The Egyptian economy is among the very few emerging markets (EMs) that is growing, and would continue to grow next year despite the novel coronavirus (COVID-19) pandemic shock, according to a new report released by Deutsche Bank.
Growing but below potential
Egypt’s economic growth is going to be significantly below potential, estimated at 3.4% in fiscal year (FY) 2019/20, with a slow recovery going forward that is expected to bring growth up to 3.5% in FY 2020/21.
While the break on economic growth has come from lockdown measures, the halt in the tourism activity, and weak household consumption, growth is being supported by several factors. These include public spending, large public construction projects, a boom in the telecommunications and energy sectors, and improvements in net exports.
All eyes are on remittances
Egypt’s external dynamics have shown resilience given the narrowing of the trade deficit, significant external financial support, and portfolio investments. Remittance inflows have so far outperformed expectations, and could significantly contribute to the growth and foreign exchange (FX) liquidity, if it continues to do so.
In particular, the trade deficit is narrowing down significantly, the government and banks have secured significant external financial support, and the local debt market has seen the return of portfolio investors since June 2020.
The latest trade data show that the foreign trade deficit narrowed for the 15th consecutive month in July by 51% y-o-y to $2.3bn, the driver being weaker domestic absorption and lower oil prices.
According to Deutsche Bank estimates, secured loans from international financial institutions and banks exceed $15bn, and foreign holdings of local Treasury bills (T-bills) rose by $3.1bn.
In addition, Deutsche Bank is expecting widening of the current account deficit to 4% of GDP in FY 2019/20, from the 3.6% deficit recorded in the previous FY on the back of the fall in tourism.
Given the weakening of Egypt’s traditional sources of FX due to the weak external backdrop, the elephant in the room is remittance inflows into the Egyptian economy. This has actually increased robustly by 7.8% y-o-y to $17bn in the first seven months (7M) of 2020. Remittances are Egypt’s single largest non-debt source of FX, followed by exports, tourism, FDI, and Suez Canal receipts, all of which are seeing fewer inflows.
In general, the continued outperformance of remittances would not only contribute to growth via supporting the subdued private consumption, it would be also crucial for FX liquidity in the banking sector.
Note that the pandemic sell-off of local debt instruments in the first quarter (Q1) of 2020 was mainly absorbed by public banks, which led to the deterioration of their FX position.
“Together with better international investors’ risk sentiment, we could see a higher accumulation of FX reserves compared to most market projections, including IMF projections,” said Deutsche Bank research.
Overall, keeping with the call that FX reserves would edge up by $5bn in the current FY, the pace of the accumulation of Egypt FX reserves could surprise market expectations to the upside.
Inflation to increase but not significantly
Egyptian prices saw another deflationary month in August, on the back of depressed demand. Urban CPI slowed for the third straight month in August, to 3.4% y-o-y from 4.2% y-o-y in the previous month, on the back of falling food prices and low housing and utilities inflation.
September’s inflation print is due next week, where Deutsche Bank expects inflation to edge up this time, to 3.9% y-o-y. It attributes this to the re-opening of the economy, which in general is expected to give rise to inflationary pressures in Q4 of 2020, although at moderate levels.
Furthermore, in September, annual core inflation is expected to be affected by unfavourable base effect, given the release of the 10th CPI series. The figures are also likely to be affected by its linking methodology with the 9th CPI series starting, with September 2019 data.
Given moderate oil prices, high real rates, the EGP appreciation, and government interventions in the food market, Deutsche Bank actually expects inflation to stand at around 5% by the end of this year.
Further easing before year-end cannot be ruled out
The Central Bank of Egypt’s (CBE) Monetary Policy Committee (MPC) decided to deliver a 50bps cut to CBE’s overnight deposit rate and overnight lending rate last week, with the official rate now at 8.75%. The decision came on the back of record-low inflation levels of 3.4% y-o-y, strong external financing support, and concerns revolving around the moderate recovery process.
The bank thinks the cut came on the back of the CBE’s credibility and its cautious approach and higher confidence regarding Egypt’s external dynamics. This is given the importance of the current real rates environment in supporting the carry trade and portfolio inflows, and that the CBE has acknowledged that financial stability concerns are input to its decision making.
Nonetheless, real rates would continue to remain high and in fact, it may increase from the current 4.9% to 5.3% next month. This would occur if the bank’s inflation projection for October turns out to be correct, seeing headline falling on the back of favourable base effects.
Despite the importance of portfolio investments as a source of Egypt’s external financing needs, the cautious cut may also signal CBE’s desire to lower rates further on the back of uncertain growth dynamics.
Deutsche Bank observes that the gradual recovery of economic activity may be a source of concern for the CBE because of the country’s high debt levels. Although debt dynamics are sustainable now, this may not be true anymore if the impact and duration of the pandemic exceed expectations.
Overall, Deutsche Bank is expecting another cut of 50bps in December to 8.25%, and a cumulative of 150bps cut in 2021. The CBE is likely to remain on hold in the November meeting, to assess the impacts of this week’s cut, while remaining cautious in face of the likely market volatility due to highly uncertain US elections.
Strong recent inflows support constructive view
In contrast to most other EM countries, where foreign flows are neutral to slightly negative and the share of foreign holdings continues to decline (given record high local bond supply), recent flow dynamics are positive in Egypt.
After record outflows during the initial COVID-19 shock, Egypt saw a sharp rebound over the summer months. The local markets suffered from $12.7bn of outflows between March and May, which implied a decline in the share from 20.1% to only 7.1%.
In June, flows slightly recovered (+0.7bn = +0.7pp in the share), however, the most noticeable rebound happened in July with $3.2bn of inflows and a share of foreign holdings back at 10.6%. This was the second-largest amount of month-on-month (m-o-m) inflows in Egypt on record and no other EM country saw more inflows in July, not even South Korea with only $3.1bn inflows.
“To some extent, Egypt behaved as expected from an EM country; record outflows during the initial shock, followed by a sharp rebound thereafter,” Deutsche Bank research said, “For most other EM countries, we are still waiting for the rebound.”
Local markets stay bullish on fixed income
Deutsche Bank stays bullish on local fixed income, justifying this view with high real rates, a gradual easing cycle with well-anchored inflation, stable FX, attractive fixed income valuation, and improving foreign demand at the weekly auctions.
Since then, the local markets performance was robust and Egypt outperformed peers (mainly due to the FX), fixed income valuation has hardly changed, inflation has fallen further and foreign demand has remained strong.
In fact, the bank expects Egypt to outperform all Central and Eastern Europe, Middle East and Africa (CEEMEA) region peers from a risk-return perspective by the end of the year. It anticipates that gradual easing could lead to further inflows without FX weakness, which should be particularly supportive for duration.
Overall, Deutsche Bank expects real rates to remain high, particularly compared to Turkey, while inflation is well anchored.
Furthermore, positioning in T-bills and bonds are still reasonable light, demand dynamics are improving further and bond yields are attractive. As a result, the bank continues to prefer longer-duration bonds, but acknowledge the higher credit risk and lower liquidity.
Demand remains strongest for shorter-duration bonds, hence it sees that five-year and seven-year bonds as the sweet spot.
