Looking ahead, the incumbent interim regime is planning to provide a fiscal stimulus focused on labour intensive housing, transport and utilities to the tune of EGP22 billion (just over USD3 billion, or a mere 1% of projected FY14 GDP). The government’s fiscal package is being aided by monetary policy, wherein the CBE has already started cutting rates. This could well continue at the next Monetary Policy Committee (MPC) meeting on September 19.
What this will amount to is difficult to say –economic agents may well want to wait till there is greater clarity and certainty on what the incumbent government’s transition process will bring. In our view, it is difficult to see any major improvement in headline indicators over the course of the current fiscal year (FY14) – growth is likely to remain anaemic (2-3% mark), inflation around current levels (9-10%), external financing needs significant (USD15-16 billion), the fiscal deficit elevated (10-11% of GDP) preventing any significant improvement in high government debt levels (80%+ of GDP).
That said, barring a major deterioration in the social situation, support from GCC countries will help the interim government meet financing needs till at least the end of the transition period next year. This easier financing picture, coupled with market appetite for laggards and the high yields on Egyptian assets, has likely been the driving force behind recent market price action. Perhaps there is also an element of the market getting used to the political noise out of Egypt, and an expectation that the interim government will be able to ‘manage’ the Muslim Brotherhood’s response to the on-going crackdown. Our view remains that more than anything else, political stability is the key to improving the outlook for the Egyptian economy. As things stand, such stability remains elusive.
Data for Q1-2013 (Q3-FY13) suggests that headline growth slowed for the third consecutive quarter to 2.5% (YoY; 4 quarter average), from 2.5% in the last quarter and 2.9% over the comparable period last year, driven by continued contraction in mining (down 1.6% YoY in Q1-2013; share of 16.9% in real GDP). The picture beyond that was not much rosy either. Base effects helped across much of the economy, but particularly in agriculture, retail and wholesale trade, manufacturing, real estate and hotels/restaurants with a combined weight of ~50% in the real economy. Other sectors including transport, communication, information (share of 6.6% cumulatively) along with finance and insurance (6.8% share) displayed weaker growth.
These outcomes are not surprizing given that the politics was deteriorating for much of the first half of 2013 – just have a look at the Egypt 5Y CDS chart between Jan-Jun 2013, or the pace at which currency in circulation was growing or government indices of electricity consumption, cement production and cement/steel sales which were all contracting - while uncertainties over the IMF program were continuing to linger. Further, inflation had started to pick-up, while weakness in the EGP since the end of 2012 had not helped export growth; imports though actually contracted, perhaps reflecting the response of domestic demand to EGP weakness.
Indeed, the impact of the above and of the political unrest is also evident in looking at GDP by expenditure data – both consumption and investment had slowed significantly from their peaks around mid-2012, with growth in final consumption having fallen to 1.9% (YoY) in Q1-2013 (latest data available) and gross fixed capital formation actually contracting for the third consecutive quarter at a rate of 6.5% (YoY). The resulting impact has thus pushed headline growth to an average 2% compared to over 5% in the aftermath of the global financial crisis and before the start of pro-democracy protests in January 2011, and an average 8.5% in the three years leading up to the global financial crisis.
Looking ahead, it is difficult to see headline growth levels rising till the transition process is complete. Under the timeline announced by the incumbent interim government, this is likely to be completed in the first half of calendar 2014. Therefore, headline growth will probably towards the upper end of a 2.5% -3.0% range, helped perhaps by the USD3 billion stimulus package that the government is working on, and lower than the government target/Bloomberg consensus forecasts of 3.5%. Once the constitutional reform process is complete, elections to the lower and upper house done and a new government is in place, growth could more than double by FY15, as pent up investment demand begins to be met.
Inflation and Monetary Policy
Such rapid falls in headline growth numbers have helped bring inflation down from a 20% levcel in September 2008 to as low as just over 4% in end 2012. Since then, there has been some resilience with the most recent data for August showing inflation at 10.9% YoY (CPI national) and 9.8% YoY (CPI urban), more than double the lows of late last year, but lower compared to the 11.5% and 10.3% realized in July. The modest slowdown compared to the previous month was due largely to lower prices for food (39.9% weight in CPI) and clothing/footwear (5.4% weight). Worryingly though, despite this fall and global food prices (as measured by the UN Food and Agriculture Organization's World Food Price Index) showing deflation/stability, annualised food inflation in Egypt is still averaging 13% over the last 3 months. Part of the reason might be distribution/logistical challenges and shortages given recent political unrest especially before Mr Mursi ouster, while other factors include EGP weakness; by end August 2013, the EGP was down ~13% since the end of last year.
The decline in inflation comes after the surprise Central Bank of Egypt (CBE) decision to cut the benchmark interest rate corridor 50bp to 9.25-10.25% in early August. That was predicated upon a CBE assessment that the upside risks to inflation had moderated and the downside risks to the growth outlook outweighed them. As noted above, the CBE's assessment has turned out to be correct with domestic food price inflation receding modestly. This, coupled with the recent appreciation of the EGP (negative for inflation) and pressure perhaps from the government to compliment the announced expansion in fiscal policy, means the CBE might well cut rates again when its Monetary Policy Committee (MPC) meets on 19 September (the sixth out of eight meetings planned for 2013).
Looking ahead, we expect the noted depreciation of the EGP and the anticipated fiscal package to keep inflation around the 9-10% mark, in line with Bloomberg consensus forecasts. This implies that the CBE does not have a lot of room to cut rates, particularly as the EGP/external sector remains vulnerable (see below), while the government’s financing needs are still large.
External sector, debt and exchange rate
As of Q1-2013, the latest data available, Egypt’s current account deficit is running at USD5.4 billion annualized (1.7% of projected FY14 nominal GDP of USD312.9 billion). At this level, the current account deficit is at its lowest Dollar level since March 2010 and despite a near 30% increase in the trade deficit to an annualized USD31.9 billion by March 2013 (annualized; 10.2% of GDP), a level nearly 30% higher than the global financial crisis.
The latter is itself due to the stagnation in exports around USD25 billion, some 15% lower than the pre global financial crisis peak. In contrast, imports have risen to higher than pre global financial crisis levels, driven by food and fuel imports. Highlighting this, over 2008-12, food and fuel imports nearly doubled to USD27.9 billion (+93.1% over 2008; International Trade Centre Data), taking their share in total imports from 27% in 2008 to 40% by 2012 (ITC data).
While lower exports are due to weaker economic conditions in export markets (in 2012, some ~30% of Egyptian exports went to Europe and 8.5% to the Americas/Canada), the increase in imports is the result of positive price and quantity effects in both fuel and food imports; wheat is the principal commodity in the latter accounting for 36% of food imports, reflecting Egypt’s position as the world largest importer (and per capita consumer) of wheat, partly the result of subsidized government provision.
Despite this, the fact that the resultantly large trade deficit does not filter through to the current account deficit is due to three factors: (a) the size of incoming remittances, running at an annualized USD18.8 billion in Q1-2013 (6% of GDP), more than double their level since the global financial crisis; (b) tourism revenues of USD10.4 billion annualized (3.3% of GDP), still 7.5% lower than Sep-08; and, Suez Canal receipts amounting to USD5.1 billion annualized (1.7% of GDP), 6.3% lower than Sep-08.
As impressive as these inflows still are, perspective is important – Egypt’s annual goods and service imports are running at around USD75 billion implying import cover from current (August) CBE FX reserves of just 3.1 months; in end March 2013, this was 2.2 months. Just how precarious these levels are, is well highlighted in the fact that Egypt’s food and fuel import bill totalled over USD27 billion in 2012 (food imports of USD14.8 billion and mineral fuel imports of USD13.1 billion; ITC data).
Further challenges in the external sector are evident in the capital and financial account of the balance of payments. While net FDI has done well to remain around the USD3 billion mark (annualized) over the previous four quarter, net portfolio investment has remained in the red since the ouster of Hosni Mubarak in early 2011. In fact, since the start of pro-democracy protests, total net outflows under this head have amounted to USD12.9 billion compared to an annualized level of USD10.9 billion before the start of the pro democracy protests. Further, net errors and omissions (a proxy for capital flight) are running at an annualized USD3.3 billion as of Q1-2013, their highest level since early 2009. Taken together, the above balance of payments dynamics have led to reserves decline of a whopping USD23.7 billion between January 2011 and March 2013 as per BOP data.
This though is the net impact on FX reserves; in gross terms, the picture is even worse. For one thing, the CBE kept hot money inflows as deposits with commercial banks in the lead-up to the global financial crisis. Their drawdown (stock of USD7.2 billion in end December 2010, almost depleted by end February 2011) raises actual reserve loss to USD30.9 billion. Then, let’s not forget the USD8 billion in financial support from Qatar, USD2 billion from Libya, USD1 billion from Turkey, USD6.6 billion in one year dollar-denominated T-bills, and USD1.6 billion in Euro-denominated T-bills. Adding this up, the total reserve loss between January 2011 and March 2013 is about USD50 billion (excluding relatively smaller disbursements from multilateral and Western bilateral donors).
What would typically help mitigate risks on the external sector is the fact that despite the borrowing noted above, Egypt’s external debt is still low – about USD38 billion, or 15% of GDP in Q1-2013 as per data from the Egyptian Ministry of Finance. While market access may be somewhat restricted/expensive given the premium the government would have to pay, the only cheaper option is borrowing from official sources, both multilateral and bilateral. However, with Egypt having secured assistance from most oil rich countries in the region over the last two years – with the exception of Iraq and Algeria – the overwhelming focus will have to be multilateral institutions, and the West. Herein, multilateral assistance could well be impacted by the army’s ouster of former president Mr Mursi from office after overwhelming popular protests, and their demand to see a credible reform program that will undoubtedly entail difficult decisions on public finances in particular.
In conclusion, support from GCC countries has enabled Egypt to weather portfolio outflows and capital flight on account of political unrest since January 2011. The external sector, and the EGP, remains vulnerable, particularly in view of Egypt’s still large external financing needs. In our estimate, Egypt’s gross external financing requirement over the next 12 months is USD15.8 billion, made up of a USD5-6 billion current account deficit, USD6.8 billion in short term external debt and medium/LT debt servicing of USD3.0 billion or so.
The above exclude FX-denominated T-bills (issued to domestic banks), assume zero capital flight (errors & omissions alone at USD3 billion annualized at present) and only include the non-resident component of foreign currency accounts with Egyptian commercial banks (USD620 million in March 2013). The risks for the EGP and CBE FX reserves are evident in the total stock of non-government FX deposits of USD33 billion in March 2013. Needless to state, persistent heightened political unrest, or any shocks that shake confidence in the EGP could lead to depositors pulling their money. This though is not our ‘base case’ scenario, which is why Bloomberg consensus forecasts for USDEGP at 7.2 by end 2013 (4.2% weaker from current levels) seem too much. Even if depreciation pressures resume – which we do expect – we do not expect the EGP to weaken significantly past the 7 mark by the end of this year.
Public Finances and Public Debt
Egypt principal macroeconomic weakness in the lead-up to the global financial crisis was public finances. And while political unrest over the last two years have created external sector constraints, the binding constraint on the macro side is still the poor state of public finances. The problem herein is two-fold: one, the low level of tax collection highlighted general government tax revenues to GDP ratio of just 13.5% in 2012, and even this is lower than its 15.3% level in 2008; and two, the high levels of public expenditures, wherein public wages amount to 8.1% of GDP, subsidies of 8.9% of GDP and debt servicing of 6.1% of GDP. Given the sticky nature of this spending, not only do these heads account for nearly 70% of total spending – leaving little for more productive spending – but increases therein have kept fiscal deficit large. Pertinent to note that revenues in particular since the pro-democracy protests – reflecting weaker growth - has actually driven the overall deficit from 8.1% of GDP in FY10 to 13.8% of GDP in FY13 (preliminary; Egyptian Ministry of Finance); note that at the time of the global financial crisis, the fiscal deficit was 6.8% of GDP (June 2008), roughly half current levels.
Such large public sector financing needs have pushed public sector debt levels to 83.4% of GDP (June 2013), 16.4% of GDP higher than FY08. And while most of public sector debt is domestic (78.3% of GDP), its maturity profile is heavily short-term. The latter is well exhibited in the fact that Fitch estimated annual maturities at nearly 25.5% of GDP (roughly USD68.9 billion in 2012). Further still, given high domestic interest rates, the debt servicing burden this imposes is also large at 18% of total spending, or over 6% of GDP (2012). Further still, this level of financing need is clearly crowding out the private sector – as of May 2013, the stock of domestic credit to the public sector and state owned enterprises was about USD120 billion, or 48% of estimated FY13 GDP, while that to the private sector was 24% of GDP, compared to nearly 36% of GDP at the end of FY08.
Looking ahead, beyond the near 14% deficit for FY13 (ended June 2013), the FY14 budget targets a central government deficit of 9.1% of GDP. This is based on a sharp increase in public revenues from EGP344.6 billion in FY13 (budget sector) to EGP505.5 billion in FY14. This 46.7% increase is not likely to be materialized, and not just because growth will underperform the government’s target but also because any fiscal reforms – that significantly reduce unproductive expenditures - will be difficult to implement in the transition period. Therefore, we expect only a minor fiscal consolidation of around 1-2% of GDP by end of the current fiscal year, for a full year fiscal deficit in the range of 11-12% of GDP. This will imply that public sector debt levels will remain around present levels (80%+ of GDP).