EGP Forecast Update We have revised our forecasts for the Egyptian pound, and are now projecting the currency to fall to 8.75 by the end of FY2015/16 and 9.00 by end-2016. There are risks to this outlook, particularly following the resignation of the Central Bank of Egypt’s governor, Hisham Ramez, and the subsequent uncertainty surrounding the policy preferences of the incoming governor, Tarek Amer. Nevertheless, from a fundamental macro perspective, most indicators suggest the currency is overvalued, while recent developments have raised concerns that the economy’s balance of payments position could weaken even further in the months ahead. As a result, although the timing of a devaluation (or the start of a managed depreciation) remains uncertain, the future direction of the currency is not.

Economics 17 November 2015

Egypt’s external position has failed to improve in recent months, highlighted by a sharp decline in exports (Chart #1), a widening in the current account deficit (Chart #2), and steady depletion in FX reserves (despite the presence of capital controls). The unfortunate Russian airline disaster, which has led to Russia banning all flights to Egypt, and the UK stopping flights to Sharm el-Sheikh, is also likely going to lead to lower tourism export receipts than previously expected (which were USD7.3bn last fiscal year). Given the apparent softening in economic activity across the GCC since the start of H2, there are also concerns surrounding a potential drop in direct aid transfers, and more importantly, remittance inflows (USD19.22bn last year). As we highlighted in a recent research note, there is a strong correlation between nominal Saudi GDP and total remittances into Egypt, and we therefore suspect a prolonged period of low oil prices can threaten this important source of external capital. While the CBE’s efforts at defending the pound’s de facto USD peg have helped contain inflationary pressures, it has also resulted in a steady drain on FX reserves. As of October, total FX reserves came in at USD16.4bn, of which USD2.4bn is in gold, USD1.1bn fall under IMF Special Drawing Rights, and USD12.8bn is in FX (Chart #3). This equates to roughly 2.6 months of goods and service imports, and 3.4 months of goods imports. While the presence of capital controls have helped slow the rate of FX reserve depletion, they have also resulted in FX shortages across the economy, and are a key factor undermining private sector business activity according to monthly manufacturing surveys. Continued on next page…

Jean-Paul Pigat Senior Economist +971 4 230 7807 [email protected]

Egyptian Pound 9

Black Market

Official

8.5

Black Market Vanishes

8

7.5

7

6.5 Feb-13

Jun-13

Oct-13

Feb-14

Source: Bloomberg, Emirates NBD Research

Jun-14

Oct-14

Feb-15

Jun-15

Oct-15

As a result, a key priority for the CBE over the coming months is likely to be initiating the process of removing these controls. However, given the low level of FX reserves, the concern would be that this could result in a further outflow in capital and a much sharper-than-expected fall in the EGP. In this context, the recent decision by several local banks to raise interest rates on local currency certificates of deposits to 12.5% from 10.0% appears to be a move aimed at increasing EGP liquidity, and helping to stem the risk of an outflow in capital and magnitude of potential FX losses if the central bank scales back its support for the currency. As of August, private sector EGP deposits had increased 20.2% y/y (Chart #4).

Policy Uncertainty Clouds Outlook As previously mentioned, the appointment of a new central bank governor has added to the uncertainty on Egypt’s exchange rate outlook. However, assuming we are correct in our assumptions that the new governor will be willing to accept a greater degree of flexibility than his predecessor, and that pressures on the EGP are to the downside, the question then becomes one of determining how CBE policy will evolve in the months ahead. The most likely scenario, in our view, is for a more flexible ‘managed crawl’ exchange rate, whereby the central bank will gradually oversee a period of EGP weakness to bring the currency more into line with fundamentals. Other scenarios cannot be completely ruled out however, particularly the potential for the CBE to initiate the process through an initial one-off ‘mini-devaluation’. This has been the favored policy in the past, having taken place roughly seven times since 2001, and three times in 2015 alone (Chart #5). The main drawback to this policy is that if the adjustment is not large enough, and if investors expect further losses, it does little to help spur an adjustment in the economy’s external asymmetries or help facilitate foreign capital inflows. Due to institutional capacity constraints, other potential exchange rate regimes (i.e. a more freely floating currency) are unlikely at this moment.

overstating the magnitude of further weakness over the coming year (Chart #8).

Timing of Potential Devaluation While we are confident in the direction of the EGP over the coming year, the timing of an initial move lower remains uncertain (and is ultimately in the hands of the CBE). One possibility would be following the conclusion of parliamentary elections in early December and before a new government is sworn in in Q1 2016, which would allow a new administration to operate without the burden of overseeing a devaluation. Coincidently, the next CBE monetary policy meeting will be on December 17, which is the same day the U.S. Federal Reserve is set announce whether it has decided to raise interest rates. This could prove to be an opportune time to begin overseeing a managed devaluation of the EGP, particularly if the Fed begins to normalize monetary policy, which we believe would likely play into additional USD strength (and thus a further drop in competitiveness for Egypt). Ultimately, our conviction on the timing of a devaluation is quite low, however we would reiterate that it remains a question of when and not if. Most importantly perhaps, a move lower in the EGP should be seen as a necessary adjustment that will eventually help spark a stronger macro recovery. By removing a key element of uncertainty and boosting Egypt’s competitiveness, private sector foreign capital which has remained on the side-lines in recent years is also more likely to return (Chart #9).

Magnitude of Potential Devaluation There are several ways to gauge the magnitude of potential losses in the months ahead. Indeed, through the imposition of capital controls, the official rate has been held artificially strong, with the CBE recently adjusting the currency even higher to 7.83 in midNovember. However, on the black market, which is a more accurate reflection of supply-demand dynamics, the EGP was last quoted at 8.70. This represents roughly an 11% premium to the official rate, which is one of the highest levels since 2013. Bloomberg has also been tracking the currency’s implied value since April, which it gathers based on the overseas listings of Egypt’s three most liquid stocks, and which was last at 9.15 (Chart #6). Our base case sees the EGP falling roughly 10% against the USD over the remainder of FY2015/16, and 13% by the end of 2016. While this might seem significant, it is still less than the 14% appreciation against the Euro that has taken place since the start of 2014 (Chart #7). Moreover, it is also significantly below the value implied through 12m EGP NDFs (10.17) which appear to be

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Current Account Deficit

Goods Trade Imports Exports

50

Q110 Q410 Q311 Q212 Q113 Q413 Q314 Q215 0

40

-500 -1000

20

-1500

USDmn

% y/y (3mmavg)

30

10 0

-2000 -2500

-10

-3000

-20

-3500

-30 Jan-10 Nov-10 Sep-11 Jul-12 May-13 Mar-14 Jan-15 Chart #1 Source: Haver Analytics, Emirates NBD Research

-4000 -4500 Chart #2 Source: Haver Analytics, Emirates NBD Research

Private Sector Deposits

FX Reserves

EGP FX

25

40 FX SDRs Gold

35 30

20 15

% y/y

USDbn

25 20 15

10 5

10 0

5 0 Jan-11 Oct-11

Jul-12

Apr-13 Jan-14 Oct-14

-5 Dec-10

Jul-15

Chart #3 Source: Haver Analytics, Emirates NBD Research

EGP Long-Term Performance 8 7 6

Oct-11

Aug-12

Jun-13

Apr-14

Feb-15

Chart #4 Source: Haver Analytics, Emirates NBD Research

Implied EGP 9.4

8.9

8.4

5 7.9 4 3 Jan-99 Mar-01 May-03 Jul-05 Sep-07 Nov-09 Jan-12 Mar-14 Chart #5 Source: Bloomberg, Emirates NBD Research

7.4 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Oct-15 Nov-15 Chart #6 Source: Bloomberg

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EGP 12m NDF

EUR-EGP

11

10

10.5 9.5

10

9

9.5 9

8.5

8.5 8

8 7.5

7.5

7

7

6.5 6.5 Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

6 Jan-11

Jan-15

Chart #7 Source: Bloomberg, Emirates NBD Research

Foreign Customers’ Holdings of T-Bills

Jan-13

Jan-14

Jan-15

FX Performance Against USD EGP

25 20 15 10 5 0 Jan-10 Nov-10 Sep-11 Jul-12 May-13 Mar-14 Jan-15

% spot performance since Jan 2014

30

% of total

Jan-12

Chart #8 Source: Bloomberg, Emirates NBD Research

TND

MAD

EUR

TRY

RUB

0 -10 -20 -30 -40 -50 -60

Chart #10 Source: Bloomberg, Emirates NBD Research

Chart #9 Source: Haver Analytics, Bloomberg Emirates NBD Research

EGP Real Effective Exchange Rate

FX Performance Against EUR % spot performance since Jan 2014

20 105 10 100 0 95 -10

90

-20

85

-30

80

-40 EGP

MAD

TND

Chart #11 Source: Bloomberg, Emirates NBD Research

TRY

RUB

75 Jan-05 Jun-06 Nov-07 Apr-09 Sep-10 Feb-12 Jul-13 Dec-14 Chart #12 Source: Haver Analytics, Emirates NBD Research

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