Decomposition of the Sources of Real Exchange Rate Misalignment in Egypt: Evidence from the ARDL Model

Rana Hosni

doi:10.15388/omee.2021.12.58

Abstract

   This paper examines the behavior of the real exchange rate in Egypt over the period 1965–2018 by attempting to pursue three interrelated purposes. The first is to investigate the extent of deviations between the actual exchange rate and its equilibrium level and illustrate the magnitude of any currency misalignments. The second is to search for the different phases of over- and undervaluation of the local currency and explain the accompanying economic policies and/or factors leading to them. The third and ultimate purpose is to explore the role of transitory and permanent factors in deviating the actual real exchange rate from its equilibrium level. Understanding these factors should help in the design of economic policies directed to address the misalignment of the local currency. An autoregressive distributed lag (ARDL) bound test approach is used and conducted for both the bilateral and effective real exchange rates to achieve these three purposes during the selected period. To derive the equilibrium exchange rate estimate, the behavioral equilibrium exchange rate (BEER) approach is adopted. The findings reveal that the Egyptian pound was misaligned from its equilibrium value during most of the examined period. The results confirm the relative importance of the terms of trade and degree of openness variables in determining the equilibrium real exchange rate in Egypt followed by investment ratio and government consumption variables. The local currency witnessed a recent phase of overvaluation, which began in 2009, until the free float of the local currency in November 2016, after which, the Egyptian pound was found to have experienced a new phase of undervaluation till the end of the period examined. The findings show a considerable relative impact of fundamental-based factors over a prolonged period spanning from 1986 to 2003 and at the end of the period examined as well. Moreover, the documented results lend general support to the fact that both permanent or fundamental-based factors and short-run shocks prove to be important influential factors impacting currency misalignment in Egypt.  

Highlights

An economy’s real exchange rate is a critical economic indicator since it links the domestic economy with the rest of the world
Using the vector-error correction model (VECM) and employing the productivity, government consumption, trade openness, real GDP per capita and net foreign assets variables, the results indicate a light undervaluation of the Malaysian Ringgit
The lag length on the extra terms can be determined by data dependent methods such as the Akaike Information criterion (AIC) or Schwartz Bayesian criterion (SBC)

Summary

Introduction

An economy’s real exchange rate is a critical economic indicator since it links the domestic economy with the rest of the world. Real exchange rate plays a pivotal role in impacting a country’s economic growth and competitiveness in the international markets. Any country should seek the right level of its exchange rate – that is, the equilibrium exchange rate. Deviations of the actual exchange rate from the equilibrium level can signal crucial information to policymakers, central banks and financial institutions. Any misalignment may indicate future probabilities of currency crises that can lead to realignments of the exchange rate at the end (Holtemöller & Mallick, 2013; Giannellis & Koukouritakis, 2013). G., overvalued) exchange rate, which may lead to speculations by foreign investors who start an attack on the domestic currency. Extended phases of overvaluation and undervaluation of the local currency can have vast social effects in the economy

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Conclusion