Much ado about the Egyptian pound: Exchange Rate Misalignment and the path towards Equilibrium

This paper estimates Egypt’s equilibrium real exchange rate and exchange rate misalignment based on economic fundamentals over the period 2001Q3-2017Q3. Focusing on the more recent period, we find that the Egyptian pound was undervalued by about 22.3 percent in 2017Q1 due to overshooting its equilibrium value after floating the currency in 2016Q4. The currency undervaluation then declined to 18.5 percent in 2017Q3 driven by an increase in the real effective exchange rate due to a surge in domestic inflation. With regard to the determinants of the equilibrium real exchange rate, we find the productivity differential (vis-à-vis Egypt’s trade partners) and trade openness to be the most significant factors. We also provide projections for the equilibrium real exchange rate and exchange rate misalignment until 2020Q4, which reveal that the exchange rate undervaluation will be dissipating fast due to high inflation. If the nominal exchange rate stabilizes at its level in 2017Q3 (17.73 pounds per US dollar), the currency will be overvalued by 13.1 percent in 2020Q4. Given the uncertainty surrounding the projections, a forecast combination approach is also presented. Finally, the paper highlights the implications of the empirical findings for the conduct of monetary policy in Egypt.