Egypt bolstered by reforms

Egypt’s long-term foreign-currency issuer default rating (IDR) has been kept at B+, with stable outlook by Fitch Ratings, on the back of its track record of fiscal and economic reforms.

The ratings are also supported by Egypt’s large economy, which has demonstrated stability and resilience through the global health crisis.

However, the ratings are constrained by still-large fiscal deficits, high general government debt to gross domestic (GDP) and domestic and regional security and political risks.

External vulnerabilities, including the reliance on short-term portfolio inflows, are also reflected in the ratings.

Continued economic growth and a modest coronavirus support package limited the crisis’ impact on Egypt’s public finances.

Fitch estimates a modest widening in the general government overall deficit to 7.5% of GDP in the fiscal year ending June 2021. This is compared to 7% in 2020 and 7.9% 2019.

The rating agency expects a slightly lower 2022 deficit on the back of revenue measures, including a customs law, various fee revisions and modernisation of the tax system.

This is in line with a government target to increase tax revenue to GDP by 2 percentage points (pp) over the next four years.

Fiscal policy is anchored by a primary surplus target of 2% of GDP over the medium term – the primary surplus averaged 1.8% of GDP in the past three years.

The coronavirus crisis interrupted Egypt’s two-year debt-reduction trend, and public finances remain a core weakness of the rating.

However, Fitch expects government debt to GDP to resume a downward path from 2022, and Egypt has significant financing flexibility.

Consolidated general government debt to GDP hit an estimated 88% in 2020 and 2021, up from 84% in 2019.

Fitch expects faster growth and ongoing primary surpluses to reduce government debt to GDP to 86% in 2022.

Debt metrics are well above B medians. However, more than half of government external debt is owed to multilateral institutions, with which Egypt has good relations, and the large domestic banking sector is a captive investor in local-currency debt.

Egypt’s economic growth outperformed the vast majority of Fitch-rated countries throughout the coronavirus crisis. This was supported by resilient domestic demand, gas production and a public-sector investment programme in the face of sagging tourism and export-oriented sectors.

Real GDP grew 3.3% in 2021, down from 3.6% in 2020 and 5.6% in 2019.

Global economic recovery and resumption of tourism to Egypt, helped by the end of a 6-year ban on Russian flights to Egypt’s Red Sea resorts, will drive an increase to 5.5% growth in 2022 and 2023.

 

The Central Bank of Egypt (CBE) has kept its headline overnight deposit rate unchanged at 8.25% after a cumulative 400 basis points (bp) of cuts in 2020.

This has supported private-sector credit growth, which stands at 21% as of 2021, compared to 20% as of 2020.

However, Egypt’s high real interest rates could be eroded by inflation rising to an average of 7% in 2022, in the middle of the CBE’s target range, 4.8% as of 2021.

Higher and more persistent inflation than anticipated, a shift in sentiment towards emerging markets or tightening global liquidity conditions, could force the CBE to tighten rates again, with knock-on effects on growth.

Global monetary conditions are becoming less favourable for Egypt and represent key risks to the positive trends in its public finance and macro fundamentals, in Fitch’s view.

Since mid-2020, there has been a mutually reinforcing dynamic between exchange rate stability and non-resident inflows into the Egyptian pound government bond market.

This is against the backdrop of high real rates in Egypt and easy global monetary conditions and risk on sentiment globally.

Foreign holdings of government treasury bills (T-bills) and treasury bonds (T-bonds) reached an all-time-high of $34 billion in September 2021. This was over 12% of government domestic debt and 85% of CBE foreign reserves.

This is compared to a trough of less than $10 billion in June 2020. However, these flows could reverse in response to any confidence shock or shift in global liquidity conditions, putting pressure on foreign exchange liquidity, interest rates and the exchange rate.

Egypt’s inclusion in the JP Morgan GBI-EM bond index from January 2022 will provide some structural support to non-resident investor demand, as could the settlement of Egyptian bonds by Euroclear Bank, anticipated later in 2022.

In Fitch’s view, continued exchange rate rigidity poses risks to macroeconomic stability and current account performance in the medium term.

Real effective appreciation has eroded a large part of the competitiveness gain from the 2016 devaluation and increases the risk of another sharp nominal exchange rate adjustment in the future.

This potentially undermines price stability and domestic confidence. Nevertheless, the CBE maintains that it is committed to exchange rate flexibility, intervening only to mitigate disorderly market movements.

Egypt’s current account deficit widened to 4.6% of GDP, just over $18 billion, in 2021 from 3.1% in 2020, and 3.6% in 2019. This is with strong domestic demand growth putting pressure on the goods account, even as travel receipts remained muted.

Fitch expects the current account deficit to narrow in 2022 to 2023 as global demand and tourist flows pick up.

Egypt’s external funding conditions have remained broadly favourable. The government has issued about $3 billion in external bonds so far in 2022. This follows about $5 billion in each of 2020 and 2021.

The country also recently received the final $1.7 billion disbursement under the $5.2 billion IMF stand-by arrangement (SBA) agreed in June last year. This was followed by $2.8 billion as part of the global allocation of special drawing rights.

Net foreign direct investment fell to $4.8 billion in 2021, from $7.1 billion in 2020.

Egypt’s net external debt, at 17% of GDP in 2021, including non-resident holdings of local-currency debt is significantly smaller than B category medians.

Government borrowing and a return of non-resident portfolio investors allowed the CBE and commercial banks to partly rebuild their net foreign asset positions.

However, the commercial banks’ position has seen significant deterioration again in 2021.

The decline in banks’ NFA could be partly explained by their use to fund the current account and to cover maturing external liabilities, indirectly supporting CBE reserves.

CBE’s official gross foreign reserves have recovered to $40 billion by September 2021, after dipping to $35 billion in May last year as the CBE intervened to support the exchange rate.

The CBE’s net foreign assets, just over $15 billion in September remain significantly lower than its gross reserves.

However, CBE’s liabilities, $29 billion are medium-to long-term and have repeatedly been rolled over, and Fitch continues to view CBE’s gross reserves as the most relevant indicator of its external liquidity.

The potential for political instability remains a significant tail risk, in Fitch’s view, given ongoing structural problems including deficiencies in governance and high youth unemployment.

However, the headline overall unemployment rate has fallen to about 7% in 2021, after approaching 10% in the second half of 2020. This is against the backdrop of a low participation rate of 41%, which has been declining in recent years.

The government has sought to mitigate this risk through targeted social spending and economic reforms, while the space for political opposition and freedom of expression is restricted.

Fitch would downgrade the rating if there were renewed signs of external financing strains. This would include persistent downward pressure on international reserves and rapid outflow of non-resident portfolio investments from Egypt’s financial system.

A prolonged hit to economic growth from the coronavirus shock and backsliding on the country’s economic reform programme, would also lead to a downgrade.

Fitch would also downgrade the rating if there was failure to resume a path of narrowing the fiscal deficit and reducing government debt to GDP following the negative impact of the coronavirus crisis.

The rating agency would lift the rating if there was reduction in external vulnerabilities. This would be for example, through lower dependence on non-resident portfolio flows, narrowing of the current account deficit – and build-up of international reserves or other liquidity buffers.

This comes after Egypt’s long-term foreign and local currency issuer ratings were affirmed at B2, by Moody’s Investors Service on the back of its track record of fiscal and economic reforms, earlier in 2021.

Fitch would also lift the rating if there was sustained progress on fiscal consolidation leading to a further substantial reduction in the gross general government debt to GDP ratio.

Significant improvement across structural factors over the medium term to levels closer to B and BB rated countries may also lead to an upgrade.

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