Egypt: Tides Are Changing, Or Is History Repeating Itself?

CAIRO (Capital Markets in Africa) – Egypt is flashing once again at the centre of emerging markets’ radar screen after a long recede, ever since the outbreak of the 2011 revolution and the years of political and economic instability that followed. The Government has just embarked upon long-awaited and badly needed structural reforms, including, but not limited to, a shift to a flexible exchange rate regime that aims to tackle the currency shortage and attract investments, a higher degree of fiscal discipline and a fresh batch of external financial support from international organizations to close the existing funding gap.

On 3 November 2016, Egypt announced a full floatation of the Egyptian Pound (EGP), which had lost about 56% of its value since then. In parallel, the Central Bank of Egypt hiked interest rates by 300bps, aiming to fend off inflation, while the Government raised fuel prices to ease off some of the fiscal burden (subsidies comprise 25% of the total budget, of which fuel subsidies represent 68%). Earlier, the Government had adopted a value-added tax (VAT), which it estimates would save an equivalent of 1.5% of the GDP. Foreign and domestic investors have welcomed these reform measures, with EGX (the local bourse) surging by almost 60% in the past couple of months (+10% in dollar terms).

Foreign investors, in particular, have been consistently net buyers in the Egyptian market, with recent reports suggesting an almost USD400 million of foreign inflows into the equity market and more than USD1 billion of inflows into the Egyptian treasuries by fixed-income investors, attracted by the combination of both i) exceptionally high yields (Egypt’s gross 3M treasury yield stands at 19.8%); and ii) lower currency risk post-floatation. Today, Egypt treasuries stand out as the most attractive against their counterparts in emerging and frontier markets on a combination of both price (yield) and risk (credit default swap is currently 440bps).

On 11 November 2016, Egypt signed a three-year USD12 billion loan with the IMF and received an initial payment of USD2.75 billion. Egypt’s agreement with the IMF was an important milestone in promoting its reform programme for investors and other lenders such as the World Bank, which approved a USD3 billion support facility for Egypt (of which USD2 billion have been disbursed) and the African Development Bank (USD1 billion). Egypt reserves have improved to approximately USD25 billion (at the end of 2016) compared to USD15 billion in mid-2016.

Nevertheless, the road to recovery is bumpy, at best. Egyptians will have to endure a significant rise in price levels and an inevitable cut in ‘real’ income as the economy rebalances toward more investments and less consumption. This will be so burdensome, indeed, particularly for the middle class, which will typically pay the lion’s share of the economic reform bill.

Years of overvalued currency have artificially stimulated high levels of consumption in the economy at the expense of investments, despite the deteriorating budget deficit (13% of GDP in 2016, from 8% in 2010) and severe pressure on the balance of payment. Egypt’s imports have risen by approximately 15% since 2011, while its exports have fallen by 22% during the same period. Egypt’s public wage bill has more than doubled after 2011 revolution (26% of the total budget).

Private consumption has averaged 81% of the entire GDP in the preceding five years (2011-16), compared to 71% during 2005-10. Simultaneously, investments’ share in the economy has fallen to 15% on average since 2011 (down from 20% during 2005-10). Expectedly, therefore, the official unemployment rate had risen from 9% in 2010 to 13% in 2016 and is a candidate for a further increase in 2017 as the corporate sector struggles with higher cost structure and a temporary demand stagnation. The devaluation of the currency sparked a surge in the cost of imports (Egypt’s imports bill is about USD60 billion annually, of which 75% are classified as essential goods). This, together with the implementation of the value-added tax and the hike in fuel prices, has spurred a high inflationary cycle that Egyptians will have to endure in the short term. Egypt’s urban consumer prices skyrocketed to 28% year-on-year in December.

Like it or not, this shall weigh on growth, at least in 2017. The Government’s growth target of almost 5% will be challenged by local demand stagnation and a typical time lag for private sector investments to normalise once again. High-interest rates will slow down credit growth in the economy, with many companies planning to limit their borrowing activities to working capital management only. While exporters and commodity producers should benefit immediately from a weaker EGP, the majority of companies will take a time to adapt to the new cost structure as the economy rebalances over time.

“Egypt is flashing once again at the centre of emerging markets’ radar screen after a long recede, ever since the outbreak of the 2011 revolution.”

Yet, the picture is anything but bleak. The removal of foreign currency overhang, in the medium term, will unleash some economic activities that have been severely constrained by the chronic dollar shortage. The industrial sector, which has been operating below 70% of its capacity since 2011, should be able to improve utilisation rates gradually and improve efficiency levels as the energy shortages fade. Similarly, recent signs of improved liquidity in the financial sector will help lower interest rates, which will support investments.

Foreign capital is key to Egypt at this critical juncture, given the structural imbalances in its balance of payment. So, the recent foreign buying into Egyptian equities and debt markets is definitely good news. After all, Egypt’s foreign debt stands at 22% of GDP, a more than manageable level should the reform measures bear fruit.

Egypt has always covered its negative trade balance by a positive contribution from services, namely tourism and Suez Canal revenues, in addition to remittances from Egyptians working abroad. Tourism revenues have been declining since 2011 on concerns over political and security situation until they were severely hit by the fall of the Russian Metrojet flight over Sinai last year. Suez Canal revenues flattened on weaker global trade, while remittances have deserted the official sector, as the official exchange rate was at some 40% discount to the parallel market. Today, remittances should flow back normally following the EGP floatation, which removes the economic incentive from dealing with the unofficial channels. A weaker EGP should also reduce imports and help exports, leading to a natural improvement in the current account, whose deficit today stands at 6% of GDP (from 2% in 2010). Recent data suggest imports have already started to fall off significantly after November 3rd decisions.

“While banking sector indicators remain sound in Egypt, reliance on banks to finance growing government budget deficits and the foreign currency shortage is restraining business and household borrowing”

In fact, it is not the first time for Egypt to make such a significant economic adjustment. In the 1990s, Egypt signed a deal with the IMF and adopted the Economic Reform and Structural Adjustment Program (ERSAP), after which it managed to achieve an impressive large fiscal adjustment, bringing down its deficit of 15% of GDP in 1991 to only 1.2% in 1995. During that time, Egypt grew by an average of 4.5% almost double its anemic growth rate that prevailed during the preceding five years (1985-91). In 2003, a similar (albeit not identical) currency adjustment was made to address the shortage in foreign currency, after which growth rates surged to the average of 6% and peaked at 7% in 2007 right before the global financial crisis. Most importantly, both periods were followed by a significant rise in foreign capital inflows that improved productivity gains and fostered growth and job creation.

“Growth in Egypt dipped slightly, to 4.3 percent, in 2016 and expects to grow by 4.0 percent and 4.7 percent in 2017 and 2018 respectively, World Bank Group estimates”

Indeed, it is different this time around, given the geopolitical challenges and the global economic outlook, particularly in the EU, to which Egypt is leveraged, albeit, there is still no reason to believe Egypt’s economy would not return to growth soon after the economic adjustments take place. Yet, if policy makers learn the lessons from the past, it is not just a matter of growth; Egypt needs an inclusive growth that targets labour-intensive industries, strong productivity gains via sustainable foreign direct investments, education and vocational training and a new socioeconomic contract with an effective social safety net for the unprivileged.

This article features in the February 2017 edition of INTO AFRICA Magazine, insights on Africa’s economic prospects for 2017.

Contributor’s Profile
Ahmed Shams El Din is a Managing Director and Head of Research at EFG Hermes, the largest investment bank in the Middle East and North Africa, with a rich and vast hands-on experience in the financial services and advisory fields. Shams El Din led EFG Hermes’s research coverage in different economic sectors, where he assessed and valued some of the largest listed companies in the MENA and international (LSE, Euronext Amsterdam) exchanges. He is a top-ranked analyst by international institutional investors in global surveys (including the Euromoney Middle East Best Research Management, Thomson Reuters Extel and Institutional Investors (II), in which he won the third place amongst chemicals analysts in Europe, Middle East and Africa, EMEA, in 2016). Shams El Din is also a volunteer finance trainer, and a business writer with interest in financial markets, political and economic development affairs.