The IMF and Egypt have reached a staff-level agreement on 3-year loan program. Egypt still faces significant challenges ahead, but the IMF program should give them some breathing room. Implementation is key, and we think the pound will be devalued again.
Three years after toppling the Morsi government, President el-Sisi retains a firm grip on power. Parliamentary elections last year cemented his rule, but voter turnout was less than 30%. Municipal elections in 2017 may show rising voter dissatisfaction with the ruling party. Unemployment remains high at 12.7% in Q1, adding to social tensions and periodic protests.
The IMF program will require fiscal tightening in order to address chronic budget deficits (see below). As such, the government faces a delicate balancing act since austerity would feed into civil unrest. Officials will try to limit this by boosting food subsidies and social transfers.
Egypt has burned through billions of dollars of aid from neighboring countries that include Saudi Arabia, Kuwait, and UAE. However, we suspect the regional purse-strings have been tightened (partly due to low oil prices, partly due to Egypt’s continued mismanagement), making an IMF program the only option for Egypt.
Egypt now ranks 131 out of 189 in the World Bank’s “Ease of Doing Business” rankings, down from 126 last year. The ranking remains poor, and the direction is bad. Allowing the pound to trade more freely would help Egypt’s competitiveness a bit, but there are clearly deeper structural problems that need to be addressed.
An optimistic take is that the IMF program will put the Egyptian economy back on a sustainable recovery path. A pessimistic take would be that entrenched interests and endemic corruption will prevent successful implementation of the IMF program. We think the truth lies somewhere in between.
The economy is slowing. GDP growth is forecast to decelerate modestly to around 3% in 2016 before picking up to around 4% in 2017. GDP rose 2.2% y/y in Q4, and suggests downside risks to the growth forecasts. Likely austerity measures to be required by the IMF would also add to the headwinds.
Price pressures are still rising, with CPI up 14.0% y/y in both June and July. This is the highest rate since January 2009, and suggests that monetary policy will be tightened further. Indeed, the proposed VAT would also feed into higher inflation.
The central bank hiked rates 150 bp in March and then another 100 bp in June to take the policy rate to 11.75%. The next policy meeting is September 22, and another hike seems likely then. We could see an earlier rate hike if and when the exchange rate is weakened in order to lend the pound some support and help prevent pass-through to inflation.
Fiscal deficits remain chronic. The deficit was around -11% of GDP last year, and is likely to remain there in 2016 as well. The gap is expected to narrow slightly to near -10% in 2017. Austerity measure would help limit spending, but this would have a negative knock on effect on revenues if the economy slows as a result.
The IMF program calls in principle for lowering energy subsidies and increasing revenue collection under a new VAT that is currently being discussed in parliament. The proposed VAT rate of 14% is higher than the current 10% sales tax. However, the government emphasized that many basic goods will be exempt from the VAT, limiting the impact somewhat on the poor.
The external accounts are worsening. Tourism has yet to recover fully, but low energy prices have helped reduce imports. Overall, the current account gap is still widening. It was about -4% of GDP in 2015, and the IMF expects it to widen to nearly -5.5% in both 2016 and 2017.
Foreign reserves fell $2 bln in July to $15.6 bln, the lowest since March 2015. This covers barely 2 months of imports, but is 1.33 times greater than short-term external debt. Egypt clearly needs to get foreign aid quickly. News reports suggest it’s in talks with Saudi Arabia and the UAE for another slug of money, to the tune of $2 bln.
Under the current quasi-peg arrangement, the Egyptian pound has generally performed in the middle of the EM pack. However, it is subject to periodic stepwise devaluations. In 2015, EGP lost -9% vs. USD. This compares to the worst performers ARS (-35%), BRL (-33%), ZAR (-25%), and COP (-25%). So far this year, EGP is -12% YTD and is amongst the worst performers in EM. The others are ARS (-12%), MXN (-6%), and CNY (-2%).
EGP has basically been pegged near 8.88 since the March devaluation, but we don’t think this can be maintained much longer. Egypt and the IMF have agreed in principle to a 3-year IMF program worth $12 bln, with details to be hammered out. We believe the peg will be dropped, as the IMF will not want its funds wasted defending an unsustainable peg. Another stepwise devaluation seems likely soon, perhaps on the scale of the 15% move back in March.
Egyptian equities have outperformed this year after a poor 2015. Last year, MSCI Egypt was -21% while MSCI EM was -17%. So far in 2016, MSCI Egypt is up 40% YTD, and compares to 13% YTD for MSCI EM. This outperformance should ebb a bit, as our EM Equity model has Egypt at a VERY UNDERWEIGHT position.
Our latest sovereign ratings model update saw Egypt’s score worsen, pushing its implied rating down a notch to B/B2/B and reversing last quarter’s improvement. Actual ratings of B-/B3/B are subject to some mild downgrade risk but appear more or less correct.