Banking, Credit, and Inflation

Banking, Credit, and Inflation

Like other economic sectors, banking fell under government control during the Nasser era. Banks were nationalized and amalgamated in 1963 into four big commercial banks: the National Bank of Egypt, the Bank of Alexandria, Bank Misr, and the Bank of Cairo. They were owned and regulated by the Central Bank. Numerous special-purpose banks were also created, including those for industrial and agricultural credit, mortgages, and social security funds. They held about 9 percent of total assets of the banking system.

When Law Number 43 (of 1974) for Arab and Foreign Capital Investment and Free Zones was extended to the domestic private sector, banking boomed and its structure was altered. The number of banks grew between 1974 and 1988 from 8 to more than 100. Furthermore, banking absorbed a big chunk of investment outlays. In 1983, for example, 54 percent of the ŁE2.1 billion capital investment went into banking and associated financial activities. The banking sector thrived because the Central Bank allowed a highly profitable mark-up of 6 percent over fund costs of banks, pushing banking investment returns to about 70 percent, probably a higher rate of return than in any other sector. The most important change in the banking structure was the emergence of three types of establishments: private, joint venture, and, after 1984, Islamic investment companies. Nevertheless, the big four banks, partly because they had branches throughout the country, continued to handle about 60 to 70 percent of total assets.

Banks were highly liquid throughout the 1980s. Time and foreign currency deposits increased from nearly ŁE3.6 billion to nearly ŁE34 billion between 1980 and 1988, or at an annual rate of 32.4 percent. Part of the increase came from the revaluation of foreign currency deposits against the depreciating pound. The largest shares of the increase, were those of time deposits and foreign currency. It was difficult to determine the savings rate, because the Central Bank did not separate time deposits from foreign currency. Some estimates showed that Egypt had a savings rate of 17 percent of GNP, one of the highest in the world. This was mostly private savings; public savings fell considerably in the 1970s and 1980s because of military expenditures, the high cost of subsidies, and the growth of foreign debt.

The generally good performance of the banking sector was marred by corruption, embezzlement, smuggling of hard currency abroad, and a stormy confrontation between the government and the Islamic investment companies. In one case in 1984, a black marketer was able, through bribery, to obtain loans worth US$3 billion and then to smuggle the funds abroad. It was estimated that in 1981 about 54 percent of hard currency deposits in private banks were placed with overseas branches or corresponding banks. The government believed there were ŁE40 to ŁE70 billion abroad, which either had flowed out of, or never flowed into, the country.

Islamic investment companies came into being in 1984 and were dominated by four or five major enterprises. They grew spectacularly and accumulated deposits totaling billions of dollars. Their practices differed from those of other banks in that they offered depositors risky open-ended mutual fund certificates instead of interest, which Islamic law forbade as usury. Initially, they were able to offer depositors returns of 20 percent. The government, and many observers, accused them of being able to do so through black-market money trading and by luring depositors with "pyramid" schemes, such as the establishment of fictitious corporations, by which dividends were paid from old investments. They were also charged with smuggling large sums of hard currency abroad and with defrauding many depositors. The government issued new regulations in 1988 that required the companies to reconstitute themselves as stockholding enterprises, issue share certificates, and place deposits under official scrutiny. Whether the companies would submit to such regulations remained unclear. It was feared that if they refused and liquidated themselves instead, they could cause havoc in the financial market.

The increase in bank liquidity was reflected in the growth of credit. Banks were permitted to lend only 60 percent to 65 percent of the value of their deposits, except to the government, which could borrow at will. The value of loans grew steadily in the 1980s, increasing as much as 20.7 percent per year. Part of the increase resulted from the depreciation of the pound. The highest loans were consistently to the government, which borrowed heavily to finance its chronic deficit. Government borrowing represented from 40 percent to 60 percent of the total. Public sector enterprises, although they received direct funds from the government budget, were the second-largest borrower until the mid1980s .

After 1985 the private sector replaced the public sector as the second largest debtor after the government. By the second half of the 1980s, private borrowers were becoming less and less able to honor their obligations. As a result, banks, especially some foreign and joint venture banks that were not allowed to deal in local currency, faced a depressed business atmosphere.

Nominal interest rates remained essentially the same through most of the 1980s. They ranged from 5 to 13 percent for deposits and 11 to 17 percent for loans. That real interest rates were consistently negative because of higher inflation rates apparently did not lead to excessive borrowing by the public sector. In spite of IMF insistence on raising interest rates, the government was reluctant to increase them by more than 1 percent to 2 percent, for fear of slowing economic growth.

The increase in the money supply probably also contributed to the rise in inflation levels. Total money supply increased between 1980 and 1988 at an annual rate of 23 percent. Major sources of this increase were government borrowing, revaluation of foreign currency holdings, and private-sector borrowing. Double-digit inflation marked the economy in the 1980s. The consumer price index rose by 336 percent between 1980 and 1988, or at an annual rate of 16 percent, about 5 to 6 percentage points higher than the rate in the 1970s. Since 1987, annual inflation rates have risen between 20 percent and 30 percent. Economists spoke of "stagflation," the combination of low growth and high inflation, as characterizing the Egyptian economy in the second half of the 1980s.

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