Why Devaluation is Not Going to Solve it All

Why Devaluation is Not Going to Solve it All Beyond the imminent EGP/USD adjustment According to government officials, Egypt has secured the USD6 billion required by the IMF to close the funding gap in FY016/17. Since the government of Egypt (GoE) has reached a staff-level agreement with the IMF, Egypt did receive a sum of USD4 billion from the GCC and development agencies (USD1 billion from the UAE, USD billion from KSA and USD1 billion from the World Bank). While no details were provided regarding the remaining USD billion, the IMF revealed that Egypt was negotiating with the G7 over financial packages worth USD billion. While the IMF board is getting ready to discuss the USD1 billion loan package, Egypt is also getting ready to devalue its currency and cut energy subsidies. Although investors have been longing for such a shift in monetary policy, we examine below the repercussions of switching to a more flexible exchange rate regime on the external sector, and whether it would be the magic solution to Egypt s tight external position. Improving FCY liquidity in the official market is a key success factor whether we opt for full floatation or managed float Starting with the ongoing discussions about the forthcoming exchange rate regime, we would like to remind our clients that the ultimate objective is to improve foreign currency (FCY) liquidity in the official FX market. Accordingly, maintaining a fixed or semi-fixed exchange rate in the absence of a sustainable FCY inflow to support the foreign reserves is an unrealistic assumption. We note that a crucial part of the IMF package implies setting a floor for the net foreign reserves. Such a floor means that the CBE s ability to intervene in the FX market will be limited. That is exactly why more exchange rate flexibility is truly expected. Although we believe a full EGP floatation is the best course of action, we understand that such a decision depends on political aspects rather than pure macroeconomic sense, and would have its repercussions on inflation and more importantly on the budget deficit, which is another corner stone of the IMF agreement. External sector pressure to persist, pulling EGP further down in FY017 In FY015/16, Egypt s merchandise trade deficit narrowed from 11.9% of GDP in the previous year to 10. of GDP in FY015/16 on lower commodity prices. On the other hand, services surplus shrunk from 1. of GDP in FY014/15 to 0. of GDP in FY015/16. In reaction to private transfers (mainly remittances of Egyptians working abroad) sharp decline by 1. YoY, the current account deficit widened from 3. of GDP in FY014/15 to 5. in FY015/16. Revisiting Egypt s main sustainable sources of FCY would help us estimate short-term reactions to applying a more flexible exchange rate. Ramy Oraby ramy.oraby@pharosholding.com Radwa El Swaify radwa.elswaify@pharosholding.com 1

Non-petroleum exports of goods: High inflation to negate benefits from local currency weakness Theoretically, local currency weakness should boost non-oil exports competitiveness. In Egypt, this was the case following EGP floatation in 003 as non-oil exports went up from 6.% of the GDP in FY00/03 to 9. in FY004/05 (Figure 1). However, the fact that domestic inflation is already high (double digit) is the reason why we are not so optimistic in 016. In other words, exporters cost of production (labor and raw materials) will minimize the benefits of the EGP weakness. 16 14 1 10 8 6 4 0 Non-oil exports are one of the few winners Non-petroleum exports (USDbn) Following the CBE's decision to float the EGP in Jan 003, non-oil exports rose from 6.% in 00/03 of GDP to 9. of GDP in 004/05. Non-petroleum exports (% of GDP) (RHS) 9% % Remittances are highly affected by oil price as much as it is by the confidence in the Egyptian banking system Indeed, closing the gap between the official and parallel markets exchange rate will redirect remittances back to the official channels ( the banking system). However, the fact that the majority of Egyptian expats are located in GCC countries means that oil price is another key factor to monitor for remittances rebound (Figure ). The impact of the current economic slowdown in the GCC (especially in Saudi Arabia) in addition to the recently announced plans to diversify the GCC economies induce speeding up labor market reforms (Saudization, Emiratization, etc.). This could be another reason to slightly offset potential positive effect from the expected slight oil price recovery. Tourism is highly affected by security concerns and not only devaluation The number of tourists visiting Egypt went down 59.9% YoY mainly affected by the Russian plane explosion over Sinai in November 015 (Figure 3). Accordingly, we believe that a major rebound in tourism revenues has more to do with domestic and regional security issues rather than EGP devaluation. Suez Canal revenues are negatively affected by global trade rather than the value of the currency This is another source of FCY that is not directly affected by exchange rate fluctuations. Last month, the World Trade Organization (WTO) downgraded the global trade growth projection of 016 and 017, from. and 3., to 1. and 3., respectively, growing at the slowest pace since 009, which is absolutely bad news for the Suez Canal revenues (Figure 4). Source: Centeral Bank of Egypt, Pharos research Oil price fluctuations impact on remittances Private transfers (%YoY) Oil price (%YoY) (two quarters lagged) 10 8 6 4 - -4-6 Q1 05/06 Q3 05/06 Q1 06/07 Q3 06/07 Q1 07/08 Q3 07/08 Q1 08/09 Q3 08/09 Q1 09/10 Q3 09/10 Q1 10/11 Q3 10/11 Q1 11/1 Q3 11/1 Q1 1/13 Q3 1/13 Q1 13/14 Q3 13/14 Q1 14/15 Q3 14/15 Q1 15/16 Q3 15/16 Q1 16/17 Q3 16/17f Source: Centeral Bank of Egypt, Pharos research Tourism revenues rebound is not just a matter of FX adjustment Number of tourists visiting Egypt (%YoY) Tourism revenues (as % of GDP) (RHS) 3 - - -3-4 % -5-6 -7 Source: Central Bank of Egypt, Bloomberg, Pharos research

Foreign direct investment is a key winner of floatation, but needs elimination of capital controls Net foreign direct investments (FDIs) was the one positive development. It rose marginally from USD6.4 billion in FY014/15 to USD6.8 billion in FY015/16 (Figure 5). Given the current rigid capital restrictions, such an increase shows at least a sign of interest in the Egyptian economy. Indeed, Egypt is in dire need for more FDIs in order to support employment and growth. Improving FCY liquidity as a result of a more flexible exchange rate policy is expected to encourage more inflows through lower capital restrictions. Moreover, the Egyptian prime minister has announced recently that the amendments of the investment law will be introduced to the parliament shortly. The government is pinning hopes on these amendments to enhance the business environment in Egypt and attract more FDIs. World trade growth rates in 016 and 017 were revised down Baltic dry index (%YoY) SC revenues (% YoY) (RHS) 14 3 10 8 1 6 4 - - -4-6 - -8-1 Imports declined on low commodity prices and due to import controls, slowly readjusting to FX movements Egypt s merchandise imports went down 8.1 YoY from USD61.3 billion in FY014/15 to USD56.3 billion in FY015/16. Oil prices sharp decline led 6 of the annual decline, while the remaining 4 represents the decline in non-oil imports. Examining the key determinants of the imports movements over the last five years, we note that the CBE s policy to defend the EGP implied supporting consumption (the growth rate of consumer goods imports averaged 3. in the last 5 years) at the expense of intermediate and investment goods imports (imported intermediate and investment goods growth rate averaged 0. in the last 5 years). As the FCY crisis intensified in FY015/16, the CBE started to target consumption as nearly all importers felt the FX crunch. Exchange rate flexibility in addition to fiscal tightening will result in readjusting households savings and consumption behaviors. However, we note that the consumption pattern adjustment won t be rapid due to the low price elasticity of most imported goods. Egypt needs more FDIs to support employment and growth Foreign direct investments (USDbn) Foreign direct investments (as % of GDP) 14 1 10 8 6 4 0 Contribution to merchandise imports annual growth rate 1 Intermediate and investment goods 9% % We expect further EGP weakening in FY016/17 In conclusion, we expected more EGP weakening in the future, even after the implementation of a more flexible exchange rate policy. We also stress on the fact that the anticipated weakness is a reaction to Egypt s macro fundamentals. It would be wrong to consider the coming FX adjustment as a one-off devaluation. Unlike China, Egypt is not in a luxurious position to undertake a competitive devaluation. As a result of devaluation, we expect the annual headline inflation rate to rise to an average of 18. in FY016/17, compared with an average of 10.% in FY015/16. - - FY010/11 FY011/1 FY01/13 FY013/14 FY014/15 9M 015/16 Fuel, Mineral oils & products Raw materials Consumer Goods Other imports Merchandise Imports (%YoY) 3

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