The Direct Cost of Exchange Rate Flexibility in Times of Crisis

Assessing IMF Conditionality in Egypt

Exchange Rate Flexibility and IMF Conditionality

Every time Egypt successfully completes another review under the International Monetary Fund's Extended Fund Facility (EFF), the IMF repeats almost the same praise, focusing on improvements in foreign exchange reserves, stronger fiscal indicators, particularly the primary surplus, and, above all, exchange rate flexibility.

The Egyptian government welcomes this praise enthusiastically and reiterates that it reflects the IMF's confidence in the Egyptian economy. The latest such praise came in an article written by the IMF's mission chief for Egypt following the programme's seventh review. He considered the government's commitment to exchange rate flexibility one of the most important factors that helped contain the financial shock resulting from escalating regional tensions. Particular praise was directed at the Central Bank's response to pressures arising from the withdrawal of foreign portfolio investments. Non-residents' holdings of government debt instruments denominated in Egyptian pounds fell from USD 39.1 billion in February to USD 22.2 billion in early April, while the pound depreciated by approximately 14% to 17% during the crisis. The IMF considered that allowing the exchange rate to decline, rather than defending a specific value of the pound using foreign reserves, helped the economy absorb the shock without it developing into a broader crisis in the foreign exchange market. Foreign inflows subsequently returned gradually, and the pound recovered a substantial part of its losses. However, the same cycle returned more forcefully at the end of September, with the Egyptian currency entering another wave of depreciation in October. The dollar rose from EGP 49 to EGP 55, an increase of approximately 12% over September and October.

The immediate cause of the pound's depreciation was the repeated withdrawal of portfolio investors, commonly referred to as hot money. Several factors contributed to this, including the Federal Reserve's return to raising interest rates by 25 basis points on 16 September, for the first time since 2023, which generated additional financing pressures on emerging markets. In Egypt's case, this global monetary tightening coincided with geopolitical instability and escalating regional tensions, particularly the renewed war between Saudi Arabia and Yemen and the Houthis' near-complete control of the Bab el-Mandeb Strait. These developments are seen as directly affecting the Egyptian government's dollar revenues, particularly those generated by the Suez Canal.

The IMF argues that exchange rate flexibility protects the Egyptian economy from external shocks. However, a closer examination of the consequences of this flexibility reveals a broader crisis in the real economy, related to the Central Bank's overall response to Egypt's economic crisis. Although exchange rate flexibility may preserve some dollar liquidity within the economy, the approach to managing the economic crisis and borrowing reflects deeper structural problems that remain unresolved in Egypt.

Under the current programme, IMF conditionality has focused on exchange rate flexibility. Following the programme's signing at the end of 2022, reviews of Egypt's Extended Fund Facility (EFF) agreement were suspended for more than a year because the government maintained a fixed exchange rate throughout 2023. Then, in February 2024, the Ras El Hekma deal brought approximately USD 25 billion in direct investment for the purchase of land on the North Coast, alongside the cancellation of USD 11 billion in Emirati deposits, in a deal valued at USD 35 billion. The deal represented the financial rescue that the IMF and the Egyptian government had been seeking from the Gulf, prompting the government to commit to exchange rate flexibility as part of following the IMF's advice.

The Depreciation of the Egyptian Pound and Its Impact on Inflation

When the current programme began in Egypt, the exchange rate stood at approximately EGP 30 per US dollar. The programme is expected to end in mid-December, and the exchange rate now stands at nearly EGP 55 per dollar. This means that the pound has lost approximately 56% of its value over nearly 48 months, the total duration of the current programme with the IMF.

This continuous depreciation has translated into imported inflation through higher import costs, making inflation in Egypt increasingly persistent over time. Inflation stickiness refers to the phenomenon whereby inflation rates remain elevated for extended periods, even after the economic shocks that initially caused prices to rise have subsided. This is linked to several domestic market factors in Egypt, including the transmission of price increases across sectors, particularly those relying on imported production inputs or intermediate goods. Consumer expectations also play a role, as consumers gradually become accustomed to previous inflation levels, while goods and services are repriced on the assumption that economic shocks will continue. In Egypt's case, therefore, the easing of the dollar liquidity crisis in the initial months did not prevent prices from continuing to rise. New waves of price increases emerged whenever the government adhered more closely to the IMF's recommendation to maintain exchange rate flexibility as part of managing Egypt's structural foreign exchange crisis.

Inflation and Purchasing Power: Beyond the Official Indicators

Egypt's inflation data reveal one of the most important contradictions of the economic reform programme with the IMF, particularly regarding inflation control. Nearly four years after the December 2022 agreement was signed, and three years after inflation peaked at 38% in September 2023, the monetary and fiscal policies adopted have failed to bring inflation back to the levels recorded before the repeated depreciations of the pound that began in March 2022.

Annual urban inflation reached 13.9% in September 2026, compared with 7.3% in January 2022. Meanwhile, the average inflation rate during the first nine months of 2026 remained close to the 2025 average, at approximately 14.2%. More importantly, the downward trend was not stable. After falling to 11.7% in September 2025, inflation rose again to 15.2% in March 2026, before stabilising at around 14% in the following months.

Declines in the annual inflation rate do not reflect the reality of Egypt's cost-of-living crisis. After all, the annual rate measures the speed at which prices are rising compared with the same month of the previous year, rather than the actual price level reached by the economy. A clearer picture of price increases can be obtained by calculating the rise in the overall Consumer Price Index (CPI). Using February 2022 as the reference point for the beginning of the latest waves of exchange rate depreciation during Egypt's recent crisis, the overall price level increased by approximately 145% by September 2026. Meanwhile, the prices of the food basket measured by the Central Agency for Public Mobilization and Statistics rose by around 176%. Thus, the decline in annual food inflation from a peak of approximately 73.6% in September 2023 to around 7.2% in September 2026 does not mean that food prices have fallen. Rather, they continue to rise, but at a slower pace. This is commonly referred to as the base effect, whereby annual inflation figures can improve significantly because they are being compared with months that experienced sharp price increases in previous years. All of this can happen without citizens experiencing any improvement in their purchasing power.

High Interest Rates and the Cost of Containing Inflation

These findings raise questions about the limits of relying on monetary tightening and exchange rate flexibility as the two principal tools for containing inflation. In an economy heavily dependent on imports, where prices are affected by external shocks, energy costs and the exchange rate, higher interest rates may have limited capacity to address the underlying causes of inflation, even if they help contain demand and inflation expectations. At the same time, high interest rates increase borrowing costs for both the government and the private sector, placing pressure on investment, production and employment opportunities. Consequently, the cost of slowing inflation becomes part of the economic crisis itself. This does not mean that monetary policy is unnecessary, but rather that its success cannot be assessed separately from the fiscal, productive and social costs borne by the economy during periods of economic reform.

Egypt's response to successive waves of inflation has relied heavily on raising interest rates and maintaining them at elevated levels for prolonged periods in order to increase the attractiveness of the Egyptian pound against the dollar in international debt markets, particularly with regard to the short-term capital inflows on which the Egyptian government relies to maintain dollar liquidity in the economy. However, this comes at a significant cost, as interest payments rise steadily both as a share of government expenditure and as a share of GDP. Interest rates also directly affect access to financing more broadly, while channelling the limited savings available in the Egyptian economy towards rent-seeking sectors.

Raising interest rates is based on a well-established economic rationale. When inflation rises, people tend to spend, and increasing the cost of credit through higher interest rates can theoretically help moderate spending and aggregate demand, thereby preventing further price increases. However, a substantial part of inflation in Egypt in recent years has been driven primarily by currency depreciation, alongside rising global costs of food and energy imports. Together, food and energy accounted for approximately 40% of Egyptian imports, according to the latest available data for 2025. With an open capital account and an economy integrated into international debt markets, this inflation is transmitted to the domestic economy. This does not mean that interest rates were incapable of containing inflation, but that, at best, their effect was temporary. Even under the most optimistic assessment, their effectiveness depended on managing expectations within the economy and preventing price shocks from turning into continuous waves of increases, or into broader dollarisation and economic collapse.

Exchange Rate Flexibility and the Transmission of Shocks to the Real Economy

Exchange rate flexibility does indeed work well. Perhaps this explains the IMF's repeated praise for the government's commitment to this condition over the past three years, particularly since February 2024. At the same time, however, exchange rate flexibility and the decision not to use foreign exchange reserves to defend the pound act as channels through which shocks are transmitted to the rest of the economy. During the withdrawal of hot money in March 2026, amid the American war against Iran, approximately USD 5–8 billion in foreign investments in domestic debt instruments left the country over a short period. The Central Bank did not defend the pound and instead allowed it to depreciate, predictably pushing inflation higher in the following months and making it more persistent.

Therefore, when looking at the real economy, the economic shock generated by geopolitical tensions in the region did not disappear; it was transmitted through another channel. The Central Bank protected foreign exchange reserves, while the government and the Central Bank continued to follow the IMF's advice not to use reserves to defend the pound. The IMF has consistently opposed such interventions, even though central bank interventions in exchange rates have become increasingly common in advanced economies in recent years as part of managing the effects of the American trade war and the global energy crisis, as well as their repercussions for inflation and interest rates.

In this sense, exchange rate flexibility protects foreign exchange reserves and does reduce the likelihood of a dollar liquidity crisis during periods of economic stability. However, a liquidity crisis will emerge sooner or later because of the chronic deficit in the external balance of payments. Its causes include external debt payments, which have increased significantly since 2022, as well as the marked widening of the trade deficit during the crisis due to higher import costs.

Dependence on Hot Money and the Vicious Cycle of Debt

This is precisely where the problem lies in the financing model, rather than merely in the choice of exchange rate regime. Egypt relies heavily on short-term foreign purchases of Treasury bills to finance part of its budgetary needs. At the same time, the dollars accompanying these inflows provide an important source of foreign currency liquidity. Before the March 2026 shock, foreign holdings of Egyptian pound-denominated Treasury bills stood at approximately USD 39 billion in February 2026, falling to USD 22 billion within roughly one month. This rapid withdrawal of hot money reflects a genuine crisis that prevents the exchange rate from being used to control inflation. Moreover, because Egypt's import structure consists primarily of intermediate goods, energy and food, it is difficult to control imported inflation resulting from higher import costs. The crisis therefore reproduces itself, not as a dollar liquidity crisis, but as a broader form of stagflation affecting the Egyptian economy.

Maintaining high interest rates for prolonged periods makes Egyptian debt instruments more attractive and helps retain more dollars within the banking system. At the same time, however, it raises borrowing costs for both the state and the private sector. More importantly, it constrains fiscal space in the budget, as interest payments account for approximately half of government expenditure during the current fiscal year. This, in turn, affects spending on education and healthcare, both of which remain below constitutionally mandated levels, as well as subsidies and social protection, whose shares of expenditure and GDP have clearly declined since the programme began, as part of the fiscal consolidation recommended by the IMF.

All of this takes place in the real economy merely to buy some time before debt payments once again put pressure on foreign currency resources, reproducing the same vicious cycle of debt that the Egyptian economy has experienced over the past decade and that has accelerated since 2022. None of this can therefore be considered a foundation for stability, even if exchange rates stabilise. The structural factors contributing to the chronic balance-of-payments deficit remain in place, meaning that the conditionality imposed by the IMF treats the symptoms rather than the underlying disease.