On Egypt's de facto integration in the international financial market

Abstract

This study explores whether Egypt has become de facto perfectly integrated in the international financial market following the steps taken towards the de jure liberalization of the capital and financial accounts of the balance of payments since the early 1990s. It does so by running two empirical tests, namely, the uncovered interest parity and the monetary autonomy tests using monthly data for the periods January 2000–December 2011 and July 2004–June 2008. The outcome of both tests indicates that during the periods under investigation, Egypt has maintained imperfect de facto integration in the international financial market, despite the de jure financial openness. To explore the reasons behind such imperfect de facto integration, the study estimates a vector error-correction model (VECM) using quarterly data for the period 2001/2002–2010/2011. According to the variance decompositions generated from the VECM, high inflation rate in Egypt has been a major contributor to the variability of the spread between interest rates on domestic and foreign financial assets, and thus could be deemed as a culprit behind Egypt's imperfect de facto integration.

Keywords:

• de facto international financial integration
• vector error correction model
• granger-causality
• uncovered interest parity
• monetary autonomy
• impossible trinity

Acknowledgments

The author is very grateful to Professor Peter Montiel, Williams College, who was the supervisor of unpublished academic work upon which this paper builds. Thanks go to Professor Peter Pedroni, Williams College, and Professor Alaa El Shazly, Cairo University, for useful discussions on empirical issues, and to Professor Omneia Helmy, Egyptian Center for Economic Studies and Cairo University, as well as Dr. Magda Kandil, International Monetary Fund, for helpful remarks, and to Dr. Hoda Selim, Economic Research Forum, for sharing useful resources, and to Dr. Salwa El-Antary for important clarifications regarding the history of Egypt's financial system, and to two anonymous referees for constructive comments and suggestions. Any errors remain the responsibility of the author. Comments and suggestions are welcome at [email protected].

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. A country's de facto financial integration may deviate from its de jure status. According to Bekaert and Harvey (1995), markets may turn out to be more financially integrated than one might expect based on prior knowledge of capital restrictions.

2. The Capital Openness Index is based on the binary dummy variables that codify the tabulation of restrictions on cross-border financial transactions reported in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). The index is the aggregation of the dummy variables that are assigned to the four major categories of the restrictions on external accounts (1) multiple exchange rates; (2) restrictions on current account transactions; (3) restrictions on capital account transactions; and (4) surrender requirements of export proceeds. Starting 1996, the IMF switched from binary coding to a disaggregated coding. The lowest aggregate score reflects presence of restrictions in all categories of restrictions on external accounts, and vice versa (Chinn & Ito, 2008).

3. In 2003, a special exchange rate (of LE 5.35 per $1) applicable to key imported foods was introduced. Also, private and state-owned exporting companies were required to sell at least 75% of their foreign currency earnings to state-owned banks. Foreign investors’ remittances of profits and dividends were made subject to delays.

4. Treasury bills were first introduced in 1991 on a weekly auction basis. The objective was to initiate a market mechanism to determine interest rates, introduce an instrument to regulate banks' reserves, and absorb excess liquidity as well as dampen the impact of capital inflows (i.e. sterilization), besides financing the budget deficit (Al-Mashat & Billmeier, 2007; El-Refaie, 2002).

5. It is worth noting that domestic interest rates shot upwards following the financial liberalization reforms that were undertaken in the early 1990s (Abdel-Khalek, 2001). Also, the Central Bank of Egypt maintained a tight monetary policy under ERSAP, and thus there was a positive and noticeable differential between Egyptian and developed countries' interest rates (El-Refaie, 2002).

6. Monthly data for the 3-month Egyptian Treasury bill rate are available from the Central Bank of Egypt (upon request) starting from fiscal year 1996/1997.

7. ‘Asset pricing' can be considered another strand of literature on the study of international financial market integration. According to Bekaert and Harvey (1995), asset pricing models assume that capital markets are either totally segmented, or perfectly integrated, or in between the two poles. ‘Capital Asset Pricing Models (CAPM)' are tested in case the market is assumed to be segmented. ‘World CAPM', ‘CAPM with exchange rate risk', and the ‘World Arbitrage Pricing Theory' are among the models tested in case the market is assumed to be integrated. Finally, the ‘Mild segmentation model' assumes that the market is partially integrated/segmented. These models have limited applicability when trying to assess international financial integration in the context of macroeconomic management.

8. See Montiel (1994) and Frankel (1996) for a review of other popular methodologies for empirically measuring international financial integration.

9. Equation (1) is an alternative representation of the UIP condition. Another representation is as follows:

in which case the UIP condition would consist of testing the joint hypothesis that a = 0 and b = 1 (Chinn & Meredith, 2004).

However, we use the specification derived from Equation (1) above, as we are interested in the responsiveness of the domestic interest rate against changes in the exchange rate-adjusted foreign counterpart.

Further, for the Egyptian case, it is shown in Table 1 below that the term (S_t+1 − S_t) is stationary, whereas the term (i_t − i_t*) is non-stationary, therefore the UIP condition cannot be tested in the fashion just described here.

10. For example, if we are considering the 3-month Treasury bill rate, then k is equal to 3.

11. Cheung, Chinn, and Fujii (2006) also test for other criteria of integration, namely, real interest parity and real purchasing power parity. But we focus solely on their findings in the UIP test as they are the most relevant to this study.

12. Unit of expansion here means: expansion of domestic credit by one unit of domestic currency.

13. They argued that

[e]ven if the interest rate is not the primary instrument of monetary policy, it should be directly affected by monetary policy changes, and thus would still serve as a measure of the stance of policy. If the interest rate is insulated from global market conditions by capital controls, this is important as well in that it demonstrates how capital controls can allow monetary autonomy and a fixed exchange rate to exist simultaneously.

14. Discussion of data sources and issues is deferred to Appendix 2.

15. This piece of information is useful for the cointegration/VECM analysis that is conducted in this study (the third empirical test), as the spread between the Egyptian and US 3-month Treasury bill rate (i – i*) enters the cointegration /VECM as the variable of interest, in the investigation of the reason behind the imperfect level of Egypt's international financial integration.

16. Selim (2012b) provides empirical evidence that Egypt's exchange rate has been de facto fixed years after the announced floatation.

17. That the ‘conduct of monetary policy is complicated by capital mobility' is a recently oft-cited argument (for example in: International Monetary Fund (IMF), 2009, 2010 Article IV consultation, p. 17 and p. 5, respectively)

18. In this part of the empirical analysis, the interest rate differential is calculated as the spread between the domestic and foreign interest rates (i – i*). As mentioned earlier in the empirical section, it is the interest rate spread that is responsible for the non-stationarity of the exchange rate-adjusted interest differential (see footnote 15).

19. The seminal Meese and Rogoff (1983) article indicated that fundamentals-based exchange rate determination models (including the Dornbusch model) are not superior to a random walk model for exchange rate determination. Nevertheless, such models are very useful as frameworks of analysis.

20. ADF tests are not presented here, but can be furnished by the author upon request.

21. It is noted, however, that this is not presented as an estimation of the causal relationships. We refrain from presenting this as an estimated interest rate differential because monetary models (including Dornbusch's sticky- price monetary model which we rely on) have been generally used in the literature to explain the behavior of the exchange rate and not the interest rate differential. Later when the VECM is estimated, the exchange rate is modeled as the dependent variable in the cointegrating vector.

22. Having a statistically insignificant monetary differential may be explained by monetary neutrality. That is, monetary shocks ‘die out' in the long-run, and thus their effect on the real economy is only transitory.

23. The effect of foreign variables is opposite to that discussed above for the domestic variables.

24. The VECM is a restricted form of the vector autoregression (VAR). VECM not only models the joint behavior of the endogenous variables, but also allows for the presence of an additional term that corrects for short-run deviations from the long-run equilibrium. Therefore, in the presence of such a long-run equilibrium relationship, estimating an unconstrained VAR may amount to a mis-specified model, as the short-run deviations are thought to be an important factor that characterizes the relationship between the endogenous variables of our model (Enders, 1996).

25. The ordering of the variables in the VECM is important. The variable that comes first is considered to have a contemporaneous effect on itself and all the other variables in the system, whereas the second variable in the ordering is considered to have a contemporaneous effect on itself and the variables that follow it in the ordering, but not on the preceding variable. The VECM was estimated using the following ordering: exchange rate, M2 differential, real GDP differential, inflation differential and interest rate differential. Exchange rate comes first as it is the variable of interest in the Dornbusch model (i.e. it is the explained variable). For the rest of the endogenous variables, the ordering is ad-hoc, and it follows from the way the Dornbusch model equation is presented in various papers that attempted to estimate it starting with a monetary shock (see, for example, Frankel (1984)). And thus, the M2 differential comes as the second endogenous variable in the ordering, as the monetary shock could be thought of as the policy variable in this model; the central bank's tool to stimulate the economy, and thus would have a contemporaneous effect on the other endogenous variables in the model. It is worth noting that the variance decomposition results (which are our main focus for analysis) do not change drastically for other trials with different orderings.

26. Details of the ‘interest spread' equation estimated within the VECM are presented in Appendix 3.

27. Once again, the empirical finding that the monetary aggregate differential (M2diff) Granger-causes the interest rate differential is an indicator of an autonomous monetary policy in Egypt.

28. The Egyptian Financial Supervisory Authority (EFSA), established by law 10/2009, replaced the Egyptian Insurance Supervisory Authority, the Capital Market Authority, and the Mortgage Finance Authority in application of the provisions of the supervision and regulation of insurance law no. 10 of 1981, the capital market law no. 95 of 1992, the depository and central registry law no. 93 of 2000, the mortgage finance law no. 148 of 2001, as well as other related laws and decrees that are part of the mandates of the above authorities.

29. CMA was later on replaced by EFSA (See previous footnote).