Egypt Outlook Revised To Stable On Likely Support From IMF; Ratings Affirmed At ‘B-/B’

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Overview

S&P Global Ratings logoAfter the Egyptian authorities’ decision last week to float the Egyptian pound and to cut fuel subsidies, we expect the IMF will likely approve the three-year US$12 billion Extended Fund Facility, announced on Aug. 11, 2016.

The increase in inflation in the near term on the back of recent currency devaluation and subsidy cuts on top of recent interest rate hikes will weigh on domestic consumption and may raise social tensions, while fiscal and external deficits remain.

We are revising our outlook on Egypt to stable from negative and affirming our ‘B-/B’ long and short-term sovereign credit ratings on the country.

The stable outlook balances Egypt’s external and fiscal vulnerabilities, against likely IMF support following the government’s upfront delivery on program reforms.

Rating Action

On Nov. 11, 2016, S&P Global Ratings revised its outlook on the long-term sovereign credit rating on the Arab Republic of Egypt to stable from negative. At the same time, we affirmed our ‘B- long-term and ‘B’ short-term foreign and local currency sovereign credit ratings.

Rationale

After last week’s decision by the Central Bank of Egypt to float the Egyptian pound, we expect the International Monetary Fund (IMF) to approve the three-year US$12 billion Extended Fund Facility (EFF) that it announced on Aug. 11, 2016. The authorities’ shift to a more flexible exchange rate regime fulfilled a key IMF condition, and is also a vital step toward alleviating Egypt’s acute foreign currency shortage, narrowing the differential between
the official and unofficial exchange rates and improving the country’s export competitiveness.

We revised the outlook to stable to reflect the balance between Egypt’s long-standing external and fiscal vulnerabilities and our expectation that the IMF’s EFF program will provide external financing to Egypt to meet its foreign exchange requirements over the coming 12 months. Nevertheless, our ratings on Egypt remain constrained by wide fiscal deficits, high public debt, low income levels, and institutional and social fragility.

On Nov. 3, 2016, the central bank formally moved to a floating exchange rate regime. As a consequence, the official exchange rate depreciated 48% against the U.S. dollar, converging close to the rate quoted in the parallel market. The authorities’ shift to a more flexible exchange rate regime is also a key step toward alleviating Egypt’s acute foreign currency shortage. A more competitive exchange rate could benefit Egypt’s export of goods and services, particularly the depressed tourism sector, if the security environment stabilizes further. The new foreign exchange regime will also, as we understand it, improve monetary policy effectiveness because inflation targeting through interest rate setting will replace exchange rate targeting.

Last week the central bank raised its key overnight deposit and lending rates by 300 basis points, to 14.75% and 15.75%, respectively. This interest rate hike is also intended to tighten monetary conditions and prevent second-round inflationary pressures.

We project that Egypt’s real GDP growth will exceed 4% by 2019. Several factors constrain the gradual economic recovery in the near term–in particular, the projected fiscal and monetary tightening, still-elevated dollar backlog, and the significant drop in tourism. However, we anticipate Egypt’s economic growth will start recovering in 2018-2019, fueled by domestic consumption and investments. These will be underpinned by a recovering security environment, stronger capital flows, resilient remittances from Egyptians working abroad, some inward foreign investment, and an improved power supply as new natural gas developments from the Zohr field come on stream by 2017 or 2018.

Eni SpA discovered the Zohr natural gas field offshore of Egypt, which it estimates to be capable of producing 850 billion cubic meters or 200,000 barrels of oil equivalent per day. We consider that the discovery could support Egypt’s economic growth by encouraging investment in the oil and gas sector and alleviating fuel shortages. Production at the Zohr field is expected to start by year-end 2017 and be fully scaled up by 2019. It could improve the country’s energy and trade imbalances starting 2018-2019. However, we understand that the Egyptian General Petroleum Corp. still owes arrears to foreign oil companies, which could delay the development of the field. We believe that any delays in paying back foreign oil companies could discourage investment in the Egyptian oil and gas sector, particularly as long as oil prices remain low.

Egypt’s fiscal deficit, which stood at 12.2% of GDP in 2016, remains one of the highest among the sovereigns we rate at ‘B-‘. We anticipate that gradual fiscal consolidation will continue as a result of the second phase of fuel subsidy cuts, new fiscal measures (including those involving the implementation of value-added tax (VAT) and the increase of electricity
prices), and low energy prices. In our view, the government has a very limited ability to significantly cut spending, given Egypt’s large wage bill, the need for social assistance to low-income individuals and families, and the country’s high debt service cost. Spending on public wages and salaries, subsidies and social transfers, and debt service represents about 80% of the total expenditures in the 2015-2016 budget. Moreover, the government is obliged to channel some of the savings from subsidy reforms into constitutionally mandated higher spending on health, education, and scientific research.

We forecast that general government debt will increase to 91% of GDP in 2016. We estimate the annual change in general government debt will average about 13% of GDP in 2016-2019, down from 14% of GDP in 2012-2015. We project that general government interest expenditure will reach 37% of general government revenues on average in 2016-2019. Financial assistance from official lenders, such as the IMF, the World Bank, and some Gulf Cooperation Council (GCC) countries, remains an important component in the government’s debt financing strategy. We understand that the executive board of the IMF will likely approve Egypt’s loan on Friday Nov. 11. Once approved, Egypt anticipates
receiving the first $US2.75 billion tranche of the loan in the coming weeks.

The government’s debt strategy during this fiscal year (July 2016 to June 2017) also includes the possible issuance of a new Eurobond of up to US$3 billion, and up to US$1.5 billion from the World Bank and the African Development Bank via a development policy financing loan. In November 2015, Egypt reached an agreement with the World Bank and the African Development Bank to receive US$4.5 billion in concessional funding over the next three years, of which US$1.5 billion have already been disbursed.

The remaining fiscal funding will most likely be raised from the Egyptian banking system. Domestic banks are heavily exposed to Egyptian government debt. They tend to invest their excess liquidity in domestic government debt. The Egyptian authorities have increasingly been relying on the central bank to finance budget deficits.

We forecast current account deficits will narrow to about 3% of GDP in 2017-2019, from 5.5% as a result of the improvement of the trade balance. We anticipate that the Egyptian pound’s devaluation will make imports more expensive and exports of goods and services relatively cheaper. Moreover, it could eventually lead to substitution of domestic production for those imported goods over the medium term.

Over the past four years, Saudi Arabia, the United Arab Emirates (UAE), and Kuwait have demonstrated support to Egypt by providing substantial financing–totaling close to US$25 billion–in grants, aid, and concessionary loans, because they view Egypt as an important geopolitical ally. Egypt’s central bank received US$6 billion in deposits from the Gulf states in April 2015, which has helped increase Egypt’s foreign currency reserves to US$20.5 billion. We understand that Egypt received an additional US$3 billion in deposits from Saudi Arabia and the UAE, which have helped support Egypt’s international reserve position, currently at US$19 billion as of Oct. 31, 2016. In addition, the central bank has reportedly agreed with China on US$2.7 billion in bilateral aid that will include a deposit and yuan currency swap.
This week, the central bank has reportedly agreed with a consortium of international banks for a repurchase deal of US$2 billion with a maturity of one year. These measures are designed to bolster the country’s foreign currency reserves.

We assess Egypt’s monetary policy flexibility as low, reflecting our appraisal of its central bank’s exposure (along with that of the banking system) to the government domestic debt and an annual inflation rate exceeding 10%. Egypt’s core inflation increased to 15.7% in October, up from 13.9% in September. We anticipate inflation will remain at elevated levels in the coming months, reflecting upward pressures stemming from the pass-through of the currency depreciation, the implementation of VAT, and subsidy cuts.

The security and sociopolitical environment in Egypt remains fragile. About 26% of the population in Egypt lives in poverty. This high level of poverty is also fueled by a high 13% rate of unemployment. Mounting public discontent, especially from vulnerable groups as a result of the rising cost of living, is a concern. At the same time, we understand from authorities that social protection and new compensatory measures are an important component of the fiscal consolidation program. Other contentious issues in Egypt include the
transfer of islands in the Red Sea to Saudi Arabia, and continued hostility between the Egyptian security forces and the militant group ISIS in Northern Sinai.

Outlook

The stable outlook balances Egypt’s current external and fiscal vulnerabilities against our expectation that the IMF’s EFF framework, once approved, will provide external financing to Egypt to meet its foreign exchange requirements over the coming 12 months and at the same time assist the government in implementing the planned fiscal consolidation and exchange rate regime reform.

We could lower the ratings if external imbalances increase beyond our current expectations, for example, if foreign exchange reserves decreased more quickly than we currently expect. We could also lower the ratings if current account financing, including from GCC countries, became less forthcoming. Deteriorating domestic fiscal funding options, increased political risk, or a weaker institutional environment could also lead us to lower the ratings.

We could raise the ratings if Egypt improves its fiscal and external positions substantially, and if GDP growth picks up beyond our expectations.