Egypt on the brink

Haphazard management has left the Arab world’s most populous country facing a future of rising unemployment and capital flight
By Massoud A. Derhally
Sun 17 Feb 2013 08:50 AM

Capital is always a coward. So goes the saying. It goes where there is political stability and it leaves when political risk increases, confidence has been eroded and the investment environment becomes unstable.

For Egypt, the toppling of Hosni Mubarak's regime two years ago brought tremendous euphoria to thousands of people who hoped the demise of the old system would usher in a new era of accountability, stability, transparency and some measure of equity when it comes to wealth distribution that would diminish the existing disparities in society.

Instead, Egypt has been on a thorny road, infused with violence and a chaotic state of disorder that bodes little for reconciliation or a democratic transition in a post-Mubarak era. The prevailing environment has failed to restore investor sentiment.

Egypt's new president Mohamed Mursi, who comes from the Muslim Brotherhood, has irked only regional governments who fear the destabilising influence of his Islamist allies on their countries. The new Egyptian president has, more importantly, failed to dispel people's fear that he's not very different from his predecessor. Attempts to expand his constitutional powers and deem them “unchallengeable" last year - until a new constitution was ratified and new parliament elected - ignited widespread protests from liberals, secularists, Coptic Christians and members of the judiciary.

His election has been marred by ensuing violence that has essentially left the country in a state of limbo, with the economy in a state of inertia. Egypt’s talks for a $4.8bn loan from the International Monetary Fund (IMF) have stalled, making it much more difficult for the country to find other means of funding or to carry out much-needed reforms.

“Political unrest makes it more difficult to take economic decisions," says Richard Fox, head of Middle East and Africa sovereign ratings at Fitch Ratings. “The president revoked sales tax adjustments that were a key prior action for the IMF programme, which is also crucial for economic progress as it would demonstrate that the government was finally getting to grips with the economy. It would also catalyse substantial multilateral and bilateral funding."

Egypt's sovereign rating has been cut by Standard and Poor's and Fitch Ratings to junk status which puts it on a par with Greece. The central bank's foreign currency reserves have nose-dived more than 60 percent in two years to $13.6bn (enough to cover about three months of imports). In 2011, the regulator spent an average of $1.4bn a month to defend the Egyptian pound in the wake of declining tourism receipts. That has made it all the more challenging to retain confidence in the currency, which has lost about 8 percent of its value against the dollar since end of last year - leading Egyptians to buy up foreign currency in the market and the re-emergence of a black market.

“The central bank has only limited firepower to defend the pound," says William Jackson, an economist at London-based Capital Economics. “It has tried to alleviate pressures on the pound by letting it fall gradually and limiting banks' access to foreign currency. However, in the absence of private capital inflows, this policy is unsustainable."

The concern now is about rising unemployment (estimated at above 12 percent), declining tourism receipts (forecast to have plunged more than 30 percent to about $7bn) and surging inflation, as market expectations point to a further devaluation in the currency.

“We are going down an inflationary path, everything that is happening is pointing in this direction," says Wael Ziada, Head of Research at the Cairo-based EFG Hermes investment bank. “Unfortunately the performance of the government from an economic standpoint has not been one that could prevent an inflationary shock or slow down the impact. One would have hoped for a better-orchestrated plan to prevent inflationary shocks but at this stage and with the current government performance I don't believe this is avoidable."

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The North African's country's economy is forecast to grow 3 percent in 2013 from about 2 percent last year after slowing to 1.8 percent in 2011, according to IMF estimates. Investment bank EFG-Hermes estimates growth for the fiscal period ending June 2013 will be below the projections of the IMF at 1.7 percent, while the Economist Intelligence Unit (EIU) has a forecast of 2.7 percent.

Inflation is forecast to rise to 10.7 percent this year from about 8.6 percent in 2012, according to the Washington-based organisation. Inflation could rise higher if the currency continues to weaken, in line with EFG-Hermes' estimates. Last year, Egypt's trade deficit reached $31.7bn and it could widen further if the pound continues to weaken. The investment bank estimates volatility in the country will push the pound to trade at 7.75 to the US dollar within six months, compared with about 6.7 at the moment.

The Central Bank of Egypt (CBE) sold fewer dollars to banks on 11 February than it has since introducing foreign exchange auctions in December to avert a currency crisis, Reuters reported. The CBE sold $37.8m for Egyptian pounds at the auction, less than the $40m it had offered.

“The pressures are very clear and mostly have been driven by a significant decline in foreign currency resources and an increase in demand for basic goods that consume currency, chief among them is hydrocarbon demand," says Ziada.

The government has banned travellers from carrying more than $10,000 in foreign currency into or out of the country. Were it not for about $4bn in bilateral assistance and aid from Qatar, Turkey and Saudi Arabia, the decline in foreign currency reserves would not have slowed down since the spring of last year.

Interest rates on deposits may rise to try and curtail rising dollarisation, says Ziada.

To move forward, much hinges on Egypt's Islamist government going ahead with the loan agreement with the IMF that was frozen in December. The country had requested the loan to help it bridge gaps in its fiscal deficit this year, however it later informed the Washington-based organisation it was revising its economic reform programme on which the agreement was initially based.

In January, a delegation from the IMF visited Cairo and said it remains committed to helping Egypt deal with its economic challenges exacerbated by the country's turbulent political environment.

“I am encouraged by the authorities’ commitment to take steps necessary to achieve fiscal and external sustainability," IMF Middle East and Central Asia Director Masood Ahmed said after meeting with Egyptian officials last month. Egyptian officials had “expressed their firm commitment to articulate and implement a home grown macroeconomic programme that enjoys broad support and addresses these challenges,'' Ahmed said, adding they had also "reiterated their request for financial support from the IMF for such a program".

Last week, the US ambassador to Egypt, Ann Patterson, urged Cairo's government to focus on the most “critical economic needs'' of the Egyptian people and that the country's indicators painted a “bleak picture". Patterson drew reference to the billions of dollars the government owes oil companies and the increasing difficulty the country may face in paying for its imports in the face of less foreign exchange.

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“If Egypt cannot pay its import bill, her people will not be missing out on television sets and cars, but on electricity, gasoline and food," she said. “The most catastrophic path is for the government and the political leadership of the country – whether in power or in opposition – to avoid decisions, to show no leadership, to ignore the economic situation of the country," Patterson added.

In the absence of government policy, banks have been reluctant to lend to small and medium-sized enterprises (SMEs) which Patterson and economists see as an important engine of growth for the economic recovery.

Egypt will, as a result of the IMF agreement, need to raise taxes and reduce its fuel subsidies which have contributed to double-digit budget deficits and constrained the government's ability to create much-needed jobs and deploy funding on infrastructure. If and when the money from the IMF comes through, it would be a signal of confidence to other potential investors and lenders, which would eventually help the country address its structural imbalances.

The IMF credit is part of a $14.5bn package that includes funds from the World Bank, the EU, the US and Gulf Arab states. The EU approved a €5bn ($6.4bn) financial support package in mid-November. Securing the agreement also help restore confidence in attracting capital inflows that would help reduce pressure on the pound.

If capital inflows do begin to return, then the central bank should be able to let the pound fall a little lower at a gradual pace. But if the political situation deteriorates once again and confidence in the pound evaporates, then capital outflows will increase and Egyptians may well seek to change their hard-won deposits from pounds to dollars.

In this situation, the central bank’s foreign currency reserves may not be enough to support the pound in which case it would have to let the currency depreciate further, says Jackson of Capital Economics. That means inflation could spike while the central bank might have to hike interest rates to attract capital inflows.

“Putting it off for longer or perhaps deciding not to go through with it in the end would have very detrimental consequences for the economy," says Karin Maree at the EIU in London. “As a signal to the market, it’s crucial," she adds.

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