Egypt Outlook Revised To Negative On External Financing Risks; ‘B/B’ Ratings Affirmed “the link“

Overview

We expect Egypt’s high external funding needs will largely be met by multilateral and bilateral lenders, but risks to the disbursement of funds have increased.

Delays to currency and structural reforms put pressure on the Egyptian pound, increasing the risk for the government and the broader economy of further sharp currency devaluations, higher inflation, and rising interest rates.

We therefore revised our outlook on Egypt to negative from stable and affirmed our ‘B/B’ long- and short-term ratings.

Rating Action

On April 21, 2023, S&P Global Ratings revised its outlook on Egypt to negative from stable. At the same time, we affirmed our ‘B/B’ long- and short-term foreign and local currency sovereign credit ratings on the country.

The transfer and convertibility assessment on Egypt remains ‘B’.

Outlook

The negative outlook reflects risks that the policy measures implemented by the Egyptian authorities may be insufficient to stabilize the exchange rate and attract foreign currency inflows to meet the sovereign’s high external financing needs.

Downside scenario

We could lower the ratings over the next 12 months if multilateral and bilateral funding support is more limited than expected.

We could also take a negative rating action if Egypt’s external profile comes under greater strain than we expect and inflationary pressures persist such that risk of domestic unrest increases, among other potential repercussions.

Upside scenario

We could revise the outlook to stable if we observe a higher possibility of Egypt’s foreign currency funding needs being met, for example, by a track record of exchange rate flexibility and attracting sizable foreign currency inflows via the sales of state-owned enterprises (SOEs)–key tenets of the IMF program.

Rationale

The outlook revision reflects our view that Egypt’s funding sources may not cover its high external financing requirements of about $17 billion in the fiscal year ending June 30, 2023, and $20 billion in fiscal 2024. Absent sufficient foreign currency funding, Egyptian transactions with the rest of the world would slow significantly, with negative implications for GDP growth, and this could translate into less incentives to service external debt.

We estimate that the Egyptian government allocates over two-fifths of all revenue collected for interest payments on its high stock of debt. Most of these payments service domestic debt rather than external obligations. Given competing pressures for public spending, including on households hit hard by still-elevated energy and food prices, reducing such a high interest to revenue ratio (the third highest of all 137 sovereigns rated globally) will be a significant challenge for the government.

The Egyptian authorities’ weighty reforms, announced in December 2022, could result in a steady inflow of foreign currency if they are implemented fully. The reforms are backed by a $3 billion program under the IMF’s extended fund facility, and these policies include fiscal consolidation, implementation of conditions sufficient to allow for a fully flexible exchange rate, and a plan to sell mostly minority stakes in select SOEs.

However, relatively limited evidence of the reform’s implementation has increased pressure on the Egyptian pound, particularly considering Egypt’s high external funding needs. In our opinion, lack of progress increases risks that multilateral lenders and foreign investors, including key Gulf Cooperation Council (GCC) countries, potentially delay or do not provide Egypt with the agreed funds, with implications for imports, inflation, interest rates, and the government’s debt stock and interest payments.

The Egyptian pound has fallen by 50% against the U.S. dollar since the start of 2022. A key component of the IMF program, is “a permanent shift to a flexible exchange rate regime to increase resilience against external shocks and to rebuild external buffers.” There is currently limited day-to-day movement in the official exchange rate. We understand that this is due to limited demand as market participants appear reluctant to purchase foreign currency, while rumors of further devaluations circulate.

In our view, significant progress regarding the sale of SOE assets likely hinges on more clarity from the authorities on exchange rate policy. Foreign investors may also be concerned about limitations on transparency of the SOEs’ accounts and how the operating environment will evolve if the government or military maintain competing companies in the same sectors.

Notwithstanding the longer-term benefit of a more flexible exchange rate on the economy, its decline is currently adding to already-high inflation. Egypt is a largely import-dependent country, and the weaker currency is increasing import costs. Inflation reached 32.7% in March, and we expect it to average 23.0% for fiscal 2023, moderating to 18.0% in fiscal 2024.

The Egyptian society was able to absorb, albeit uncomfortably, relatively similar rates of inflation rates in 2017, when the country last saw a sharp currency devaluation. The government is providing fiscal support for those most affected by the current inflationary pressures, reducing the risk of large protests.

We see modest growth prospects for Egypt in the next three years, underpinned by the ongoing implementation of fiscal and economic reforms. We expect general government balances to remain elevated over our forecast period through fiscal 2026. Nevertheless, high GDP deflator growth rates should support a decline in the net government debt-to-GDP ratio over the period through fiscal 2026, having increased sharply to about 82% of GDP in fiscal 2023, largely because of the effect of the exchange rate devaluation on the government’s foreign currency debt stock (about 34% of the total in fiscal 2023). Still, Egypt’s debt burden and debt-servicing needs will remain very high and sensitive to movements in the exchange rate.

Institutional and economic profile: Implementation of reforms, including the reduction of the state’s economic footprint, are key to Egypt’s economic prospects

We expect Egyptian economic growth to average 4% over the next three years.

The government plans to reduce its footprint in the economy and encourage foreign direct investment (FDI) inflows rather than more flighty portfolio investment.

We expect the government’s headline deficit to increase to 7% of GDP in fiscal 2023, alongside a more pronounced weakening of the primary fiscal surplus due to rising government interest costs.

Key structural constraints to economic growth include the large informal sector; relatively weak, albeit improving, governance and transparency of state-owned enterprises; and barriers to competition that restrict private-sector activity. The government has furthered efforts to improve the business operating environment, such as a new customs law, settlement of arrears to exporters, and industrial land allocation mechanisms, which could support growth in the next two to three years.

The government is also embarking on a plan to reduce its dominance of much of Egypt’s productive sectors. In December 2022, President Abdel Fattah el-Sisi approved a state ownership policy document that outlines the government’s vision for the future role of the state in the economy. This includes raising the participation of the private sector in public investments to 65%, from 30% currently, within three-to-five years. The government’s intention is to raise $2.5 billion (0.7% of GDP) in the first phase of pre-IPO stake sales by the end of fiscal 2023 and $4.6 billion (1.5%) in fiscal 2024. Previous plans to bolster the private sector have had limited success. However, with GCC governments pledging to invest in Egyptian companies, the current plan should have some impact.

Recovery in tourism and manufacturing supported economic activity in fiscal 2022, while public infrastructure projects supported the construction industry. Over our forecast horizon to fiscal 2026, we expect economic growth to average 4% per year, with the construction and energy sectors as key drivers, along with sectors such as IT and communications, wholesale and retail trade, agriculture, and health care. The Hayah Karima program, which aims to improve living standards in rural communities, should help develop the quality of infrastructure.

Tourism should fully recover in 2023. The sector contributed about 12% of GDP, 10% of total employment, and 16% of current account receipts (CARs) in 2019 (the last pre-COVID, pre-Ukraine-Russia conflict data point) and is an important source of foreign currency earnings for Egypt. This year, tourism revenue on the balance of payments should increase close to the $13 billion peak achieved in fiscal 2019, supported by Egypt’s hosting of the 2022 United Nations Climate Change Conference, more commonly referred to as COP27, and its inauguration of the Grand Egyptian Museum later this year. We understand that Russia (18%) and Ukraine (the remainder) together accounted for 25%-30% of Egypt’s pre-war inbound tourism by volume. A pickup in tourists from other countries, including Germany, the U.K., the U.S., and Saudi Arabia, has partially offset the decline in Russian and Ukrainian arrivals. Egypt has started operating direct flights between Tel Aviv (Israel) and Sharm El Sheikh (Egypt) for the first time, and this should help boost tourism receipts. Also, the country is reportedly looking to adopt the Russian Mir payment system, allowing for payments in rubles, to encourage Russian tourists.

The sociopolitical environment in Egypt remains relatively fragile, in our view, with about 30% of Egypt’s 105 million population below the poverty line. Sporadic small-scale protests reflect the discontent of more vulnerable and younger sections of society. The 2011 political uprising, which unseated long-time president Hosni Mubarak, was partly spurred by high unemployment and food price inflation. Under the existing subsidies program, more than 60 million Egyptians, or nearly two-thirds of the population, get five loaves of round bread daily for 50 U.S. cents a month; this has barely changed since countrywide bread riots prevented a price hike in the 1970s. Given these political dynamics, the government largely covered the cost of higher wheat prices in 2022 and postponed a reform to the bread subsidy scheme.

We expect the government to continue fiscal consolidation and economic reforms over the next two to three years, absent a significant increase in social unrest. We assume President Sisi will win reelection in 2024 and lead the government in its pursuit of the key tenets of the IMF program, including:

A durable shift to a flexible exchange rate regime;

Monetary policy aimed at gradually reducing inflation;

Fiscal consolidation to ensure a downward public debt trajectory while enhancing social safety nets to protect the vulnerable; and

Wide-ranging structural reforms to reduce the state footprint and strengthen governance and transparency.

We do not rule out an escalation of geopolitical tensions with neighboring Libya and Ethiopia, the latter relating to the Grand Renaissance Dam, although this is not our base-case scenario. Ethiopia continues to fill the reservoir behind the dam, raising concerns of water shortages in Egypt and Sudan, which also depend on the Nile’s waters. Ethiopia is filling the reservoir to power a turbine and increase electricity provision in the country. To mitigate the risk, Egypt is directing more water from Lake Nasser, the reservoir behind its own hydropower Aswan High Dam, into the Nile and implementing several desalination projects and water management strategies, such as the recycling of agricultural waste and surface water.

Flexibility and performance profile: High inflation somewhat masks Egypt’s deteriorating fiscal position

We expect Egypt’s high external funding needs will largely be met by multilateral and bilateral lenders.

We project that Egypt’s general government deficit will widen by nearly 50% in fiscal 2023 compared with the previous fiscal year, but due to our estimate of a 25% increase in the GDP deflator, the deficit increases by only one percentage point of GDP.

Inflationary pressures remain high, despite significant monetary policy tightening over the past year.

Egypt’s current account balance is broadly characterized by a large deficit on the goods balance, alongside a deficit on net income, which the surpluses on the services and transfers balances are insufficient to offset. We estimate that the current account deficit will narrow to about $13 billion in fiscal 2023 and stay around that level over the period through fiscal 2026, falling as a share of GDP to 3.5% from 3.9% over the period. We expect import prices to moderate, while export volumes and remittances from Egyptians living abroad remain robust. Over the period through fiscal 2026, government measures to promote non-oil exports should also prevent a widening of the current account deficit.

In terms of external funding, we expect net flows to the financial account to be sufficient to compensate for the current account deficits over the period through fiscal 2026, with the Central Bank of Egypt’s (CBE’s) gross reserves being maintained at about $32 billion on average. The IMF has a more optimistic view, projecting gross reserves to reach $64 billion over the same period, as the balance of payments improves and program financing is disbursed.

Of Egypt’s total external financing requirement of $20 billion in fiscal 2024, about $13 billion relates to our estimate of the country’s current account deficit and $7 billion to government principal repayments on debt. Egypt refinanced a $1.5 billion, 5.577% coupon Eurobond maturing in February 2024, with a $1.25 billion sukuk with a coupon at close to 11% (see “Presale: The Egyptian Financial Company for Sovereign Taskeek,” published Feb. 14, 2023, on RatingsDirect). Egypt has another $500 million Eurobond maturing in November 2023, and $2 billion maturing in 2024.

We expect FDI of almost $10 billion to provide most of the current account funding, with the remainder met by FDI from GCC and other parties, some return of portfolio flows, and net external borrowing, largely by the government from by multilateral and bilateral lenders as bond yields on Egyptian Eurobonds remain elevated at close to 23%. We assume that any external funding gaps will be covered by additional GCC government support. This is notwithstanding media reports that GCC states are pushing Egypt to implement reforms before disbursing funds to purchase Egyptian SOEs. The GCC has provided $28 billion in deposits at the central bank over recent years, $13 billion of which were provided in 2022 shortly after the current foreign currency stresses emerged. Although the GCC states are pushing for better returns on the support they give to Egypt, negotiations regarding the partial sale of the state-owned assets to GCC investors is taking longer than expected. We think GCC states are still likely to provide additional aid to Egypt if needed.

We forecast the Egyptian pound to decline by about 53% by the end of fiscal 2023, compared with the previous fiscal year, followed by a modest depreciation in the subsequent years.

In our view, a key component of the recent sharp currency depreciation has been commercial entities hoarding foreign currency earnings, given the uncertainty regarding the Egyptian pound’s value. We understand that foreign currency earning sectors such as tourism have been holding on to their dollars, while there has been relatively limited availability of foreign currency on the interbank market since domestic, but more importantly, foreign banks have been uncomfortable with the level of policy uncertainty.

To preserve foreign currency, the government has introduced measures to halt capital expenditure (capex) on projects that have yet to start and called on budget entities and other governmental bodies to cut back spending in areas such as awards and travelling expenses.

Given the short-term nature of the inflow of GCC deposits, our external liquidity metric deteriorated in 2022. We expect gross external financing needs as a share of current account receipts (CARs) and usable reserves estimated at about 150% over the four years through fiscal 2026, and usable reserves covering about 2.7 months of current account payments over the period through fiscal 2026. Our estimate of usable reserves deducts required reserves from officially reported reserves.

We expect Egypt’s net external debt, adjusted for liquid external assets, to average about 145% of CARS over the period through fiscal 2026. The surge in CARs in fiscal 2022 associated with the stronger performance of the tourism and hydrocarbons sectors resulted in a decline in the ratio to about 119% of CARs.

About 70% of Egypt’s government debt is domestic and in local currency. The main funding source for this domestic debt is the Egyptian banking system, which, in our view, remains liquid and can increase its holdings of government debt if necessary, despite its already-high exposure. Deposit growth is high, averaging above 15% annually over the past three years, partly due to the low base of financial inclusion. We estimate that Egyptian domestic banks–of which the two state-owned banks, National Bank of Egypt and Banque Misr, constitute close to half in terms of total assets–hold more than 60% of general government debt.

We estimate that the general government fiscal deficit will remain high, at about 7% of GDP on average, over the period through fiscal 2026. We estimate that given current challenges, the primary surplus (deducting interest costs from the headline deficit) will average about 1% of GDP over fiscals 2023-2026, but note that in the previous four years, the average was closer to 2%, suggesting some upside to our fiscal forecasts. We expect a positive impact on the fiscal balance thanks to tax administration reforms and a broadening of the tax base. On the spending side, growth will be largely spurred by capital investments, subsidies, grants, social benefits, and salaries.

Headline inflation is well above the upper boundary of the CBE’s target range of 7% plus or minus 2%, partly as food prices, which had been increasing even before the Russia-Ukraine conflict, continue to rise. Inflation has been trending upward since mid-2021, and reached 32.7% in March 2023. The CBE tightened its monetary policy stance by increasing the overnight deposit and lending rates by 1,000 basis point (bps) since March 2022. The overnight deposit and lending rates, as well as the rate of main operation, currently stand at 18.25%, 19.25%, and 18.75%, respectively, while the discount rate is at 18.75%. In its latest policy meeting in March, the CBE raised the key policy rates by 200 bps.

We think the recent pound devaluation is unlikely to harm banks’ asset quality, since foreign currency lending (less than 20% of total loans) is usually granted to companies that generate revenue in the same currency (see “Banking Industry Country Risk Assessment: Egypt,” published Sept. 1, 2022). However, under our base case, we still expect credit losses to increase due to expanded lending to inherently riskier small and midsize enterprises (SMEs). The CBE raised the threshold for SME lending to 25% of banks’ loan books on December 2022, from 20% previously, and set a new 10% minimum threshold for lending to small enterprises. We nevertheless expect the banking sector’s pre-provision income to more than offset the hit from increased loan loss provisions, thus not hindering capital. Overall, we think the banking sector has solid domestic liquidity, with a low loan-to-deposit ratio at 48% as of December 2022. Banks’ decisions to offer high yield certificates of deposits may weigh on profitability, although the impact appears to be manageable based on the volume issued as of today.

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