Egypt’s debt in Focus

By Ahmed Farhat

Egypt’s debt may have reached what some call dangerously high levels but those responsible for the debt are also enjoying the best times they have since the revolution in January three years ago.

This is because the cost of borrowing is down by 4% in the past two months, bringing it to its lowest levels since January 2011. The Government benefited greatly from the morale-boosting effect of the aid pledged by several Arab countries following the ouster of the Muslim Brotherhood last July. Although its budgetary situation remains difficult, the $12 billion (EGP 86 billion) in aid has helped to bring down interest rates.

The government will borrow 206 billion EGP in the second quarter of the fiscal year, bringing total borrowing from the local market during the first half of the year to EGP 406 billion.

The elevated interest rates on government debt, still above 10% for short-term treasury bonds, has compelled the Ministry of Finance’s public debt unit to seek new investors after many foreign investors pulled out.

The unit is currently looking into opening an index fund, with the goal of energising the secondary market so as to lower the interest rate. However, if past efforts are any indication, government actions in this direction will be very slow. The unit has also issued zero-coupon bonds to attract investors uninterested in other government debt instruments. Most of these new bonds have a term of 18 months, and were popular in their first offering last September. The unit also introduced the idea of floating rate bonds last year. Their interest rate is determined according to the average revenue of bi-annual bonds in the last four auctions. EGP 1 billion was raised through this tool in the past but it has not been re-issued.

For the issuance and repurchase of debt the Egyptian government depends on the system of primary dealers and this process gives fifteen local banks a monopoly in the initial market for government debt. Although many have called for the replacement of this process with a more efficient system of mediation, no change has occurred. Some accuse the Central Bank of Egypt of preventing the switch. It seems as if the proposal for an index fund is a step from the Government to make clear the bank’s insistence on the current system of primary dealers.

In spite of the large size of the non-banking financial sector in Egypt, it is not permitted to participate independently in the primary market for government debt. Perhaps for this reason, this sector›s investment in government debt is limited compared to the banking sector›s, which holds more than two-thirds of the total.

The current system for issuing government debt exposes it to significant risks when liquidity in the banking sector is limited. This problem plagued the Government throughout the past year, when the interest rate on government debt reached to historic highs. The non-banking financial sector was not able to lighten the liquidity pressures in the banking sector.

Mohamed Taha, vice president for Investment Affairs on Banque du Caire’s board of trustees, says that banks are largely funded by customer deposits, and they direct their resources for maximum benefit, whether granting loans to consumers or the government. Taha added that the Government has introduced new funding tools to reduce local government debt, currently at EGP 1.4 trillion, such as zero-coupon bonds. He explained that the Government was issuing debt according to its funding needs. He pointed to the $12 billion in recent aid from the Emirates, Kuwait, and Saudi Arabia, which has supplemented Egypt’s foreign currency reserves and helped bring the interest rate on government debt down from 14% to ten per cent.  According to Taha, because of Egypt’s low credit rating in the last two years, lower even than that of countries like Cyprus and Greece, it has become difficult to turn to international financial markets.

Standard and Poor’s (S&P) and Moody’s, two major credit rating agencies, both rate Egypt’s debt a CCC+. Moody’s recently announced that due to the political difficulties that Egypt is going through, it will likely not raise its rating anytime soon. Taha said that the reduction of Egypt’s credit rating makes it difficult to get aid from organisations like the International Monetary Fund (IMF) or the European Union. It also prevents Egypt from issuing dollar-backed bonds in the global markets, since their interest rate would be too high, particularly given the increased cost of insurance for Egypt’s foreign debt.

With the help of a guaranteed buyer in Qatar, the previous government was able to resort to international markets to convert the $2 billion Qatari aid into bonds. However, unless there are similar arrangements with other Gulf states this is a one-time possibility.

The deficit target in the current fiscal year’s budget is EGP 186 billion, which represents 10% of Egypt’s GDP, but the Government’s expansive fiscal policy will increase this deficit. This policy is seen in measures such as the sudden 50% increase in the minimum wage and other measures meant to calm protests by improving conditions for most Egyptians.

Walid Hegazy, the founding partner of Hegazy and Associates, in cooperation with law firm Crowell & Moring, says the Government does not have many choices.

The Muslim Brotherhood-led government tried desperately to introduce Sukuk bonds to the Egyptian markets as part of its efforts to support Islamic financing and it succeeded in passing a Sukuk law after serious protests. But the current government has not taken advantage of this law since its passage.

Hegazy said the Muslim Brotherhood’s government faced much criticism when it proposed the Sukuk law because of rumours it would be selling state assets. However, the law has provisions to preserve public ownership and under Sukuk, the sales would actually be rentals for a specified period. The law also allowed investors and individuals to fund projects for infrastructure and economic development which ought to create new job opportunities.

He explained that Sukuk could invigorate the government debt market by attracting those who think that it is inappropriate to buy debt in its present form, because it violates the system of borrowing in Islamic law. This is what impeded the Muslim Brotherhood’s efforts to get substantial funding from the Gulf region.

Before the January 2011 revolution, the government sometimes resorted to selling its assets when in need of funding. This has become difficult since 2011 because of the government’s need to be sensitive to strong public sentiment against privatisation. This sentiment arose during campaigns organised to protest several acts of privatisation as well as through judicial rulings that cancelled a number of privatization contracts.  Hegazy suggested to the current government, led by Prime Minister Hazem El-Beblawi, ought to raise revenue by reappraising its assets and then renting them to investors for specific periods, rather than privatizing them.

Public criticism has also intensified against other government policies since the revolution, making it difficult to conclude sizeable deals to sell land to companies, as was done when Ahmed Nazif was Prime Minister in the Mubarak era. Nor are there many opportunities on the horizon to raise revenue by selling licences, like in 2006 when the government sold Etisalat a licence for 3G mobile communications for EGP 17 billion. Such deals seem unlikely in the near future, especially given that the 4G license was issued for free.

S&P said two months ago that they believed it would be difficult for Egypt to rely upon increased tax revenues to fund spending. They estimated per capita GDP in 2013 at $3200, which is too low to provide sufficient tax revenue. The agency said that after long years of sustained and powerful growth, production can now only rise and expand slowly in the absence of political stability.

While trying to obtain an IMF loan of $4.8 billion last year, Prime Minister Hesham Qandil’s government imposed taxes on a number of goods it described as non-fundamental. However, these taxes faced massive popular objections which compelled the previous president, Mohammed Morsi, to delay the measure, and it has not been raised again since. However, the current government seems committed to moving forward with the previous government’s plans of transforming the traditional system of sales taxes to a value-added tax (VAT) system, and this could increase revenues. Egypt has historically depended upon taxes to fund government spending and they make up more than two-thirds of government revenue.

Given the expansive financial policies the current government is implementing, it seems that the path to an agreement with the IMF may be closed because the policies are the opposite of what the IMF requested from previous governments.

Farid Fawzy, a member of the board of directors of the Egyptian Society of Accountants and Auditors, said that conditions currently prevented the government from increasing or imposing new taxes, given the economic stagnation that the Egyptian economy is going through due to recent political upheaval. He has several ideas for alternative means to raise revenue.

He explained that new taxes could generate new revenue, including in the informal economy, which makes up forty per cent of economic activity in Egypt. This sector could be brought in by offering assurances that if they registered and paid taxes there would be no additional taxes in the near future. This could have a substantial positive effect on revenue, especially if the Government was able to get 10% of this activity annually.

Fawzy also suggested accelerating the tax process for companies by estimating their appropriate tax brackets, rather than delaying their tax payments while waiting for matters to be settled through the courts. This could solve most of the contested cases between the Government and taxpayers in order to get revenue quickly.

The Government should place a 2% tariff on imports to companies in the free trade zones. He also suggested reforming the system of property taxes with simplified rules and consistent application which could raise revenue between EGP 2.5 and 3 billion.

The government should also make agreements with other African countries to limit customs fees and increase exports, Fawzy said. Car companies could be encouraged with investment benefits to open facilities in the Egyptian markets along the lines of what some Moroccan companies do, provided that they export their products from Egypt. Increased investment would help raise government revenue by expanding the economy and creating a labour force that will increase overall demand.

Mostafa Al Nasharty, professor of economics at Misr University for Science and Technology, said that the reduction in Egypt’s credit rating limited the current government’s opportunities to obtain foreign aid as the IMF is demanding a strict programme of economic reform and a stable exchange rate. Al Nasharty explained that the recent Gulf aid provided much needed foreign reserves but it is not sufficient to cover foreign imports for more than six months. This places the Government in a difficult position. Domestic borrowing through treasury bonds will absorb 50% of the involved banks’ funds, and could generate competition between the Government and the private sector for investment, driving up interest rates. Al Nasharty suggested that the current government seek new alternative funding along the lines of property taxes and a VAT, noting that they would directly increase government revenue.