling price of goods to protect against fluctuations in exchange rates, this will directly contribute to the market’s return to price stability. On the other hand, this mechanism guarantees that the exporter realizes the required profit margin on their exports and that profits resulting from export revenues are not lost amid fluctuations in the currency exchange rate. Given that the exporter may also be an importer of some production inputs, entering into an FEC eliminates the impact of currency fluctuations on the manufacturing process and increases the likelihood that the exporter will earn a satisfactory rate of return. Applying that mechanism, ergo, benefits everyone involved (the exporter, the importer, the state, and the citizens).