Egypt devalues – now the hard work starts

Posted on November 3, 2016

After struggling with a lack of dollars in its economy for over a year, the Egyptian central bank finally threw in the towel, moving to a liberalisation of the pound against the dollar to allow the market to set the rate and the economy to start moving again.

The initial range of devaluation is from 8.9/$ to 13/$, meaning the pound has more than halved from the level it was at during the Arab Spring. This is in line with where the black market rate has been in recent days as the economy ground to a halt, having appreciated from a rate of 18/$ over the weekend and from 15/$ last week. The uncertainty in the value of the pound over the last few weeks has caused an economy under pressure, with GDP missing its 5 per cent growth target at 3.8 per cent, to slow further, even as a series of deals were negotiated with the IMF, Gulf nations, the G7 and China for nearly $20bn in support once a series of reforms were implemented.

Investors have been wary of Egyptian assets and investment over the past year due to the artificially high currency backed by insufficient foreign exchange reserves, despite attractive yields in the context of emerging markets. Alternate foreign exchange paths were available for new investors but these were limited, so the preference was to wait until the central bank was forced to act to clear the market. Interest rates were also increased by 300 basis points today, providing one of the highest yields for EM investors should the currency find a stable level.

The initial reaction in the stock market is likely to be positive, as the hope of a marginal buyer returns with primary currency risk now receding. This will also allow Egypt to access capital markets in a more efficient manner, ideally issuing a series of benchmark bonds to establish a proper yield curve and increase the monetary tools at the country’s disposal, although even hard currency premiums are likely to be high with net debt to GDP exceeding 100 per cent and external debt having shot up in recent years as the government borrowed over $20bn from the Gulf since 2013.

While the picture now looks positive from an investment standpoint and there is reasonable potential for outsized returns due to the extreme situation in which Egypt finds itself and the high premium it must pay to retain solvency, the social costs are far more concerning.

Even before this devaluation, urban inflation had already topped 12 per cent, with changes to subsidies and a further series of reforms such as the introduction of value added taxes of 12 per cent or more increasing the cost of goods further. This puts real pressure on the populace as the economy continues to struggle to create jobs for a young population, with 30m below the poverty line. In particular, food inflation is a key concern as Egypt imports over half of its intake, particularly wheat, with devaluation directly hitting the pockets of consumers. In contrast, the export response from a weakening pound is likely to be tepid as Egypt imports many of its raw materials, although the current account balance should start to contract having doubled to almost $9bn in recent years.

The budget deficit also widened this year to 12.2 per cent of GDP. The government has been forced to raise taxes as most of its tax take is going to simply servicing its debt burden. Tourism, a key driver of the economy (11.4 per cent of GDP) and employment, has fallen precipitously, down 42 per cent in the first nine months of 2016, led by a 65 per cent fall in Russian tourists after last year’s Metrojet disaster. The security situation appears to be improving slowly, with Germany resuming flights to Sharm el-Sheikh but this could change in an instant, with a period of stability required for any real recovery.

While foreign direct investment has picked up steadily and is likely to be accelerated by this move, heading back to the $10bn or more a year Egypt needs, the reality is that years of economic mismanagement, diversion of real resources to the benefit of rentier groups and an incorrect focus on large megaprojects to stimulate growth have led to structural imbalances that will take years to unwind.

The current leadership has had more than three years to prove its worth since the ouster of President Mohamed Morsi in July 2013. The situation for many Egyptians has demonstrably worsened since then, with the focus being on macro factors rather than providing a social security net for those struggling as key industries come under pressure. While Egypt has won a seat on the UN Human Rights Council, chaired by Saudi Arabia, continuing mass detentions, deprivation of due process and continued crackdown on civil liberties create a volatile environment for when a populace comes under pressure, with worrying regional precedent.

Egypt needs significant international support at the macro level if it is to regain its economic stability and start to achieve its significant potential. However, care should be taken to minimise the real human toll on the population through measures to preserve social stability and basic human dignity. If not, the prognosis for Egypt and the region will continue to look bleak.

Emad Mostaque is a strategist at Ecstrat, an emerging markets consultancy.

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