How the Egyptian pound is affected by interest and inflation rates!

How does the Central Bank of Egypt (CBE) think? What is the relationship between interest rates, inflation rates, and exchange rates? How does all of this affect the Egyptian pound?
By Markets Chimp

7/15/17 5:44 PM

Mahmoud Gad, CMA

This is the first of a series of articles in which I will examine the exchange rate of the US dollar against the Egyptian pound and try to explain how inflation and interest rates in Egypt and the United States can be affected, and how this could affect exchange rates between the two countries.

 

Again, the CBE raises interest rates, by 200 basis points …

On Thursday, 6 July 2017, the CBE decided to raise interest rates by 200 basis points (i.e. 2%). This is the third hike since the floatation of the Egyptian pound versus the US dollar on 3 November 2016—a total of 700 basis points. Accordingly, deposit and lending rates reached 18.75% and 19.75%, respectively. This is double the interest rates before March 2016.

… to achieve the same results desired previously

The CBE is targeting by its latest decision, which it described as “temporary”, to (1) curb the expected inflation after the recent reduction in fuel and electricity subsidies and higher value-added tax (VAT) and (2) to maintain the purchasing power of the Egyptian pound. The CBE announced in May 2017 that, by raising interest rates, it aims to reduce inflation rates to 13% (± 3%) by the fourth quarter of 2018. It is worthy to mention that headline inflations reached 29.8% in June 2017, compared to 30.6% in May 2017.

 

The US dollar versus the Egyptian pound remained with the EGP18.00-18.20 range during the last three months before declining since the first of July below EGP18 to reach EGP17.85-17.96.

 

For more analysis about the reasons behind CBE’s decisions and its expected impact of raising interests on investment decisions, please read Markets Chimp article titled What does the Central Bank of Egypt want to do? published on 11 July 2017, my article titled How investors can reap the fruits despite the thorns? published on 18 June 2017, and my article titled Investors' dream of La-La Land in Egypt, despite CBE decisions! on 11 June 2017.

 

But what is the relationship between interest rates, inflation rates, and exchange rates?

The International Parity Relationships and Forecasting FX Rates

According to the international parity relationships, when comparing two countries (e.g. Egypt and the United States):

  • Interest rates differential between Egypt and the United States should reflect the expected inflation rates differential between the two countries. This is known as International Fisher Effect (IFE).
  • Expected future spot rate of the US dollar versus the Egyptian pound should reflect the expected inflation differential in both countries. This is known as Relative Purchasing Power Parity (RPPP).
  • Expected future spot rate of the US dollar versus the Egyptian pound should reflect the interest rate differential between the two countries. This is known as Uncovered Interest Rate Parity (UIRP).
  • The difference between a forward contract exchange rate and the current spot rate for the US dollar versus the Egyptian pound should be equal to the interest rate differential between the two countries. This is known as Covered Interest Rate Parity (CIRP). Therefore, if the forward contract exchange rate is equivalent to the expected future spot rate, then the forward rate is an unbiased or of the future spot rate (i.e. no arbitrage). If this not achieved, there is an opportunity for the arbitrage which would push the forward contract exchange rate to the “no-arbitrage” level.

The figure below illustrates the international parity relationships:

 

In my next articles, I will try to use these theories to assess the current interest rate in Egypt and how it is appropriate with the expected inflation rate and, hence, forecasting the exchange rate of the US dollar versus the Egyptian pound within 12 months. It is worth noting that these parties are more useful in forecasting long-term exchange rates.

Could these theories, practically, be applied to Egypt?

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