Markets have welcomed the statement released by the government that it is nearing the final stages of negotiations with the International Monetary Fund (IMF) for a three-year loan programme.
The cabinet stated that it is targeting $7bn of funding per year over three years, which makes up a considerable 2% of GDP in financing per year. The IMF will provide $4bn, the World Bank $1bn, the African Development Bank $500m, and the remainder will come from bilateral accords such as with the European Bank of Reconstruction and Development and a planned bond issuance later this year.
Investors, unlike the government and the people, are more concerned with the conditionality that comes with IMF and World Bank lending as opposed to the “no strings attached” Gulf funding. They hope that the conditionality applied on Egypt will force the government to address three key issues: the budget deficit, the currency instability, and the need for improvements to the business environment.
“The finalisation of an IMF deal would be key in turning the market,” says Daniel Salter, head of equity strategy at Renaissance Capital. Investors are hoping that a free floating exchange rate will end the series of devaluations that started more than a year ago, allowing for investors to stop avoiding Egypt as an investment destination.
Research shows that while a country devalues its currency, investors stay away, but when the currency at official rates is equal to informal markets, investment returns and inflation ultimately decline once the impact from the devaluation has passed.
Egyptian growth of 3-4% is better than that of many competitors, but is still below government targeted growth rates of 5-6%. The fall in oil prices is bad news for Egypt as it struggles with an ongoing shortage of foreign currency reserves. Remittances are the largest source of foreign currency for the country and are mainly from Gulf countries, where the bulk of Egyptian labour abroad work.
Remittances fell by 12% in the second half of 2015 compared to the same period in 2014. Energy exports are also down 42%, which in turn has made it more beneficial to use the Cape of Good Hope around South Africa than the Suez Canal. This has made the expected gains from the Suez Canal expansion unnoticeable as revenue has fallen 7%.
Tourism has also completely bottomed out. Travel receipts fell 33% in the second half of 2015, and the number of Russian tourists fell by 99% in January 2016 from the previous year. The past three months have been the worst in a decade regarding foreign tourism to Egypt. Although domestic tourism has partially filled the space left by foreign tourism, revenue from the sector is likely to remain weak until late 2016 or early 2017. Oil prices are expected to improve after August.
‘Step in the right direction’
The depreciation of the Egyptian pound is a step in the right direction. A floating exchange rate will be good for investors who want to abolish Egypt’s capital controls.
No one is sure when the depreciation of the Egyptian pound will be complete. The Egyptian government last depressed the value of the Egyptian pound in 2000-2003, a process which took 28 months to complete. Renaissance Capital expects the devaluation to continue for eight to eleven months, bringing it back to the average rate of the past 20 years. The Egyptian pound has moved from the most expensive to the fourth most expensive of all emerging market economies’ currencies. The latest currency shift leaves the Egyptian pound only 15% away from the bureau de change rate, compared to the currency of Africa’s most successful economy (Nigeria), which stands more than 50% apart from that rate.
Inflation is the main determinant of future currency moves and cuts in subsidies. When food prices were stable in 2000-2003, the government felt more secure letting utility prices rise or decrease the value of the currency. Further subsidy guts and the addition of the value-added tax (VAT) are planned for 2016 and 2017 as the official fiscal deficit target is still an extreme burden at 10% of GDP.
Like Nigeria, Egypt is experiencing the downside of a dual currency exchange in which the official exchange rate of EGP 8.9 to the US dollar is used for the import of food, essential items, and investment goods, which authorities attempt to keep from abuse by individuals exchanging currencies. However, Egypt’s position is not nearly as dire as Nigeria. The official rate of the Egyptian pound only remains 15% below the informal market exchange rate, whereas Nigeria’s currency remains 50% away from informal markets.
Egypt will be unable to fully liberalise the exchange rate; however, if Egypt were to fully float the exchange rate, Egypt’s subsidies are still so expensive that the competitiveness gains from a large devaluation may be wiped out by the extra fiscal cost to the government. Egypt has been unable to reform subsidies as fast as a country like Morocco due to sensitivity to the public’s needs, as food price inflation increased from 9% in February to above 10% in May, which gave the Central Bank of Egypt (CBE) the confidence to make the devaluation. Last time Egypt devaluated the currency, in 2000-2003, inflation was just 2-3%.
This gives the government a choice: cut subsidies or devalue the pound, to which they will probably do neither if food prices don’t remain stable. Prices on food have reached a one-year low and, as a result, currency devaluation is likely to continue and is expected to be completed by mid-2017. Introduction of VAT is expected in the 2016-2017 budgets.
The government projects the budget deficit for fiscal year (FY) 2015/2016 to stand at 11.5% of the GDP while targeting to cut the deficit to 9.9% of the GDP in FY 2016/2017, which assumes a growth of 4.4%. However, the lack of tax revenue remains a major obstacle to these targets. IMF and Renaissance Capital both expect account deficits of 5.3% of the GDP in 2016 and a total of around $15bn.
Egypt’s current account balance has been affected by the drop in exports as exports to other Arab countries made up 20% of Egypt’s total exports. Syria, Libya, Iraq, and Yemen are all bogged down in civil war. The export of energy products has declined 42%, seeing exports fall to $1.5bn.
Renaissance states that the current account deficit could improve to 3.6%, but the IMF remains firm at 5.3%.
Imports have been maintained through two main factors: an increase in credit growth from 0-10% to 15-20% between 2010 and 2014 and Gulf support of $25bn since President Abdel Fattah Al-Sisi took power, which has also given the government breathing room in investment projects and strategic imports. Renaissance Capital argues that private sector growth could have been fast if not for currency controls.
Renaissance Capital stated that they have been given information pertaining to Egypt-Saudi relations, which their reports state is the most “reliable yet”. Among this information, it is stated that Egypt has received $25bn a year in financing from the Gulf since Al-Sisi took power, totalling $50bn in the form of loans, grants, or cheap oil products. Saudi Arabia, Kuwait, and the UAE have also invested heavily in the Suez Canal Industrial Zone.
Renaissance Capital states that the IMF deal is “90% likely” and is encouraged by the willingness to take large loans from a number of international financial institutions, the weakening of the Egyptian pound, and the continued removal of subsidies as an indicator of a government friendly to private sector interests.
According to the report, the government is not suspicious or reluctant to receive billions of dollars in financing from international financial intuitions as “the new team in the finance ministry is well regarded and the government is full of private sector liberal capitalists”.
Despite declining investment and growth due to dwindling exports and currency blockages, more US dollar funding from the Gulf, more electricity, more investments in infrastructure, and the exchange spread between official and unofficial rates close to equilibrium have served to make Egypt’s position on the continent far less dire than that of Nigeria.