Predicting the currency crisis: Could Egypt’s “November 2016” have been foreseen?

(Photo courtesy of epSos.de)

The devaluation of the Egyptian pound in November 2016 was accompanied by a severe drop of foreign currency in the country. Reserves were dwindling as subsidies were cut and prices rose, while the exchange rate of the Egyptian pound against the US dollar neared the LE20 per $1 mark. Hence, a currency crisis was in place – namely a severe depreciation of the currency, preceded or accompanied by a drop in foreign reserves. But could this crisis have been predicted? .

In their research paper “Identifying currency crises indicators: the case of Egypt”, John Adams and Ali Metwally from the Department of Economics at the British University in Egypt (BUE) aim to establish which economic variables are more useful in predicting currency crises by looking into the country’s annual data and indicators from 1977-2017.

According to the authors, the crisis of 2016 “perhaps could have been avoided or at least ameliorated by better understanding of how such crises develop”.

Egypt’s history of currency crises
Between 1977 and 2017, Egypt witnessed five currency crises. The ones in 1979 and 1989 were caused by a severe devaluation of the local currency, while switching to a flexible exchange rate regime caused the crises in 2003 and 2016. In 2011, the prolonged depletion of foreign reserves and the political instability that came with the January 25 Revolution were behind the depreciation of the currency.

What can different indicators reveal?
The five variables that are deemed to best predict a currency crisis are the domestic interest rate spread, domestic current account, interest rates of the United States (US), real exchange rate (RER) and the real interest rate (RIR), according to the paper. However, there are a number of other indicators that can signal the phenomenon (Click on infograph to enlarge):

What could be done in the future?
The authors suggest that “policy makers, in particular the Central Bank of Egypt (CBE), should take into consideration these indicators […] before implementing any policy that could ‘agitate’ them, raising the probability of speculative attacks and ending in a currency crisis that cannot be contained.”

Hence, these indicators should be monitored on a continuous basis. Adams and Metwally recommend that should the CBE update its monitoring and tracking system accordingly, the issue of central bank independence needs to be re-discussed by the government.

The research paper can be found here.

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