Egypt hot money skips happy ending encore

By Gary Kleiman of Kleiman International Consultants April 25, 2023

In a familiar pattern for emerging market investors the past decade, Egypt again went from darling to dud last year as $20bn in so-called “hot money” chasing double-digit yield local Treasury bonds exited in a rush.

Around half of foreign exchange reserves vanished in a classic capital flow sudden stop, as foreign buyers

awoke to the reality behind pound instruments’ claim to the highest real yields after inflation in the asset class. They served to perpetuate an exchange rate peg widely cast as overvalued after an initial devaluation under the International Monetary Fund’s 2016 $12bn rescue, which also called for rapid divestment of state enterprises and other structural reforms where headway was modest.

The main achievement commonly cited was the rollback of fuel subsidies to curb the chronic fiscal deficit, a drawn-out ordeal which left food support untouched with the political instability history of bread riots against President Al-Sisi’s predecessors. The Russia-Ukraine war aggravated underlying vulnerabilities as the main wheat import and tourism source, but fund managers could have readily seized on a broad range of economic and financial performance lapses the past five years to justify minimal exposure.

Egypt is the second-largest borrower from the IMF after Argentina, and the $3bn program signed in December was deliberately designed to avoid concentration risk, while taking into account the Gulf ally $20bn central bank deposit and sovereign/private investment pledges as a second backup line. Of the $40bn that Saudi Arabia, the United Arab Emirates (UEA) and Kuwait have in outstanding assistance to the region, including Pakistan, about half is for Egypt as engagement stepped up a decade ago after the Muslim Brotherhood government of Mohamed Morsi was ousted, and he was placed under arrest. These allocations come to half of the $35bn in international reserves, originally at a concessional 3.5% borrowing cost and now with the option to convert deposits into investment.

GCC providers now emphasize that the days of open-ended aid are over, and they intend to reap returns and a demonstrable track record as influential bilateral creditors. Late last year several billion dollars of deals for stakes in state fertilizer producers, banks, and other companies were completed, but the bulk of the $20bn promised remains at home.

Senior Egyptian officials have fanned out to urge royal families to loosen the purse strings, and President Al-Sisi himself came back from a Riyadh visit empty-handed. The same message was echoed throughout official and private channels to clean up the foreign exchange mess, army control of the economy, and lavish image but not productive infrastructure spending, including the $70bn blueprint for a new administrative capital.

According to the central bank, $3bn in non-resident local bond inflows returned in January after the IMF accord, but the pattern has been dismal since with an auction in early April only getting an historic embarrassing single bid. Investors demand a return to real yields with 30% inflation, but the government is straining at a 20% coupon with debt/GDP at 95%, and interest service at half of the budget revenue.

For international buyers, the most visible deterrent is the currency, which has lost half of its value over the past year. The IMF’s call for flexibility was finally heeded short of an outright float, in part because usable reserves for exchange rate defence are thin with Gulf deposits that can be pulled and foreign development infusions not to be mobilized for that purpose. The central bank had for years drawn on commercial bank holdings for intervention, but their net foreign assets have turned into billions of dollars in liabilities. Three different rates are cited to add to business and consumer confusion, but the universal depreciation direction is clear. The interbank quote is over 30, the parallel market 35, and offshore 12-month forwards above 40.

The stock market was down 5% in dollar terms on the MSCI index through March, and up in local currency by the same amount as debt appetite was diverted, and 30 state companies, mostly dating from a previous calendar, were scheduled for partial stake offloading. $2bn is to be raised by June under the IMF timetable, but delays have proliferated with arguments over majority control and sensitive sectors. Gulf sovereign funds tend to prefer lead shareholder status, and ports are just one strategic industry with links to the headline Suez Canal where the military has pushed back hard to retain its prerogatives, while popular opinion accuses the government of attempting to sell off “crown jewels.”

Privatization is tied to bridging the 5% overall budget deficit and boosting the 1% primary surplus, and to increasing foreign direct investment by $5bn annually to $20bn to shrink the 3% of gross domestic product (GDP) range current account gap. The President issued an overarching declaration to limit the state role in the economy to no more than 25% over the coming decade, but the incremental roadmap tweaks the status quo, especially if he fears interfering with army tax free and below minimum wage labour advantages over private sector competitors. As a general, he maintains cultural affinity, and political and security calculation override periodic IMF staff reviews with widespread reports of arbitrary opposition and media figure arrests and harsh treatment.

Egypt at one time was labelled the Mideast tiger with 7% GDP growth, but those days have long passed as the latest fiscal year forecast was pared to 4%. Domestic consumption is a main pillar, but poverty has risen to an estimated one-third of the population in the pandemic aftermath. Business sentiment languishes, as evidenced in a two-year run with the benchmark purchasing managers manufacturing index below 50.

Exports rose one-fifth last year to a record $50bn, about one-third petroleum related products, with the largest partner Turkey where relations have begun to normalize with presidential visits. Garments are a mainstay and rely on imported inputs, which remain stuck in port with the lack of bank letters of credit for foreign exchange. Russian tourists continue to arrive at Sharm el Sheikh beach resorts through regular flights despite Western sanctions, but the numbers are far from pre-covid peaks, then the largest contingent. Cairo also continues to import its fuel and wheat, and more broadly hedges geopolitical bets through new membership in the so-called BRICs New Development Bank.

In monetary policy, the new central bank chief, in the post since a housecleaning last year, has consistently been behind the curve. It only in March hiked interest rates 200 basis points to near 20% on headline inflation over 30%, and core 45%. Private lending/GDP jumped 10% in 2022 to 30% with a subsidized small business scheme the government has since ended.

Although banks are conservatively managed with deposit-to-loan and capital adequacy ratios in the safe zone at first blush, a domestic debt restructuring could wreak balance sheet havoc. With Gulf money reliance so paramount the system is also under pressure to embrace Sharia-compliant Islamic finance. A debut $1.5bn external sukuk was placed in Q1, and local rules promote domestic versions that do not require credit ratings.

A final risk spooking on the ground investors is the regime’s closes tie with Sudan’s military junta again proposing joint civilian rule, and with General Hiftar in Eastern Libya still in sporadic civil war mode. Bank and business engagement have ensued, and President Al-Sisi has prepared in the past to send his own forces to back Hiftar’s. In South Sudan, Egyptian banks have established a presence, and companies have offered humanitarian aid alongside their commercial functions in the world’s number three ranking refugee crisis. Tunisia has also been a pro-West security partner before President Saied came to power with a preoccupation of overhauling the constitution, at the cost of an economic collapse scenario that could cause another mass displacement, according to EU foreign policy chief Josep Borrell.

Egypt could be a model for the broader region if it manages eventually to float the pound, embark on wide-scale privatization, and minimize fiscal and current account deficits, but the near-term adjustments will be wrenching with the hangover from post-Arab Spring economic and political stagnation. The Gulf actors will be instrumental in the outcome, and they too have embraced change on their own terms, despite a Cairo expectation disconnect that will force both sides to rein in ambitions so that outside investors can predictably position for viable goals.

Gary Kleiman, senior partner, Kleiman International Consultants, Inc.

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