Egypt (NYSEARCA:EGPT) has long been one of the more intriguing emerging markets (NYSEARCA:EEM)(NASDAQ:ADRE) given its high yields, yet its sovereign debt and currency have long been unavailable or effectively untradeable to most foreign investors. The Central Bank of Egypt (“CBE”) announced last week that it would work to move to a free float of its Egyptian pound (“EGP”) currency, better opening up one part of its market. The liberalization of Egypt’s exchange-rate regime will result in a much needed and awaited depreciation of the currency, which has remained overvalued as a result of its peg to the US dollar. Since March, the EGP had been pegged to the USD at 8.875 – up from lower previous pegs – all while black market activity has seen the currency trade to north of 17 per dollar.
The devaluation was a necessary point of order by the International Monetary Funds (“IMF”) for it to approve a $12 billion loan designed to help relieve the country’s substantial budget deficit of 11.5% of GDP (least measured as of year-end 2015). This metric was tied for the world among 181 countries with available data (behind only Libya, Afghanistan, East Timor, Oman, Saudi Arabia, Brunei, and tied with Venezuela). The figure is likely to remain above 11% for 2016.
Tourism and foreign investors have stayed away since the country’s 2011 revolution to protest the social, economic, and political shortcomings under President Hosni Mubarak. The government’s decision to spend $1.8 billion on easing food shortages and suspending oil deliveries from the Gulf nations (NYSEARCA:MES) worsened the country’s budgetary issues. A $2.7 billion IMF-mandated currency swap with China and foreign aid support from the Gulf states (through $6 billion in bilateral creditor funding) will assist in the devaluation process.
An increase in inflation is expected, which is a natural response to a devaluation; as currencies depreciate, the cost of imports effectively rise and consumers’ purchasing power declines generally. Egypt’s inflation rate stood at 14.1% year over year as of September, down from August’s 15.5% peak, but still effectively around seven-year highs.
Double-digit inflation is never met with social approval – particularly with unemployment as high as it is – and the country’s support for President Sisi has declined 23 percentage points since June (from 91% to 68%). To combat the potential of further inflation and avoid any consequent imbalances that may come out of a momentous policy shift, the CBE increased overnight deposit rates to 14.75% from 11.75%. Moreover, the bank renounced capital controls regarding a priority list of imports, which will hurt domestic production, but open the economy to trade, a pro-growth measure.
The CBE’s interest rate hike will also buoy the currency, with the higher rates attractive to foreign investors. The increase also initially pushed Egypt’s one-year Treasury bill yields to above 16%, a figure that hadn’t been reached since mid-2012, and to above 20% following.
While this may be positive for foreign inflows, it also comes at the cost of higher government borrowing costs. Interest payments accounted for nearly 25% of all government expenditures over the past year and total debt repayments constituted over half of budget outlays (source: Egyptian Ministry of Finance). Borrowing costs are also expected to rise as a consequence of the devaluation’s direct influence on increasing inflation expectations. While depreciation of this magnitude increases repayment costs in foreign-denominated currencies, Egypt’s non-domestic debt stands at around only 15% of GDP.
The removal of the peg will also work to ease the burden of maintaining high levels of foreign reserves and the central banks will be liberated from the responsibility of needing to buy the currency on the open market to maintain the specific price level. Devaluations are also inherently expansionary by increasing the money supply, which in turn supports investment and growth of the overall economy. Egypt is currently growing at a 2.3% year-over-year pace, although the jobless rate remains relatively high at 12.5%. GDP per capita stands at around $4,000. (By comparison, US GDP per capita stands at $55,800.)
Egypt’s GDP growth rate has likely sunk to around the mid-3% range in 2016 versus its 4.2% reading for 2015. But the benefit to the country’s current account will be multi-fold through increased trade competitiveness, improved foreign direct investment, and an uptick in remittance payments entering the country. Accordingly, despite likely near-term volatility in the EGP, the long-term growth outlook will likely be improved, which should compensate for any potential increase in social discontent related to a reduction in consumers’ purchasing power. The CBE tentatively announced foreign-exchange rate guidance of EGP13.00 per US dollar, but has since traded up to the same 17-18 mark that characterized the currency’s black market value.
The country’s current account will also benefit the liberalization policy, which widened by nearly 3% from the fiscal year ending in June 2015 to June 2016, from 3.7% to 5.6% of GDP. The liquidity will come in handy with respect to paying its sovereign debt, which comes with a coupon payment of 17.15%. The country also remains indebted to several international oil and gas companies to the extent of $3.58 billion as of the end of September. A bit over a year ago, the country made the pronouncement that it wanted to entirely pay off its debt in this category by the end of the 2016 calendar year, but has risen nearly $400 million over the course of this point last year. To meet these payments, the CBE drained over $4 billion worth of foreign currency reserves from June 2015 to July 2016, or about 20% of its total (source: CBE).
Conclusion
Egypt’s free float of its pound currency was a necessary measure to pass requirements put forth by the IMF to secure $12 billion in funding. The funding is necessary to help ameliorate the country’s woefully large budget deficit, which is strained by its own sovereign debt payments and mounting arrears to foreign oil and gas companies. The devaluation will also assist in these budgetary matters and increase the country’s trade competitiveness and allure to foreign investors. While a level of volatility in the price of the EGP is expected in the short term, in addition to the general level of anxiety that comes forth when the status quo is disrupted, Egypt’s exchange-rate liberalization is likely to improve long-term economic growth and benefit the country’s credit and equities markets accordingly.
