How do banks currently determine the exchange rate? If the Egyptian pound was tradable in the forex market like the dollar, euro or yen, it would have been much easier to grasp. Currencies listed in the forex market get bought and sold by individuals, entities, investors, companies, banks, and central banks; accordingly the announced exchange rate is a combination of several economic and financial views that leads to the depreciation, stability, and appreciation in the value of the currency. However, the Egyptian pound is not tradable in the forex system, so after the flotation, who sets the USD/EGP rate? How? And on what basis? On 3 November 2016, the Egyptian central bank announced the liberalisation of the exchange rate, saying that “the exchange rate is now liberalised in order to give banks more flexibility to set the prices for selling and buying foreign currencies,” and “now Egyptian banks are fully responsible for the foreign currency market.” When banks are given the responsibility to set the exchange rate and the foreign currency market becomes their main responsibility, one must pause and fully grasp how this is done. Are there any financial/econometric models that give a currency estimate when banks plug in the inflow and outflow of dollars? Or is it subject to individual judgement of people working at banks, such as dealing rooms and specifically forex trading desks? If it is subject to individual judgements, what do such efforts include? Do they include a deep, fundamental analysis of the medium or long-term economic situation? Or is it an event-based action that is prompted by a short-term view? If we have a closer look at the exchange rate fluctuations from 3 November until today, the answer would be: it is subject to individual judgments that are stirred by the short-term view -- and this is worrying. Exchange rate fluctuations since the flotation The exchange rate fluctuated, and wasn't not volatile because volatility means a lower range of movement, several times since 3 November in a bizarre illogical way. The exchange rate passed through six major rounds, starting with the pound depreciating by 22 percent from 3 to 8 November, then appreciated by around 15 percent from 8 to 15 November, and then depreciated once again by 20 percent from 15 November to 20 December, and stayed at that level until 1 February of this year. During the last two rounds, the pound appreciated by 20 percent from 1 to 23 February, approaching the final round, the current one, with a reversal, an 11 percent depreciation. All of this happened in just four months. Leading indicators generally forecast what will happen in the future, and the exchange rate is one of such leading indicators. The rate appreciates or depreciates in expectation of a better or worse economy, just like when the black market started to appear in 2015, before the economy worsened in 2016. So for the pound to witness such fluctuations, it only means that those who set the exchange rate have changed their forecasts of the Egyptian economy from optimistic to pessimist five times in a row! Currencies appreciate or depreciate by such magnitude only during major events, such as the UK's Black Wednesday in 1992, Brexit, the 2008 financial crisis etc, but not due to a mere inflows and outflows of a couple of billion dollars in an economy that has an import bill of around $90 billion. By all means, this is illogical and can't be scientifically true, because the Egyptian economy's outlook hasn't changed since flotation day in any way that would explain such fluctuations. The only explanation for these fluctuations is that the banks' strategy for forex pricing was affected by short-term events, and they thus appreciated the currency when inflows occurred and depreciated when outflows occurred, regardless of the future economic outlook. The risk of an economic pause Some don't comprehend the economic damage that such fluctuations might precipitate. When there is future economic uncertainty and especially exchange rate uncertainty, the supply side of the economy, ie factories and producers, face major difficulties in determining their raw material input prices, which makes it extremely risky to put down a certain price for the product. They therefore choose either to stop production and hold their inventory until the future is clearer, or to implement price premiums to hedge against any exchange rate fluctuations. As for the demand side, during uncertain times, consumers tend to have varying views regarding the forex rate , which greatly affects their consumption patterns; some might prefer to wait for a lower rate while others prefer to consume now. Producers and consumers end up with numerous economic views, and demand and supply side may never meet in the midst of such different views. This causes what is called “an economic pause”. This is different to a recession, which is driven by a lower purchasing power or a supply side shock; an economic pause is driven by a clear choice on the part of producers and consumers to willingly not consume or produce. Getting out of an economic pause is much harder for an economy than escaping recession because the psychological part becomes the main player and it becomes very difficult for the state to change it. Thus it is always preferable not to reach such an economic pause, by having a stable forex price. A way forward - an exchange rate committee If banks set the exchange rate prices based on a short-term view regardless of the medium or long-term aspect, thus causing such major fluctuations, this puts the Egyptian economy in a critical situation that could get worse. We therefore need to ask ourselves if the current exchange rate mechanism is accurate, and if it is not, what is the solution? One possibility would be a new Egyptian exchange rate committee. It would be formed of 22 members -- five economists, five representatives of the export industry, five representatives of the import industry, representatives of the five largest banks in Egypt, a central bank representative, and a government representative. Economists would set the future outlook of the Egyptian economy for the medium and long-term, and draft a base case scenario for the coming 6-12 months, putting all assumptions into consideration, and logically such an outlook would not change unless major developments occur. Those six economists will also set their currency estimates based on their outlook. The 10 representatives of the export-import industry will also set their currency estimates based on their views regarding the consumption patterns inside and outside Egypt. The bank representatives would also set their estimates, which would allow them to handle the tactical movements of the exchange rate on the short-term. The central bank and government representatives would also set their currency estimates. An average of the 22 currency estimates would then be calculated and used as a currency guideline by banks. Banks would be allowed to manoeuvre the guideline by a range of 10 percent. The exchange rate committee would meet twice a month initially, and after six months in place, it would only meet on a monthly basis, to discuss major updates. An emergency meeting could also be called when needed to discuss unforeseen events. The outcome of such a committee accounting for all participants' views and inputs would be a closer estimate of the pound's fair value, allowing it to settle with a lower range of volatility, which is driven by known seasonal effects. Formation of the exchange rate committee does not oppose the free float principle; the work of such a committee would continue until the economy reaches a more stable and mature level, and then this committee would take on an advisory role. Unusual events require unusual measures. Noaman Khalid is a macroeconomist at CI Capital Asset Management (CIAM)
