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Egypt: Downgrade local debt to Sell amid devaluation concerns

  • There is a growing consensus that the EGP is overvalued and further depreciation is necessary to reduce BOP imbalances

  • Resignation of CBE governor could signal policy shift, but today's decision to hold rates will keep pressure on EGP

  • Overvalued currency and low real yields, and EGP-US$ yield differential make local debt unattractive; downgrade to Sell

Egypt: Downgrade local debt to Sell amid devaluation concerns
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

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Tellimer Research
18 August 2022
Published byTellimer Research

The chorus of those calling for a devaluation of the EGP continues to grow amid rising external pressures. Since the EGP was devalued by 15% in March the central bank (CBE) has snuffed out the hope of renewed exchange rate flexibility, with the EGP falling by a mere 3.2% in nominal terms versus the US$ since and rising by 4.4% in real effective terms. Egypt’s REER has now appreciated by 66.5% since its 2016 devaluation and sits 5% above its 10-year average and 15.5% above its 20-year average, pointing to the need for further adjustment (estimates reported in the media have ranged from c5-25%).

REER

Forward markets have increasingly priced in further EGP depreciation, with NDFs pricing nearly 10% of depreciation over the next 3 months and over 22% over the next year (roughly 2x and 4x, respectively, of what they were pricing both a month ago and ahead of the March devaluation). However, the CBE has stubbornly refused to allow greater exchange rate flexibility, which we have previously said (see here and here) is key to avoiding a balance of payments (BOP) crisis and securing an IMF programme.

NDFs

However, the surprise resignation yesterday of CBE Governor Tarek Amer after nearly seven years at the helm and replacement with United Media Services chairman Hassan Abdalla as Acting Governor has prompted speculation that a shift in policy may be imminent. His resignation preceded today’s MPC meeting, in which the CBE decided to hold rates at 11.25% (6 of the 12 analysts surveyed by Bloomberg projected a hold, with the other 6 projecting hikes of 50-200bps).

Policy rate

With inflation continuing to rise to 13.6% yoy in July, Egypt’s real policy rate has fallen to -2.4% from +2.4% at the end of 2021 and a high of over 10% in late 2019. While we broadly agree with the MPC's assertion that much of the rise in inflation is supply driven (with food & NAB prices up 22.4% yoy in July), the decision to hold rates will exacerbate pressure on the EGP and further hikes are likely needed to reduce external imbalances in the absence of greater EGP depreciation. However, there were no signals in the MPC statement of a shift in exchange rate policy (though it may still be too early to tell).

Worsening external imbalances will also put pressure on the EGP, with the current account widening to US$5.8bn in Q1 22 from US$3.8bn in Q4 21. Alongside sharp financial outflows, totally a widely cited US$20bn from Egypt’s domestic government debt market since Russia’s invasion of Ukraine, this has put pressure on reserves. Official liquid reserve assets have declined from US$40bn in February to US$31bn in July (equal to 3.75 months of trailing goods & services imports).

Current account

Reserves

While outflows have reduced the risk of capital flight, foreigners still hold US$8.4bn of Egyptian T-bills as of June. And while a comprehensive data series on non-resident holdings of bonds does not exist, the total amount of non-resident debt holdings is likely even higher once bonds are factored in (IIP data showed non-resident bond holdings of cUS$1.1bn in March, which would bring the total stock to US$9.5bn). As such, there is still some residual risk of capital flight despite the recent outflows.

Foreign holdings

Adding external principal payments of US$26.5bn due from July 2022 to June 2023 to the trailing current account deficit of US$18.7bn in the 12 months through March leaves Egypt with gross external financing requirement (GEFR) of over US$45bn in FY22/23 assuming an unchanged current account, equal to 10% of projected full-year GDP and nearly 145% of Egypt’s liquid official reserve assets. This leaves Egypt especially vulnerable to tight global financial conditions, with few countries facing such a sizeable GEFR.

GEFR (US$ mn)

GEFR (% of reserves)

Against this backdrop, the IMF’s statement last month that “decisive progress on deeper fiscal and structural reforms is needed to boost the economy’s competitiveness, improve governance, and strengthen its resilience against shocks” was interpreted by many investors as meaning that more work is needed to secure an IMF programme and that additional external financing sources will therefore be required, increasing the risk of a BOP crisis if that funding cannot be secured.

That said, Egypt enjoys an “exorbitant privilege” by virtue of its strategic and geopolitical importance, which will likely increase financing availability as Egypt’s bilateral partners step in to limit the risk of a destabilising economic crisis. Indeed, Egypt has already received commitments for at least US$22bn of funding through deposits, loans and investments from Saudi Arabia, the UAE and Qatar, which will help plug its funding gap in the near-term (although the timing of these flows is uncertain).

Egypt’s privatisation drive is also a key pillar of its external financing pipeline, with the Planning Ministry targeting US$10bn of FDI in FY 22/23 (up from just under US$7.5bn in the 12 months to March). Lastly, Egypt has sought alternative sources of private financing amid delayed IMF talks and a lack of market access (with its 10-year eurobond yielding 12.5% despite the recent rally from >16% in mid-July), reportedly securing US$2.5bn from UAE-based lenders.

Egypt’s external funding gap will remain large nevertheless. With some of the US$22bn of the pledged external funding from the Gulf already disbursed and some already factored into the US$10bn FDI target for the year, Egypt will have to secure at least US$10bn (and potentially much more) of additional funding in FY 22/23 to keep reserves steady (with the IMF only likely to plug a small portion of the gap given Egypt’s cumulative access of c700% of quota versus the 435% exceptional access threshold).

From this perspective, the need for further exchange rate flexibility is clear. Not only is it likely necessary to unlock an IMF programme and funding (with the recent IMF statement emphasising that “greater exchange rate variability during the SBA could have been entrenched to avoid a build-up of external imbalances”), but it will crucially also lower the current account deficit by reducing import demand and boosting the attractiveness of exports and improve the prospects for portfolio and direct investment.

In response to growing calls for another devaluation, CBE Deputy Governor Gamal Negm said in a recent interview that import restrictions implemented since April have narrowed the monthly FX shortfall to US$400mn in July from US$3.9bn in February, rendering a further devaluation unnecessary. However, barring a sudden improvement in external financing conditions that allows Egypt to plug its large funding gap, we think this optimism is misplaced.

And while reliance on ad hoc bilateral funding may succeed in plugging the gap in the near term, ultimately this is only a band-aid. With the current account deficit reaching 4.6% of GDP in 2021 versus a 2010-19 average of 2.6% of GDP (once the exceptionally high deficits of c6% of GDP in 2016-17 are stripped out), the current account deficit likely has to contract by c2% of GDP to restore equilibrium to Egypt’s BOP (which implies a 10% REER overvaluation based on a 0.2 CA-to-REER elasticity, roughly in line with the c12% parallel market premium implied by our alternative crypto dataset).

Fixed income implications – downgrade local debt to Sell

Since downgrading our recommendation on Egyptian T-bills from Buy to Hold in March, the Bloomberg Egypt Local Currency Index has returned -1.2% in total return US$ terms versus -4.7% for the Bloomberg EM Local Currency Aggregate, outperforming the index by 3.5%. However, since we think further devaluation of the EGP is necessary to avoid a BOP crisis, we think this outperformance is likely to be short-lived and eventually reversed.

While the average auction yield of Egypt’s 12-month T-bill has risen from just over 13% in March to 16.5% most recently, this has been more than offset by the rise in inflation, keeping the real rate just below 3% versus the high double-digit yields that prevailed throughout 2020-21. While this is still relatively high, it is no longer sufficient to compensate for the risk of imminent EGP devaluation.

Real T-bill yield

Further, after briefly falling into negative territory at the height of the EM credit selloff in mid-July, the yield premium for holding local currency over US$-denominated government debt now sits just above 4.5%. This is just over half the 10-year average, and, alongside less attractive real rates and the impending EGP devaluation, makes any portfolio inflows to the local government debt market unlikely.

HCY vs LCY yields

Against this backdrop, we downgrade our recommendation on 12-month Egyptian T-bills to Sell from Hold, and apply the recommendation across the entirety of Egypt’s local government debt curve. Further EGP depreciation, higher real interest rates, and a larger premium between the yield on EGP and US$-denominated debt are all necessary prerequisites, in our view, to consider an upgrade.

On the hard currency front, the Bloomberg Egypt USD Sovereign Index has fallen by 17.6% in total return terms since we upgraded it to Buy on 20 October, in line with the -17.9% return on the Bloomberg EM Sovereign USD Aggregate. While the z-spread on the EGYPT 7 ⅝ 05/29/2032s has fallen by 355bps since its mid-July peak amid a broader EM credit rally (with the Bloomberg EM Sovereign High Yield spread declining by 205bps over that period), it is over 450bps above its 12-month low.

32s

Despite the BOP risks outlined above, we think Egypt will be able to leverage its strategic importance to plug its external funding gap and avoid a BOP crisis (contingent in part on further EGP weakness and securing an IMF programme). Alongside the low cash price of just over US$70 on the ‘32s, we still think that Egypt’s eurobonds are attractive from a valuation perspective and, if the EM rally continues, will likely continue to claw back this year’s losses.

That said, if the EM rally reverses then Egyptian eurobonds are likely to outperform, and a fundamentally positive long-term view on Egyptian credit requires a sustained commitment to difficult structural reforms that Egypt has thus far failed to deliver on. While these would form the cornerstone of any IMF programme, implementation will remain difficult and we have seen little evidence of progress aside from some apparent momentum on the privatisation front.

As such, we maintain our Buy recommendation on the EGYPT 7 ⅝ 05/29/2032s at US$70.3 (1,035bps z-spread) as of cob on 17 August on Bloomberg, with further spread compression likely over the medium term, but the potential for a more attractive entry point if the ongoing 4-week EM rally reverses and a weak longer-term fundamental outlook capping the upside and making compression back below 500bps unlikely.  

Egypt equities attractive for a recovery trade, not a reform thesis

Egypt equities (EGX30 Index) are down 29% year-to-date in US$ total return terms, with 18% FX rate depreciation. Forward PE is merely 5.6x, alongside 12% consensus aggregate earnings growth and 5.2% dividend yield. This PE multiple is about a 40% discount to the 5-year median.

If we crudely adjust this PE multiple to 6.4x, to reflect the c15% devaluation implied by the difference between the Egypt Pound spot rate and the 12-month non-deliverable forward, that still implies about a 35% discount to the 5-year median.

The current factors driving Egyptian equities to their cheapest valuation in at least a decade, measured by forward PE, are largely global – US rate hikes and tighter global liquidity, the global growth slowdown and reduced risk appetite, and high commodity food prices (albeit these have cooled recently). 

The positive real interest rate, which reassured foreign portfolio investors for much of the last year, relative to other commodity importing emerging and frontier markets, is now negative 2.4%.

Uncertainty over the authorities willingness to take difficult counter-inflation measures, allow exchange rate flexibility, and secure IMF funding is exacerbating these factors. We have been through this before, eg in 2008, 2011, and 2015. 

But the precedents from each of these crises is that there is an ultimate acceptance for unpopular policies by those that remain the key determinant of policy, the military elite. This time round should be no different. That makes current valuation look attractive.

However, there is little prospect of the deep-rooted structural reform, essentially levelling the commercial playing field for the private sector, required to escape this crisis-recovery cycle, given the vested commercial and political interests of the military, which is even more entrenched now compared to any point since the 1952 revolution (see Egypt priced for distress: Too harsh but don't expect the army to drive reform).

Egypt equities

Related reading

Egypt: Priced for distress: Too harsh but don’t expect the army to drive reform, July 2022 (Malik)

Egypt reaches critical point amid rising risk of debt distress, May 2022

Egypt: Currency devalued to combat rising external risks, March 2022

Egypt: Upgrade to Buy after selloff, October 2021

Fixed income strategy: Top picks for Q4 2021, September 2021

Egypt makes progress on reforms by external vulnerability is rising, April 2021

Fixed income strategy: Our top picks for 2021, December 2020

Discussion with Egypt’s IMF Mission Chief, October 2020

Egypt: Carry trade alive and well once again, July 2020