Monday, 14 March 2016

Is devaluation in Egypt inevitable?

By defending an overvalued currency, the Central Bank of Egypt is merely delaying the inevitable.

Egypt’s currency crisis is intensifying. The price of the US dollar reached 9.8 Egyptian pounds last week, 27% higher than the official rate. Despite this, the central bank is still resistant to any devaluation of the currency. Its resistance could prove ultimately successful only if it is supported by economic fundamentals. But these point to an official exchange rate which is well above its fair value.

The starting point for estimating the fair value of any currency is the theory that prices of identical goods must be the same everywhere. Suppose that the price of a can of Pepsi is $1 in the US and 2 pounds in Egypt. Then the theory stipulates that the exchange rate must be 2 pounds for each dollar to ensure that the price of Pepsi is the same in the two countries. If the exchange rate was instead 1 pound for each dollar, investors would find it profitable to buy the whole supply of Pepsi in the US (where it is cheaper) and sell it in Egypt (where it is more expensive), which is obviously not a sustainable situation. This theory is called Purchasing Power Parity (PPP).

But PPP needs to be modified before it can be used for obtaining a fair value of a currency. Lower labour, rent and transportation costs typically result in cheaper Pepsi in Egypt compared to the US, after taking the exchange rate into account. Consequently, the Egyptian pound has traded below the PPP-prescribed value. But deviations from PPP have been stable over time. Since 1988, the pound has tended to fluctuate around 21% of its PPP value.  We can use this historical average (21% of PPP) as a measure for the fair value of the pound.

What is the current fair value of the pound according to this method? Using the International Monetary Fund’s estimates for PPP, the method suggests that the fair value of the exchange rate is 11.9 pounds for each US dollar. This is 35% above the official exchange rate of 7.73 pounds for the dollar. The prevailing overvaluation is the largest since 1988 (see chart). No wonder there is intense market pressure to devalue the currency.

How can this situation be resolved? A gradual devaluation of the currency (say 10% each year) could allow a convergence to its fair value within a few years without causing an abrupt disruption. But irrespective of its speed, an adjustment is likely to start at some point in the near future. Resistance to devaluation runs against economic fundamentals. By defending an overvalued currency, the Central Bank of Egypt is merely delaying the inevitable.

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