4 Questions about Egypt’s Financial Crisis

When the International Monetary Fund (IMF) and Egypt reached an agreement on a $3 billion Extended Fund Facility (EFF) in December, the market had a general sense of euphoria: Egypt Government Eurobonds had already recovered a significant portion of their 2022 losses in anticipation of the agreement, and followed through with an upswing in January. Since then, realism has taken over, wiping out all IMF-inspired gains and sending the government’s financing costs through the roof. 

Against this backdrop, can Egypt weather the storm and what should we look out for? Our editor, Samuel Yip, asked Yury Zusman, a London-based emerging market strategist and the author of a research series EM Dynamics, to shed light on the four key areas that will show us where the macro picture is heading.

Currency 

Samuel Yip: How is the Egyptian government dealing with its currency situation, and what has the IMF asked of them? 

Yury Zusman: As part of the agreement with the IMF, Egyptian authorities agreed to allow for a flexible exchange rate. This way the exchange rate could adjust and the FX market could clear without the need to spend the foreign reserves of the Central Bank of Egypt (CBE). 

Generally, in a country with a current account deficit, capital flows into the country and finances the deficit. The difference between the amount of capital flowing into the country and the deficit is added to (or subtracted from) the country's FX reserves. 

In a completely free-floating exchange rate regime, the currency market clears such that capital inflows equal current account deficit and change in reserves is zero. 

However, in a regime where the central bank intervenes, the exchange rate can be at some other level where capital flows are different from the deficit and there is a change in reserves. 

A fixed exchange rate regime is an extreme example of this: the exchange rate does not adjust to a market-clearing level and any difference between capital flows and current account is met with reserves. 

This difference can be positive (implying a reserve build) or negative (implying a reserve draw). However, while a country can theoretically build unlimited reserves, it cannot draw them down indefinitely – there comes a point when the country runs out of foreign currency. At that point, the country can no longer finance the difference between capital flows and current account deficit and is forced to devalue. 

Similarly, running out of foreign currency means the country cannot make payments on its foreign liabilities and so has to default. 

Egypt started to go down this path last year. There was a global shock, driven by geopolitics and rising rates, and capital inflows in Egypt turned into very rapid outflows. Egypt, which was maintaining a fixed exchange rate regime, started to quickly run down its reserves. This was exacerbated by the fact that the exchange rate became overvalued during the pandemic leading to a widening current account deficit and a greater need for foreign capital to finance it. Investors also viewed the exchange rate as overvalued which further discouraged foreign investment into the country.

With falling reserves, Egypt became at risk of not having enough foreign currency to pay its liabilities. Ultimately, the country was forced to let the currency adjust to a significantly weaker level. 

In order to avoid running into a similar problem down the road, the IMF demanded from the country's authorities a commitment to a flexible exchange rate in exchange for fresh funding. Such exchange rate flexibility would allow Egypt's current account deficit to narrow to a more sustainable level, attract foreign capital and rebuild the country's foreign reserves.

Having said that, while Egypt did devalue its currency, it has not fully adopted a flexible exchange rate regime – USD/EGP has been fixed at close to 31 since March, while the forward market and the local "black" market suggest the currency should be weaker.

Inflation

How does inflation affect the government’s ability to contain the financial crisis?

Egypt has been struggling to bring down its inflation, with prices going up 32.7% over the past year. Part of this is due to a global commodity price shock combined with currency devaluation and FX passthrough. However, the CBE also engages in quasi-fiscal activities, including subsidized lending to a big portion of the economy, which can be extremely inflationary. 

Apart from raising the cost of living, especially for the most vulnerable parts of society, high inflation also reduces the competitiveness of domestically produced goods and services and can lead to the need for further currency devaluation. 

As part of the agreement with the IMF, the CBE committed to winding down most of these lending schemes and transitioning all remaining such activity to the fiscal authorities. 

Over the medium-term, the CBE will need to institute a credible inflation targeting regime. A successful transition will lead to higher investment and sustainable growth. It will also increase the inflow of foreign capital which will be attracted by positive real rates of return and lower devaluation risk. In the long-run, it will also help Egypt to bring down its interest costs and allow the country to finance itself with longer maturity local currency debt, which will reduce rollover risk and increase debt sustainability.

Government Reform / State Exit

The Egyptian government – in particular its military – is heavily involved in different sectors of the economy. Does the IMF agreement require any reforms relating to that? 

Yes, an important IMF requirement is for the Egyptian state to reduce its footprint in the economy by isolating the most strategic sectors and selling down its assets in the rest of the economy. 

According to the IMF, public sector companies, excluding the military-owned ones, amounted to around 16% of the economy in 2018. This figure is likely higher now. 

There is less information about the exact size of the military involvement in the economy, but another 10-15% of the economy seems like a fair estimate. Anecdotally, military-owned enterprises are involved in almost everything under the sun: bottled water manufacturing, retail fuel stations, cement production and holiday resort properties. 

While there are many other economies where the state accounts for a large share, I think the military's dominance in the private sector is quite unique to Egypt. Not surprisingly, these enterprises are not very efficient and rely heavily on subsidies, tax breaks, procurement advantages and, in the case of the military, free labour by conscripts. 

There is also a lack of transparency and accountability of public enterprises. Egypt's government statistics, in general, is actually of quite poor quality - much of it incomplete and significantly lagging. But when it comes to public enterprises, there is very little information at all. IMF also understands this problem, and improving transparency and accountability of public enterprises is, in fact, one other objective of the program.  

In the near-term, selling state assets and cutting tax breaks for public enterprises would raise the necessary revenue to service government debts. In the medium-term, retrenchment of the state from the private sector and a level playing field for private enterprises will lead to greater efficiency, higher productivity and higher long-run growth. Egypt has very high potential growth due to a lower starting base and great demographics, i.e. very young population and strong population growth. But to realize this potential, the country needs to be able to create jobs that will absorb the new labour force entrants. A dynamic private sector is a key element of this.

Debt Level

What about their government debt level? 

If successfully implemented, these reforms are designed to get Egyptian government debt back onto a sustainable path. 

When you look at the key drivers of the debt trajectory, growth, primary fiscal balance, interest expenses and currency are the key drivers of sustainability and default probabilities, both in terms of macroeconomic theory and empirical evidence. To Egypt's benefit, the government already has a primary surplus, which it achieved during the previous EFF program. It needs to maintain that and hopefully increase the surplus slightly. 

The country also historically has had very good growth, but needs to implement the aforementioned reforms to maintain it at a high level and avoid a growth shock in the near-term. 

The Egyptian government uses about 50% of its revenue to pay interest expenses, which is very high. Paying such a high proportion of revenue just to service the debt can lead to political challenges and result in the country's unwillingness to pay its debts. 

Structural reforms will help bring its interest costs down, while raising additional tax revenue will generate more revenue overall. The currency factor has two sides to it. Immediately after a devaluation, the debt level rises as FX-denominated debt becomes larger in local currency terms. However, in the long run, a flexible exchange rate will help Egypt to rebuild its foreign currency buffers, which will ultimately result in a greater capacity to service its foreign currency debts and help the economy weather future macro shocks. In totality, these reforms will reduce the risk of default and improve Egyptian credit.