Egypt uplifted by reforms

Egypt’s long-term foreign-currency issuer default rating (IDR) has been upgraded to B+ from B, with a stable outlook, according to Fitch Ratings. The ratings have been uplifted by economic and fiscal reforms.

The country has made further progress in implementing economic and fiscal reforms, which are driving improved macroeconomic stability, fiscal consolidation and stronger external finances. The authorities will complete the three-year International Monetary Fund (IMF) Extended Fund Facility (EFF) in 2019.

It seems likely these reforms will continue to generate better economic outcomes beyond the IMF agreement. General government debt/gross domestic product (GDP) is on a downward path, underpinned by structural improvements to the budget and the emergence of primary budget surpluses. Fitch expects spending on wages, subsidies and interest to fall by almost 5% of GDP from June 2016 to June 2020. Monetary policy is targeting single-digit inflation and international reserves have risen to six months of current external payments.

Fitch expects the budget sector deficit to narrow to around 8.6% of GDP in the fiscal year ending June 2019, with a primary surplus of 1.6% of GDP. This is close to the government target of 2% of GDP. In the first half of the 2019 financial year, covering July to December 2018, spending on subsidies and social benefits was flat in nominal terms. Fitch expects subsidies and social benefits spending to fall by 1.1% of GDP in the 2019 financial year. Interest spending continued to limit consolidation, but was in line with budgeted amounts. Overall, revenue grew by 28%, and expenditure by 17%, year-on-year.

For the 2020 financial year, the proposed budget again targets a 2% of GDP primary surplus and a budget deficit of 7.3% of GDP. The consolidation will mostly come from lower interest payments because of the disinflation trend, lower interest rates and lower debt as well as another round of subsidy reforms. This includes the introduction of an automatic fuel tariff adjustment mechanism. Further moderation of the wage bill/GDP and continued efforts to improve the tax administration will also contribute.

In Fitch’s view, there is political commitment for further fiscal consolidation and there have been significant structural improvements in the budget that are likely to persist. In 2020 financial year, Fitch expects wages and compensation to fall below 5% of GDP, down from an average of 8% in the 2015 to 2016 financial year. This is underpinned by the civil service law.

Fitch also expect subsidies and social spending to fall to 5.3% in 2020 financial year, from 8% in 2017. This follows several rounds of tariff hikes across utilities and other regulated prices. Interest payments are likely to peak in the 2019 financial year at 10.2% of GDP. This is before falling by at least 1percentage points (pp) of GDP in the 2020 financial year. The main risk to policy slippage would be a return of political instability and/or a negative shock to economic growth.

For the medium term, by the 2022 financial year, the government aims to narrow the deficit to 4.5% of GDP by continuing to run 2% of GDP primary surpluses. Fitch forecasts smaller primary surpluses, but nevertheless that consolidated general government debt/GDP will decline to 83% in 2020 financial year. This is from 93% in the 2018 financial year and a peak of 103% in 2017. A risk to this forecast is if a portion of government guaranteed debt, of around 20% of GDP, crystallises on the government balance sheet.

Macroeconomic stability has improved, with stronger growth and disinflation. Average consumer price inflation dropped to 14.4% year-on year in 2018 from almost 30% in 2017, following sharp depreciation of the Egyptian pound in November 2016. The Central Bank of Egypt’s (CBE’s) target has shifted down from 13%, plus or minus 3%, in the forth quarter of 2018, to  9%, plus or minus 3%, in the forth quarter of 2020.

Fitch forecasts an average inflation of 12% and 10% in 2019 and 2020 respectively, building in another round of subsidy reforms by July 2019. CBE cut its overnight deposit rate by 100basis points (bp) to 15.75% in February 2019, maintaining positive real interest rates. Fitch forecasts that real GDP growth will remain robust at 5.5% in the 2019 and 2020 financial years, with risks tilted slightly to the downside.

The rating agency estimates that the current account deficit (CAD) moderated to 2.5% of GDP in 2018 from 3.5% in 2017, with the CAD plus net FDI close to balance. CAD will average 2.3% of GDP in 2019 to 2020, according to Fitch. This is supported by growth in tourism revenues, non-oil exports and rising gas production which has eliminated the need to import gas for now. Stronger overall import growth will nonetheless prevent a smaller CAD.

The central banks’ official international reserves rose to $42 billion at end-2018, covering an estimated six months of current external payments, from $36 billion at 2017 year-end. This is despite $11 billion to $12 billion of outflows on non-resident holdings of Egyptian pound government debt in between April and December 2018.

These outflows hit the net foreign asset position of the banking sector and the CBE’s other FX assets, deposits, not included in official reserves. The central bank uses these other reserves as a buffer to limit volatility in the headline number for official reserves. Official reserves increased further to $44 billion at the end of February. The central bank’s other FX assets, deposits, increased to $7.4 billion, from $5.2 billion. This followed $4 billion in bond issuance and a $2 billion IMF tranche.

Fitch projects Egypt’s external debt service to average around $10 billion or 12% of current external receipts between 2019 and 2020, in line with the current B peer median. Within this Fitch forecasts sovereign external amortisation and interest costs at around $7.5 billion on the average between 2019 and 2020. This assumes further rollover of the majority, 75%, of projected maturing Gulf Cooperation Council (GCC) deposits at the central bank.

The sustained health of Egypt’s external finances will depend on the flexibility of the Egyptian pound, which has not displayed much volatility since the large depreciation in 2016. Inflation between 2017 and 2018 has eroded a large part of the initial competitiveness gains. The central bank cancellation in December of the profit repatriation mechanism, which in Fitch’s view mitigated potential upward or downward pressures on the currency from portfolio inflows, should herald greater Egyptian pound volatility.

The pound weakened only modestly, by 1.7%, against the US dollar between mid-April and end-December, during the period of portfolio outflows. With the return of portfolio inflows in 2019, equivalent to a quarter of the previous outflows, the Eqyptian pound has appreciated by 3% against the US dollar up to mid-March.

Egypt’s ratings also reflect relatively weak governance, together with security and political risks, which continue to weigh on the rating. The county scores below the B median on the composite World Bank governance indicator.

The potential for political instability remains a risk, in Fitch’s view, given the economic adjustment programme. This is in addition to ongoing structural problems including high youth unemployment and deficiencies in governance, as well as intermittent security issues, which have previously harmed tourism.

The government has sought to mitigate the risk of discontent by bolstering social safety nets. This includes cash transfer schemes, maintaining food subsidies and boosting electricity provision. This is while the space for political opposition and freedom of expression is restricted, in Fitch’s view.