Egypt
Highlights Tight fiscal and monetary policies under the auspices of the IMF agreement and a relatively benign balance of payments position will allow authorities to avoid currency devaluation in the next 6-12 months. However, these tight policies are creating a vicious circle of low nominal growth, underwhelming government revenues and causing missed fiscal targets. Consequently, the public debt-to-GDP ratio will continue rising, i.e., public debt sustainability will not be achieved. Stagnant incomes and the failure to stabilize the public debt-to GDP ratio will eventually force authorities to abandon a tight fiscal and monetary policy mix. Yet, the adoption of reflationary policies will come at the expense of rising devaluation pressures on the exchange rate. Feature There is no imminent threat of currency devaluation in the next 6-12 months. Elevated local domestic interest rates, fiscal tightening and high natural gas prices will support the currency in the short run (Chart 1). Beyond the next 12 months, tight fiscal and monetary policies will not be sustainable due to pain from very subdued growth. Given weak nominal GDP growth, the public debt-to-GDP ratio will fail to stabilize, i.e., it will continue rising. Eventually, faced with low income growth and lingering high unemployment, authorities will likely abandon these tight macro policies. When they do so, the currency will come under severe devaluation pressures. No Imminent Danger Of Devaluation, For Now… In the medium term (6-12 months), authorities will avoid devaluing the Egyptian pound. High interest rates, tight fiscal policy spearheaded by the IMF and high natural gas prices will ensure exchange rate stability. Specifically: The country’s balance of payments is at zero (Chart 2). This will assure that in the short run the de facto exchange rate peg can withstand a firming US dollar and rising US bond yields. Chart 1The Two Pillars To EGP Near-Term Stability Chart 2Egypt: No BoP Strains Previous currency devaluations in Egypt occurred due to severe balance of payments strains and had little to do with trends in US interest rates and the US dollar. Egypt’s current account deficit could narrow further due the following: (1) high local interest rates depressing domestic demand and imports; (2) strong remittances from the Gulf as well as improving tourism revenues; (3) high natural gas prices bolstering exports. Notably, high natural gas prices and record production volumes will reinforce strong net natural gas exports over the coming 6-12 months (Chart 3). Conversely, higher domestic grain inventories will reduce food imports in the coming months. Importantly, the central bank has adequate foreign exchange reserves to cover any short-term outflows and foreign debt servicing needs (Chart 4, top panel). For instance, the ratio of foreign exchange reserves to local currency money supply remains above 2016 levels when the country was forced to devalue the pound (Chart 4, bottom panel). Chart 3Egypt Is Benefiting From High Natural Gas Prices Chart 4Egypt's Foreign Exchange Reserves Chart 5Egypt: Foreigners Have Been Pouring Into Domestic Bonds Lastly, the increased dependence on portfolio (debt) inflows will discourage the Central Bank of Egypt (CBE) from cutting interest rates. Notably, the ownership of local domestic government bonds by foreigners has risen substantially to 23% of total outstanding from 8% in 2020 (Chart 5). High real local rates will for now preclude lasting portfolio capital outflows. Bottom Line: A relatively benign balance of payments position will allow authorities to avoid currency devaluation in the next 6-12 months. …But Fiscal And Monetary Austerity Are Not Sustainable In The Long Run Policymakers are willing to pursue tight fiscal and monetary policies. However, the latter will result in weak domestic demand and feeble nominal income growth. The accumulating deflationary pressures will ultimately create socio-political tensions, warranting a policy reversal – substantial fiscal and monetary easing. The latter will necessitate the devaluation of the Egyptian pound. Fiscal Policy Fiscal policy is tightening with guidance from the IMF. According to IMF estimates, the primary fiscal thrust for FY 2021/22 & 2022/23 is expected to be -1.5% and 0% of GDP, respectively (Chart 6). In turn, the government is expected to run a primary fiscal surplus over the next few years. According to IMF/government projections, nominal primary spending is expected to grow by 14.9% and 10.9% in FY 2021/22 and FY 2022/23. In turn, nominal GDP growth will expand by 11% and 10%, while nominal government revenue growth is expected to expand by 17% and 14%, respectively for FY 2021/22 & 2022/23. As a result, according to these IMF/government projections, the public debt-to-GDP ratio will decline from 91.3% now to 85.7% of GDP by FY 2022/23 (Chart 7). Chart 6Egypt: Fiscal Austerity For The Next 2 Years Chart 7Egypt: The IMF Public Debt Forecast Is Too Optimistic! We do not think these public debt projections are reasonable. Fiscal cutbacks will depress nominal GDP growth causing government revenues to severely undershoot projections: At 17% of GDP, government primary spending is substantial, even though it has fallen a lot in recent years. Further retrenchment in fiscal spending will depress income growth, domestic demand and nominal GDP. Aggregate interest payments (both local and foreign currency) on total public debt – the effective interest rate on public debt – will be well above nominal GDP growth (Chart 8). So long as interest rates on government debt remain above nominal growth, the public debt-to-GDP ratio will rise. Further, interest payments on public debt consume 50% of government revenue and take over a third of government spending (Chart 9). This is enormous. Chart 8Egypt: Public Debt-To-GDP Will Rise Due to Low Nominal GDP Growth Chart 9Egypt: Interest Expenditures Are Too High! Authorities are reducing subsidies for food items, which will lead to higher food prices. They are also raising electricity and fuel prices. Meanwhile, public sector wages will be contained, and sluggish employment growth will cap aggregate household income. All of these together will curb household disposable income available for discretionary spending and will depress domestic demand. The vaccination rate remains low at below 5% of the total population. Therefore, the country is at risk of further spreads of new variants and rising infection rates. Already, core inflation measures remain depressed at the lower end of the CBE target band of 5% to 9% (Chart 10). Chart 10Egypt: Inflation Is Low Monetary Policy Policymakers will likely keep monetary policy tight by pursuing high real interest rates to attract portfolio capital flows. In fact, in the past 12 months Egypt has been attracting primarily fixed-income foreign portfolio inflows due to its high domestic fixed-income market yield. At the same time, high real lending rates have decimated domestic demand. Profitability of domestic businesses has been dismal. Consequently, the country has been receiving very low amounts of foreign equity inflows and foreign direct investment (FDI). An inability to attract FDI will weigh on the nation’s productivity, competitiveness and, hence, the pound stability in the long run. While the real policy rate is 4.2% (deflated by core CPI), real lending rates are well above 10% (Chart 1 above). As a result, private credit growth will decelerate from current levels as higher base effects from last year’s subsidized lending scheme dissipate. Bottom Line: With the IMF’s blessing, the government will maintain tight fiscal and monetary policies. These policies are creating a vicious circle of low nominal growth, underwhelming government revenues and missing fiscal targets. Consequently, the public debt-to-GDP ratio will continue rising, i.e., public debt sustainability will not be achieved. How To Break A Vicious Deflationary Cycle? Fiscal and monetary austerity will ultimately produce socio-political discontent among the population, which will force authorities to ease both fiscal and monetary policies substantially. A changing macro policy will in turn increase pressure on authorities to devalue the currency. Faced with very sluggish nominal income growth and a very high and rising public debt-to-GDP ratio, policymakers will be forced to cut interest rates and increase government spending. These will boost nominal income and domestic demand. The upshot will also be lower real interest rates and a widening current account deficit. Both are conducive to currency devaluation. Given that 80% of government debt is denominated in local currency, authorities can afford to devalue the currency. In other words, creditors (holders of domestic government bonds) will be hit more than the government. As foreigners rush to sell local currency bonds, Egyptian commercial banks can purchase these, which could cap interest rates from rising too high. This will effectively amount to monetization of public debt by commercial banks and will also herald currency depreciation. Meanwhile, the debt-servicing on external debt could be restructured as three-quarters of it is owed to international bi- and multi-lateral creditors. Bottom Line: Stagnant incomes and the failure to stabilize the public debt-to GDP ratio will eventually force authorities to abandon a tight fiscal and monetary policy mix. Such a policy reversal will eventually boost economic growth. However, it will come at the expense of rising devaluation pressures on the exchange rate. In sum, beyond the next 12 months, chances of a material exchange rate devaluation are substantial. Investment Implications Investors should overweight local currency bonds within an EM local currency bond portfolio. Egyptian domestic bond yields in real terms (adjusted for inflation) are amongst the highest in the world and it is highly likely that the pound will not be meaningfully devalued within the next 6-12 months. This contrasts with our view on other EM currencies, which holds that rising US bond yields and weak EM domestic fundamentals will cause many EM currencies to depreciate versus the US dollar in the next three to six months. A tight macro policy mix will also favor Egyptian sovereign US$ credit relative to EM and more particularly, Kenyan sovereign credit. Go long Egypt / short Kenya sovereign USD bonds (Chart 11). The Report on Kenya can be accessed here. In absolute terms, Egyptian sovereign spreads will likely widen due to a border selloff in EM (Chart 12). Chart 11Long Egyptian / Short Kenyan Sovereign Credit Chart 12Egyptian Sovereign Credit: Spreads And Excess Return Lackluster domestic growth due to tight fiscal and monetary policies will cause Egyptian stocks to underperform. Investors should avoid / underweight this bourse. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes
Highlights Authorities will be reluctant to devalue the currency this year to avoid a pass-through of higher global food prices into domestic food prices. Yet, chronically underwhelming economic growth will ultimately force the government to abandon tight fiscal and monetary policies and adopt a pro-growth agenda. A part of such a policy shift will be currency devaluation. Egypt’s productivity gains will be limited, which will keep potential GDP growth tame. A major buying opportunity in Egyptian local currency bonds, sovereign credit and equities will follow on the heels of currency devaluation. Feature The Egyptian government is facing a dilemma between tolerating very weak economic growth and a rising public debt burden on the one hand and currency devaluation on the other hand. In the near-term, they will continue pursuing tight fiscal and monetary policies to avoid currency devaluation. However, over a long-run time horizon, the dismal productivity outlook leaves them with no option except to ease fiscal policy and reduce interest rates substantially to boost (nominal) growth. The upshot will be significant depreciation pressure on the exchange rate. No Appetite To Devalue … Yet Chart 1Rising Food Prices Is A Major Constraint To Currency Devaluation Over the near-term, Egyptian authorities will not devalue the currency because of the following: Rising food prices carry both economic and socio-political risks. Egypt imports 62% of its wheat and 60% of its corn consumption. Global food prices have risen sharply in the past 12 months. Devaluing the pound would exert pain on household budgets by raising the price of key imported grains in local currency terms (Chart 1). Higher food prices can reduce popular support for the government and heighten socio-political instability. Provided that food accounts for 35% of the consumer basket, rising food prices will curtail disposable income left after food expenditures. In turn, that will depress non-food household spending with negative implications for the entire economy. In brief, macro economic policy choices are presently constrained by high global food prices and the country’s large dependence of food imports. Currency devaluation is currently not a palatable political option. Structurally, Egypt’s domestic agricultural production is unable to meet its domestic consumption needs. Food insecurity has socio-political ramifications and also affects macro policy choices available to and made by authorities (for a more detailed discussion on food insecurity, please refer to Box 1). Box 1 Food Insecurity In the coming years, Egypt will continue to encounter severe challenges in food production and, hence, securing sufficient supplies of food for its rising population. Over the past decade, only 5% of overall investments went into agriculture while private investments into agriculture fell. This has resulted in stagnant agriculture productivity. Chart 2 illustrates that output per area harvested of wheat, corn and rice has been flat over the past decade. Of greater concern is the fact that wheat and corn production per capita have been falling while their consumption per capita has been rising (Chart 3). Faced with a projected population increase of 30 million by 2030 (from 100 million to 130 million), Egypt will be forced to spend more on food imports. Thus, these dynamics will expose Egypt even further to global food price fluctuations. In addition, Egypt faces a severe risk of fresh water shortages due to the Grand Ethiopian Renaissance Dam (GERD) construction on the Nile by Ethiopia. Critically, Egypt relies almost entirely on this source of water from the Nile for agriculture. Any major resolution appears unlikely to be reached between Egypt and Ethiopia. In particular, Ethiopia views the dam as part of its own national economic interests in the region. Above all, Ethiopia will not be materially pressured by the US or Europe to back down from its own national economic interest surronding the dam, as has been argued by BCA Research’s Geopolitical Strategy Service. Abroad, President Biden is focused on restoring relations with Iran and countering Chinese and Russian regional ambitions, while not showing major interest in the Horn of Africa. The Europeans, for their part, will not react too punitively towards Ethiopia, not wishing to destabilize Ehtiopia’s stability for now. Bottom Line: There are risks that Egypt’s food production per capita could decline due to shortages of fresh water in the years ahead. In such a scenario, the nation’s food insecurity will rise and will have ravaging effects on Egypt’s balance of payments and the economy as well as might also lead to socio-political distress. Chart 2Egypt: Stagnant Crop Productivity Chart 3A Large Gap Between Food Production And Consumption Chart 4Egypt: A Large Portion Of Foreign Debt Obligations Is Owed To Bilateral Creditors At $14.5 billion for the next six months, foreign debt obligations are manageable (Chart 4). FDOs measure the sum of maturing short-term claims, interest payments and amortization over the next 6 months. Two thirds of FDOs are composed of short-term banking claims that can be extended/rolled over. Meanwhile, amortization and interest payments make up about $5 billion of the FDOs due over the next six months. Critically, three-quarters of these payments are owed to bi-and multi-lateral creditors. Egypt’s bi-lateral partners include Gulf states as well as the IMF and the World Bank. All of them have an interest in the country’s stability and are likely to roll over Egypt’s debt. Even though the central bank’s net foreign currency reserves are only $14 billion, its gross reserves are $39 billion (Chart 5). Additionally, if needed authorities may request additional financing from their bi-and multi-lateral creditors to preclude a major currency depreciation in the coming months. The current account deficit will not widen in the coming months (Chart 6, top panel). Exports will benefit from high natural gas and oil prices (Chart 6, bottom panel). Energy represents 32% of the nation’s exports. Chart 5Egypt: FX Reserves Are Above 2016 Devaluation Levels Chart 6Egypt: Current Account Will Improve With Rising Nat Gas Prices... Besides, tourism revenues will improve later this year as European travellers, who represent two-thirds of tourist entries, resume vacationing amid a broadening rollout of vaccines. Further, remittances have remained resilient in the face of the pandemic (Chart 7, top panel). In the meantime, export revenues from transportation – primarily, from the Suez Canal – will be bolstered by booming global trade (Chart 7, bottom panel). In turn, tame fiscal spending and high real lending rates will keep a lid on domestic demand and, thereby, imports (Chart 8). Chart 7...And Rising Remittances And Transport Revenues Chart 8Egypt: High Real Interest Rates Are Weighing On Growth Chart 9Egypt: Real Bond Yields Are High Lastly, multi-decade low inflation, fiscal and monetary prudence, and high real bond yields will preclude large foreign outflows from local currency government bonds (Chart 9). This will help the government to avoid currency devaluation. Remarkably, the overwhelming majority of foreign portfolio inflows have been into domestic bonds, not equities. Therefore, as long as investors in local currency bonds do not flee, the authorities will manage to avoid devaluation. Besides, Egypt offers one of the highest real bond yields in EM, and as such offers value to investors in an environment of low global yields (Chart 9). Bottom Line: Authorities will be reluctant to devalue the currency this year to avoid a pass-through of higher global food prices into domestic food prices. They will do everything they can to defend the exchange rate in the coming months, including requesting more US dollar financing from bi-and multi-lateral creditors and possibly hiking domestic interest rates. An Unsustainable Macro Policy Mix Chart 10Egypt: Nominal GDP Growth Needs To Be Above Borrowing Costs Beyond the next six months or so, authorities will be compelled to choose between tolerating very weak economic growth and the rising public debt burden on the one hand and currency devaluation on the other hand. The rationale is as follows: Egypt has pursued very high interest rate policy to attract portfolio capital and preclude exchange rate depreciation. Interest rates in real terms have been extremely high (Chart 9 above). This has depressed economic activity and inflation. In fact, nominal GDP growth has fallen well below nominal government bond yields, lethal dynamics for public debt sustainability (Chart 10). We elaborated on Egypt’s public debt sustainability in our report from June 10th, 2020 and concluded that its public debt dynamics are on a dangerous trajectory due to elevated interest rates. Egypt needs to bring down local interest rates substantially and rapidly. In so doing, the central bank will lose control of the exchange rate. This analysis remains valid today. With interest payments on public debt consuming 50% of government revenues, 35% of government expenditures and 10.5% of GDP (Chart 11), high domestic interest rates are unsustainable in the long run. Given that local currency government debt makes up 80% of total public debt, lower domestic interest rates are critical to reduce interest payments on government debt and stabilize the public debt-to-GDP ratio which at the end of 2019 stood at 100% of GDP – the latest for which data is available. Tight fiscal policy has been, and will continue to be, used to cap the rise in public debt. The government is expected to run a primary fiscal surplus equivalent to 1.5% of GDP for the 2021/22 fiscal year (Chart 12). Chart 11Egypt: Interest Payments On Public Debt Are Enormous... Chart 12...Leaving Little For Fiscal Spending Yet, depressed government non-interest spending is capping nominal income growth and contributes to lower GDP growth. Overall, tight monetary and fiscal policies are not sustainable in the long run as they will continue to depress income growth, ultimately resulting in socio-political discontent. Given that the productivity outlook remains dismal (please refer to the section below), the only option to boost (nominal) growth is to ease fiscal policy and reduce interest rates substantially. The upshot will be significant depreciation pressure on the exchange rate. Fiscal and monetary easing along with currency devaluation will boost nominal GDP growth, pushing it above borrowing costs. In time, the public debt-to-GDP ratio will stabilize due to a faster rising denominator. This will remove the constraint on fiscal policy, allowing the government to abandon fiscal austerity and meaningfully boost public sector wages, various subsidies and social benefits (Chart 13). This will also allow, authorities to counter rising food prices with greater outlays to support lower-income households. Importantly, the split between local and foreign currency denominated public debt is 80% and 20%. The majority of local currency public debt is held by domestic institutions and local banks (Table 1). Foreigners own only 15% of government local currency bonds. Thus, local institutions will blunt the impact of foreign selling amid fears of currency devaluation. Chart 13Egypt: Fiscal Spending Has Been Downshifting For Several Years Table 1Egypt: Composition Of Domestic Bond Holdings Meanwhile, loans from international and bilateral organizations account for three-quarters of foreign currency public debt. These can be restructured, and debt servicing can be delayed, providing fiscal authorities with some breathing room. Bottom Line: Chronically underwhelming economic growth will ultimately force the government to abandon tight fiscal and monetary policies and adopt a pro-growth agenda. A part of such a policy shift will be currency devaluation. No Structural Growth Improvement Chart 14Egypt: Structural Deficiencies The only way an economy can grow faster in an environemnt characterized by tight fiscal and monetary policies and no currency devaluation is via higher productivity growth. Odds of higher productivity growth in Egypt are low. The nation has not implemented the structural reforms necessary to improve productivity growth. Egypt’s structural vulnerabilities, namely depressed investment, an uncompetitive manufacturing sector and a lack of skilled labor, will all hinder productivity gains (Chart 14). Privatization plans for most SoEs have been canceled or delayed. Only one major state asset has been sold to private entities since 2015. Nevertheless, some recently enacted reforms will incentivize foreign companies to increase investment in some key strategic sectors, particularly in the oil & gas sector. For instance, all foreign firms which are now able to own 100% of their investments in Egypt, have the ability to repatriate all of their capital and profits and have been offerred guarantees against nationalisation and price controls on goods. Bottom Line: Egypt’s productivity gains will be limited, which will keep potential GDP growth tame. As a result, the economy can only rely on the reflationary push from fiscal and monetary policies and currency devaluation to achive higher (nominal) growth. Investment Conclusions The Egyptian pound’s valuations are presently neutral (Chart 15). Authorities are unlikely to devalue the exchange rate in the coming months. This creates a window of opportunity to collect the carry by being long currency bonds without hedging currency risk. That said, Egypt’s domestic bond yields could rise along with US bond yields (Chart 16, top panel). Chart 15Egypt: Currency Is Fairly Valued Chart 16Egypt: High Carry But Yields Could Rise Alongside US Yields Nevertheless, in the long run, a major currency devaluation is likely as continued fiscal and monetary austerity, a depressed economy and rising public debt are not viable options for the government. Substantial fiscal and monetary easing will be required to reflate the economy. The upshot of this will be a considerable currency devaluation. Chart 17Egypt: Wait For Reflationary Policies To Upgrade Equities Concerning US dollar bonds, dedicated EM credit portfolios should remain neutral on Egypt. In the near term, spreads could widen as public debt stress builds up amid very weak nominal GDP growth. In the long term, currency devaluation will be a trigger to go long/overweight this sovereign credit. Finally, equity investors should continue avoiding this stock market until authorities adopt reflationary policies and devalue the exchange rate (Chart 17). Fiscal easing and lower interest rates will herald higher nominal growth and will be conducive to higher share prices. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com
Highlights In the short run, extreme policy uncertainty is problematic for risk assets. In the long run, gargantuan fiscal and monetary stimulus continues to support cyclical trades. Equity volatility always increases in the lead-up to US presidential elections. Trump has a 35% chance of reelection. The US-China trade deal is intact for now but the risk of a strategic crisis or tariffs is about 40%. Our Turkish GeoRisk Indicator is lower than it should be based on Turkey’s regional escapades. Feature US equities fell back by 2.6% on June 24 as investors took notice of rising near-term risks to the rally. With gargantuan global monetary and fiscal stimulus, we expect the global stock-to-bond ratio to rise over the long run (Chart 1). However, we still see downside risks prevailing in the near term related to the pandemic, US politics, geopolitics, and the rollout of additional stimulus this summer. Chart 1Risk-On Phase Continues - But Risks Mounting Chart 2Policy Uncertainty Hitting Extremes Global economic policy uncertainty is skyrocketing – particularly due to the epic the November 3 US election showdown. Yet Chinese policy uncertainty remains elevated and will rise higher given that the pandemic epicenter now faces an unprecedented challenge to its economic and political order. China’s economic instability will increase emerging market policy uncertainty (Chart 2). Only Europe is seeing political risk fall, yet Trump’s threats of tariffs against Europe this week highlight that he will resort to protectionism if his approval rating does not benefit from stock market gains, which is currently the case. The COVID-19 outbreak is accelerating in the US in the wake of economic reopening and insufficient public adherence to health precautions and distancing measures. The divergence with Europe is stark (Chart 3). Authorities will struggle to institute sweeping lockdowns again, but some states are tightening restrictions on the margin and this will grow. Chart 3US COVID-19 Outbreak The divergence between daily new infection cases and new deaths in the US, as well as countries as disparate as Sweden and Iran, is not entirely reassuring. The US is effectively following Sweden’s “light touch” model. Ultimately COVID is not much of a risk if deaths are minimized – but tighter social restrictions will frighten the markets regardless (Chart 4). President Trump’s election chances have fallen under the weight of the pandemic – followed by social unrest and controversy over race relations. But net approval on handling the economy is holding up well enough (Chart 5). Chart 4Divergence In New Cases Versus New Deaths Chart 5Trump’s Lifeline Is The Economy Our subjective 35% odds of reelection still seem appropriate for now – but we will upgrade Trump if the financial and economic rebound is sustained while his polling improves. His approval should pick up in the face of a collapse of law and order, not to mention left-wing anarchists removing or vandalizing historical monuments to America’s Founding Fathers and some great public figures who had nothing to do with the Confederacy in the Civil War. Equity volatility will increase ahead of the US election. Chart 6Volatility Always Rises Before US Elections Equity volatility always increases in the lead up to modern American elections (Chart 6) and this year’s extreme polarization, high unemployment, and precarious geopolitical environment suggest that negative surprises could be worse than usual, notwithstanding the tsunami of stimulus. So far this year the S&P 500 is tracing along the lower end of its historical performance during presidential election years. This is consistent with a change of government in November, unless it continues to power upward over the next four months – typically a change of ruling party requires a technical correction on the year. Our US Equity Strategist, Anastasios Avgeriou, also expects the market to begin reacting to political risk – and he precisely timed the market’s peak and trough over the past year (Chart 7). We suspect that the positive correlation between the S&P and the Democratic Party’s odds of a full sweep of government is spurious. The reason the S&P has recovered is because of the economic snapback from the lockdowns and the global stimulus. The reason the odds of a Blue Wave election have surged is because the pandemic and recession decimated Trump and the Republicans. Going forward, the market needs to do more to discount a Democratic sweep. At 35%, this scenario is underrated in Chart 8, which considers all possible presidential and congressional combinations. Standalone bets put the odds of a Blue Wave at slightly above 50%. We have always argued that the party that wins the White House in 2020 is highly likely to take the Senate. Chart 7Market At Risk Of Election Cycle Chart 8Market Will Soon Worry About 'Blue Wave' True, the US is monetizing debt and this will push risk assets higher regardless over the long run. But if former Vice President Joe Biden wins the presidency, he will create a negative regulatory shock for American businesses, and if his party takes the Senate, then corporate taxes, capital gains taxes, federal minimum wages, liability insurance, and the cost of carbon (implicitly or explicitly) will all rise. The market must also reckon with the possibility that Trump is reelected or that he becomes firmly established as a “lame duck” and thus takes desperate measures prior to the election. His threat to impose tariffs on Europe this week underscores our point that if Trump’s approval rating stays low, despite a rising stock market, then the temptation to spend financial capital in pursuit of political capital will rise. This will involve a hard line on immigration and trade. Bottom Line: Tactically, there is more downside. Strategically, we remain pro-cyclical. Stimulus Hiccups This Summer One reason we have urged investors to buy insurance against downside risks this month is because of hurdles in rolling out the next round of fiscal stimulus. The four key drivers of the global growth rebound are liquidity, fiscal easing (Chart 9), an enthusiastic private sector response, and the large cushion of household wealth prior to the crisis. This is according to Mathieu Savary – author of our flagship Bank Credit Analyst report. Mathieu argues that it will be harder for investors to overlook policy uncertainty after the stimulus slows, i.e. the second derivative of liquidity turns negative. Chart 9Gargantuan Fiscal Stimulus The massive increase in budget deficits and the quick recovery in activity amid reopening have reduced politicians’ sense of urgency. We fear that the stock market will have to put more pressure on lawmakers to force them to provide more largesse. Ultimately they will do so – but if they delay, and if delay looks like it is turning into botching the job, then markets will temporarily panic. Why are we confident stimulus will prevail? In the United States, fiscal bills have flown through Congress despite record polarization. Democrats cannot afford to obstruct the stimulus just to hurt the economy and the president’s reelection chances. Instead they have gone hog wild – promoting massive spending across the board to demonstrate their fundamental proposition that government can play a larger and more positive role in Americans’ lives. Their latest proposal is worth $3 trillion, plus an infrastructure bill that nominally amounts to $500 billion over five years. President Trump, for his part, was always fiscally profligate and now wants $2 trillion in stimulus to fuel the economic recovery, thus increasing his chances of reelection as voters grow more optimistic in the second half of the year. He also wants $1 trillion in new infrastructure spending over five years. Yet Republican Senators are dragging their feet and offering only a $1 trillion package. In the end they will adopt Trump’s position because if they do not hang together, they will all hang separately in November. The debate will center on whether the extra $600 in monthly unemployment benefits will be continued (at a cost of $276bn in the previous Coronavirus Aid, Relief, and Economic Security Act). Republicans want to tie benefits to returning to work, since this generous subsidy created perverse incentives and made it more economical for many to stay on the dole. There will also be a debate over whether to issue another round of direct cash checks to citizens ($290bn in the CARES Act). Republicans want to prioritize payroll tax cuts, again focusing on reducing unemployment (Chart 10). Chart 10US Fiscal Stimulus Breakdown Our US bond strategist, Ryan Swift, has shown that the cash handouts present a substantial fiscal “cliff.” Without the original one-time stimulus checks, real personal income would have fallen 5% since February, instead of rising 9% (Chart 11). If Republicans refuse to issue a new round of checks, yet the extra unemployment benefits stay, then over $1 trillion in income will be needed to fill the gap so that overall personal income will end up flat since February. In other words, an ~8% increase in income less transfers from current levels is necessary to prevent overall personal income from falling below its February level. China and the EU will eventually provide more largesse. Republican Senators will capitulate, but the process could be rocky and the market should see volatility this summer. China may also be forced to provide more stimulus in late July at its mid-year Politburo meeting – any lack of dovishness at that meeting will disappoint investors. European talks on the Next Generation recovery fund could also see delays (though they are progressing well so far). Brexit trade deal negotiations pose a near-term risk. There is also a non-negligible chance that the German Constitutional Court will raise further obstructions with the European Central Bank’s quantitative easing programs on August 5. European risks are manageable on the whole, but the market is not discounting much (Chart 12). Chart 11Will Congress Takeaway The Money Tree? Bottom Line: We expect the S&P 500 to trade in a range between 2800 and 3200 points during this period of limbo in which risks over pandemic response and political risks will come to the fore while the market awaits new stimulus measures, which may not be perfectly timely. Chart 12European Risks Are Getting Priced Has The Phase One China Deal Failed Yet? President Trump’s threat this week to slap Europe with tariffs, if it imposes travel restrictions on the US over the coronavirus, points to the dynamic we have highlighted on the more consequential issue of whether Trump hikes broad-based tariffs on China, and/or nullifies the “Phase One” trade deal. Our sense is that if Trump is doing extremely poorly, or extremely well, in terms of opinion polls and the stock market, then the roughly 40% odds of sweeping punitive measures of some kind will go up (Diagram 1). Cumulatively we see the chance of a major tariff hike at 40%. Diagram 1Decision Tree: Risk Of Significant Trump Punitive Measures On China In 2020 White House trade czar Peter Navarro’s comments earlier this week, suggesting that the Phase One trade deal was already over, prompted Trump to tweet that he still fully supports the deal. Negotiations between Secretary of State Mike Pompeo and Chinese Politburo member Yang Jiechi also nominally kept the lid on tensions. However, China may need to depreciate the renminbi to ease deflationary pressures on its economy – and this would provoke Trump to retaliate (Chart 13). Chart 13Chinese Depreciation Would Provoke Trump We have always argued against the durability of the Phase One trade deal. Investors should plan for it to fall apart. Judging by our China GeoRisk Indicator, investors are putting in a higher risk premium into Chinese equities (Chart 14). They are also doing so with Korean equities, which are ultimately connected with US-China tensions. Only Taiwan is pricing zero political risk, which is undeserved and explains why we are short Taiwanese equities. After China’s imposition of a controversial national security law in Hong Kong and America’s decision to prepare retaliatory sanctions, reports emerged that Chinese authorities ordered state-owned agricultural traders to halt imports of soybean and pork – and potentially corn and cotton. These reports were swiftly followed by others that highlighted that state-owned Chinese firms purchased at least three cargoes of US soybeans on June 1, in spite of China’s decision to stop imports.1 Thus this aspect of the deal has not yet collapsed. But we would emphasize that the constraints against a failure of the deal are not prohibitive this year. The $200 billion worth of additional Chinese imports over 2020-2021 promised in the deal included $32 billion worth of additional US farm purchases – with at least $12.5 billion in 2020 and $19.5 billion in 2021 over 2017 imports of $24 billion. However, to date, US agricultural exports to China suggest that China may not even meet 2017 levels (Chart 15). Chart 14GeoRisk Indicators Show Rising Risk Chart 15Trade Deal Durability Still Shaky Soybeans account for roughly 60% of US agricultural exports to China. While Chinese imports are up so far this year relative to 2019, they remain well below pre-trade war levels. Although lower hog herds on the back of the African Swine Flu and disruptions caused by COVID-19 may be blamed, they are not the only cause of subdued purchases. The share of Chinese soybean imports coming from the US is also still below pre-trade war levels (Chart 16). Chart 16China Still Substituting Away From US New Chinese regulation requiring documents assuring food shipments to China are COVID-19 free adds another hurdle – China already banned poultry imports from Tyson Foods Inc. plants. Although the US’s share of China’s pork imports has picked up significantly, it will not go far toward meeting the trade deal requirements. China’s pork purchases from the US were valued at $0.3 billion in 2017, while soybean imports came in at $14 billion. Bottom Line: Trump’s only lifeline at the moment is the economy which pushes against canceling the US-China deal. But if he becomes a lame duck – or if exogenous factors humiliate him – then all bets are off. The passage of massive stimulus in the US and China removes economic constraints to conflict. Will Erdogan Overstep In Libya? We have long been bearish on Turkey relative to other emerging markets due to President Tayyip Erdogan’s populist policies, which erode monetary and fiscal responsibility and governance. Turkey’s intervention in Libya has marked a turning point in the Libyan civil war. The offensive to seize Tripoli on the part of General Khalifa Haftar of the Tobruk-based Libyan National Army (LNA) has been met with defeat (Map 1). Map 1Libya’s Battlefront Is Closing In On The Oil Crescent Foreign backing has enabled the conflict. Egypt, the UAE, Saudi Arabia, and Russia are the Libyan National Army’s main supporters, while Turkey and Qatar support Prime Minister Fayez al-Sarraj of the UN recognized Government of National Accord (GNA). The GNA’s successes this year can be credited to Turkey, which ramped up its intervention in Libya, even as oil prices collapsed, hurting Haftar and his supporters. Now the battlefront has shifted to Sirte and the al-Jufra airbase – the largest in Libya – and is closing in on the eastern oil-producing crescent, which contains over 60% of Libya’s oil. The victor in Sirte will also have control over the oil ports of Sidra, Ras Lanuf, Marsa al-Brega, and Zuwetina. With all parties eying the prize, the conflict is intensifying. Tripoli faces greater resistance as its forces move east. Egyptian President Abdel Fattah al-Sisi’s June 6 ceasefire proposal, dubbed the Cairo Initiative, was rejected by al-Sarraj and Turkey. Instead, the Tripoli-based government wants to capture Sirte and al-Jufra before coming to the table. The recapturing of oil infrastructure would bring back some of Libya's lost output (Chart 17). Nevertheless, OPEC 2.0 is committed to keeping oil markets on track to rebalance, reducing the net effect of a Libyan production increase on global supplies. However, the GNA’s swift successes in the West may not be replicable as it moves further East, where support for Haftar is deeper and where the stakes are higher for both sides. This is demonstrated by the GNA’s failed attempt to capture Sirte on June 6. The battlefront is now at Egypt’s red line – GNA control of al-Jufra would pose a direct threat to Egypt and is thus considered a border in Egypt’s national security strategy. A push eastward risks escalating the conflict further by drawing in Egypt militarily. In a televised speech on June 20, al-Sisi threatened to deploy Egypt’s military if the red line is crossed. The statement was interpreted by Ankara as a declaration of war, raising the possibility that Egypt will go to war with Turkey in Libya. On paper, Egypt’s military is up to the task. Its recent upgrades have pulled up its ranking to ninth globally according to the Global Fire Power Index, surpassing Turkey’s strength in land and naval forces (Chart 18). However, while Turkey’s military has been active in other foreign conflicts such as in Syria, Egypt’s army is untested on foreign soil. Its most recent military encounter was the 1973 Yom Kippur War. Even after years of fighting, it has yet to declare victory against terrorist cells in the Sinai Peninsula. Thus Egypt’s rusty forces could face a protracted conflict in Libya rather than a swift victory. Chart 17GNA/Turkish Success Would Revive Libyan Oil Production Chart 18Egypt Is Militarily Capable … On Paper Other constraints may also deter al-Sisi from following through on his threat: Other Arab backers of the Libyan National Army – the UAE and Saudi Arabia – are unlikely to provide much support as their economies have been hammered by low oil prices. Egypt’s own economy is in poor shape to withstand a protracted war, with public debt on an unsustainable path. Not coincidentally, Egypt faces another potential military escalation to its south where it has been clashing with Ethiopia over the construction of the Grand Ethiopian Renaissance Dam on the Blue Nile. The dam will control Egypt’s water supply. The latest round of negotiations failed last week. While Cairo is hoping to obtain a bilateral agreement over the schedule for filling the dam, Addis Ababa has indicated that it will begin filling the dam in July regardless of whether an agreement is reached. Al-Sisi’s response to the deadlocked situation has been to request an intervention by the UN Security Council. However, as the July filling date nears, the Egypt-Ethiopia standoff risks escalating into war. For Egypt, there is an urgency to secure its future water supplies now before Ethiopia begins filling the dam. And while resolving the Libyan conflict is also a matter of national security – Egypt sees the Libyan National Army as a buffer between its porous western border and the extremist elements of the GNA – the risks are not as pressing. Thus a military intervention in Libya would distract Egypt from the Ethiopian conflict and risk drawing it into a war on two fronts. Moreover, Egypt generally, and al-Sisi in particular, risk losing credibility in case of a defeat. That said, Egypt has high stakes in Libya. A GNA defeat could annul the recent Libya-Turkey maritime demarcation agreement – a positive for Egypt’s gas ambitions – and eliminate the presence of unfriendly militias on its Western border. Thus, if the GNA or GNA-allied forces kill Egyptian citizens, or look as if they are capable of utterly defeating Haftar on his own turf, then it would be a prompt for intervention. Meanwhile Turkey’s regional influence and foreign policy assertiveness is growing – and at risk of over-extension. Erdogan’s interests in Libya stem from both economic and strategic objectives. In addition to benefitting from oil and gas rights and rebuilding contracts, Ankara’s strategy is in line with its pursuit of greater regional influence as set out in the Mavi Vatan, its current strategic doctrine.2 There are already rumors of Turkish plans to establish bases in the recently captured al-Watiya air base and Misrata naval base. This would be in addition to Ankara’s bases in Somalia and in norther Iraq. Erdogan is partly driven into these foreign policy adventures to distract from his domestic challenges and keep his support level elevated ahead of the 2023 general election (Chart 19). However, his growing assertiveness threatens to alienate European neighbors and NATO allies, which have so far played a minimal role in the Libyan conflict yet have important interests there. For now, the western powers seem focused on countering Russian intervention in Libya and the broader Mediterranean. Prime Minister al-Sarraj and General Stephen Townsend, head of US Africa Command (AFRICOM), met earlier this week and reiterated the need to return to the negotiating table and respect Libyan sovereignty and the UN arms embargo, with a focus on stemming Russian interference. However, Turkish relations with the West may take a turn for the worse if Erdogan oversteps. Turkey continues to threaten Europe with floods of refugees and immigrants if its demands are not met. This pressure will grow due to the COVID-19 crisis, which will ripple across the Middle East, Africa, and South Asia. Ankara also continues to press territorial claims in the Mediterranean Sea, ostensibly for energy development.3 Turkey has recently clashed with Greece and France on the seas. In sum, the Libyan conflict is intensifying as it moves into the oil crescent. The Turkey-backed GNA will face greater resistance in Sirte and al-Jufra, even assuming that Egypt does not follow through on its threat of intervening militarily. Erdogan’s foreign adventurism will provoke greater opposition in Libya and elsewhere among key western powers, Russia, and the Gulf Arab states. Bottom Line: The implication is that a deterioration in Turkey’s relationship with the West, military overextension, and continued domestic economic mismanagement will push up our Turkey GeoRisk Indicator, which is a way of saying that it will weigh on the currency (Chart 20). Chart 19Erdogan’s Fear Of Opposition Drives Bold Policy Chart 20Foreign And Domestic Factors Will Push Up Turkish Risk Stay short our “Strongman Basket” of emerging market currencies, including the Turkish lira. Investment Takeaways We entered the year by going strategically long EUR-USD, but closed the trade upon the COVID-19 lockdowns. We have resisted reinitiating it despite the 5% rally over the past three months due to extreme political risks this year, namely the US election and trade risks. Trump’s threat of tariffs on Europe this week highlights our concern. We will wait until the election outcome before reinstituting this trade, which should benefit over time as global and Chinese growth recover and the US dollar drops on yawning twin deficits. Throughout this year’s crisis we have periodically added cyclical and value plays to our strategic portfolio. We favor stocks over bonds and recommend going long global equities relative to the US 30-year treasuries. We are particularly interested in commodities that will benefit from ultra-reflationary policy and supply constraints due to insufficient capital spending. This month we recommend investors go long our BCA Rare Earth Basket, which features producers of rare earth elements and metals that can substitute for Chinese production (Chart 21). This trade reflects our macro outlook as well as our sense that the secular US-China strategic conflict will heat up before it cools down. Chart 21Position For An Escalation In The US-China Conflict Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see Karl Plume et al, "China buys U.S. soybeans after halt to U.S. purchases ordered: sources," Reuters, June 1, 2020. 2 The Mavi Vatan or “Blue Homeland Doctrine” was announced by Turkish Admiral Cem Gurdeniz in 2006 and sets targets to Turkish control in two main regions. The first region is the three seas surrounding it – the Mediterranean Sea, Aegean Sea, and Black Sea with the goal of securing energy supplies and supporting Turkey’s economic growth. The second region encompasses the Red Sea, Caspian Sea and Arabian Sea where Ankara has strategic objectives. 3 Ankara’s gas drilling activities off Cyprus have been a form of frequent provocation for Greece and Cyprus. Ankara has also stated that it may begin oil exploration under a controversial maritime deal with Libya as early as August. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar
BCA Research's Emerging Markets Strategy service believes that the Central Bank of Egypt (CBE) will allow the currency to depreciate and will cut interest rates materially. A Devaluation would offer an attractive opportunity to buy Egyptian stocks. …
Highlights Egypt’s balance of payments have deteriorated materially due to both the crash in oil prices and the global pandemic. The country’s foreign funding requirements in 2020 are high and the currency is under depreciation pressures. Unless domestic interest rates are brought considerably lower, the nation’s public debt is on an unsustainable trajectory. Hence, Egypt needs to reduce local interest rates substantially and rapidly. And in so doing, the central bank cannot control or defend the exchange rate. The latter is set to depreciate. Investors should buy Egyptian local currency bonds while hedging their currency exposure. Feature The Central Bank of Egypt (CBE) is depleting its foreign exchange (FX) reserves to defend the currency (Chart I-1). As the CBE’s foreign exchange reserves diminish, so will its ability to support the currency. As such, the Egyptian pound will likely depreciate in the next 6-9 months. Interestingly, despite being a net importer of energy, many of Egypt’s critical macro parameters are positively correlated with oil prices (Chart I-2). Egypt is in fact deeply integrated in the Gulf oil-economy network via trade and capital flows. In other words, Egypt is a veiled play on oil. Chart I-1The CBE Has Been Defending The Currency Chart I-2Egypt: A Veiled Play On Oil Although oil prices have rallied sharply recently, the Emerging Markets Strategy team believes upside is limited and that oil prices will average about $40 over the next three years.1 In addition, local interest rates that are persistently above 10% are disastrous for both Egypt’s domestic demand and public debt sustainability. Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. To preclude a vicious cycle in both the economy and public debt, the CBE should reduce interest rates materially and rapidly. Therefore, higher interest rates cannot be used to defend the exchange rate. Balance Of Payments Strains Egypt’s balance of payments (BoP) dynamics have deteriorated and the probability of a currency devaluation has risen: Current Account: The current account deficit – which stood at $9 billion and 3% of the GDP as of December 2019 – is widening significantly due to the plunge in oil prices this year (Chart I-2, top panel). Egypt’s current account balance strongly correlates with oil prices because of the strong interlinkages that exist between Egypt and the oil-exporting Gulf countries. The latter have been hard hit by the twin shocks of the coronavirus pandemic and the oil crash. First, Egypt’s $27 billion in annual remittances are drying up (Chart I-2, bottom panel). The majority of these transmittals come from Egyptian workers working in Gulf countries. Second, Egypt’s tourism industry – which brings in $13 billion in annual revenues or 4% of GDP – has collapsed due to the pandemic. Tourist arrivals from Middle Eastern countries – which makeup 20% of total tourist arrivals into Egypt – will diminish substantially due to both the pandemic and the negative income shock that the Gulf economies have experienced (Chart I-3). Third, Egyptian exports are in freefall (Chart I-4, top panel). Not only is this due to the freeze in global trade, but also because the country’s exports to the oil-leveraged Arab economies have taken a massive hit. The latter make up 25% of Egypt’s total goods shipments. Chart I-3Egypt: Tourism Is Linked To Oil Prices Chart I-4Exports Revenues Swing With Oil Prices Furthermore, since 2019 Egypt has been increasingly exporting natural gas. The collapse in gas prices has probably already wiped out a large of chunk its natural gas export revenues (Chart I-5). Chart 6 exhibits the structure of Egypt’s exports of goods and services. Energy, tourism and transportation constituted 67% of total exports in 2019. Chart I-5Gas Export Revenues Are At Risk Chart I-6Egypt: Structure Of Goods & Services Exports Chart I-7Exports Are Shrinking Amid Resilient Imports Finally, while export revenues have plunged, imports remain resilient (Chart I-7). Critically, 26% of Egypt’s imports are composed of essential and basic items such as consumer non-durable goods, wheat and maize. Consumption of these staples and goods are less sensitive to business cycle oscillations. Therefore, the nation’s current account deficit has ballooned. A wider current account deficit needs to be funded by foreign inflows. With foreign investors reluctant to provide funds, the CBE has lately been financing BoP by depleting its foreign exchange reserves (Chart I-1, on page 1). Foreign Funding Requirements: Not only is Egypt facing a massively deteriorating current account deficit, but the country also carries large foreign funding debt obligations (FDO). FDOs are the sum of debt expiring in the next 12 months, and interest as well as amortization payments over the next 12 months. FDOs due in 2020 were $24 billion.2 In turn, Egypt’s total foreign funding requirements (FFR) – which is the sum of FDOs and the country’s current account deficit – has risen to $33 billion.3 Importantly, this FFR amount is based on the current account for 2019 and, thereby, does not take Egypt’s deteriorating current account deficit into consideration – as discussed above. Meanwhile, the central bank has net FX reserves of only $8 billion.4 If the monetary authorities continue to fund FFR of $33 billion in 2020 to prevent the pound from depreciating, the CBE will soon run out of its net FX reserves. Overall, Chart I-8 compares Egypt to the rest of the EM universe: with respect to (1) exports-to-FDO on the x-axis and (2) foreign exchange reserves-to-FFR on the y-axis. Based on these two measurements, Egypt is among the most vulnerable EM countries in terms of the balance of payments as it has the lowest FX reserves-to-FFR ratio and a low export-to-FDO ratio as well. Chart I-8Egypt Is One Of The Most Exposed EM Countries To Currency Depreciation Chart I-9FDI Inflows Are Set To Diminish Foreign Funding of Private Sector: Egypt will struggle to attract private-sector foreign inflows to meet its large FFR amid this adverse regional economic environment and the likely renewed relapse in oil prices in the months ahead. FDI inflows are set to drop (Chart I-9). The oil & gas sector has been the largest recipient of FDI inflows recently (around 55% in 2019 according to the central bank). The crash in both crude oil and natural gas prices will therefore ensure that FDIs into this sector will dry up. Besides, overall FDI inflows emanating from Gulf countries are poised to shrink substantially.5 Chart I-10The Egyptian Pound Is Once Again Expensive Foreign Funding of Government: With FDI inflows diminishing, the Egyptian government has once again been forced to approach the IMF for assistance. The country managed to secure $8 billion in assistance from the IMF ($2.8 billion in May and $5.2 in June). This has ameliorated international investor confidence in Egypt. Indeed, the country raised $5 billion by issuing US dollar-denominated sovereign bonds in May. Egypt is now seeking another $4 billion from other international lenders. Crucially, assuming Egypt manages to get the $4 billion loan, which would allow it to raise a total of $17 billion, Egypt would still be short on foreign funding to finance its $33 billion in FFR. Therefore, the currency will come under pressure of devaluation. As we argue below, the nation’s public debt sustainability is in jeopardy unless local currency interest rates are brought down substantially. This can only happen if the currency is allowed to depreciate. Consistently, foreign investors might be unwilling to lend to Egypt until interest rates are pushed lower and the country’s public debt trajectory is placed back on a sustainable path. Finally, the Egyptian pound has once again become expensive according to the real effective exchange rate (REER) which is based on both consumer and producer prices (Chart I-10). Bottom Line: Egypt is facing sharply slowing foreign inflows due to both the crash in oil prices and the global pandemic. This is occurring amid increased FFRs. Meanwhile, the CBE’s net FX reserves are insufficient to defend the exchange rate. Public Debt Sustainability The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. In turn, without currency devaluation that ultimately allows local interest rates to drop dramatically, the sustainability of Egypt’s public debt will worsen considerably. The BoP strains discussed above are forcing the CBE to keep interest rates high to prevent the currency from depreciating. Yet the country’s public debt is on a dangerous path due to elevated interest rates. To start, Egypt’s public debt stands at 97% of GDP – local currency and foreign currency debt account for 79% and 18% of GDP respectively (Chart I-11, top panel). Chart I-12 illustrates that interest payments on public debt is already using up 60% of government revenue and stands at 10% of GDP. Chart I-11Egypt: Public Debt Profile Chart I-12The Government's Interest Payments Are Unsustainable Therefore, if the CBE keeps interest rates at the current level, then the government will continue to pay high interest on its debt. Generally, two conditions need to be met to ensure public debt sustainability in any country (i.e., to ensure that the public debt-to-GDP ratio does not to surge). Nominal GDP growth needs to be higher than government borrowing costs. The government needs to run persistently large primary fiscal surpluses. Chart I-13Egypt: Nominal GDP Growth And Government Borrowing Costs Regarding the first condition, nominal GDP growth was already dangerously close to the level of Egypt’s government borrowing costs even before the pandemic hit Egypt (Chart I-13). With the pandemic, both domestic demand and exports have plunged. Consequently, nominal GDP is likely close to zero while local currency borrowing costs are above 10%. So long as nominal GDP growth remains below borrowing costs, the public debt sustainability will continue to deteriorate. As to the second condition, Egypt only started running primary fiscal surpluses in 2018 as it implemented extremely tight fiscal policy by cutting non-interest expenditures (Chart I-14). However, that was only possible because economic growth was then strong. As growth has slumped, government revenue is most likely shrinking. Chart I-14Egypt Only Recently Started Running A Primary Fiscal Surplus Tightening fiscal policy amid the economic downturn will be ruinous. Cutting non-interest expenditures further will depress the already weak economy, drying up both nominal GDP and government revenues even more. This will bring about a vicious economic cycle. Needless to say, the latter option is politically unviable. The most feasible option to ensure sustainability of public debt dynamics is to bring down domestic interest rates considerably. Lower local interest rates will reduce interest expenditures on its domestic debt and will either narrow overall fiscal deficit or free up space for the government to spend elsewhere, boosting much needed economic growth. Meanwhile lower interest rates will boost demand for credit and revive private-sector domestic demand. Provided Egypt’s public debt has a short maturity profile, lower interest rates will reasonably quickly feed into lower interest payments for the government. This means that lower interest rates could reasonably quickly feed to lower interest payments for the government. Importantly, there is a trade-off between the exchange rates and interest rates. Lowering interest rates entail currency depreciation. According to the impossible trinity theory, a central bank facing an open capital needs to choose between controlling interest rates or the exchange rate, it cannot control both simultaneously. As such, if the Central Bank of Egypt opts to bring down local interest rates, while keeping the capital account reasonably open, it needs to tolerate a weaker currency amid its ongoing BoP strains. Bottom Line: Public debt dynamics are treading on a dangerous path. Egypt needs to bring down local interest rates down substantially and rapidly. And in so doing, the CBE cannot control and defend the exchange rate. Devaluation Is Needed All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. The latter will help stimulate economic growth and make public debt sustainable. Specifically, if the Central Bank of Egypt opts for defending the currency from depreciation, it will need to tolerate much higher interest rates for a long period of time. The CBE would essentially need to deplete whatever little net FX reserves it currently has to fund BoP deficits. This would simultaneously shrink local banking system liquidity, pushing domestic interbank rates higher. All in all, the Egyptian authorities are facing a tight tradeoff: (1) either they continue to defend the currency at the expense of depressing the economy and worsening public debt dynamic, or (2) they tolerate a one-off currency devaluation which would allow the monetary authorities reduce interest rates aggressively. Worryingly, not only would high interest rates devastate the already shaky Egyptian economy, but higher domestic interest rates carry major ramifications for Egypt’s public debt sustainability as discussed earlier. A one-off currency devaluation is painful and carries some political risks yet, it is still the least worst choice for Egypt from a longer-term perspective. Although inflation will spike due to pass-through from currency devaluation, it will be a transitory one-off increase (Chart I-15). Besides, the pertinent risk to the Egyptian economy currently is low inflation and high real interest rates (Chart I-16). Chart I-15Egypt: Currency-Induced Inflation Is A One-Off Chart I-16Egypt: Real Interest Rates Are High In turn, currency depreciation will ultimately provide the CBE with scope to reduce its policy rate which will help stimulate the ailing economy as well as make public debt trajectory more sustainable. Finally, odds are high that Egyptian authorities might choose to devalue the currency sooner rather than later. The basis for this is that the government’s foreign public debt is still relatively small at 18% of the GDP and 19% of the total government debt (Chart I-11, on page 8). Further, the majority (70%) of Egypt’s foreign public debt remains linked to international and bilateral government loans making it easier to renegotiate their terms than in the case of publicly traded sovereign US dollar bonds (Chart I-11, bottom panel). This means that currency depreciation will not materially deteriorate the government’s debt servicing ability. Furthermore, Egypt has experience managing and tolerating currency depreciation. The currency depreciated against the US dollar by 50% in 2016 and before that by 12% in 2013. Bottom Line: The Central Bank of Egypt will not hike interest rates or sell its foreign currency reserves for too long to defend the pound. Odds are high that it will allow the currency to depreciate and will cut interest rates materially. Investment Recommendations Chart I-17Egyptian Pound In The Forward Market Investors should buy Egyptian 3-year local currency bonds while hedging their currency exposure. The basis is that low inflation and a depressed economy in Egypt will lead the CBE to cut rates by several hundred basis points over the next 12 months while allowing currency to depreciate. Forward markets are pricing 5% depreciation in the EGP in the next 6 months and 10% in the next 12 months (Chart I-17). We would assign a higher probability of depreciation. For now, EM credit portfolios should have a neutral allocation on Egyptian sovereign credit. While another potential drop in oil prices and the currency devaluation could push sovereign spreads wider (Chart I-18), eventually large rate cuts by the CBE will make public debt dynamics more sustainable. Absolute return investors should wait for devaluation to go long on Egypt’s US dollar sovereign bonds. Chart I-18Remain Neutral On Egypt's Sovereign Credit Chart I-19Remain Neutral On Egyptian Equities Equity investors should keep a neutral allocation on Egyptian stocks with an EM equity portfolio (Chart I-19). Lower interest rates ahead will eventually boost this stock market. Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com 1 This is the view of BCA’s Emerging Markets Strategy service and it differs from the view of BCA’s Commodities and Energy Strategy service. 2 We exclude the Central Bank’s foreign liabilities due in 2020 as they are mostly deposits at the Central Bank of Egypt owed to Gulf countries. It is highly likely that Gulf lenders will agree to extend these deposits given the difficulties Egypt is experiencing. 3 Excluding the Central Bank’s foreign liabilities due in the next 12 months. Please refer to above footnote. 4 The amount of net foreign exchange reserves currently at the Central Bank – i.e. excluding the Bank’s foreign liabilities– are now low at $8 billion. 5 Gulf Co-operation Countries (GCC) are in no position to provide much financial assistance due to the pandemic and oil crash as they are under severe financial strain themselves. Also, GCC countries run strict currency pegs and need to preserve their dwindling foreign exchange reserves to defend their currency pegs to the US dollar.
For one, Egypt remains heavily reliant on its external environment. This environment has been largely cooperative throughout Sisi’s term in office, but a global or EM downturn could cause investment to collapse. Meanwhile, the cyclical rise in oil prices will…
Global trade is plummeting as commodity prices remain depressed and emerging markets unravel. Even if oil were not plumbing new lows, we would remain bearish on EM economies, where poor governance and low efficiency suggest that more crises will rear their heads. Above all, we are watching China for policy clarity. After seizing 14% of global exports in recent years, it is now exporting surplus goods into an already deflationary world. Protectionism - not a coordinated response among leading countries - is the likely result. In essence, we reiterate our theme that globalization has peaked. Along the way, we call attention to five geopolitical "Black Swans" that <i>no one</i> is talking about.