The overthrow of President Mohamad Morsi by popular demand and supported by the army inaugurates yet another volatile episode in Egypt’s long and turbulent transition. Macro stabilisation in Egypt hinges on a swift and cohesive transition, and given the current bloodshed, that appears unlikely - which leaves Barclays 'muddle-through scenario' - where political/religious divides delay formation of civilian government - as the most likely; postponing fiscal reforms indefinitely, and undermining further the fiscal and debt sustainability of the already-troubled nation. This is a major problem, since, after all; among the main reasons behind the mass protests of 30 June were the continued deterioration in most socioeconomic indicators, faltering public services (notably provisions of fuel and electricity), rising risks of macroeconomic instability and slow progress in implementing socioeconomic and fiscal reforms over the past year.
Egypt, The Day After
The overthrow of President Mohamad Morsi by popular demand and supported by the army inaugurates yet another volatile episode in Egypt’s long and turbulent transition. The temporary suspension of the constitution and appointment of an interim civilian president precede the difficult formation of a new government, as well as expected early parliamentary and presidential elections, for which no timetable has been set. However, this is happening against the background of deepening divides and polarisation across the body politic.
The ability of the army to embrace an inclusive transitional process and avoid a violent crackdown is essential to avoid further radicalisation and an escalation of violence. As long as the Muslim Brotherhood (MB) remains defiant, refusing to engage and participate in the political process, further turbulence and confrontation is likely.
The actions of the military could also determine the fate of US assistance. A relatively speedy transfer of power back to an elected government and respect for the rule of law by the army should keep US assistance to Egypt intact. However, if the transition is protracted or the crackdown on members of the MB intensifies, aid may have to be suspended.
Political and religious divides across supporters of the 30 June uprising may risk delaying the formation of a cohesive government and instituting constitutional amendments and elections swiftly, thus causing further deterioration in the fiscal stance under a muddle-through scenario. If these divides can be overcome or put aside temporarily, we believe a government of technocrats and experts could help to put the economy on track and proceed with reform, with or without IMF support.
While the fragile security situation will keep Egypt’s external financing needs elevated, given weakening tourism receipts and capital inflows, prospects for strong support from the UAE, Saudi Arabia and other GCC countries should help to bridge financing gaps (USD7-8bn in FY 13-14), although this will increase Egypt’s dependence on short-term bilateral debt flows.
Macro stabilisation hinges on a swift and cohesive transition
The deteriorating security situation and continued protests amid deepening polarisation risks delaying the agreement on and implementation of the transitional road map, severely affecting the country’s already dire economic outlook.
After all, among the main reasons behind the mass protests of 30 June were the continued deterioration in most socioeconomic indicators, faltering public services (notably provisions of fuel and electricity), rising risks of macroeconomic instability and slow progress in implementing socioeconomic and fiscal reforms over the past year.
Figures 1 to 6 provide a snapshot of Egypt’s key macroeconomic indicators:
- growth is weak and remains lower than pre-2011 levels, with investment still in contraction mode (Figure 1);
- unemployment reached 13.2% in Q1 13, up from less than 9% at end-2010 (Figure 2);
- the fiscal deficit widened from almost 8% of GDP in FY 09-10 to almost 13% of GDP by June 30 (Figure 3),
- pushing gross public debt above 88% of GDP, up from less than 73% of GDP during the same period (Figure 4).
- Most critical is the persistent deterioration in FX reserves which reached USD14.9bn, or barely three months of imports, at end-June (Figure 5), and which recently have been replenished largely by resorting to short-term, debt-creating flows from neighbouring countries (Turkey, Qatar, Libya),
- raising thus the ratio of short-term debt to net international reserves (NIR) from 8.7% at end 2010 to 44% by end 2012 (Figure 6).
Swift transition to cohesive government essential for fiscal sustainability
Recognising the challenges outlined in the previous sections, two scenarios seem most likely over the coming six months, in our opinion.
First, a muddle-through scenario, in which political and religious divides among those supporting Morsi’s overthrow step up more forcefully, while the MB continues to exclude itself from the political process and oppose cooperation with the interim civilian president and government. This could exacerbate the deterioration in he security situation (notably in Sinai), prevent a swift formation of a new national unity government. It likely would also delay necessary amendments to the constitution and the enactment of an election law in the next three to four months, thus undermining the transition process and possibly lengthening it beyond the new year.
In this case, we would expect a pattern of slow/no reform mode to prevail, similar to the past months, and discussions with the IMF to be postponed indefinitely, while the country continues to rely on stop-gap bilateral funding from regional governments (notably the UAE and Saudi Arabia this time around) to meet its external financing needs and avert a full blown currency crisis. Under such a scenario, the timetable for implementing the planned fiscal reforms, recently approved by the Shura Council, is likely to be delayed further, negatively affecting the country’s fiscal and debt sustainability prospects. With an estimated overall deficit of almost 13% of GDP and a gross debt-to-GDP ratio of about 88% in FY 12-13, a planned reduction of the deficit to 11% of GDP in the new fiscal year starting 1 July now appears too optimistic, in our opinion.
Moreover, a longer transitional period with unclear political and governance outlook would likely keep capital flows away from Egypt and force the government to continue to rely on higher-cost domestic sources and short-term external borrowing to fund its deficit.
An alternative scenario is one in which the military, pressed by the international community, eager to preserve its strategic interests with the US and having learnt its lessons from 2011, pushes for an agreement on a national unity government in the coming weeks.
It gathers personalities recognised for their expertise and competence who are widely respected across the political spectrum and manages to reach some form of agreement with the MB, whether with the main leadership or with splinter factions (if any), to include the MB in the new government and/or to participate in future elections. A (semi-) technocratic government would then focus on the economy and elections as top priorities, and work with regional and international partners to support a broad-based economic revival plan after building a domestic consensus around it. In the short term, however, such a government would likely proceed with fiscal consolidation measures while continuing to rely on a mix of stop-gap financing from regional bilateral and multilateral funding.
In parallel, it also would likely pursue discussions with the IMF on implementing reforms. However, if building consensus on an IMF-endorsed reform plan proves difficult owing to political opposition, we would not be surprised to see the government proceed with its own reform plan and timetable, relying on regional funding. In this case, prospects for a reduction in fiscal deficit would be more promising, in our view.
Strategy: Still too many questions
The Egypt market outlook is mixed. The pace of the pound’s depreciation, given the prospects for more bilateral support from UAE and Saudi Arabia to support the army-led transition, should slow, at least until the end of Ramadan. Though the tail risks for the pound are large, the risk premium on the market is already high. The political transition period, particularly given possibility of more bilateral lending, is likely to solidify the CBE’s stance to tightly control the pace of depreciation.
Amid limited trading liquidity, Egypt credit spreads have reacted sharply to recent developments. After the significant widening over the past few weeks, driven by the increasing tensions in Egypt and exacerbated by the difficult overall market environment, the overthrow of President Morsi led to a rebound in spreads, possibly supported by short covering. Prospects of a more technocrat-oriented government may raise some hopes of an improvement in Egypt’s overall macroeconomic prospects, which, given Egypt’s comparatively low external debt levels, could make current spreads look generous. However, also taking into account the limited liquidity, we think that risks still outweigh opportunities at this stage. Thus, on balance, we retain our underweight/cautious stance on Egypt credit.