Fitch affirms Egypt rating at ‘B’ with ‘stable’ outlook

Fitch Ratings has affirmed on December 15th Egypt’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) at ‘B’ with a ‘Stable’ Outlook.

The issue ratings on Egypt’s senior unsecured foreign- and local-currency bonds are also affirmed at ‘B’. The Country Ceiling and the Short-Term Foreign- and Local-Currency IDRs are all affirmed at ‘B’.

KEY RATING DRIVERS
Egypt’s ratings balance a large fiscal deficit, a high general government debt/GDP ratio, strains on the balance of payments and recent volatile political history, with low albeit rising external debt and renewed progress in implementing an economic and fiscal reform programme.

The government’s programme of economic and fiscal reform has regained momentum, after stalling in the fiscal year to June 2016 when the budget deficit widened to a preliminary 12.2% of GDP. In July the government implemented a second round of electricity subsidy reform by raising prices 35%-40%. VAT came into effect in September, after parliament approved an amended law, which put the rate at 13% initially and 14% at the start of FY17.

The central bank floated the EGP on 3 November, leading to a sharp depreciation of the currency, which has since averaged EGP17.1 against the USD (up to 12 December), compared with a prior auction rate of EGP8.8. This followed an extended period of pressure on the currency amid depressed levels of foreign exchange, which was severely limiting economic activity. The government also enacted a second round of fuel subsidy reform (the first round was in mid-2014), raising fuel prices by 30.5%-46.8%. This step was part of the government’s programme following the EGP flotation to control the fiscal cost of imported fuel.

IMF board approval for the three-year USD12bn extended fund facility followed these reforms, on 11 November with a first tranche of USD2.7bn disbursed immediately. Details of the IMF agreement have yet to be released beyond the following general aims: reducing government debt/GDP by almost 10 percentage points by the end of the programme, implementing structural reforms and entrenching the newly liberalised exchange rate regime.

Egypt has also been raising external financing from a number of other sources, including the GCC, the World Bank, a currency swap with China worth around USD2.6bn, and USD2bn from a consortium of international banks. The liberalisation of the EGP has attracted renewed portfolio inflows. Egypt’s stock of international reserves climbed to USD23.1bn at end-November, from USD19.1bn in October and a low of USD15.6bn in July. We estimate that current reserve levels are just above four months of current external payments (CXP), a ratio that had been less than three in 2012-15.

Net external debt/GDP (11.7%) and net sovereign external debt/GDP (8.1%) are lower than the ‘B’ peer medians in 2016, but are rising on the back of greater recourse to foreign financing. Nevertheless, the bulk of sovereign external debt is concessional and the ratings are supported by the absence of a recent history of debt restructuring.

The public finances will remain a key weakness of Egypt’s credit profile. Despite VAT and subsidy reforms, we expect only modest narrowing in the budget deficit in FY17, to 11.6% of GDP. Tax revenue growth will be strong and the civil service law (approved by parliament in October) will continue to restrain public-sector wage growth. However, the subsidy bill will increase because the impact of the weaker EGP on import costs of fuel, for example, outweighs the subsidy price reform. Also, the higher interest rates that accompanied the EGP flotation imply a substantial increase in interest payments. We expect greater fiscal consolidation in FY18, with the budget deficit narrowing to 9% of GDP and the primary deficit to 0.3% of GDP.

Government debt/GDP is likely to peak in FY17, at around 99%, pushed higher by the combined effect of large additions to external debt and a sharply weaker EGP (assuming an end-June exchange rate of EGP16 to the USD). We forecast government debt/GDP to fall to 93% in FY18, on a smaller budget deficit and currency appreciation to EGP14.5. The level of guaranteed debt and contingent liabilities is currently unclear. The Public Finance Management unit, recently established within the MoF, expects to release data on this in early 2017.

We expect that GDP growth will be weaker in FY17, at 3.3%, given the challenges the economy was facing before the EGP flotation, especially in manufacturing and tourism, and because the fiscal and monetary reforms will initially be a drag on private consumption. Despite fiscal consolidation, we forecast stronger GDP growth in FY18, at 4.5%, as the exchange rate adjustment beds in, as gas production starts at the giant Zohr field, and with stronger investment.

With inflation set to rise above 20% in the first half of 2017, fiscal and monetary reforms present some risk of social backlash, especially given ongoing structural problems including high youth unemployment, deficiencies in governance and the business environment, as well as intermittent security issues. The government is seeking to mitigate these risks by emphasising that it is bolstering social safety nets (including cash transfer schemes) and that the reforms will deliver better economic performance and employment. Furthermore, food subsidy allocations have increased and electricity provision has improved markedly.

SOVEREIGN RATING MODEL (SRM) and QUALITATIVE OVERLAY (QO)
Fitch’s proprietary SRM assigns Egypt a score equivalent to a rating of ‘B’ on the Long-Term Foreign Currency IDR scale.

Fitch’s sovereign rating committee did not adjust the output from the SRM to arrive at the final Long-Term Foreign Currency IDR.

Fitch’s SRM is the agency’s proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign Currency IDR. Fitch’s QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch’s assessment that upside and downside risks to the ratings are currently balanced.

The main factors that, individually or collectively, could lead to a positive action are:
– A track record of progress on fiscal consolidation leading to declining government debt/GDP.
– Sustained stronger economic growth supported by reforms to the business environment leading to increased investment and employment.
– Significant accumulation of international reserves following a sustained narrowing of the current account deficit and higher net foreign direct investments.

The main factors that, individually or collectively, could lead to a negative rating action are:
– Failure to narrow the fiscal deficit and put government debt/GDP on a downward trend.
– Reversal of fiscal and/or monetary reforms, for example in the face of social unrest.
– Renewed downward pressure on international reserves due to further strains on the balance of payments, including weaker access to foreign financing.

KEY ASSUMPTIONS
Fitch assumes local banks remain willing and able to finance the fiscal deficit.

The political environment is assumed to be more stable than in 2011-2013, although sporadic, and at times serious, attacks on security forces are assumed to continue and underlying political tensions will remain.

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