Simplified Example Imagine that the whole world has only 3 countries, and each country produces only one commodity, which is pasteurized milk
Today’s exchange rates:
$1 = EGP 20
EUR 1 = $1
EUR 1 = EGP 20
Milk price per liter:
Egypt = EGP 20
America = $1
Eurozone = EUR 1
The exchange rates and the prices of a liter of milk are equilibrium prices because they make the price of one liter of milk in all countries.
For example, if a company in the eurozone imports a liter from Egypt, they will convert EUR 1 = EGP 20 and EGP 20 = 1 liter = the same price in the euro area.
Scenario 1: A year later Milk prices do not change
EUR 1 = 50 cents (the euro depreciates against the dollar)
$1 dollar = EGP 20 (the exchange rate of the EGP is fixed against the USD)
In this case, the exchange rates will be adjusted as follows:
$1 = EGP 20 (no change)
EUR 1 = 50 cents (or $1 dollar = EUR 2)
EUR 1 = EGP 10 (EGP 20 = $1 = EUR 2)
Since milk price has not changed in the Eurozone (EUR 1), imported milk from the EUROZONE will be 50% cheaper than milk in Egypt or America.
Consequently, Egypt will lose the European market completely, and European milk will be exported to Egypt in huge quantities, which leads to the deterioration of the trade balance in Egypt.
The benefit of the EGP index against a basket of currencies If all eyes are on the exchange rate of the USD against the EGP, many will think the exchange rate is fixed and the prices in Egypt and America are fixed, so there is no problem with external competition.
But if we describe Egypt’s foreign trade with America and the other half with the Eurozone, the exchange rate index against the basket of currencies will indicate an imbalance in the exchange rate as follows:
First, determine the relative weight of each business partner
Second, the calculation of the index on the base day (a currency for EGP 1)
EGP 1 = 5 cents
EGP 1 = 5 European cents
The indicator in the base year = 100 and is calculated as follows: (5 cents ÷ 5 cents) x 100 x 50% = 50 + (5 cents ÷ 5 cents) x 100 x 50% = 50 = Index on base day = 100
Note: The index number 100 does not mean anything in itself, but its importance lies in calculating the percentage of change in it from one period to another.
After a Year
EGP 1 = 5 cents, change of 0%
EGP 1 = 10 euro cents, a change of 100%
Calculation of the index after a year (5 cents today ÷ 5 cents last year) x 100 x 50% = 50 + (10 euro cents today ÷ 5 euro cents last year) x 100 x 50% = 100 = Index this year = 150
So, the message that the index sends a year later is that the EGP has risen by 50% against the basket of currencies of trading partners (100% has risen against the euro and the euro is 50% of the basket).
The investor uses this signal to determine whether the EGP exchange rate is high or low against a basket of currencies, and thus the need to hedge against a sudden drop or rise in the exchange rate.
The main points
To restore the EGP competitiveness in the previous case, it is necessary to let the EGP exchange rate decline against the USD in order to compensate for the rise against the EUR. Changing the exchange rate will automatically take care of this adjustment
To ensure that competitiveness does not deteriorate, the index must be kept close to 100, which is the equilibrium point. A rise in the index above 100 = an increase in the value of the EGP and a decrease in the index under 100 = a decrease in the value of the EGP against a basket of currencies
The above indicator is known as the Nominal effective exchange rate index or NEER index
There is another indicator similar to the one above, but it combines the change in the price of a liter of milk with the change in the exchange rates, and it is known as the Real effective exchange rate index or REER index
The main objective of the index is to help the investor determine the deviation of the EGP’s value from its fair value (analysis tool) and thus determine the need to hedge through futures contracts or not (implementation tool).