Monday, 13 July 2015

Boosting Egyptian exports – why inflation matters

When it comes to boosting exports, inflation matters at least as much as the exchange rate.

The decision by the Central Bank of Egypt (CBE) to let the Egyptian pound depreciate was applauded by some commentators. They argued that a weaker pound can boost exports by making them cheaper relative to their competitors. However, even in theory, this argument is incomplete and misses important ingredients. Careful analysis shows that when it comes to boosting exports, inflation matters at least as much as the exchange rate.

Let’s take an example. Consider a situation in which Egypt and the US produce an identical good, which they export to the rest of the world. Suppose that the price of the Egyptian good is 100 pounds, and the price of the US-produced good is $100. Now, assume that the exchange rate is such that 1 pound = $1. This means the price of the Egyptian good in dollars is $100, exactly the same as the price of its American counterpart. Consumers will therefore be indifferent between buying either.

Suppose that the CBE then decides to let the pound depreciate by 10%, so that $1 = 1.1 pound. The price of the Egyptian good is still 100 pounds, but its price in dollars is now $91 (=100/1.1). Because the Egyptian good costs less than the American one (which is sold at $100), consumers will choose to buy more of the Egyptian good at the expense of the American one. This is exactly the argument that proponents of the recent depreciation of the pound make.

Assume then that inflation in Egypt is 20% but it is zero in the US. This level of inflation implies that the Egyptian good now costs 120 pounds.  This is equivalent to $109 (=120/1.1). The Egyptian good is now more expensive than the American one, which still costs $100. Inflation has basically wiped out all the competitiveness gains from the currency depreciation.

What are the lessons of this simple example?

1. Inflation is at least as important as the exchange rate when it comes to making exports more competitive in international markets. In other words, it is real exchange rate (which also takes inflation into account) not nominal exchange rate that matters for exports.  

2. With Egypt running double-digit inflation and most of the rest of the world operating at below 2% inflation rates, the CBE has room to improve the appeal of Egyptian exports by reducing inflation, not just the value of the currency.

Of course, these conclusions are under the assumption that Egyptian exports respond to improvements in price competitiveness (equivalently, a fall in the real exchange rate)—an assumption that is not uncontroversial. But this is another story.

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