By Sujata Rao
LONDON (Reuters) - The key to preventing a messy devaluation of Egypt's pound may lie with the country's households, whose dollar holdings are being eyed by foreign investors as a critical gauge of trust in the authorities.
Countless emerging market crises have shown over the decades that it is not the withdrawal of foreign investors from a market but the flight of local households and businesses from a currency that is instrumental in its collapse.
Egypt, despite months of upheaval, is not there yet.
But investors are watching closely for evidence of a significant rise in ordinary Egyptians' dollar holdings.
Households' dollarization ratio -- broadly, the level of foreign currency holdings as a proportion of money supply -- was 15.5 percent at the end of October 2012, according to Bank of America-Merrill Lynch estimates, based on central bank data.
That will undoubtedly have gone up in recent weeks as panicky Egyptians have rushed out to buy dollars in the face of rising political turmoil and as the central bank has allowed the currency to fall -- by 0.5 percent a day for the past week.
In Luxor, for example, a town that makes its living from the tourists who visit its Pharaonic temples, some taxi drivers have started asking for payment in euros or dollars.
But the household dollarization ratio is still likely to be well below the 41 percent ratio among companies, or the 33 percent household dollarization levels seen back in 2004.
"Increased household dollarization and a run on the currency, that's the big risk," says Jean Michel Saliba, BofA-Merrill Middle East economist, who estimates households account for more than 70 percent of deposits in the banking system.
In contrast, foreigners hold a mere 3-4 percent of the local bond market, according to other estimates from Barclays.
"If the (dollarisation) ratio goes back to the 2004 peak that would create additional demand for $15 billion and will wipe out the central bank's reserves," Saliba says.
What could precipitate such a move?
The central bank's decision to allow some weakening in the pound after spending two years and $20 billion propping it up, has broadly been welcomed by economists and equity investors who say Egyptian exports need to become more competitive.
But this is a tightrope from which it is easy to fall.
Moved from a peg to a managed float in 2003, the pound has traded between 5.5-6 per dollar since then and citizens have enjoyed some reassurance from the central bank's sturdy defense of the exchange rate during the 2011-2012 turmoil.
But Egypt's hard currency reserves are at $15 billion or below the three-month import cover deemed the minimum safe level, and that has forced it to embark on dollar auctions allowing the pound to sink to a series of record lows.
Around a third of the pound's depreciation since early-2011 has come in the past week and that may well have spooked households who hold over 600 billion pounds ($93.05 billion)in local currency bank savings.
"I felt (devaluation) was coming. So for hedging purposes I changed half my savings into dollars just a couple of days before the pound slump," said one Egyptian who works in the financial sector and who asked not to be named.
"I don't trust the current regime ... and see no opportunity for growth on the short term ... no hope," he said. "I think that the pound slump is not going to stop." Continued...