A month is a long time in MENA macro-economics. As the revolution rages, economists have downgraded projections for the country's economic output and sounded the alarm about ballooning inflation, current account and fiscal deficit.
The policy mix to avert a debt spiral will be crucial. Policy-makers face a stark trade-off between high inflation and boosting growth versus a stable exchange rate and a stable interest rate regime.
Citigroup expects populist economic policies to take centre stage including a fiscal blowout and possibly capital controls to avert the slump in the Egyptian pound. It has provisionally forecast that Egypt will run a current account deficit in the order of 6 per cent of GDP compared to its 1.3 per cent forecast at the start of 2011, pushing the country into a balance of payments deficit.
This comes at a perilous time: the decision to increase pay and pensions by 15 per cent for the roughly 6m public sector workers in the country alone, pushes the fiscal deficit forecast to 9 per cent from 8.5 per cent. But given the risk of extra giveaways, spending on fuel and food subsidies, support for small-scale businesses, lost revenue and the cost of holding elections, it could see a deficit closer to an eye-watering 15 per cent of GDP for 2011, estimates Citi. Egypt already had a weak deficit coming into the revolution but investors shrugged this off, attracted to the local yields, with carry trade offering 8 per cent returns, for example.
Now, Egyptian investors are massively underweight credit, foreign exchange and when the stock market re-opens, expected this Sunday, foreign investors are expected to unwind their holdings en mass -- though, that depends on how the crisis evolves.
Lack of foreign investor confidence has historically created havoc for EM economies with balance of payment deficits. But as FT Tilt has reported extensively, Egypt is not facing a classic emerging market-like crisis in the form of an external financing shortfall thanks to domestic liquidity buffers. The Central Bank of Egypt (CBE) has $36bn of foreign exchange reserves, sufficient for more than six months of import cover, and enough to cover the country's projected external financing requirements for the entire year.
In addition, Egypt is benefiting from its underdeveloped banking system in the sense that savings are barely inter-mediated through borrowers and savers, as loans-to-deposit ratio is exceptionally high and banks are extremely liquid. The net foreign assets positions of commercial banks is about $20bn, sufficient to cover the entire stock of equity investments and T-bills holdings by foreigners, according to the Royal Bank of Scotland.
Debt spiral
But the political crisis has come at a precipitous time: investor flight has seen local government bond yields rise just when the government faces high roll-over requirements. The central bank was forced to downgrade its auction and pay higher interest rates last week. Before the crisis broke out, the Egyptian Ministry of Finance intended to issue some EGP 135bn in T-bills in the first three months of this year, indicating that the stock of t-bills (EGP268bn in September 2010) is geared towards the shorter end.
What's more, there is a lot of pent-up demand for liquidity, including compensation for businesses suffered due to the protests, repairing infrastructure and greater spending for civil services.
The government then faces higher financing costs. What's more, Citi estimate that core inflation could rise to 20 per cent in 2011 due to the weakness of the Egyptian pound, commodity prices, a fiscal blowout, infrastructure bottlenecks and the risk that central bank will ease monetary policy under political pressure to boost growth. As a result, Egypt's debt to GDP ratio will surely take a massive beating.
The outlook for borrowers then is stark: as domestic banks and insurance funds snap up government paper, capital available for private sector borrowers will be crowded out and market interest rates will edge up.
Egypt then faces high inflation, a fiscal blowout, and a balance of payments shortfall that will force the government to raid domestic banking sources. No wonder investors are underweight Egyptian assets.
But here's some quantum of solace: it's worth remembering that internally generated funds tend to finance SME's and businesses in frontier economies and Egypt is no exception - and retail credit demand this year was always going to be low due to low disposable incomes. That's why tight credit conditions for the private sector don't affect headline economic growth in underdeveloped export-led economies like Egypt as much as developed markets. What's more, the medium-term outlook for the economy looks promising if and when democracy takes root, boosting stability and reducing corruption.
Source: Institute of International Finance, 4 February report
See also:
Coverage of the MENA crisis - FT Tilt
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