Thomas Byrne (Moody’s Sovereign Risk Group)
Moody’s Investors Service today downgraded Egypt’s government bond ratings to Caa1 from B3. The rating outlook is negative.
Today’s one-notch downgrade was prompted by the following factors:
1) More than two years into the Egyptian revolution, the continued unsettled political conditions have significantly weakened Egypt’s economy.
2) The sustained deterioration in Egypt’s external payments position and government finances have reached a level at which the country’s vulnerability to economic or political shocks has widened and the risk of default has consequently increased.
3) The lack of predictability in economic and fiscal policies and outcomes, which is underscored by continued uncertainty surrounding the Egyptian government’s ability to secure financial support from the International Monetary Fund (IMF).
Overall, even if the Egyptian government’s third attempt in two years to gain IMF support were to succeed, Moody’s believes that the risks facing a successful completion of a stand-by arrangement have risen in light of the economic and political challenges that have intensified as Egypt’s revolution has unfolded. As a result, there is more uncertainty over Egypt’s ability to regain macroeconomic stability and shore up its external and fiscal positions.
As part of today’s rating action, Moody’s has also lowered the country ceiling for foreign-currency bank deposits by one notch to Caa2, the B1 country ceiling for foreign-currency bonds by two notches to B3, and the Ba2 local-currency bond and deposit ceilings by one notch to Ba3. The short-term country ceiling for foreign-currency bonds remains unaffected at Not-Prime (NP).
Egypt’s Caa1 bond rating indicates that the probability of default has risen materially but that the risk of default is not necessarily imminent.
At the Caa1 rating level, the historical record shows that the average, cumulative default rate over a one-year horizon is close to 10% and over a five-year horizon slightly under 40%.
The primary driver behind Moody’s decision to downgrade Egypt’s government bond ratings is the deep polarisation of the country’s democratically elected government and those in opposition as a result of the ongoing unsettled political conditions and repeated episodes of violent civil unrest. This polarisation is in turn impeding the government’s ability to govern effectively, restore social stability and avert a worsening of the already severe disruption to the economy. Real GDP growth has slowed to the low, single-digit range from the mid- to high-single digit range, and the government’s budget deficit has risen into the double-digit range in the aftermath of the revolution.
Egypt’s continued political difficulties are further highlighted by the Administrative Court’s recent decision to suspend, pending review by the Supreme Constitutional Court, the lower house legislative elections which were supposed to be held from April to June.
The second and interrelated factor underlying Moody’s one-notch downgrade is the further weakening in Egypt’s strained external payments position. Although the country’s gross international reserves edged down by only $0.1bn in February, this small decline followed a large drop of $1.4bn in January, the largest decline in 12 months and a sharp departure from the semblance of stability seen throughout most of 2012, during which Moody’s had maintained a B2 rating on Egyptian government bonds.
While gross reserves of $13.5bn, including $4.5bn of gold and IMF Special Drawing Rights, presently provide ample coverage for debt falling due in the 12 months ahead on a one-year residual maturity basis, the cushion could wear thin if external financial support is not forthcoming or from capital flight, and if a longer time horizon than one year is taken into consideration.
Moody’s notes that strains on the external balance of payments prompted the Central Bank of Egypt on 30 December 2012 to relax its grip on the exchange rate and to impose selected capital controls, with the aim of limiting foreign-currency cash withdrawals and cross-border transfers for current transactions. The Egyptian pound has consequently depreciated by around 9% against the dollar so far this year.
Future stability in the external payments position could be undermined if the Gulf Cooperation Council governments, especially Saudi Arabia and Qatar, decide not to be as generous in providing financial support in the future as they have been over the past year or so. To some extent, such bilateral grants, loans and deposits are likely to be tied to a future IMF program. Nevertheless, there is a considerable degree of unpredictability over whether such governments would provide timely exceptional support if needed.
The third driver underpinning today’s rating action is the lack of predictability in Egypt’s economic and fiscal policies, as reflected in the continued uncertainty surrounding the government’s ability to secure financial support from the IMF. Although a renewed effort between the government and IMF on a possible $4.8 billion stand-by arrangement was announced on 17 March, Moody’s notes that previous attempts had faltered and led to the postponement of preliminary, staff-level agreements in June 2011 and again in December 2012.
In the absence of a robust reform program, Egypt’s budget deficits and debt servicing costs will likely remain elevated, with government bond yields stuck well within the double-digit level. Moody’s also expects that such a scenario would deprive Egypt of fiscal resources that could otherwise be directed towards infrastructure development and poverty reduction.