The near-term outlook for Egypt is positive. There has been a turnaround in Egypt’s external vulnerabilities, with strengthening foreign exchange (FX) reserves accumulation, stated Deutsche Bank (DB) Markets Research in a recent special report.
The report noted that FX reserves grew to $28.6bn in April, adding that the Egyptian pound has seen a 0.39% quarter-to-date (qtd) gain.
The DB pointed out that, in parallel to this qtd gain, Egypt’s GDP growth is likely to have reached 3.9% in the first quarter of 2017, and the International Monetary Fund (IMF) estimates that the primary fiscal deficit has fallen by 2%, from 4% in 2015/2016 (overall deficit stood at 12% in 2015/2016, according to the IMF). The Ministry of Finance has drafted an ambitious budget for 2017/2018 that is now under review by the parliament.
The report, which focused on Egypt’s outlook in terms of different indicators, including both the targets achieved and the risks and expectations in the future, noted that risks to the outlook stem from reform fatigue and high inflation. “It is likely that growth in 2017 will be below the authorities’ 4.6% estimate,” it pointed out. It added that structural reforms supported by the IMF programme may run into reform fatigue, leading to fiscal slippages, especially ahead of the 2018 presidential elections. Stubborn inflation may force the Central Bank of Egypt (CBE) to continue tightening, especially if the Egyptian pound underperforms.
Using a simple purchasing power parity (PPP) metric, the DB said that they believe the currency is undervalued, as manifested by the CBE’s reserve accumulation. The PPP implies that nominal exchange rates move in tandem with inflation differentials.
In other words, this implies a mean-reverting real effective exchange rate (REER). Hence, it defines their PPP misalignment as the percentage difference between REER and its 10-year rolling average. At the end of October 2016, before the exchange rate peg was removed, the Egyptian pound was overvalued by 24% by DB measures. Currently, it is undervalued by 26% following the sharp depreciation.
The DB pointed out that the IMF programme is on track for now, where on 12 May, in its first review of the $12bn extended fund facility (EFF), the IMF provided a positive assessment of the authorities’ reform agenda. Subject to the IMF’s board approval, a disbursement of $1.25bn will be made, bringing the total amount disbursed to $4bn.
Balance of payments improvement exceeded expectations
The report stated that the CBE’s reserve position has continued to improve. Egypt’s gross foreign exchange reserves rose to a six-year high of $28.6bn in April, sufficient to cover more than five months of imports. The report praised the CBE as being already way ahead of its target to raise foreign exchange reserves. “However, sustained net inflows are needed to cover the large financing needs in 2017/2018 and 2018/2019,” it stressed, adding that Egypt needs to raise $7bn in 2017/2018 and an additional $4bn in 2018/2019 to reach 136% of the IMF’s reserve adequacy metric for flexible exchange rate regimes.
The report pointed out that the current account position is improving, as after a prominent plunge in REER (of more than 45% year-over-year by December 2016), early signs of expenditure switching are starting to occur, with imports nearly flat in the fourth quarter (Q4) of 2016, and exports up 18% year-over-year (y-o-y). In addition, quarterly overseas workers’ remittances grew more than 10% y-o-y in the same quarter, following a protracted period of declines, according to the report. It added that seasonally adjusted quarterly figures show that the current account deficit narrowed to $4.36bn in the last quarter of 2016, versus a $5.47bn deficit in the previous quarter. It attributed this increase to inflows and an important recovery in workers’ remittances, even as donor support (grants) from the Gulf Cooperation Council (GCC) slowed.
Moreover, the DB stated that further improvements in the current account will likely be less pronounced.
Imports of staples (especially food and energy) tend to be inelastic, limiting the extent to which the bank can expect a correction in the deficit to happen.
“Moreover, recent inflows have tended to put appreciating pressure on the REER, and exports growth has already decelerated in March, decreasing more than 13% over the previous month, in seasonally adjusted terms,” it highlighted.
The DB also praised the authorities, saying, “they are on track with donors’ programmes.” In March, the World Bank disbursed $1bn, out of a $3bn loan. The next tranche of $1bn is expected by December 2017. World Banks’ Takaful and Karama programme, with 6.7 million beneficiaries, has disbursed $306.21m so far. Following the completion of the first review, total disbursements from the IMF will reach $4bn this fiscal year.
Similarly, the DB said that private sector inflows have exceeded expectations, highlighting that Egypt raised $2bn in financing from international banks in November, followed by a $4bn Eurobond in January and $3bn in May, far exceeding expectations.
Minister of Finance Amr El-Garhy said that Eurobond issuance, to “a large extent”, covers financing needs for 2017/2018, and the next issuance is planned for February/March 2018.
“Remarkably, since the CBE hiked interest rates earlier this month, foreign inflows into Egypt’s debt and equity have surged,” the report read, adding that the treasury bill (T-Bill) auctions over the last week recorded near $1bn in foreign investor inflows. As of May 30, according to the Egyptian Finance Ministry, overseas holdings of treasury bills rose to $7.5bn. Furthermore, in an effort to attract more inflows, Egypt’s parliament voted on Monday to extend for three more years a freeze on its capital gains tax.
Moreover, it stated that foreign direct investment has recovered, but remains below the pre-2011 averages. The discovery of the Zohr offshore natural gas field is expected to attract foreign direct investment (FDI) and bolster exports of natural gas some time in 2018. In addition, Egypt secured agreements on coal-fired and renewable plants, which are envisioned to strengthen the electricity generation infrastructure. In May, the Egyptian cabinet approved six agreements between the Egyptian General Petroleum Corporation (EGPC) and a number of foreign companies on oil exploration in Egypt’s western desert.
Fiscal position is marginally improving but challenging
The authorities target an overall deficit of 9% of GDP in the 2017/2018 budget. In the draft budget interest, payments are the largest item, estimated at EGP 381bn ($21bn), almost one-third of total expenditure. Debt-service costs, therefore, remain a challenge, given the recent tightening of monetary policy, the DB pointed out.
On the revenue side, taxes on goods and services are set to rise by 41% in 2017/2018, making up 36% of the total budget revenue, under the assumption that the value-added tax (VAT) will do most of the job (a hike of 1pp to 14%). However, tax revenue is likely to fall below the government’s projections, given the short-run impact of the stabilisation policies on domestic demand.
On the expenditure side, the report noted, cuts to fuel subsidies are penciled in, but actual spending on fuel subsidies is likely to be similar to the last year, given that the Egyptian pound has depreciated below budget assumptions (EGP 16 to the USD) and higher commodity prices. Current levels of the Egyptian pound have also pushed up the budgetary cost of petroleum product subsidies. Early in May, media reports suggested the fuel subsidy bill was already well above EGP 110bn. The 2016/2017 fuel subsidy budget estimate was EGP 35.04bn, (with EGP at 9.00 and Brent at $40). The IMF’s indicative target on that fuel subsidy bill is a ceiling at EGP 62bn by June 2017. The budget also pencils in a 7.6% y-o-y increase in public sector employee compensation, substantially below the current inflation. Though not yet confirmed, the DB stated that electricity prices are planned to increase from the start of July this year.
In addition, while the IMF gave a positive review of the Egyptian authorities’ efforts, it has left the timing of fuel price hikes to Egypt. “However, the timing of fuel energy reform may once again turn to be a thorny issue due to their impact on inflation and political concerns as we near the 2018 presidential elections,” it stressed.
Nonetheless, it is unlikely that debt will exhibit explosive dynamics in the coming two years, assuming the FX remains stable. At current yield levels, under the DB’s baseline of high inflation and moderate growth, debt dynamics are set to improve in the next two years, according to the report. “Inflation is doing much of the heavy lifting,” it signaled. The automatic debt dynamics may turn explosive again after 2019, however, with inflation coming off, moderate growth below 4%, and likely higher funding costs.
The DB considered two stress scenarios. In the first scenario, it assumes that inflation comes down, as in the baseline, and GDP growth stays stable around 4%. However, yields spike in 2018 as a result of US monetary policy normalisation. Under this scenario, debt turns explosive in 2018, creating a turnaround in debt accumulation, and reaching more than 100% of GDP by 2020.
Meanwhile, in scenario 2, in addition to the above, domestic conditions worsen. “Growth deteriorates substantially, and inflation comes down faster than the baseline as a result. Under such circumstances, the debt-to-GDP ratio will reach 100% in 2019. Although automatic debt dynamics should start marginally improving in 2020, the debt-to-GDP ratio would have already reached 108% by then,” the report explained.
We expect inflation to come off to about 20% by end-2017: DB
The CBE has moved to a dirty peg FX regime, supported by goals for both monetary aggregates and inflation levels, and recently has been forced to pre-empt second-round effects on inflation expectations—arising from supply shocks—by hiking the policy rate by 200bps to 16.75% on 21 May. The CBE communicated in its Monetary Policy Committee’s (MPC) press release that despite the moderation of monthly inflation rates as of late, risks related to inflation expectations had already materialised. In addition, the committee also cited demand pull forces on core inflation.
Moreover, the report explained that the recent hike may take a long time to transmit into the real economy, and inflation is likely to stay elevated for a while. In addition, while reserve accumulation is desirable to build buffers against a balance of payments (BoP) crisis, the CBE may be running into the limits of sterilisation. FX accumulation over time could pose a threat to the monetary aggregates’ targets. The y-o-y growth of the ratio of money and quasi money (M2-to-GDP) stood at 34% in Q4 2016.
The DB stated that the CBE may also force a hike in response to second-round effects of subsidy removal and the VAT hike. The IMF sees a 24.8% and 11.6% average headline consumer price index (CPI) in 2017 and 2018 respectively. In the DB’s view, average inflation could hover around 30% in 2017 and 16.9% in 2018. It expected asymmetric upside risks in the near term, derived from the uncertain effects of price liberalisation, VAT reforms, and commodity price recovery in 2018.
Improving ratings outlook
Fitch has the most bullish view on Egypt, rating it at B, one notch higher than both Moody’s and S&P (Stable outlook) since December 2014. S&P recently affirmed their B-rating, and their next review will take place in November. Moody’s next review is due on 18 August. Fitch doesn’t have a specific date, but the DB expects the next review to happen sometime in June/July 2017.
According to the report, Moody’s might consider upgrading Egypt’s ratings to B2 from B3 in their upcoming review (18 August), given the accelerated build-up of FX reserves and prospects of lowering fiscal deficit as per the draft budget plans. However, high inflation and risks to the growth outlook might act as potential deterrents.
Fitch, the DB believes, is most likely to affirm the ratings at B and at best might upgrade their outlook to Positive from Stable.
However, looking at historical timelines and the upcoming key events (the budget, as well as the IMF board meeting), the DB stated that it expects the next review to happen sometime in June/July 2017. “We believe that Fitch would like to see more sustainable progress on several criteria points to be able to consider a rating upgrade,” it explained. The report noted that Egypt will have to fulfill several points: progress on fiscal consolidation, economic growth and reform measures, and accumulation of FX reserves. Of all these, the DB noted that Egypt’s reserve position has improved significantly (up 68% y-o-y in April).
Credit market valuation, risk premium has diminished
The report held a constructive view on Egypt’s credit given the positive outlook, but at the current valuation, it added that the bank would take a neutral position and look to add on dips. If credit market valuation on Egypt’s Eurobonds is slightly on the rich side based on the spread/credit rating relationship, it does not appear overtly expensive.
The credit market has generally rewarded sovereigns that are perceived to be on a positive path in their credit standings (eg Argentina, Mongolia), but it has punished the ones that are not (eg El Salvador, Ecuador). While fiscal outlook remains challenging due to the large deficit, high debt repayment burden, high inflation, various structural issues, supports from the IMF, and other official sources have helped prevent a balance of payment crisis, while the associated fiscal consolidation efforts and reforms (as mandated by the IMF programme) help restore Egypt’s macroeconomic stability, putting its debt dynamic on an improving path. The improving outlook has been recognised by markets, as Egypt’s Eurobonds were among the best performers in the past six months, with its subindex having tightened by 90bp year-to-date.
The IMF agreement, which took place in November 2016, the floating of currency, and successful bond issuances in January 2017 all contributed to positive performance. However, after a significant rally, Egypt’s outperformance has stalled since April, as the risk premium in the credit had been all but removed by then.
Credit relative value, the new bonds maturing on 2027 and 2047 (27s and 47s) remain cheap; the curve looks too steep, and Egypt has issued a total of $11bn of Eurobonds over the past six months ($4bn in November 2016, $4bn in January 2017, and $3bn on 24 May through taps). While the issuances were generally met by strong demand, the sheer amount of supplies has added some pressure to the curve. Significant levels of concessions were offered in January issuances of 17s, 27s, and 47s.
According to the report, those new bonds were gradually catching up, but the 24 May re-taps helped cause some re-cheapening. Currently, the 27s are 20-25bp cheap in comparison to the 25s (the latter look particularly rich,) while the 47s are about 15bp cheap to the 40s, according to the DB term structure model. While investors continue to digest the recent taps, DB said it expects the cheapness in these bonds to be gradually removed. “We do not expect Egypt to issue any more bonds this year,” it concluded.
Therefore, the DB recommended switching from 25s to 27s (current spread differential: 50bp; target: 25bp) and from 40s to 47s, noting that the 40s have limited liquidity given their small size—only $500m. The main risk to these switch recommendations is that some investors favour low-priced bonds on the curve and ignore the valuation disparity between these bonds.
Finally, the 10s-30s curve in Egypt appears very steep from a cross-sectional point of view. Typically, Europe, the Middle East, and Africa (EMEA) curves and higher yielding curves in Latin America feature a flatter 10s-30s slope, but Egypt’s slope—measured at around 100bp—look very out of place; it is in fact comparable with LatAm low beta names. Among credits with a similar credit rating, only Argentina and El Savador have 30Y bonds, but both have a much flatter curve (50bp and 10bp respectively). From an asset-allocation perspective, the DB stressed it favours the long end of the curve, especially the 47s.
What to watch for in the coming 12 months?
In conclusion, and while the near-term outlook is positive, there are important milestones in the coming year: the passage of the 2017/2018 budget, the deceleration in inflation towards the end of 2017, and the continued compliance with the IMF programme.
The DB pointed out that the presidential elections will take place by mid-2018, stressing that risks of social instability are low. “While President Abdel Fattah Al-Sisi has significantly tightened security, two attacks on the Coptic Christian community since the beginning of the year will weigh on tourism but unlikely to put a significant dent in president’s popularity as opposition is limited,” it added.
The report stated that investors should watch for the end-June passage of the 2017/2018 budget that is in line with the IMF programme and includes further reduction in energy subsidies, payment of the arrears to international oil companies expected in June of $750m (total outstanding $3.5bn), and for Fitch (June/July) and Moody’s (18 August), as they may consider improving their rating/outlook. In addition, it recommended watching for a June/July IMF disbursement following a staff-level agreement on the first review reached in May 2017; a second review by the IMF regarding the performance criteria of the end of June; the further relaxation of the FX regime and a reduction in capital controls by the end of 2017; and the presidential elections by mid-2018, as nominations will begin in March 2018, and the election process to begin 120 days before the end of the current presidential term.
