By Markets Chimp

7/19/17 1:52 AM

**Mahmoud Gad, CMA**

**This is the second 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.**

Here is the link to our last article titled How the Egyptian pound is affected by interest and inflation rates! dated 15 July 2017.

**Real Interest Rate Parity (RIRP)**

According to **Real Interest Rate Parity (RIRP)**, real interest rates should converge among different countries. Therefore, the equation is as follows:

Real interest rate in Country A = Real interest rate in Country B, where:

Real interest rate = Nominal interest rate — Inflation rate

*Source: Schweser*

Nominal interest rate is the rate declared by banks, which depositors receive on their deposits.

__Example:__

If a basket of goods was sold at the beginning of the year for EGP1,000, then its price reached EGP1,070 at the end of the year, this means that inflation rate is 7%.

Instead of buying this basket at the beginning of the year, if you deposit the same amount at the bank at an interest rate of 10% per annum, which is the nominal interest, you will receive at the end of the year a return of EGP100 for a total amount of EGP1,100.

Now you have EGP1,100, and the basket price is EGP1,070. After you buy the basket of goods, you will save with EGP30, so the real interest you earned from your investment is 3% (30 ÷ 1,000), which is the difference between the nominal interest rate and the inflation rate (10% — 7%).

**International Fisher Effect (IFE)**

According to IFE, the difference between nominal interest rates in two countries should converge with the difference between inflation rates in both countries.

Using the RIRP equation,

Real interest rate in Country A = Real interest rate in Country B

We can reformulate it as follows:

Nominal interest rate in Country A — Inflation rate in Country A = Nominal interest rate in Country B — Inflation rate in Country B

or

Nominal interest rate in Country A — Nominal interest rate in Country B = Inflation rate in Country A — Inflation rates in Country B

This is known as International Fisher Effect (IFE).

*Source: Schweser*

**How can we use IFE to examine the relationship between interest and inflation rates in Egypt and the United States?**

According to the following assumptions, we will examine the impact of IFE on Egypt and the United States over the next 12 months:

**Expected inflation rates in Egypt within 12 months:**

In our earlier article titled How investors can reap the fruits despite the thorns? published on 18 June 2017, we discussed how the increase in interest rates led to an increase in the internal rate of return for investment, which would keep inflation rates in 2017 and 2018 between 20% and 35% (at growth rates of demand between + 5% and -5%). This means an average of 27.5% in both years, and these are the inflation rates we expect to see in the next 12 months.

**Expected inflation rates in the United States within 12 months:**

Inflation in the United States is expected to average 2.52% in 12 months (2017 and 2018 inflation at 2.65% and 2.38% respectively, IMF estimates).

**Interest on one-year Egyptian T-Bills:**

The average yield on one-year Egyptian T-Bills was around 21% before the recent increase in interest rates. Adding the 2% increase, we assumed that the return would be around 23%. It is worthy to mention that the average yield on one-year Egyptian T-Bills reached recently, after the recent increase in interest rates, 22% for accepted bids, while the maximum yield for submitted bids was 23.5%.

**Interest on US Treasuries for the year:**

The US Treasury yield is 1.2%. Source: Bloomberg.

*Accordingly:*

Nominal interest rates in Egypt - Nominal interest rates in the United States = Inflation rates in Egypt - Inflation rates in the United States

23.0% - 1.2% should equal 27.5% - 2.5%

21.8% should equal 25.0%

The imbalance is evident, as we expect a difference of 3.2%, which means a difference in real interest rates between the two countries by 3.2 percentage points. Since the theory of real interest rates requires convergence rather than equality of real interest rates between countries, we note that the difference is not large, compared to the histrorical real interest rate differential between the two countries at an average of 1.6% during 2009-2016, which means to some extent the existence of this convergence. We note a sharpe decline in real interest in Egypt in 2017.

However, assuming we need to achieve the equality, this difference implies (1) that the CBE's estimates of inflation for the next 12 months are 24.3%, lower than our expectations, or (2) assuming our expected inflation rate in Egypt, yields on one-year Egyptian T-Bills would reach 26.2%.

**Sensitivity Analysis**

The following is a sensitivity analysis, which shows the yields on one-year Egyptian T-Bills, which are supposed to be realized at different rates of inflation:

We conclude that yields on one-year Egyptian T-Bills, according to IFE, are supposed to reach a range of 19.5% and 26.5% at inflation rates between 20.5% and 27.5% over the coming 12 months. So, when the inflation rates reach the CBE’s targete of 13% (± 3%) by the fourth quarter of 2018, we expect that the CBE would lower the interest rates in order to achieve yields on one-year Egyptian T-Bills down to 12% (± 3%).

Eventually, according to IFE, the higher the expected inflation rate in a country, the higher interest rates will be required in that country. This means that expected inflation rate is the driver for moving interest rates, not vice versa. So, why does the CBE consider raising interest rates as a tool to curb inflation?

In my opinion, as higher inflation leads to lower real interest rates, the decline in real interest would push current and/or potential depositors to save less. Instead, they would use their money to buy goods that are expected to see their prices increase, to maintain the purchasing power of their money. This would increase demand and thus increase inflation more than expected.

Given the example above, if the price of the basket is expected to reach EGP1,120 at the end of the year, the total amount of EGP1,100 with you will not be enough to buy that basket. The real interest became -20% after it was +30%. Accordingly, it is better for the depositor not to deposit his or her money (EGP1,000) with the bank but instead to buy the basket today (at EGP1,000).

**Does the CBE really follow the IFE in setting the interest rates?**

Now, how do (1) expected inflation rates and (2) interest rates in Egypt can affect the US dollar against the Egyptian pound? This is what we will examine in our next articles.

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