Egypt is now within reach of the first US$2.75bn tranche of an IMF US$12bn loan, after securing a US$2bn syndicated loan from international banks on Thursday.
With FX reserves depleted, the pound was looking increasingly over-valued in the weeks before the Central Bank of Egypt’s decision to float the currency earlier this month, and was trading at a record EGP18.25 to the dollar on the black market.
The flotation devalued the currency by about a third from its former peg of 8.8 against the dollar, and it continued to drop in the following week, passing the EGP20 per US dollar mark on Wednesday, before recovering slightly amid the dollar’s decline. As of Friday it stood at 18.24 per dollar.
“The currency has now probably overshot its fair value and we have seen it retreat a little in recent days,” said Middle East economist Jason Tuvey of Capital Economics. “There are a couple of reasons for that. One is that it had fallen sharply on the black market prior to the float. The other is that, as trade shifted from black to official markets, banks have had to offer more attractive – meaning extremely weak – rates.”
“We expect the rate to settle around 14-15 to the dollar by the end of the year,” he continued.
As a result, Egyptian stocks continued to rally in record volumes this week, driven by last week’s rate hike to 14.75% and signs that hard currency had begun to flow in. Egypt's blue chip index surged 25% since the currency was floated.
The broader EGX 100 index was up by its 5% limit two minutes before the close, causing trade to be suspended.
The Egyptian government has mulled the measure over the last few months as the Middle Eastern country, plagued by economic woes since 2011, looks to secure a much needed US$12bn IMF funding package. Experts agree that the move was long overdue.
“In all honesty, the flotation was probably a few years overdue. The pound’s position has been pretty dire for a number of years, and in the past they resorted to a series of micro-devaluations to muddle through,” Tuvey noted.
“In the run up to the flotation they saw shortages grow, sugar in particular. In the end, going for a fully-fledged float is a positive, albeit belated, move.”
Devaluation was one of a number of measures taken by the Central Bank, which included liberating exchange rates at which market participants are allowed to trade, permitting banks to stay open at out-of-work hours, and abolishing ‘priority imports lists’. The Central Bank also set cash deposit and withdrawal limits for companies importing non-basic goods.
In addition, the government finally complied with a demand to cut fuel price subsidies, with 80-octane gasoline rising almost 47% to EGP2.35 per litre. The price of subsidised butane cylinders used for cooking almost doubled to EGP15, oil ministry spokesman Hamdy Abdel Aziz said in an interview with CBC television.
“In order to get the IMF package, which is critical for the economy, they needed to implement two measures: the devaluation and the fuel subsidy cuts. They did both of those last week,” an international banker told Bonds & Loans.
Although largely seen as a positive step, the floatation appears to have been the Central Bank’s only available option, and is expected put more pressure on a population already suffering from high inflation, currently at 14.1%, and growing net debt to GDP, a ratio which now exceeds 100%.
“The economy will be hit very hard by the float, with inflation expected to reach 20% in the coming months, according to our estimates. But the weakened pound helped to make Egyptian assets cheaper, so we expect investment flows to increase in coming months,” explained Tuvey.
Egypt’s FX reserves have shrunk by 40% since 2011 down to under US$16bn in July as the Central Bank was forced to splash out billions of dollars to peg the currency. Bilateral loans from its Gulf neighbours, namely Saudi Arabia and the UAE, provided some liquidity relief, but its budget deficit widened to 12.1%, compared to 11.5% in the last financial year.
The overnight post-flotation currency drop has been the largest in two years globally, dwarfing Azerbaijan’s 33% and Nigeria’s 28%. For Egypt it will be crucial to avoid the traditional pitfalls associated with a sudden removal of a currency peg, and to model the process on the Russian Central Bank’s management of the process, rather than Nigeria’s.
“The final pricing suggests the move has been a success,” said the banker. “But now they need to keep an eye on the reserves – there is still the danger of repeating Nigeria’s mistake, which did not have enough reserves to stop the currency from plummeting.”
Egypt has always taken a hands-on approach to its exchange rate, so the process will be painful for at least a year, but the authorities must resist the temptation to interfere, as half-measures could only exacerbate the crisis.
“There has been talk of FX auctions, but the Central Bank decided in the end not to intervene. So far we have not seen any evidence that it has, despite the currency dropping more than expected,” Tuvey continued.
“We may still see some measures taken to prop up the currency, but judging by the massive drop in volume of hard currency the Central Bank planned to auction, from an initial US$4bn to just US$100mn, the level of interference is not expected to be significant,” the international banker agreed.
Foreign direct investment has picked up steadily, rising from US$1.5bn to nearly US$3.5bn over the course of this year, and the flotation is likely to boost it further towards the US$10bn a year target.
There are already indications that confidence is returning to the markets, with average yields on six-month and one-year treasury bills dropping significantly at an auction on Thursday. The 182-day treasury bills dropped to 18.469% from 19.521% in the previous auction and yields for 364-day sovereign notes likewise dropped to 18.903% from 20.519%.
Furthermore, on Thursday Egypt’s Finance Ministry announced a US$4bn private bond placement on the Irish Stock Exchange, part of which was the US$2bn loan from international banks.
“It seems to be a Central Bank measure to boost short-term FX reserves. Basically, the Ministry of Finance issued the bond directly to the Central Bank, which used it as part of a repo agreement to get the US$2bn loan from international banks. So the overall effect has been a boost to the country’s FX reserves,” Tuvey said.
But it is clear that conditions have to continue to improve if Egypt is to attract more foreign capital, the banker continued. The big question is whether the government will be able to maintain social and political stability as it is forced to slash spending and introduce tighter fiscal policies.
“With street protests flaring up as fiscal measures are implemented, there are questions about the government’s ability to go through with those policies,” Tuvey concluded.
The images of social turmoil and popular protests in 2011 are still imprinted on the minds of those investors who had to count their losses after the revolt. When it comes to Egypt’s recovery, they may not be so easy to convince.