Egypt: Politics unlikely to get in way of reform

Muslim Brotherhood electoral gains unlikely to get in the way of reform – Privatisation program remains key in the face of high fiscal deficits – Egyptian pound may be supported by increased inward FDI.

 

Egypt had a frantic Q4 2005 with the parliamentary elections ending in controversial nature amidst allegations that the authorities intervened in order to stop the Muslim Brotherhood, under the guise of independent politicians, from making further inroads in political terms.

Still, the Muslim Brotherhood won more than 50% of the seats it contested and managed to wrestle around 20% of the seats away from the ruling coalition – some seats are still being disputed. This comes at a key point in the reform process. As we argued in 2005, the government had done a good job of implementing the so-called easy and painless reform measures. But more crucial was what lay ahead.

Would the government feel pressured by political losses into slowing the reform program in order to limit the short-term social consequences of such policies? Or would it proceed in the knowledge this is necessary for job creation and thus for it to retain widespread support over the longer term? Recent indications are that the government remains intent on reforming.

In its 2005 report, ’Doing Business in 2006: Creating Jobs’, the World Bank highlighted that Egypt was amongst the top three reformers in the world in 2005. Still, its competitive ranking remained a dismal 141st out of 157 countries covered and was in the top half in only one of the ten broad categories covered (trading across borders).

While some of the results from this survey have raised eyebrows when presented across the business community, these findings with respect to Egypt have not been a surprise to those who have operations in the country. Clearly, there is a risk-return relationship in all investment decisions. For instance, as one of the larger populations in the region, Egypt presents a great opportunity for investors.

However, the hurdle rate is high due to the risks faced and most businessmen who have invested or are investing in the country acknowledge that turning the investment into a profitable venture usually takes a long time.

It is against this backdrop, matched with a very young population that will require a huge number of jobs to be created in the coming years, that the government embarked on an aggressive reform agenda, despite the President’s historical hesitance to pursue reform. One of the decisions was to make the environment more business friendly by reducing corporate and income taxes.

Given the tenuous nature of the government’s fiscal position, this was risky. However, the government gambled that such a move should help to boost both private investment and consumption. This appears to have worked with the economy proving remarkably resilient, despite the Sharm al-Sheikh bombings temporarily undermining the tourist industry.

Of course, this did not come without a cost. We have seen a significant deterioration in the government’s fiscal accounts. While a case can be made that the tax cuts will ultimately pay for themselves, the cost is always taken up front while the benefits take longer to feed through. Therefore, we have seen the fiscal deficit widen to just under 10% of GDP from 6.4% in 2004. The likelihood is that we will see further deterioration in 2006 as the government has increased public sector wages and faced increased debt servicing costs.

The good news is that the government is moving aggressively to fund this deficit through privatisation receipts. The key in this regard is the government’s planned divesture of Bank of Alexandria. While this has been delayed until June, from end-2005 initially, and further delays cannot be ruled out, significant progress has been made and the completion of this sale looks likely by the end of the year.

Meanwhile, there are other efforts being made at strengthening the banking sector, including recapitalisation and consolidation. Recent times have seen bank credit relatively stagnant, especially when you strip out funding to the public sector. A healthier banking system is seen as a prerequisite to a strong and sustained economic recovery.

The slow expansion in credit creation suggests that inflation pressures will remain benign in the very short term. This is reinforced by the fact that the Egyptian pound has been strengthening in recent times, despite a sharp fall in the country’s current account surplus.

We expect the trend for EGP gains to continue given the likelihood of continued asset sales which may attract foreign bids – although there are rumours that the delay in the Bank of Alexandria sale is in part to facilitate a domestic bank to win the bid. That said, we expect further EGP gains to be relatively modest in the near-term due to the fact that the Central Bank of Egypt (CBE) to use this strength of the currency to build up the level of reserves going forward.

On the interest rate front, the CBE cut interest rates again in January in order to help spur credit creation. Its overnight deposit and lending rates were both cut by 50bps to 8.25% and 10.25%, respectively, following a 25bps cut in December.

In the backdrop of a strong currency and relatively tame inflation, the possibility of further interest rate cuts cannot be ruled out Indeed, real interest rates are still very high. However, the CBE will need to keep an eye on M1 growth which has accelerated in recent times, while local currency liquidity has jumped on the back of significant USD sales as the EGP’s fortunes have changed.