In a surprise move in November last year, the Egyptian Central Bank announced that it would let the market set the foreign exchange (FX) rate for the Egyptian Pound (EGP) and raised the interest rates by 300 basis points.
These measures were designed to stop the currency being traded on the black market and reverse the currency shortage this created in the country’s banking system.
This move has some benefits. First, the market will decide the real exchange rate and the ongoing black market for EGP should disappear. Second, more foreign investments will flow in, bringing in much needed US Dollars (USD). Third, Egyptian exports will be more competitive and some sectors, such as tourism, will get a significant boost. Last, it entails the release of the much-needed International Monetary Fund (IMF) loan of $12 billion.
Given that the Egyptian banks, for the first time, have started to trade in the currency without any central bank restrictions, some exchange rate volatility is expected until the market finds an equilibrium price for the EGP during the price discovery phase.
However, the abolition of currency controls and the steep increase in interest rates are likely to have an impact on the Egyptian economy. For one, it will put an upward pressure on inflation and the subsequent interest rate increase would mean lower credit growth, potentially having an impact on economic recovery.
For the banking industry, in particular, the resulting volatility may leave Egyptian banks vulnerable to portfolio losses. It is especially true if they have not protected against such market shocks and left their exposures unhedged. Such vulnerabilities can be found across the trading and banking book.
Consider the following scenarios:
- The bank does not have full visibility of the bank-wide currency positions in real time or on an intra-day basis.
- The bank wants to understand the impact on its liquidity profile if ten percent of its small and medium enterprise (SME) customer portfolio defaults in the next six months, due to increase in interest rates and lower economic activity.
- The bank is expecting that 15 percent of its retail customers may decide to prepay – partially or fully – their debts in three months’ time, due to increasing interest rates.
- The bank has a significant exposure to the counterparties who have a considerable USD-denominated debt portfolio.
- The bank is not able to get a clear view of its interest rate gaps or liquidity gaps on an intra-day or at least on every end-of-day basis.
- The banks is not able to stress-test its portfolio using a multi-dimensional scenario involving one or more risk factors, including FX, interest rates, credit and more.
In each of these scenarios, the lack of appropriate tools to carry out the required on-demand scenario analysis and take appropriate hedging measures could leave the bank exposed to significant risks.
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