The Egyptian Pound has significantly outperformed its emerging and frontier market peers year to date (appreciating over 1% compared to peers which have depreciated between 1% and 20%).
This is despite pressure on macroeconomic growth, the current account deficit and FX reserves resulting from Covid-19 and the drop in oil prices: ie hits to Suez Canal toll revenues, tourism, remittances from the GCC, gas prices.
Is this cause for concern? In the short-term, not really: FX reserves, REER valuation, and recent sovereign fund-raising de-risk the outlook.
But, in the long-term, yes: Egypt may be held back by excessive FX rate strength. If Egypt is to transition from an economic model based on tourism, export of labour (remittances), and export of gas to one based on job-creating manufacturing exports, then a more competitive FX rate may be part of the required policy mix.
With Vietnam's implementation of a free trade agreement with the EU, the time frame available for this transition is shortening. (Of course, whether the Army is ready to relinquish the competitive advantages its affiliated enterprises enjoy relative to the domestic and foreign private sector remains a moot point.)
Short-term, FX rate risks look moderate
In the short-term, FX rate downside risk looks moderate because of the following factors:
- FX reserves import cover is still high (8 months).
- REER (real effective exchange rate) implies merely a 10% over-valuation on an absolute basis and relative to the last ten-year median.
- Real interest rate (for "carry-trade" foreign portfolio inflows into local currency government securities) is still positive (3% plus) and inflation is under control (core inflation is below 3% yoy).
- Recent sovereign fund-raising demonstrates multilaterals and markets are still sufficiently open (policy is viewed as sufficiently credible) to meet external financing requirements – the IMF recently approved a US$2.8bn Covid-19 Rapid Finance Instrument and discussions for a potential US$5bn Standby Agreement are due to start in June, according to reports from state news agency MENA. In addition, Egypt issued US$5bn of Eurobonds on 22 May, which were reportedly four times over-subscribed, with the 4-year bonds issued at merely 5.75% yield, 50bps lower than initial guidance.
Prior to Covid-19, much of Egypt's current account improvement was down a pick-up in tourism (resulting from devaluation and better security) and growth in gas production (due to more favourable royalty terms for international oil companies). This pattern can resume (once Covid-19 passes) and that might be sufficient for foreign investors in the short-term.
Long-term, is a more competitive FX rate needed for non-oil and gas, job-creating exports?
In the longer term, however, a lower FX rate should help with export competitiveness. While foreign debt and equity investors are clearly far more confident in Egypt than prior to the 2016 devaluation and IMF deal, it remains very unclear that there is a path to the rates of growth required to keep pace with labour force growth (nearer 8% compared to GDP growth of 5.6% in 2019 and, according to IMF forecasts, 2.4% over 2020-21).
In turn, this requires fixed capital formation.
But there is patchy evidence thus far that reforms to the tax and investment laws have yielded results in terms of domestic corporate capex, which drives job-creating manufacturing exports. In 2019 the aggregate capex of the largest publicly-listed companies (represented by the EGX30) fell compared to the previous two years and was merely in line with the annual average seen since the start of the decade (which saw two disruptive regime changes). Perhaps interest rates were still too high (policy rate was still over 12% at the end of the year).
Foreign direct investment (which should not be impaired by local interest rates) has picked up, but most of this has been in the oil and gas sector (prompted by a change of the royalty regime in favour of international oil companies, huge gas discoveries, and the clearance of overdue payments from the government). There are some signs of a transition from oil and gas to other sectors (eg US$3.8bn of FDI commitments in grain storage from Ukrainian agricultural firm Nibulon, health care real estate from Saudi's Atraba Integrated, and textiles from China's Shandong Ruyi Technology). For FDI to spread into non-oil and gas sectors and, particularly, into labour-intensive sectors, perhaps a more competitive FX rate may be necessary.
All of this domestic corporate capex and FDI assumes that reform of the Suez Canal licensing regime truly has levelled the playing field for foreign companies in competition with army-affiliated enterprises and that costs are competitive with other countries that have EU free-trade agreements (eg Morocco, Romania and Vietnam).
Equity strategy: Egypt in the context of EM and FM
Egypt equities, measured by the EGX30 index, are down 24% ytd, compared to down 16%/ 17%/ 21% for MSCI EM/ FM/ Africa ex-SA, respectively. Trailing price/book of 1.4x is a 30% discount to the 5-year median and trailing price/earnings is 8.8x, a 45% discount. The equivalent valuation metrics from the EM, FM and Africa ex-SA indices are nearer parity.
Overall, we still prefer Egypt equities to peers in Africa ex-SA: ie Nigeria where foreign capital is now trapped, Kenya where there are twin deficits, a divided political elite, locusts and a very over-valued FX rate, or Morocco where there is political and FX rate stability and FDI-led exports but little value in the larger, listed equities.
We also prefer Egypt to peers in the Middle East: the GCC is yet to grapple with an expatriate exodus and duplication in non-oil diversification, and no longer has the tailwind of equity index weight increases, while Turkey has many proven corporate franchises at low valuations, with ample trading liquidity, but a macroeconomic policy framework lacking in credibility.
But we still find more attractive opportunities across most of Asia (eg Pakistan, Philippines, Vietnam, which have either more profound structural reform or a clearer path to job-creating manufacturing exports).