Exchange rate misalignment in Egypt

This dissertation presents an empirical investigation of the behavior of the real exchange rate and extent of exchange rate misalignment in Egypt. Two behavioral-based models of equilibrium real exchange rate determination are estimated. First, we use the Equilibrium Real Exchange Rate single-equation approach due to Edwards (1988). The analysis in Mongardini (1998) for the period 1987-1996 is replicated and extended to 2005. Our results for the earlier estimation suggest that real exchange rate appreciation is associated with an improvement in the terms of trade, an increase in government consumption, a reduction in the debt service ratio, a decrease in the degree of exchange rate controls, and to a lesser extent with productivity growth. Based on the derived equilibrium real exchange rate, the results show a modest undervaluation in the real exchange rate between 1987 and 1992, and an overvaluation between 1993 and 1996. The model performs poorly when the estimation period is extended to 2005. Second, we use the Behavioral Equilibrium Real Exchange Rate (BEER) approach due to Clark and MacDonald (1998) for the period 1987-2006, and derive a decomposition of the transitory and fundamentals-induced components of misalignment. The results suggest that the behavior of the real exchange rate can be explained by the relative terms of trade, relative productivity growth, and the real interest rate differential, and to a lesser extent by relative government debt and net foreign assets. Our results using recursive cointegration analysis due to Hansen and Johansen (1999) show the relationship between the real exchange rate and the explanatory variables to have increased over the estimation period. The estimated behavioral equilibrium real exchange rate shows two distinct episodes of overvaluation: 1987-1991 and 1995-2002, and an undervaluation between 2003 and 2006. The adjustment parameter suggests relatively slow speed of adjustment of the real exchange rate to disturbances. Until 2003, misalignment in the real exchange rate appeared to be driven almost equally by both transitory factors and misaligned fundamentals, but mainly by transitory factors thereafter.