In this week's special edition, we address questions about how currencies are priced, the fair value of the EGP, and the need for dollar liquidity to emerge from the current crisis and avoid a more severe devaluation of the pound
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<h2>The Egyptian Pound: Is It Really Undervalued?</h2>
Prime Minister Mustafa Madbouly&nbsp;<a href="https://www.alarabiya.net/aswaq/economy/2023/05/17/%D8%B1%D8%A6%D9%8A%D8%B3-%D8%A7%D9%84%D9%88%D8%B2%D8%B1%D8%A7%D8%A1-%D8%B2%D9%8A%D8%A7%D8%AF%D8%A9-%D8%A7%D9%84%D8%A7%D8%B3%D8%AA%D8%AB%D9%85%D8%A7%D8%B1%D8%A7%D8%AA-%D8%B3%D8%AA%D8%AD%D9%84-%D8%A3%D8%B2%D9%85%D8%A9-%D8%A7%D9%84%D8%AC%D9%86%D9%8A%D9%87-%D8%A7%D9%84%D9%85%D8%B5%D8%B1%D9%8A-%D9%88%D9%8A%D8%B9%D9%88%D8%AF-%D9%84%D9%82%D9%8A%D9%85%D8%AA%D9%87-%D8%A7%D9%84%D8%AD%D9%82%D9%8A%D9%82%D9%8A%D8%A9">declared</a>&nbsp;on May 17, 2023 that the Egyptian pound was undervalued. The currency crisis will ease, he said, with the coming increased investments, which will allow the pound to rebound to its true value and cover the country&rsquo;s dollar gap. These statements are consistent with a report issued in late April 2023 by Goldman Sachs, a multinational investment services institution, which&nbsp;<a href="https://www.asharqbusiness.com/article/49638/%D9%85%D8%B5%D8%B1-%D8%AA%D9%88%D8%A7%D8%AC%D9%87-%D9%85%D8%B9%D8%B6%D9%84%D8%A9-%D8%B5%D8%B9%D8%A8%D8%A9-%D9%84%D8%AA%D8%AD%D8%AF%D9%8A%D8%AF-%D9%85%D8%B3%D8%A7%D8%B1-%D8%A7%D9%84%D8%AC%D9%86%D9%8A%D9%87/">says</a>&nbsp;that the pound is undervalued by some 25% due to successive devaluations over the past year. In the last week of May 2023, the pound&nbsp;<a href="https://www.asharqbusiness.com/article/50390/%D8%A7%D9%84%D8%AC%D9%86%D9%8A%D9%87-%D8%A7%D9%84%D9%85%D8%B5%D8%B1%D9%8A-%D9%8A%D8%B1%D8%AA%D9%81%D8%B9-%D8%A8%D8%A7%D9%84%D8%B3%D9%88%D9%82-%D8%A7%D9%84%D9%85%D9%88%D8%A7%D8%B2%D9%8A%D8%A9-%D9%85%D8%B9-%D8%B6%D8%B9%D9%81-%D8%A7%D9%84%D8%B7%D9%84%D8%A8-%D8%B9%D9%84%D9%89-%D8%A7%D9%84%D8%AF%D9%88%D9%84%D8%A7%D8%B1/">rose</a>&nbsp;against the dollar on the black/parallel market, from EGP41&ndash;42 to EGP 37&ndash;38 per dollar, in light of expectations that the government will&nbsp;<a href="https://www.bloomberg.com/news/articles/2023-05-11/egyptian-devaluation-bets-ease-as-citi-sees-no-short-term-move#xj4y7vzkg">postpone</a> the next devaluation until after the end of the current fiscal year in June 2023, in order to contain the budget deficit.
<h3>What is the fair value of the pound?</h3>
 <img style="display: block; margin-left: auto; margin-right: auto;" src="https://mcusercontent.com/5e42bef7fee7e6a299c3d932d/images/e04d5e9a-973f-f218-d05d-45c3c591e0fa.png" width="546" height="432">
<a href="https://www.madamasr.com/ar/2022/03/15/feature/%D8%A7%D9%82%D8%AA%D8%B5%D8%A7%D8%AF/%D8%A7%D9%84%D8%AF%D9%88%D9%84%D8%A7%D8%B1-%D9%88%D8%A7%D9%84%D8%AC%D9%86%D9%8A%D9%87-%D9%88%D8%B4%D8%B1%D8%A7%D8%A1-%D8%A7%D9%84%D9%88%D9%82%D8%AA-%D8%AD%D8%AF%D9%8A%D8%AB-%D9%85%D8%AA%D8%AC%D8%AF/">Rarely</a>&nbsp;is any currency in the world priced based on its fair value. Most countries control the exchange rate, either directly or indirectly, and the currency is typically overvalued or undervalued based on numerous economic variables, among them domestic economic policy objectives.&nbsp;
Economist Hani Geneina says that most of the currency&rsquo;s fair value calculations are based on the real effective exchange rate (<a href="https://www.investopedia.com/terms/r/reer.asp">REER</a>). The REER of the Egyptian pound is calculated in relation to a basket of currencies of Egypt&rsquo;s main trading partners and their respective trade balances. Differences in inflation rates between Egypt and the US are a critical factor in calculating REER in the long term, but interest rates play a bigger role in the short term.&nbsp;
<h3 dir="ltr">How is the value of the Egyptian pound determined? </h3>
The value of a currency is determined based on the forces of domestic and international supply and demand, in conjunction with the creditworthiness of the state and its financial institutions. The greater the demand for the currency, the higher its value, and vice-versa. Medhat Nafie, former Assistant Minister of Supply, says that many factors influence a currency&rsquo;s value, <a href="https://corporatefinanceinstitute.com/resources/economics/how-is-currency-valued/">including</a>&nbsp;interest rates, the inflation rate, capital flows, and money supply or the sum total of liquid assets in a country at any given time.
Two factors are&nbsp;<a href="https://capital.com/egyptian-pound-forecast-egp-imf-deal">key</a>&nbsp;in the valuation of the Egyptian pound (ranked in a&nbsp;<a href="https://www.cnbc.com/2023/04/05/the-egyptian-pound-is-amongst-the-worst-performing-currencies-in-2023.html">report</a>&nbsp;by CNBC as among the worst performing currencies in the world in 2023):&nbsp;
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The balance of trade (the difference between a country&rsquo;s exports and imports), with a deficit that stood at about&nbsp;<a href="https://www.cbe.org.eg/-/media/project/cbe/listing/monthly-statistical-bulletin/bulletin/april/monthly-statistical-bulletin-313.pdf">USD6.4 billion</a>&nbsp;in the 2nd quarter of the current fiscal year. Balance of trade may fluctuate due to the state&rsquo;s excessive reliance on imports, in addition to rising US interest rates and, in turn, a stronger dollar, which is the most common currency used in trade and the valuation of external debt.&nbsp;&nbsp;
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Net foreign assets (the sum of foreign assets held by monetary authorities and deposit money banks, less their foreign liabilities), with a deficit that stood at about&nbsp;<a href="https://www.cbe.org.eg/-/media/project/cbe/listing/monthly-statistical-bulletin/bulletin/april/monthly-statistical-bulletin-313.pdf">EGP280 billion</a>&nbsp;by the end of February 2023.&nbsp;
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When these two indicators register a sustained, significant deficit, it puts downward pressure on the value of the currency. This is currently what is happening in Egypt due to the&nbsp;<a href="https://www.madamasr.com/ar/2023/01/16/feature/%d8%a7%d9%82%d8%aa%d8%b5%d8%a7%d8%af/%d8%af%d8%b1%d8%a7%d9%85%d8%a7-%d8%a7%d9%84%d8%aa%d8%b9%d9%88%d9%8a%d9%85-%d9%88%d8%b9%d9%88%d8%af%d8%a9-%d8%a7%d9%84%d8%a3%d9%85%d9%88%d8%a7%d9%84-%d8%a7%d9%84%d8%b3%d8%a7%d8%ae%d9%86%d8%a9/">lack</a>&nbsp;of sustainable sources of hard currency and high liabilities and external debt service.
<img style="display: block; margin-left: auto; margin-right: auto;" src="https://mcusercontent.com/5e42bef7fee7e6a299c3d932d/images/f311421f-1bd2-d280-692f-9644e566d8ea.png" width="546" height="432">
<h3 dir="ltr">The gap between fair value and market value</h3>
According to financial researcher Abanob Refaat, an imbalance between supply and demand may generate a gap between the market value and the fair value of a currency. In the event of a market shock&mdash;for example, the sudden liquidity crisis resulting from foreign investors&rsquo; exit from Egypt&mdash;the demand for hard currency increases, along with its price, which drives a change in the price of the local currency to reach equilibrium.&nbsp;
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In the case of a flexible exchange rate, the price of the currency is automatically adjusted.&nbsp;
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In the case of a fixed or managed exchange rate, however, the central bank/monetary authorities might be slow at adjusting the price. A gap arises between the true exchange rate and the market rate, which speculators exploit for profit by buying and hoarding hard currency. This again drives up demand for hard currency (and its price), further exacerbating the imbalance between supply and demand and setting off a vicious cycle. To end such speculations, the central bank must have the flexibility to adjust the exchange rate, but in our case, the CBE is constrained by several factors: high dollar-denominated external debt, which came to USD162 billion at the end of 2022; a trade deficit (Egypt relies heavily on imports for many basic goods and production inputs); and inflation rates, which will increase if the pound is again devalued. Given the state&rsquo;s limited ability to control the markets, a devaluation will have severe social and economic impacts.&nbsp;
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Amid successive devaluations of the pound in recent years and high inflation&mdash;which the CBE is attempting to curb by raising interest rates&mdash;the market has contracted and the overall deficit has grown. To compensate for reduced growth and a higher deficit, the government has resorted to borrowing, which has led to increased dollar-denominated debt service and greater demand for the dollar, reducing the value of the pound. Experts believe that as long as loans are paid off with other loans, the value of the pound will keep falling and the vicious cycle will continue unbroken.
<img style="display: block; margin-left: auto; margin-right: auto;" src="https://mcusercontent.com/5e42bef7fee7e6a299c3d932d/images/82ec6807-543c-f3ed-5f29-bfada180bd80.png" width="546" height="432">
<h3 dir="ltr">Is the Egyptian pound undervalued? </h3>
The official market value of the pound currently <a href="https://www.cbe.org.eg/en/economic-research/statistics/exchange-rates">stands at</a>&nbsp;about EGP31 to the dollar. But the&nbsp;<a href="https://www.iif.com/About-Us">Institute of International Finance</a>, a global association of financial institutions that includes the world&rsquo;s biggest commercial and investment banks,&nbsp;<a href="https://www.iif.com/Publications/ID/5282/Egypt-Exchange-Rate-Pass-Through">estimated</a>&nbsp;the fair value of the pound in February at EGP24&ndash;26 to the dollar, which supports the claim that the pound is undervalued. Even so, many international reports and investment banks are still claiming the opposite and demanding a devaluation.
Geneina and Refaat agree that the discrepancy in the valuation of the pound is attributable to the moment in time in which the REER is calculated, in addition to the tendency of some financial institutions to rely on higher (and, they believe, more accurate) inflation rates than the official figure. That is, the calculation of the REER may be:&nbsp;
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Backward looking, meaning it relies on last year&rsquo;s exchange rate and inflation rates, which supports the claim that the pound is undervalued; or
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Forward looking, meaning it relies on the current exchange rate and projected inflation rates for the coming year, which supports the assertion that the pound is overvalued. The latter valuation rests largely on the high inflation seen in Egypt this year, which is expected to continue in the coming period.
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According to Refaat, investors are focused on the future fair value of the pound, which they expect to decline in the near future. Continued high inflation rates, coupled with the existence of an official and parallel exchange rate, will erode the value of their profits and investments. They therefore demand a devaluation.&nbsp;
Nafie believes that international banks, the holders of hot money (investors in domestic debt instruments), and those with foreign investments are pressing for a devaluation to maximize their returns. They therefore adopt the narrative, spun since 2015, that the Egyptian pound is overvalued. For them, international reports are more credible than Egyptian government figures.&nbsp;
Meanwhile Geneina thinks that credit ratings agencies and international financial institutions have only limited influence on the value of the pound. They may exploit the Egyptian fiscal authorities&rsquo; slowness in taking certain actions&mdash;selling assets, addressing the multiple exchange rates, instituting economic reforms&mdash;in order to increase the return on their present and potential investments, but the CBE and the government control over it are the principal determinants of the price and value of the Egyptian pound.&nbsp;
<h3 dir="ltr">Dollar liquidity as a critical factor </h3>
Experts agree that the question of the true or fair value of the pound will remain academic as long as dollars are in short supply&mdash;a crisis resulting from a fundamental weakness in the balance of payments and the flight of hot money in the wake of the Russian invasion of Ukraine, which depleted dollar reserves in banks. In short, the more constricted the flow of dollars, the greater the gap between the pound&rsquo;s fair value and its market value.
The Egyptian government is waiting for more hard currency to enter the market before moving toward a flexible exchange rate, seeking to sell more state assets through its IPO program before making any further adjustments to the exchange rate. But experts say that waiting is&nbsp;<a href="https://almanassa.com/stories/10791">fruitless</a>. Investors are still reluctant to invest, fearing that a devaluation of the pound will erode the value of any investments made now. Nafie points out that the foreign currency inflows that followed the 2016 float did not help stabilize the exchange rate. In fact, with every devaluation, Egypt has been forced to act by pressure&mdash;from a position of weakness and need rather than a position of strength. And every time, the devaluation comes too late and so does not bring long-term stability to the exchange rate.&nbsp;
The uncertainty is reflected in the parallel dollar exchange rates and the substantial demand for gold, as well as investors&rsquo; reluctance to purchase Egyptian assets and major investment banks&rsquo; pessimistic view of the economic situation in Egypt. Accordingly, hard currency inflows remain just out of view, waiting for a better exchange rate to appear. And the longer it takes to sell assets and find sources of dollar liquidity, the higher the cost of restoring confidence and putting things back in order. Meanwhile, the value of the pound continues to slide.
<img style="display: block; margin-left: auto; margin-right: auto;" src="https://mcusercontent.com/5e42bef7fee7e6a299c3d932d/images/d7c80fdc-c690-5313-ecc3-90dc2065eee2.png" width="546" height="432">
There are also&nbsp;<a href="https://www.cbe.org.eg/en/economic-research/sdds">indications</a>&nbsp;of a domestic lack of confidence, which is further exacerbating the dollar liquidity crisis. It is estimated that Egyptians hold at least USD10 billion outside the official banking sector, based on the following:&nbsp;
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<li style="text-align: justify;">A 23%&nbsp;<a href="https://www.cbe.org.eg/en/economic-research/sdds">decline</a>&nbsp;in remittances from abroad in the first half of the current fiscal year, valued at USD5 billion. Remittances grew at a rate of more than 10% from FY2015/16 to FY2021/22. Assuming the same rate of growth, that would put the total at USD17 billion this year, instead of the actual sum of USD12 billion.&nbsp;</li>
<li style="text-align: justify;">A&nbsp;<a href="https://www.cbe.org.eg/en/economic-research/sdds">decline</a>&nbsp;in dollar deposits&rsquo; growth in the households banking sector, equivalent to USD5 billion. Such deposits used to account for 65&ndash;70% of all deposits, but now make up only 59%, and they have seen no notable increase throughout the year.&nbsp;</li>
<li>The massive demand for gold. The&nbsp;<a href="https://www.gold.org/">World Gold Council</a>&nbsp;estimates that Egyptians purchased more than 56 tons of gold from April 2022 to March 2023.&nbsp;</li>
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<h3 dir="ltr">What does the Egyptian pound need?&nbsp;</h3>
<a href="https://www.alaraby.co.uk/economy/%D8%A5%D9%84%D9%89-%D9%85%D8%AA%D9%89-%D9%8A%D8%B3%D8%AA%D9%85%D8%B1-%D8%A7%D9%86%D8%AE%D9%81%D8%A7%D8%B6-%D8%A7%D9%84%D8%AC%D9%86%D9%8A%D9%87-%D8%A7%D9%84%D9%85%D8%B5%D8%B1%D9%8A%D8%9F">Uncertainty and declining confidence</a>&nbsp;are fueling speculations against the Egyptian pound as investors test the credibility of the CBE&rsquo;s currency policy, putting more downward pressure on the pound. Experts say that restoring confidence in the local currency requires the proven ability to attract liquidity and sustainably generate revenues through a strong private sector. This will not be achieved absent genuine reforms geared to creating a value-added economy that can bring in foreign and domestic investments in Egypt, support export-oriented industries and boost their competitiveness, and attract tourism as a stable source of hard currency by providing the necessary basic infrastructure.&nbsp;
Despite the expert consensus that the pound may be undervalued, another devaluation is inevitable given the grinding dollar liquidity crisis, but as is true with every round of devaluation, it will not offer a sustainable solution over the short or long term.
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