Egypt’s painful re­forms bear fruit

NBK ECO­NOMIC RE­PORT

Kuwait Times - - BUSINESS -

Egypt’s econ­omy has been in re­cov­ery mode fol­low­ing a con­sid­er­able slow­down in 2016. A cur­rency short­age that crimped ac­tiv­ity last year was re­lieved with the de­ci­sion to float the cur­rency and the launch of a com­pre­hen­sive re­form pro­gram. A num­ber of fis­cal re­forms im­ple­mented in 2016 are al­ready hav­ing a pos­i­tive im­pact on the deficit. A $12 bil­lion IMF loan agree­ment also helped in­ject a de­gree of con­fi­dence among in­vestors. As a re­sult, the coun­try’s for­eign re­serves have im­proved sig­nif­i­cantly over the last seven months.

With re­forms ex­pected to see fis­cal and mon­e­tary pol­icy tighten, growth will be largely driven by for­eign in­vest­ment, ex­ports and tourism, all sup­ported by a more com­pet­i­tive cur­rency and by the prospect of an im­proved op­er­at­ing en­vi­ron­ment. This is al­ready be­ing felt, with ex­ports and tourism im­prov­ing in 4Q16 and 1Q17. For­eign in­vest­ment is also up, in part ben­e­fit­ing from large pledges by mul­ti­lat­eral in­sti­tu­tions.

The key risk to the out­look is a lack of progress on re­forms, though it has been rel­a­tively good so far. In­deed, the IMF re­cently pro­vided a pos­i­tive as­sess­ment as it ap­proved the dis­burse­ment of the sec­ond tranche of its loan agree­ment. The IMF felt that the au­thor­i­ties had taken im­por­tant mea­sures that are likely to “place pub­lic debt on a de­clin­ing path to sus­tain­able lev­els”. The lat­est fis­cal fig­ures also in­di­cate that progress is be­ing made.

Egypt’s de­ci­sion to join its GCC al­lies in cut­ting ties with Qatar is not likely to have a ma­te­rial im­pact on the Egyp­tian econ­omy. Over 250,000 Egyp­tians liv­ing in Qatar have not been asked to leave, though they ac­count for just 4-5 per­cent of re­mit­tances. While Qatar pro­vided over 60 per­cent of Egypt’s LNG im­ports in 2016, these ship­ments have not been halted dur­ing the cri­sis. Mean­while, au­thor­i­ties in Egypt in­di­cated that pri­vate Qatari in­vest­ments will not be af­fected, though Qatar ac­counts for only 1-2 per­cent of FDI in­flows.

Econ­omy bounces back

Af­ter slow­ing sig­nif­i­cantly dur­ing 2016, eco­nomic growth be­gan bounc­ing back late in the year. Real GDP growth rose to 3.5 per­cent year-on-year (y/y) in 4Q16, com­pared to av­er­age growth be­low 2 per­cent dur­ing the first nine months of 2016. The im­prove­ment came largely from the man­u­fac­tur­ing sec­tor, which grew 6.4 per­cent y/y in 4Q16. Growth in other sec­tors re­mained weak.

GDP growth ap­peared to im­prove fur­ther in 1Q17. The quar­ter saw a much awaited re­bound in tourism. The num­ber of tourist ar­rivals rose to a monthly av­er­age of 580,000 dur­ing the first three months of 2017. While this fig­ure is well be­low po­ten­tial, it is up 49 per­cent y/y. The im­prove­ment is re­flected in a healthy bounce in the tourism com­po­nent of the pro­duc­tion in­dex, which was up 81 per­cent y/y in March.

The sec­tor con­tin­ues to be weighed down by se­cu­rity con­cerns fol­low­ing the down­ing of a Rus­sian com­mer­cial air­line in Oc­to­ber 2015 by ter­ror­ists. In­deed, a num­ber of Euro­pean coun­tries main­tain travel re­stric­tions to the coun­try as a re­sult. Tourism, which has suf­fered since the Arab Spring in 2011, re­mains well be­low its full po­ten­tial. Ar­rivals in 1Q17 were half their 1Q10 level.

Markit’s Pur­chas­ing Man­agers’ In­dex (PMI) also in­di­cated growth may be re­turn­ing, though by that mea­sure the re­cov­ery ap­pears to be rel­a­tively weak. The in­dex rose from a low of 42 in Novem­ber 2016 to 47 in June. De­spite the im­prove­ment in the in­dex, it re­mains at lev­els con­sis­tent with GDP growth of only 2 per­cent. None­the­less, the in­dex does in­di­cate par­tic­u­lar strength in ex­ports; the new ex­port or­ders com­po­nent rose to a sur­vey-high of 54.8 in May.

The econ­omy is ex­pected to con­tinue to im­prove in 2017, de­spite head­winds from tighter fis­cal and mon­e­tary stances. Growth in FY16/17 is ex­pected to have av­er­aged 3.0 per­cent, up from 2.3 per­cent the pre­vi­ous fis­cal year. The pace is ex­pected to ac­cel­er­ate to 4 per­cent and 5 per­cent in FY17/18 and FY18/19, re­spec­tively.

Op­ti­mism

In Jan­uary, the IMF pub­lished de­tails of the re­form pro­gram that was the ba­sis of a $12 bil­lion loan ap­proved in Novem­ber 2016. It in­cludes a num­ber of fis­cal re­forms, in­clud­ing a VAT, cut­ting sub­si­dies and re­duc­ing wage bill growth. The pro­gram also seeks deep struc­tural re­form to boost job creation, for­eign in­vest­ment and ex­ports, in­clud­ing steps to im­prove the busi­ness en­vi­ron­ment with new laws gov­ern­ing in­vest­ment, in­dus­trial reg­is­tra­tion and in­sol­vency. Lib­er­al­iz­ing the ex­ter­nal ac­count is also a key part of the pro­gram, in­clud­ing float­ing the cur­rency and do­ing away with cap­i­tal con­trols im­posed since 2011. Many of these re­forms have al­ready been im­ple­mented. In­deed, float­ing the cur­rency was one of the con­di­tions of the IMF loan agree­ment and was seen as nec­es­sary to ad­dress the large ex­ter­nal im­bal­ances. The 50 per­cent de­cline in the value of the pound im­proved Egypt’s com­pet­i­tive­ness, which in turn helped boost non-oil ex­ports by more than 29 per­cent y/y in 4Q16. The pound has since been rel­a­tively sta­ble at around 18 EGP to the USD.

In­fla­tion

How­ever, the large de­cline in the value of the EGP has fu­eled in­fla­tion, as the higher price of im­ported goods pushes domestic prices higher. In­fla­tion ac­cel­er­ated to 30 per­cent by June 2017. The rate is ex­pected to re­main at those el­e­vated lev­els through­out most of 2017, be­fore cool­ing off in late 2017 and eas­ing fur­ther in 2018. We ex­pect in­fla­tion to ease to around 20 per­cent by the end of 2017 and to 10 per­cent by the end of 2018.

Pol­icy rates

In an ef­fort to fight in­fla­tion, the CBE hiked its pol­icy rates three times since the cur­rency float. The first time, in Novem­ber, the cen­tral bank lifted rates by 300 ba­sis points (bps). Au­thor­i­ties had al­ready raised rates by 300 bps in three moves over the pre­vi­ous 12 months. The CBE in­creased rates again in May and July, by 200 bps each time.

Fis­cal deficit

The key pri­or­ity for the gov­ern­ment has been ad­dress­ing the large fis­cal deficit, which is a key source of im­bal­ance for the econ­omy. Some progress has al­ready been made in that re­gard. The gov­ern­ment re­placed its sales tax with a value-added tax (VAT) in 2016. There have also been ef­forts to con­trol the wage bill and to re­duce gov­ern­ment sub­si­dies. A fi­nan­cial stamp tax was also in­tro­duced, though its fis­cal im­pact is ex­pected to be lim­ited.

The im­pact of these mea­sures on the fis­cal pic­ture has al­ready been felt. The deficit nar­rowed dur­ing the first nine months of FY16/17 through March 2017 to 11 per­cent of GDP. The im­prove­ment, around 1.1 per­cent­age points, came largely from in­creased con­trol of the wage bill and healthy tax rev­enue growth. Tax rev­enues in­creased by 27 per­cent y/y thanks to the new VAT. Dur­ing this pe­riod, the pri­mary deficit (ex­clud­ing in­ter­est pay­ments) more than halved to 1.5 per­cent of GDP. This im­prov­ing trend is ex­pected to con­tinue over the next two years. The deficit should nar­row to around 10 per­cent of GDP in FY16/17 from around 12 per­cent the prior year, and fur­ther to around 9 per­cent and 8 per­cent in FY17/18 and FY18/19, re­spec­tively.

Debt mar­ket

In an ef­fort to re­duce reliance on domestic fi­nanc­ing of the deficit, the gov­ern­ment has tapped in­ter­na­tional mar­kets. The gov­ern­ment raised $4 bil­lion in USD bonds in Jan­uary, an is­suance that was more than 3.5 times over­sub­scribed. Pric­ing also came in more fa­vor­ably than an­tic­i­pated. The debt sale, which was Africa’s largest ever, in­cluded 5-year, 10-year and 30-year tranches. An­other $3 bil­lion was raised in May with sim­i­lar ma­tu­ri­ties. Once again, ap­petite for the is­suance was strong, with the size dou­ble what the gov­ern­ment had tar­geted ini­tially.

Cur­rent ac­count

The cur­rent ac­count de­te­ri­o­rated in 2016 largely as a re­sult of the col­lapse in tourism and lower re­mit­tances, but has since im­proved in 1Q17. Tourism re­ceipts were more than halved to $2.6 bil­lion, as tourists stayed away fol­low­ing the bomb­ing of a Rus­sian pas­sen­ger air­plane. Mean­while, re­mit­tances fell by 9 per­cent to $16 bil­lion; an un­fa­vor­able of­fi­cial ex­change rate had seen over­seas work­ers in­creas­ingly use un­of­fi­cial chan­nels to repa­tri­ate their sav­ings, which hurt re­mit­tances.

These neg­a­tive trends, both of which we ex­pect will be­gin to abate in 2017, were coun­tered by more pos­i­tive trends in the goods bal­ance. The trade deficit ac­tu­ally nar­rowed by 5 per­cent thanks to strong ex­port growth. Non-oil ex­ports re­ceived a strong boost in 2016, in­creas­ing by 17 per­cent to $14.5 bil­lion. At the same time, im­port growth was flat in part thanks to a 17 per­cent drop in the oil im­port bill. Egypt con­tin­ued to ben­e­fit from healthy lev­els of for­eign di­rect in­vest­ment (FDI), which con­tin­ued to pro­vide sup­port to the bal­ance of pay­ments. FDI rose by 17 per­cent in 2016 and ac­counted for around 2.9 per­cent of GDP. FDI in 4Q16 alone saw a healthy jump to an an­nu­al­ized 4.2 per­cent of GDP, record­ing one of the best quar­ters in more than six years. The bal­ance of pay­ments saw trends im­prove strongly in 1Q17; the cur­rent ac­count deficit shrank to its low­est level in over two years (to $3.5 bil­lion or 7.3 per­cent of GDP) and port­fo­lio in­flows sky­rock­eted, as the de­cline in the pound made Egypt an at­trac­tive des­ti­na­tion. The cur­rent ac­count con­tin­ued to ben­e­fit from strong ex­port growth, which topped 30 per­cent y/y in 1Q17. The quar­ter also saw tourism re­ceipts and re­mit­tances bounce back. Mean­while, net in­vest­ment port­fo­lio in­flows shot up to $7.6 bil­lion dur­ing the quar­ter, pos­si­bly the largest such in­flow ever recorded.

For­eign re­serves

For­eign re­serves have risen sig­nif­i­cantly since the de­ci­sion to float the pound. CBE re­serves rose to their high­est level in over six years in May to $31.1 bil­lion or an es­ti­mated 7.7 months of im­ports. This is more than 60 per­cent higher than their level on the eve of the de­ci­sion and be­fore the IMF fi­nal­ized its $12 bil­lion loan to Egypt. The de­ci­sion to float the cur­rency re­lieved much of the pres­sure on re­serves; these also ben­e­fited from in­flows from a num­ber of multi-lat­eral or­ga­ni­za­tions, in­clud­ing the IMF.

Cur­rency float

The stock mar­ket has out­per­formed most mar­kets since Oc­to­ber 2016. The EGX30 in­dex was up 10.9 per­cent thus far in 2017 through 12 July. This fol­lowed a gain of 57 per­cent in 4Q16, with most of that tak­ing place in Novem­ber. De­spite the rally, gains have not been enough to counter the drop in the cur­rency; the MSCI to­tal re­turn in­dex in USD re­mains down by 16 per­cent from its level be­fore the cur­rency float.

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