In recent years, the traditional framework of exchange-rate depreciation and its impact on export volumes has been called into question.
The notion that a depreciation in the exchange rate will always lead to an increase in export volumes has been challenged by the dominant currency pricing (DCP) literature. This literature was introduced into the macroeconomic model for the global economy by the European Central Bank (ECB) in 2019 and was discussed in detail in the International Monetary Fund (IMF) working paper WP/22/24.
The DCP literature suggests that when goods are priced in a dominant currency such as the US dollar, exchange-rate movements no longer have an effect on export volumes. This is because even if the domestic currency depreciates, the prices of exported goods remain unchanged in the dominant currency. As a result, the price competitiveness of exports will not improve, limiting the potential for export volume expansion.
The extensive use of the US dollar in setting prices for international trade, regardless of the origin or the destination of trade flows, mutes the reaction of export volumes to exchange-rate movements.
Applying this paradigm to the Egyptian case reveals a stunning confirmation of it, as Egypt’s balance-of-payment figures echo its predictions with solid precision. The major sources of foreign currency receipts in Egypt, which include workers’ remittances, tourism, Suez Canal revenues, and exports of manufactured goods and oil, are either unresponsive or have a limited response to exchange-rate changes.
The revenue generated from the Suez Canal provides a case in point where demand is not influenced by changes in the pound’s exchange rate. The canal tolls are typically priced in US dollars. As a result, fluctuations in the exchange rate of the Egyptian pound do not have any impact on the revenue earned. Instead, the revenue is primarily determined by the volume of international trade passing through the canal. A devaluation of the pound, therefore, will not affect the revenue earned from the canal.
Workers’ remittances also illustrate this point. Their limited response to the 2016 devaluation is indicative of their relative independence to changes in the exchange rate. They increased slightly in the fiscal year 2016-17 to $17.4 billion from $17.08 billion in the previous year. This increase amounts to just $276 million, representing a negligible impact of 1.6 per cent in response to the about 50 per cent decline in the pound’s value.
The devaluation of March 2022 had a similar impact on workers’ remittances, as Central Bank of Egypt (CBE) figures show minor increase of $437 million in the first half of 2022 and even a decline of $3.6 billion in the second half of 2022, calculated on a year-to-year basis.
Tourism revenue and how it is impacted by the pound’s devaluation should be considered with utmost caution. Following the sharp devaluation in November 2016, tourism revenues increased by 16 per cent from $3.8 billion in 2015-16 to $4.4 billion in 2016-2017. The March 2022 devaluation was followed by a boost in tourism revenues of 60 per cent in the first quarteer of 2022 and 96 per cent in the second quarter, but it can not be attributed solely to the devaluation. The improvement in security conditions and the lifting of the travel ban by Russia are significant factors that have contributed to the increase. Tourism revenues are influenced by multiple factors, and the interaction of these factors contributes to its growth, and the currency devaluation is just one of those factors. The revenue from the exports of goods contains a significant portion (40 per cent in 2021-22) that comes from oil and gas exports, which are priced in dollars and are therefore unresponsive to exchange-rate movements. The remaining 60 per cent represents receipts of exports of goods that incorporate a significant portion of imported raw materials or intermediate goods. A devaluation will increase the cost of these inputs, further impacting the profitability and competitiveness of the exported goods.
A devaluation will also have a negative impact on the pricing of any state-owned enterprises that are planned to be sold. When the pound is devalued, the conversion of foreign currency revenue into the devalued pound will result in lower foreign currency revenue from selling these enterprises.
On the other hand, demand for imports has low price elasticity because of the nature of imported goods and services. Imported goods are either essential (such as food, medicine, and intermediate goods) or non-essential (such as consumer durables). Demand for the former is rigidly inelastic, and demand for the latter is, surprisingly, inelastic as well. The reason is that non-essential goods are deemed essential by some segments of the upper income group.
Sharp increases in the price of certain goods like cars, clothes, and electrical equipment do not bring about the normal reaction, i.e. a decrease in demand. We may even come across certain goods whose demand increases in response to an increase in their price, a phenomenon known in economics as Veblen goods. This may be attributed to the fact that the higher prices of Veblen goods make them more desirable as status symbols in the practices of conspicuous consumption and conspicuous leisure. Apparently, devaluation will never reduce demand for these goods.
Another devaluation of the pound, therefore, will not improve the country’s foreign currency receipts. Nor will it reduce outlays on imports. But the story does not end here, because there are other drawbacks of such a devaluation, particularly given its impact on the value of incomes and savings.
In an inflationary environment, rising prices will erode the purchasing power of consumers, which has a significant impact on everybody, especially wage earners and pensioners. This deepens existing levels of poverty and inequality, potentially leading to social unrest. To mitigate the impact of a devaluation and inflation on vulnerable groups, the government will most likely step in to implement measures in the form of subsidies. However, these would require increased government spending, further worsening the fiscal deficit.
A further devaluation would also inflate public debt because a major part of this is denominated in foreign currencies, mainly the US dollar. When the pound is devalued, the conversion of foreign currency debt into the devalued domestic currency will result in an increase in the debt burden, and in turn the amount of domestic currency required to service the foreign currency debt increases, straining government finances.
The latest published figures of Egyptian public debt in foreign currencies that put it at $163 billion in December 2022 mean that each one pound increase in the price of a US dollar will result in an increase of LE163 billion in the public debt and a corresponding increase in the debt-to-GDP ratio.
It is evident that a further devaluation of the Egyptian pound will not lead to the contemplated benefits and will instead bring about numerous drawbacks. The belief that a devaluation will enhance exports, reduce imports, and address the balance-of-payments gap is not supported by realities on the ground. Therefore, policymakers, in their pursuit of a decision in this regard, must tread with the utmost caution and exercise thoughtful deliberation.
They should consider the broader implications of any further devaluation on the economy, social stability, and the well-being of the population.
*The writer is a banking consultant.
* A version of this article appears in print in the 15 June, 2023 edition of Al-Ahram Weekly
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