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18 April 2013

Currency, debt and downgrades

Egypt’s two outstanding Eurobonds - the USD denominated 5.75 per cent 2020s (issue size $1 billion) and the USD denominated 6.875 per cent 2040s (issue size $500 million) – have underperformed their emerging market peers since the start of 2013.

Prices had fallen fr om above par in early January to around 80 (2040s)/86 (2020s) by end March, implying investors holding Egyptian bonds lost between 14 per cent and 20 per cent on just price action. And while broader sovereign credit markets have weakened over this time – driven by fears of the phenomenal credit rally since the middle of last year extending too far, coupled with oscillation in benchmark US Treasuries–the recent performance of Egyptian sovereign credit reflects deteriorating political and macroeconomic dynamics.

This performance comes despite ‘technical’ support factors. With cuts in sovereign ratings, high levels of political volatility, deterioration in

Egyptian assets have been hit hard since the start of the pro-democracy protests on January 25, 2011. Raza Agha, Chief Economist VTB Capital for MEA discusses Egypt’s traded external debt and its currency markets, talking through the recent performance and evaluating prospects.

Currency, debt and downgrades cont. on pg18 macroeconomic fundamentals and an uncertain outlook, all within the context of balance sheet constraints at major banks, it is likely that much of Egypt’s traded external debt is currently held by end investors (and not brokers), who are generally more stable holders. Historically, these investors have included large long term dedicated emerging markets investors (mutual funds for example) – and some domestic investors, typically local banks. Broadly speaking, given the maturity profile of bank liabilities in the MENA region, it is likely that much of the local investor positioning in

Egyptian Eurobonds is probably in the shorter dated 2020s. This also implies that most of the 2040s are probably held by international investors.

Given this supportive profile of bondholders, the amount of Egyptian

Eurobonds actually traded actively in markets appears small, making Egypt a relatively illiquid curve. This implies that relatively small transactions are likely behind the price action to date, with larger holders perhaps only marking positions lower. Needless to say, if dedicated Egyptian bondholders had started selling, yields would easily go into double digits – that’s probably another 10-12 points down.

That such selling has not happened is probably why the bonds stayed shy of their highest ever yields (or lowest cash price), despite the economic and political situation arguably being at its worst since the exit of Hosni Mubarak. Perhaps no three indicators highlight the latter point better than

Egypt’s sovereign ratings, its level of foreign currency reserves and the exchange rate. Since January 2011, Egypt’s long term foreign currency ratings have been downgraded six times by Moody’s, five times by S&P and four times by Fitch. All three agencies maintain negative outlooks, further downgrades cannot be ruled out. This is perhaps most pertinent in the case of Fitch, which now rates the Egyptian sovereign two notches above Moody’s and one notch above S&P.

Fitch though has already downgradedratings once this year, but stated that a delay to the anticipated IMF programme beyond end June and or an “abrupt” fall in central bank foreign exchange reserves and/or a “disorderly” devaluation, could trigger another cut. That further rating action could be in the offing is worrying as Egypt is already the lowest rated sovereign in the Middle East North Africa region, lower than even Lebanon, a country reeling under the impact of the Syrian crisis and its own domestic sectarian schisms. Pertinent to note is that prior to the ratings downgrades, Egypt was on the cusp of becoming investment grade with all three agencies rating the sovereign at BB+, higher than Turkey; the current rating comparable is Pakistan.

On the second indicator, Egypt’s foreign exchange reserves have fallen from $36 billion at the end of December 2010 to $13.4 billion at the end of March 2013, reflecting less than three months of import cover of goods and services. But even this mammoth $22.5 billion decline is not the full extent of reserve loss at the Central Bank of Egypt (CBE). In December 2010, the CBE had another $7.1 billion in ‘other reserve assets’ not included in reserves - ‘hot money’ inflows that poured into Egypt over 2010 were kept as central bank FX deposits with Egyptian banks, to be used as a buffer against exchange rate volatility when market sentiments turned. By end February 2011, just one month into the pro-democracy movement, the latter had fallen to just $36.5 million as foreign investors exited their positions in local currency Egyptian treasury bills in wake of the political unrest. Including this decline, total depletion of “Tier 1” and “Tier 2” CBE FX reserves is nearly $30 billion.

But even this is not the complete picture. Included in the current $13.5 billion of central bank reserves is nearly $5 billion in FX deposits from Qatar, Saudi Arabia and Turkey, while the government has also sold FX-denominated treasury bills, the stock of which amounts to about $7.8 billion at present. Further, another $4.0 billion of reserves are in gold while $1.3 billion are in IMF SDRs.

The above then highlights how critical additional donor support is for Egypt. Although reports of additional reserve deposits from Iraq and Libya – perhaps as much as $4-6 billion – are encouraging, they do not represent a sustainable resolution of the challenges facing Egypt. Critical for reviving investor confidence will be an IMF program. Here’s why: while the financing that could become available under such an IMF programme is not insignificant – a figure of $14.5 billion was mentioned by the IMF at the time of the staff-level agreement in November 2012 – much more important will be the credibility that an IMF programme lends to the economic agenda of the Freedom and Justice Party (FJP). This is all the more true since the Muslim Brotherhood, the parent organisation behind the FJP, has little experience of managing an economy. And not just that – it has to manage a large economy in a coalition government, during a time of substantial (and increasing) macroeconomic and social stress.

This donor support will also be critical in ensuring that the Egyptian pound does not depreciate in a disorderly fashion. Even with the controlled depreciation of the EGP, lim ited capital controls and higher tariffs on a range of luxury goods, the Pound has still lost over 17 per cent (7.5 per cent annualised) of its value since the start of pro-democracy protests in January 2011, with the pace of depreciation only increasing since the introduction of foreign currency auctions at the end of last year.

The Pound’s vulnerability is perhaps most apparent looking at monetary indicators – at the end of December 2010, the ratio of the CBE’s total FX reserves to money supply (M2) was about 25 per cent, higher than the 5-20 per cent range generally considered “adequate” in ensuring confidence in managed exchange rate regimes; by December 2012, the ratio had fallen close to 7.7 per cent, implying severely curtailed central bank ability to defend the currency in the face of a sustained loss of confidence/rapid capital flight.

That is worrying given signs that economic agents are losing confidence in the Pound as a store of value: not only has the demand for gold reportedly increased sharply over the last quarter of 2012, but between December 2010 and December 2012, private sector foreign currency deposits increased by $6.0 billion; they had actually fallen over the previous two year period.

As is clear from the discussion above, prospects for Egyptian assets are dependent on the political outlook and an IMF programme. Even from a medium term perspective, the challenge for the FJP-led government will be creating public policies – whether social, foreign or economic – that are supportive of growth and investment drivers, and focus on reducing fiscal imbalances thus creating the budgetary space for public investment in human and physical infrastructure. Till this happens, Egyptian assets are not for the faint hearted.

Raza Agha is the London based Chief Economist for Middle East, Africa at VTB Capital PLC, the investment business of VTB Group. Prior to starting his current role in October 2012, Raza was the Senior Economist for the MENA region and Pakistan at the Royal Bank of Scotland.

Corporate Communications VTB Capital